Question

Suppose the federal government levies a 10cent sales tax on gasoline and an economist observes that ceteris paribus consumption of gasoline in Canada does not change at all after the tax is imposed.

1. What type of good is gasoline? Illustrate and prove
2. Why do governments frequently levy taxes on goods such as gasoline? Illustrate

Answer 1

a) Since there is no effect of a tax on gasoline consumption, it appears that gasoline is a necessity and has a perfectly inelastic demand. When this happens a tax raises the price that buyers pay by the size of tax and sellers receive the same unchanged price. Consumption remains unchanged. This is shown in figure below where tax shifts supply left, the price that buyers pay rises by full amount of per unit tax and quantity consumed does not change

b) This is because for goods such as gasoline, demand may not be perfectly inelastic but remains highly inelastic and when this is the case, a price rise can raise revenue for the government. This is common with most sin taxes such as taxes on cigarettes, tobacco, alcohol, and gasoline.

P1 P 2 D'D Q1 Q0 Quantity Case a) Inelastic demand P2 D'D Q1 Q0 Quantity Case b) Elastic demand

In the given figure, a greater tax revenue (measured by the rectangle formed between the prices P1 and P2 and quantity Q1) is collected when demand is relatively inelastic.