Chapter 5: Problem 30

In a market where the supply curve is perfectly inelastic, how does an excise tax affect the price paid by consumers and the quantity bought and sold?

Short Answer

Expert verified

In a market where the supply curve is perfectly inelastic, an excise tax will lead to an increase in the price paid by consumers, as the entire tax incidence is passed on to them due to the inability of suppliers to adjust the quantity they produce. However, the quantity bought and sold in the market will remain unchanged as the supply curve is perfectly inelastic.

Step by step solution

Understanding a Perfectly Inelastic Supply Curve

A perfectly inelastic supply curve is a vertical line in the price-quantity space, meaning that the quantity supplied does not change with the price. This is because suppliers are unable to adjust the quantity they produce in response to changes in the price. An example of a good with a perfectly inelastic supply might be a rare painting - there is only one in existence, and the artist cannot create more.

Excise Tax Introduction

An excise tax is a tax levied on the production or sale of a specific good. It increases the cost of production for suppliers, who may try to pass on this cost to consumers in the form of higher prices. In our scenario, the introduction of an excise tax will shift the supply curve upward by the amount of the tax.

Graphical Representation

To see the effects of an excise tax on price and quantity in a market with perfectly inelastic supply, we can represent the situation graphically. Draw a vertical supply curve (S) to represent the perfectly inelastic supply. Also, draw an initial demand curve (D) and an initial equilibrium point (E). Now, with the implementation of the excise tax, the supply curve will shift upward by the amount of the tax, creating a new supply curve (S'). Note that because the supply curve is vertical, the quantity supplied remains unchanged.

New Equilibrium

Now, we need to find the new equilibrium point (E') with the shifted supply curve (S') and the demand curve (D). The intersection point of these two curves represents the new price and quantity that the market will adjust to.

Effects on Price and Quantity

As the supply curve is perfectly inelastic and shifted upward by the amount of the excise tax, the quantity bought and sold in the market will not change. This is because the suppliers cannot change the quantity they produce. Therefore, the entire tax incidence will be passed on to consumers in the form of higher prices. In conclusion, in a market with a perfectly inelastic supply curve, an excise tax will increase the price paid by consumers, but will not affect the quantity bought and sold.