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Price determination in a competitive market Price Elasticity of Supply and Its Determinants

Method

Define consumer surplus and producer surplus, and shade each correctly on a supply and demand diagram: consumer surplus is the triangle bounded by the demand curve above, the horizontal price line below, up to the equilibrium quantity; producer surplus is the triangle bounded by the price line above, the supply curve below, up to the same quantity.
Explain that total economic welfare, community surplus, is the sum of consumer and producer surplus, and that a competitive market equilibrium maximises this total welfare when there are no externalities.
Draw the effect of a specific, per-unit, indirect tax: the supply curve shifts vertically upward by the amount of the tax, the new equilibrium price rises and quantity falls, label the new consumer price, the lower price producers keep after tax, and the vertical gap between them as the tax per unit.
Identify and shade tax incidence on the diagram: the portion of the tax passed on to consumers is the area between the old and new price up to the demand curve; the portion absorbed by producers is the area between the old price and the lower amount they now keep.
State the elasticity rule for tax incidence: the more price inelastic demand is relative to supply, the greater the share of the tax that falls on consumers; the more elastic demand is relative to supply, the greater the share that falls on producers.
Identify and shade the resulting deadweight welfare loss, the triangle representing the value of trades that would have occurred without the tax but no longer do, and calculate total tax revenue as the tax per unit multiplied by the new equilibrium quantity.
Apply the same diagram logic, in reverse, to a subsidy: the supply curve shifts down, price to consumers falls, price producers receive rises, and government spending equals the subsidy per unit multiplied by the new equilibrium quantity.

Worked example

Before a specific tax, the equilibrium price of a good is 5 pounds and the equilibrium quantity is 200 units. The government introduces a tax of 2 pounds per unit. After the tax, consumers pay 6.20 pounds per unit and producers receive 4.20 pounds per unit, after paying the tax to the government, and the new equilibrium quantity is 180 units. Calculate the government's total tax revenue and the share of the 2 pound tax paid by consumers.

Calculate total tax revenue: tax per unit x new equilibrium quantity = 2 pounds x 180 units = 360 pounds.
Calculate the rise in the price consumers pay: 6.20 pounds - 5 pounds (original price) = 1.20 pounds, the amount of the tax passed on to consumers per unit.
Calculate the fall in the price producers keep: 5 pounds (original price) - 4.20 pounds = 0.80 pounds, the amount of the tax absorbed by producers per unit.
Check the two shares sum to the total tax: 1.20 pounds + 0.80 pounds = 2 pounds, which matches the tax per unit, confirming the split is correct.
Express as a proportion: consumers bear 1.20 / 2 = 60% of the tax burden, and producers bear 0.80 / 2 = 40%, consistent with demand being relatively more inelastic than supply around this equilibrium.

Practice questions

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Q1Define consumer surplus.Show answer

Answer: The difference between the maximum price a consumer is willing and able to pay for a good and the price they actually pay.

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Q2Define producer surplus.Show answer

Answer: The difference between the price a producer actually receives for a good and the minimum price they would have been willing to accept.

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Q3On a supply and demand diagram, where is consumer surplus shown?Show answer

Answer: The triangular area below the demand curve and above the market price, up to the equilibrium quantity.

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Q4What happens to the supply curve when a specific (per-unit) indirect tax is introduced?Show answer

Answer: It shifts vertically upward, or to the left, by the amount of the tax per unit, since firms need a higher price to supply any given quantity once they must pay the tax.

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Q5State the elasticity rule for who bears more of the burden of an indirect tax.Show answer

Answer: The side of the market, consumers or producers, with the more price inelastic curve bears the greater share of the tax burden, because they are less able to adjust the quantity they buy or sell in response to the price change.

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Q6A specific tax of 3 pounds per unit is introduced, and the new equilibrium quantity is 500 units. Calculate total tax revenue.Show answer

Answer: 3 pounds x 500 = 1,500 pounds.

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Q7What is deadweight welfare loss in the context of an indirect tax?Show answer

Answer: The loss of total economic welfare, the value of consumer and producer surplus on units that would have been traded without the tax but no longer are, because the tax has raised price and reduced the equilibrium quantity.

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Exam-style questions

Written in the style of a A Level Economics exam paper, with a full mark scheme.

Q1[6 marks]

The government places a new indirect tax on a good with price inelastic demand and relatively more price elastic supply. Using a supply and demand diagram, explain who is likely to bear the greater share of the tax burden, consumers or producers.

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Tick each line you got. Your score builds from the marks on the scheme.

correctly labelled diagram showing the original equilibrium and the supply curve shifting upward by the amount of the tax1 mark
correctly shows the new, higher price paid by consumers and the new, lower price kept by producers1 mark
correctly identifies that consumers bear the greater share of the tax burden1 mark
explains that because demand is price inelastic, quantity demanded falls only a little as price rises, so most of the tax can be passed on to consumers in a higher price1 mark
explains that because supply is relatively more elastic, producers are better able to adjust the quantity supplied rather than absorb the tax through a lower price1 mark
correctly shades or identifies the larger consumer share and smaller producer share of the tax incidence on the diagram1 mark

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Q2[15 marks]

Evaluate the case for the government using indirect taxes on goods with price inelastic demand, such as tobacco, as a way of raising tax revenue and reducing consumption.

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Tick each line you got. Your score builds from the marks on the scheme.

basic, undeveloped assertion, e.g. taxes raise money, with little diagrammatic or elasticity-based reasoning.2 marks
one or more developed chains, e.g. revenue-raising or the deadweight loss/consumption effect, but one-sided or with limited evaluation.2 marks
balanced chains covering both the case for and against this policy, referencing elasticity and the surplus/deadweight loss diagram, with a supported judgement.2 marks
Specific content: chain (for, revenue) - because demand for tobacco is price inelastic, a tax raises price but quantity demanded falls only a little, so the government collects tax revenue on almost the same volume of sales as before, giving high and stable revenue.2 marks
Specific content: chain (for, externality) - tobacco consumption creates negative externalities, e.g. health costs to the NHS, so a tax that raises price, even by a small amount given inelastic demand, still reduces consumption somewhat at the margin.2 marks
Specific content: chain (against) - because demand is inelastic, the reduction in quantity consumed is small relative to the size of the tax, so the tax is not very effective at reducing consumption on its own, and the deadweight welfare loss triangle is relatively small precisely because inelastic demand means few trades are lost.2 marks
Specific content: chain (against, equity) - indirect taxes on inelastically demanded goods like tobacco tend to be regressive, taking a larger proportion of income from lower-income smokers than higher-income smokers.1 mark
Specific content: evaluation - the case for the tax depends on the primary policy goal, revenue raising is well served by taxing an inelastic good while reducing consumption is better served by a good with more elastic demand or by combining the tax with other measures, and on how the extra revenue is used.1 mark
Specific content: judgement - a supported conclusion, e.g. that the tax is well suited to revenue raising given inelastic demand, but a government aiming primarily to cut consumption significantly needs to combine the tax with non-price policies.1 mark

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Next topics

Market failure and government intervention Taxation: Types, Principles and the Incidence of Tax Government Intervention: Indirect Taxes, Subsidies and Price Controls

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Consumer and Producer Surplus and the Incidence of Indirect Taxes

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Method

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