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APPENDIX

2
HOW DO TAXES AFFECT
EQUILIBRIUM PRICES AND
QUANTITIES?

upply and demand analysis is also a useful tool for analyzing the effects
S of various taxes. In this section we consider a constant tax per unit of
output. How will the equilibrium price and quantity of a product be af-
fected if a tax of T  10 is levied on each unit sold by the producer? There are
two equivalent ways to approach this question. The first is to suppose that the
tax is levied on the seller. In Figure A.2.1, the line SS denotes the original supply
schedule. At a price of P0  25, sellers were willing to supply Q0 units of output.
When a tax T  10 is levied on sellers, the market price would have to be P0 
10  35 for them to get the same net payment that they used to receive when the
price was P0  25. At a price of 35, then, suppliers will offer the same amount
of output they used to offer at a price of 25. The resulting after-tax supply sched-
ule is the original supply schedule shifted upward by T  10.
In Figure A.2.2, DD represents the demand curve facing the sellers who have
been taxed T  10 per unit of output. The effect of the tax is to cause the equi-
librium quantity to fall from Q* to Q*1. The price paid by the buyer rises from
P* to P*1; and the price, net of the tax, received by the seller falls to P*
1
 10.
Note in Figure A.2.2 that even though the seller pays a tax of T on each
product purchased, the total amount the seller receives per unit lies less than T
below the old equilibrium price. Note also that even though the tax is collected
from the seller, its effect is to increase the price paid by buyers. The burden of the
tax is thus divided between the buyer and the seller. 47
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48 CHAPTER 2 APPENDIX 2 HOW DO TAXES AFFECT EQUILIBRIUM PRICES AND QUANTITIES?

FIGURE A.2.1
Price
A Tax of T ⴝ 10 Levied S'
on the Seller Shifts
the Supply Schedule
T = 10 S
Upward by T Units 35 = P0 + T
The original supply schedule
tells us what price suppliers
must charge in order to cover 25 = P0
their costs at any given level
of output. From the seller’s S'
perspective, a tax of T  10
units is the same as a unit-
cost increase of 10 units. The S
new supply curve thus lies Quantity
Q0
10 units above the old one.

Algebraically, the seller’s share of the tax, denoted ts, is the reduction in the
price the seller receives, divided by the tax:

P*  1P*
1
 T2
ts  . (A.2.1)
T

Similarily, the buyer’s share of the tax, tb, is the increase in price (including tax) di-
vided by the tax:

P*
1
 P*
tb  . (A.2.2)
T

EXERCISE A.2.1
Verify that ts ⴙ tb ⴝ 1.

In general, tb and ts depend on the shapes of the supply and demand schedules. If,
for example, supply is highly unresponsive to changes in price, tb will be close to

FIGURE A.2.2
Price
Equilibrium Prices and S'
Quantities When a D
Tax of T ⴝ 10 Is Levied
on the Seller T = 10 S
The tax causes a reduction in P*1
equilibrium quantity from Q*
P*
to Q*1. The new price paid by
the buyer rises from P* to P*1 – 10
P *1. The new price received S'
by the seller falls from P * to
P 1*  10. D
S
Quantity
Q*1 Q*
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HOW DO TAXES AFFECT EQUILIBRIUM PRICES AND QUANTITIES? 49

FIGURE A.2.3
Price
The Effect of a Tax of
D T ⴝ 10 Levied on the Buyer
P1 + 10 Before the tax, buyers would
D' buy Q1 units at a price of P1.
After the tax, a price of P1
P1 becomes P1  10, which
means buyers will buy only
Q2. The effect of the tax is
to shift the demand curve
T = 10 downward by 10 units.
D

