Calculating the effects of taxes

Up to now, we've been talking about the effects of indirect taxes qualitatively. Let's use the linear
functions of the Demand and Supply subtopic to learn how to quantify these effects.
This can be done using simultaneous linear equations for demand and supply, or using data directly
from a graph, after plotting the demand and supply curves before and after the tax.

Important
When having to solve tax related calculations remember that the tax creates a wedge between the
price consumers pay (Pc) and the price producers receive (Pp), therefore Pc = (Pp + t) or (Pc - Pp) = t

Calculating the tax effects

using simultaneous linear equations
We have learnt before that if there is no external disturbance in a competitive market, the demand
and supply linear functions have the following form:
Qd = a - bP
Qs = c + dP
As the equilibrium is the point at which demand equals supply, the first step is to set supply equal to
demand and then solve P.
Now, because of the indirect tax, the price paid by consumers (Pc) is different than the one received
by producers (Pp).
Producers receive the price paid by consumers minus the amount of the tax they have to pay to the
government:
Pp = Pc - t
While consumers pay producer's price plus the amount of the tax per unit:
Pc = Pp + t

These are two faces of the same coin, two ways of expressing the same wedge created between
both prices.
Replacing each price in the corresponding equation we have that the supply curve becomes:
Qs = c + dP = c + d Pp = c + d (Pc - t)
And the demand curve is:
Qd = a - b Pc
Therefore, we have the following two equations to solve the equilibrium price in the market, which is
the price paid by consumers, Pc :
Qs = c + d (Pc - t)
Qd = a - b Pc
Once we found Pc, we can find Pp and the equilibrium quantity, Qt.
Let's try an example.

Example 1
Solve the following questions assuming that a tax of 1.5 per unit is imposed on beer cans,
whose original demand and supply curves are described by the equations:
Qd = 12 - 2P
Qs = 4 + 2P , where the price is in Euros and the quantity is in thousands of cans per month.
1. Calculate the equilibrium price and quantity before tax.
2. Calculate the price paid by consumers (new equilibrium price), the price received by
producers, and the new equilibrium quantity after tax.
3. Calculate government's total revenue collected from tax.
4. Calculate the amount of the tax paid by consumers and the tax incidence on consumers (the
burden of tax).

5. Calculate the amount of the tax paid by producers and the tax incidence on producers (the
burden of tax).
6. Calculate the change in producers' total revenue after tax.
7. Calculate the change in consumers' total expenditure after tax.
GUIDED ANSWERS:
1. Calculate the equilibrium price and quantity before tax.
Step 1 - Set supply equal to demand.
S1 = D1
(Qs = 4 + 2P) = (Qd = 12 - 2P)
4 + 2P = 12 - 2P
To find the equilibrium price, solve for P.
P = 2.00
Step 2 - Now, determine the equilibrium quantity by substituting the price into the demand and supply
functions.
Qs = 4 + 2P = 4 + 2 (2) = 4 + 4 = 8
Qd = 12 - 2P = 12 - 2 (2) = 12 - 4 = 8
Q = 8,000
Answer: The equilibrium price is 2.00 and the equilibrium quantity is 8 thousand cans per week
before the tax.
2. Calculate the price paid by consumers (new equilibrium price), the price received by
producers, and the new quantity after the tax.
Step 1 - Rewrite the demand and supply curve replacing Pc in the demand curve and Pp instead of P,
where the price received by producers is equal to the price paid by consumers minus the tax.
S2 = Qs = 4 + 2Pp

D1 = Qd = 12 - 2Pc
Pp = Pc - t
Set supply equal to demand.
S2 = D1
4 + 2Pp = 12 - 2Pc
Replace Pp.
4 + 2(Pc - t) = 12 - 2Pc
To find the new equilibrium price, solve for Pc.
Simplify by subtracting 4 on both sides.
2 (Pc - t) = 8 - 2Pc
Distribute the parenthesis.
2Pc - 2t = 8 - 2Pc
Replace t = 1.5 (the tax per unit) and simplify again by adding 2Pc on both sides.
4Pc - 2 (1.5) = 8
4Pc - 3 = 8
Simplify by adding 3 on both sides and dividing both sides by 4.
4Pc = 11
Pc = 11/4 = 2.75
Step 2 - Now, determine the new equilibrium quantity by substituting the price into the demand
function.
D1 = Qd = 12 - 2Pc = 12 - 2 (2.75) = 12 - 5.5 = 6.5
S2 = Qs = 4 + 2Pp = 4 + 2 (Pc - t) = 4 + 2 (2.75 - 1.50) = 4 + 2 (1.25) = 6.5

Qt = 6,500

Be Aware
Remember that when you replace the new equilibrium price (Pc) in both demand and supply curves,
and you don't get the same quantity as a result, then you must have made a mistake during the
procedure.
Step 3 - Finally replace the price paid by consumers to find the price received by producers.
Pp = Pc - t = 2.75 - 1.50 = 1.25
Answer: The new equilibrium price is 2.75 (price paid by consumers), the price received by
producers is 1.25, and the equilibrium quantity is 6.5 thousand cans per week after the tax.

Try for yourself!

3. Calculate government's total revenue collected from the tax.
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4. Calculate the amount of the tax paid by consumers and the tax incidence on consumers
(the burden of the tax).
Once we have the original equilibrium price, the new equilibrium price, and the new equilibrium
quantity, we have all the data to calculate the incidence of the tax on consumers.
The burden of the tax is the part of the tax that falls on consumers. Therefore, it is the difference
between the new price that consumers have to pay because of the tax, and the previous price they
were paying, times the amount of units consumed.
Step 1
Burden of the tax for consumers = (Pc - P) Qt
The new price is Pc = 2.75 (question 2)
The previous equilibrium price before the tax was P = 2.00 (question 1)
New equilibrium quantity is Qt = 6.5 (question 2)
Replace all the values into the equation,

Burden = (2.75 - 2) 6.5 = 0.75 6.5 = 4.875

Answer: The burden of the tax on consumers is 4,875.
Step 2
Now that we have the amount of the tax paid by consumers, and we have calculated the total
amount of the tax collected by the government in question 3, we can calculate the tax incidence for
consumers.

Important
The tax incidence is usually expressed as a percentage of the total amount of the tax collected by
the government.
Tax incidence = (tax burden/total amount of the tax) 100
Therefore,
(4,875/9,750) 100 = 50%
Answer: The tax incidence for consumers is 50%

Try for yourself!

5. Calculate the amount of the tax paid by producers and the tax incidence on producers (the
burden of the tax).
+ Show answer

6. Calculate the change in producers total revenue after the tax.

Be Aware
Remember that the total revenue for producers is the amount of units sold multiplied by the net price
they receive for each unit.
Therefore, the change in total revenue is calculated by:

TR = TR2 - TR1
TR1 = Q P , where Q is the equilibrium quantity before the tax and P is the equilibrium price before
the tax.
TR2 = Qt Pp , where Qt is the new equilibrium quantity after the tax and Pp is the price received by
producers net from the tax.
All of these values have been calculated in the previous questions.
TR1 = 8 2 = 16,000 (question 1)
TR2 = 6.5 1.25 = 8,125 (question 2)
Then,
TR = TR2 - TR1 = 8,125 - 16,000 = -7,875
Answer: The change in total revenue for producers is a fall of 7,875.

Try for yourself!

7. Calculate the change in consumers total expenditure after the tax.
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