3
$\begingroup$

There are intersecting supply and demand curves. A tax is levied on suppliers. Say the tax is a fixed tax (for example, VAT) and not an ad valorem tax.

Why can we not just move along the demand curve by the value of the tax (as producers just increase the price by the value of the tax)? So for any given point on the demand curve, just increase the price by the given value of the tax and that is the new demand - why does it not work like this?

Whilst I agree a parallel shift of the supply curve by the value of the tax makes sense I do not understand where is the flaw in the earlier method?

$\endgroup$
3
$\begingroup$

The answer has to do with the fact that (under typical assumptions) producers experience increasing marginal costs as output rises. This makes the supply curve upward-sloping.

Suppose firms simply increased the price by the amount of the tax. Consumers would then buy fewer units of the good, resulting in less profits for producers. However, marginal costs are also lower at the lower level of production, meaning that firms could profitably produce at a lower price than that. So they lower the price and increase production a bit to partially offset the losses caused by the tax (note, the price remains above where it would be without the tax, and production still less than without the tax).

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.