D'
Quantity
Q2 Q1

zero, ts close to 1. Conversely, if demand is highly unresponsive to price, tb will be

close to 1, ts close to zero. These claims amount to a statement that a tax tends to
fall most heavily on the side of the market that can least escape it. If buyers have no
substitute products to which they are prepared to turn, the lion’s share of the tax
will be passed on to them by suppliers. But if suppliers have no alternative other
than to go on supplying a product, most of the burden of a tax will fall on them. As
long as the supply curve is positively sloped and the demand curve is negatively
sloped, however, both ts and tb will be positive.
The second way of analyzing the effect of a tax of T  10 per unit of output is
to imagine that the tax is collected directly from the buyer. How would that affect
the demand curve for the product? In Figure A.2.3, DD is the demand curve before
the imposition of the tax. At a price of P1, buyers would demand a quantity of Q1.
After imposition of the tax, the total amount that buyers have to pay if the product
price is P1 will be P1  10. Accordingly, the quantity they demand falls from Q1 to
Q2. In like fashion, we can reckon the quantity demanded at any other price after
imposition of the tax. DD is the resulting after-tax demand curve in Figure A.2.3.
It is the original demand curve translated downward by 10 units.
If SS in Figure A.2.4 denotes the supply schedule for this market, we can
easily trace out the effects of the tax on the equilibrium price and quantity. The

FIGURE A.2.4
Price
Equilibrium Prices
D and Quantities after
S Imposition of a Tax of
D' T ⴝ 10 Paid by the Buyer
P*2 + 10 The tax causes a reduction in
equilibrium quantity from Q*
P*
to Q*2.The new price paid by
P* 2 the buyer rises from P* to
P *2  10. The new price
T = 10
received by the seller falls
D from P * to P *2.
S
D'
Quantity
Q*2 Q*
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50 CHAPTER 2 APPENDIX 2 HOW DO TAXES AFFECT EQUILIBRIUM PRICES AND QUANTITIES?

FIGURE A.2.5
Price Price
A Tax on the Buyer Leads
to the Same Outcome 10 D 10 D
as a Tax on the Seller
S'
The price received by sellers S 8 D' S
(net of the tax), the price T=2
paid by buyers (including 6 6
tax), and the equilibrium 5 5
quantity will all be the same 4 4
when the tax is collected
2 S' T=2
from sellers (panel a) as
when it is collected from S D S D' D
Quantity Quantity
buyers (panel b). 4 5 10 4 5 8 10
(a) (b)

equilibrium quantity falls from Q* to Q*2, and the equilibrium pretax price falls
from P* to P*2. The total price paid by the buyer after imposition of the tax rises
to P*2  10.
Is the effect of a tax on the seller any different from the effect of a tax on the
buyer? Not at all. To illustrate, suppose the supply and demand curves for a market
are given by P  Qs and P  10  Qd, respectively, and consider first the effect of
a tax of 2 per unit of output imposed on the seller. Figure A.2.5a shows the original
supply and demand curves and the new after-tax supply curve, SS. The original
equilibrium price and quantity are both equal to 5. The new equilibrium price to
the buyer (inclusive of tax) and quantity are 6 and 4, respectively. The price received
by sellers, net of the tax, is 4.
Now, consider a tax of 2 per unit of output imposed on the buyers. Figure
A.2.5b shows the original supply and demand curves and the new after-tax demand
curve, DD. Note that the effects on price and quantity are exactly the same as in
the case of the tax levied on sellers shown in panel a.

EXERCISE A.2.2
Consider a market whose supply and demand curves are given by P ⴝ 4Qs
and P ⴝ 12 ⴚ 2Qd, respectively. How will the equilibrium price and quantity
in this market be affected if a tax of 6 per unit of output is imposed on sell-
ers? If the same tax is imposed on buyers?

When tax revenues must be raised, many political leaders find it expedient to
propose a sales tax on corporations because “they can best afford to pay it.” But
careful analysis of the effects of a sales tax shows that its burden will be the same
whether it is imposed on buyers or sellers. The legal incidence of the tax (whether it
is imposed on buyers or on sellers) has no effect on the economic incidence of the
tax (the respective shares of the tax burden borne by buyers and sellers). Economi-
cally speaking, the entity from which the tax is actually collected is thus a matter of
complete indifference.
A word of caution: When we say that the economic burden of the tax does not
depend on the party from whom the tax is directly collected, this does not mean
that buyers and sellers always share the burden of taxes equally. Their respective
shares may, as noted, be highly unequal. The independence of legal incidence and
economic incidence simply means that the burden will be shared in the same way
no matter where the tax is placed.
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PROBLEMS 51

EXERCISE A.2.3
True or false? The steeper the demand curve for a good relative to the sup-
ply curve for that good, the greater the proportion of a tax on that good
that will fall on buyers. Explain.

