Incidence of tax

CFA Level I Economics
#1

When a tax on a good or service is imposed on the producers of the good or service, the

  1. The supply will decrease but the incidence of tax falls on both buyers and sellers

  2. The demand will decrease but the incidence of tax will fall on both buyers and sellers

Can someone explain why is it first and not second?

Producer will produce less and hence answer 1, but they can also pass 100% of the tax to buyers and continuing the same quantity, and demand will decrease.

#2

I believe that you’re confusing two ideas:

  • A decrease in demand: a shift in the demand curve
  • A decrease in the quantity demanded: a movement along the existing demand curve.

When a tax is imposed on producers, their costs increase, so there is a decrease in supply (the supply curve shifts to the left). However, there is no shift in the demand curve; the new equilibrium point is the intersection of the new (lower) supply curve and the old (unchanged) demand curve: higher price than before the tax, lower quantity than before the tax.

#3

But the cost to producers do not have to increase. What if they pass the cost to buyers?

#4

The cost does increase. The fact that it can be offset with a higher price doesn’t change that fact.

If they increase the price by the full amount of the tax, the quantity demanded will change (along the existing demand curve) to the quantity consistent with the higher price. There is no reason that the same quantity will be demanded at the higher price.

#5

So the quantity demanded can decrease, movement up along the demand curve, price to buyers will increase.

Answer two can be correct?

#6

No. Saying that the demand decreases is saying that the demand curve shifts. The demand curve doesn’t shift; we simply move along the (existing) demand curve to a new point, where it intersects the new supply curve (which has shifted; hence, a change in supply).

Changes in demand are caused by, for example:

  • An increase in consumer (disposable) income
  • A change in price for a substitute good
  • A change in price for a complementary good

The demand curve does not shift (merely) because of a change in the price of the good in question.

#7

Thanks, the sentence: saying the demand decreases is saying that the demand curve shifts helped me in my understanding.

#8

No, Answer 2 can not be correct because sellers can not directly increase their prices because they are in competitive market. If they do so they will be out of game.

It is a process that is followed by market.

#9

There is no evidence that they are in a competitive market; this question could be about a monopoly.