VJC_H2_Econ_P2_Answer

1 Answers to 2014 H2 Economics Prelim Exam (Paper 2) Question 1 The Spanish government, which is struggling to cut one of the Eurozone's largest public deficits during a recession, has raised taxes on tobacco. Source: http://www.eurocare.org, 26 June 2013, accessed on 25 August 2014 a) Explain why an increase in indirect tax on a good like tobacco tends to cause consumers to suffer more than producers. [10] b) Discuss how the combination of a recession and increases in indirect taxation might affect the markets for different goods. [15] a) Intro:  Definition of indirect tax o A compulsory levy on goods and services and producers have the legal responsibility to pay the tax to the government  To examine the impact on co nsumers and producers, we will have to make use of the concepts of price elasticity of demand and supply. Body:  Equilibrium price and quantity is determined by the intersection of the demand and supply curves.  Initial equilibrium was at point E 1, where the demand curve D 1 intersects with supply curve S1, and equilibrium price and quantity is P1 and Q1 respectively.  When a tax is levied on goods and services, it has the effect of increasing the marginal cost of production, repr esented by an upward shift of the supply curve from S 1 to S 2.  At the initial equilibrium price of P 1, the quantity supplied is Q3 and quantity demanded is Q1, resulting in a shortage of Q 3Q1 unit of goods. In light of the shortage, frustrated consumers will be willing to pay higher prices an d this signal to the producer will result in producers increasing the quantity supplied. Quantity demanded will fall and quantity supplied will increase until quantity dem and equals quantity supplied at point E 2, where quantity demanded and supplied will be Q2, and equilibrium price is P2.  Consumers will suffer as t heir expenditure on the good has now increased from OP1E1Q1 to OP2E2Q2.  Producers also suffer as their total revenue has fallen from OP 1E1Q1 to OP3BQ2

2  The relative impact on consumers and producers will depend on the relative price elasticity of demand and supply. o Price elasticity of demand measures the degree of responsiveness of a change in quantity demanded to a change in price, ceteris paribus and price elasticity of supply measures the degree of responsi veness of a change in quantity supplied to a change in price. o Consumers will suffer more because the demand for cigarettes is relatively more price inelastic due to the fact that it is habit forming and there are no close substitutes for cigarettes. Thus, firms are able to pass on the tax burden to the consumers. o This can be seen from the diagram where the tax burden for consumers, represented by the area P 2E2AP1 is larger than the tax burden for producers, P1AP3B. Conclusion Consumers will bear a greater burden when the demand for the good is relatively more price inelastic than supply. Level Desc