■ PROBLEMS ■

1. The government, fearful that a titanium shortage could jeopardize national security, im-
poses a tax of $2/oz on the retail price of this rare metal. It collects the tax from titanium
sellers. The original supply and demand schedules for titanium are as shown in the dia-
gram. Show, in the same diagram, how the short-run equilibrium price and quantity of
titanium will be affected by the tax. Label all important points clearly.

Price ($/oz)
6
S
5

1
D
Quantity (tons/yr)
0 1 2 3 4 5 6

2. In the market for titanium described in Problem 1 (with no tax), suppose that a price
floor of $4/oz results in sales of only 2 tons/yr (with no tax). Describe a transaction that
will make some buyers and sellers better off without harming others.
3. Suppose the titanium market in Problem 1, with a tax of $2/oz, experiences growth in
the demand for titanium because of new-found medical uses. The new demand curve is
P  8  Q. Find the change in government tax revenue due to the heightened demand
for titanium.
4. Suppose instead the titanium market in Problem 2, with no tax but a price floor at
$4/oz, suffers a reduction in supply because of dwindling titanium reserves. The new
supply curve is P  2  Q. How does excess supply change due to the reduction in sup-
ply? Is the price floor still binding (does it cause price to rise from its equilibrium level)?
5. Suppose state government levies a tax of $9 on each DVD sold, collected from sellers.
a. What quantity of DVDs will be sold in equilibrium?
b. What price do buyers pay?
c. How much do buyers now spend in total?
d. How much money goes to the government?
e. Show the above results graphically.
6. For the tax described in Problem 5,
a. What fraction of the tax does the seller bear?
b. What fraction of the tax does the buyer bear?
7. President Reagan negotiated a “voluntary” import quota on Japanese cars sold in the
United States in the early 1980s. Some of his advisers had recommended that he impose
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52 CHAPTER 2 APPENDIX 2 HOW DO TAXES AFFECT EQUILIBRIUM PRICES AND QUANTITIES?

a higher import tax (tariff) instead. Assuming the tariff was in the form of a constant tax
T per Japanese car sold in the United States and that T was chosen to produce the same
quantity reduction as the quota, how will the prices paid for Japanese cars by U.S. con-
sumers compare under the two policies?
8. Many studies on rats and mice have established that charred meat grilled over hot coals
causes cancer. Since the government cannot easily regulate home cooking methods, an
alternative method has been proposed to discourage the consumption of barbecued
meat. The proposal is to place a 100 percent tax at the retail level on charcoal
briquets. Suppose the daily demand for charcoal was P  120  2Q and the supply
was P  30  Q, where P is in dollars per bag and Q is the number of 20-lb bags of
charcoal sold weekly.
a. What is the before- and after-tax price of charcoal?
b. What is the before- and after-tax quantity of charcoal?
c. How is the tax divided among sellers and buyers?
9. Supply is P  4Q, while demand is P  20, where P is price in dollars per unit and Q is
units of output per week.
a. Find the equilibrium price and quantity (using both algebra and a graph).
b. If sellers must pay a tax of T  $4/unit, what happens to the quantity exchanged, the
price buyers pay, and the price sellers receive (net of the tax)?
c. How is the burden of the tax distributed across buyers and sellers and why?
10. Repeat Problem 9, but instead suppose the buyer pays the tax, demand is P  28  Q,
and supply is P  20.

■ ANSWERS TO APPENDIX EXERCISES ■

A.2.1 ts  tb  3 1P*  P*
1
 T2  1P*
1
 P*2 4 T  TT  1.
A.2.2 The original price and quantity are given by P*  8 and Q*  2, respectively. The
supply curve with the tax is given by P  6  4Qs. Letting P and Q denote the
new equilibrium values of price and quantity, we now have 6  4Q  12  2Q,
which yields Q  1, P  10, where P is the price paid by buyers. P  6  4 is
the price received by sellers. Alternatively, the demand curve with a tax of 6 levied
on buyers is given by P  6  2 Qd, and we have 4Q  6  2Q, which again
yields Q  1. P  4, where P is the price received by sellers. P  T  P  6 
10 is the price paid by buyers.
A.2.3 True.

S+T
P

S
a
b

P*
a–T
b–T
D
D'

Buyer’s share for tax with D  (a  P*)/T

Buyer’s share for tax with D  (b  P*)/T