Using the concept of elasticity explain how a tax on gasoline would affect firms and consumers Who would pay the larger burden of the tax?

Answer 1

First, a quick discussion on elasticity of demand:

• When demand for an item is perfectly elastic, as prices increase the demand for the item decreases

• When demand for an item is perfectly inelastic as prices increase the demand for the item does not change

In the real world, few items are perfectly elastic or perfectly inelastic. Gasoline is an interesting item when it comes to elasticity. Gas is nearly perfectly inelastic at some levels of consumption because most people need to use it to get to work. This is starting to change however because as technology develops alternative fuels gas may become much more elastic. At some levels of consumption gas becomes elastic, for example if prices are too high some people will choose to skip a vacation soas not to consume gas.

Now to explain elasticity of demand and taxes:

• When demand is perfectly inelastic, all of the tax will be passed on to the consumer.

• When demand is perfectly elastic, all of the tax will be passed on to the to the producer.

So now to answer the question as to who would pay the larger burden of the tax. Right now (11/2009) gasoline is much more inelastic than it normally is (although it usually is still quite inelastic). For this reason, the majority of the tax on gasoline will be paid by the consumer.