IBonomicsIndirect Tax and Inelastic DemandSL
MicroeconomicsA supply and demand diagram showing the effect of an indirect tax on a good with inelastic demand. The consumer bears a larger share of the tax burden.
Curves and elements
- demand
- Demand Curve (D): Steep, indicating inelastic demand. Shows that quantity demanded changes little with price.
- supply
- Original Supply Curve (S): Upward sloping as per the law of supply. After tax, it shifts to the left.
- supply with tax
- Supply + Indirect Tax: The new supply curve after the tax is imposed, indicating higher costs.
- equilibrium
- Old Equilibrium (Pe, Qe): Before tax. New equilibrium is at Pc and Qₜ after tax.
Key explanations
- 1
An indirect tax shifts the supply curve upward/leftward, from 'Supply' to 'Supply + Indirect Tax'.
- 2
The vertical distance between the two supply curves represents the per-unit tax imposed.
- 3
The price consumers pay rises from Pe to Pc, while the price producers effectively receive falls from Pe to Pp.
- 4
The consumer burden is represented by the area between Pc and Pe over the quantity sold (Qₜ).
- 5
The producer burden is represented by the area between Pe and Pp over Qₜ.
- 6
When demand is inelastic, consumers are less responsive to price changes, so they bear a larger share of the tax burden.
- 7
The steeper the demand curve, the larger the area of consumer burden compared to producer burden.
Example exam question
Using a diagram, explain how the incidence of an indirect tax differs when demand is inelastic.
Show example answer
When demand is inelastic, consumers are less sensitive to price changes. Therefore, after an indirect tax is imposed, most of the tax burden is passed on to consumers in the form of higher prices. This is reflected in a larger consumer burden area in the diagram, with relatively less impact on producers.
