Question

Suppose that all consumers view red pencils and blue pencils as perfect substitutes. Suppose that the supply curve for red pencils is upward sloping. Let the price of red pencils and blue pencils be pr and pb. What would happen if the government put a tax only on red pencils?

Answer 1

Two goods are R.P. and B.P. These are substitutes to each other. Therefore, the increasing price of one good only decreases the demand of that good and increases the demand of other good. The imposition of tax on R.P. increases its price, suppose (pr + 1). It decreases the demand of R.P. and increases the demand of B.P. Price Price Si S Pr +1 el D D1 Supply pb1E1 pb E O qlq R.P. 0 Q Q1 B.P.

In the above two graphs, the situation is described.

After the imposition of tax on R.P. the supply curve (S) shifts to S1; it shifts the equilibrium from e to e1, showing the price rise as pr to (pr + 1) and a reduction in demand of q to q1.

It affects in the B.P. market, as its supply is fixed but demand increases from D to D1. The equilibrium shifts upward from E to E1, causing a rise in demand of B.P. from Q to Q1 (although there is a price-rise too from Pb to Pb + 1).