What determines how far the supply or demand curves shifts after a tax is enforced? For example, equilibrium price is at $4.00. A producer tax of $1.00 is enforced, causing the supply curve to shift to the left. The new equilibrium price becomes $4.90, not $5.00. Why?

Question

anonymous · Answer

Well, in this particular case you're not giving the entire Supply and Demand equations for us to be able to tell you the precise formula for this particular situation. However, have in mind that any tax (or subsidy) on a good has both a supply-side and a demand-side element in all cases except perfect competition and perfect monopoly. Only some of the tax is actually felt by the producer of the good - the other part of it is taken by the people demanding the good.

Though that is a bit much in terms of background. Let's take an example - this specific case - after the good has been hit by an extra tax - the supplier has fundamentally seen a rise in his marginal cost for the good. Accordingly, he will have shifted his prices up to maintain the same level of output and profit. However, since Demand is elastic (though seemingly not very elastic) consumers will have noticed the price increase and decided to buy less of the good. Seeing as the supply now exceeds the demand - the supplier will need to both charge lesser prices and cut down on his output to reach the equilibrium level once again.

What determines how far these prices will fluctuate from the "logical" price that should be there after the tax is entirely up to the elasticities of the Supply and Demand. With low demand elasticity - prices will be very near the old price + tax, at pretty much the same output (think of goods like Cigarettes or Gasoline). If supply is very inelastic (it's hard to cut down on labour due to union laws, per say) - then output and price will remain close to the original level, but the firm will suffer massive losses in profit (if massive enough - the firm may have to go out of business).

Hope this helps.

anonymous · Answer

Thank you! This clarifies taxes and elasticity a lot.