Incidence of Taxation

HL only - Unit 4 - Lesson 2

Learning outcomes:
Explain, using diagrams, how the incidence
of an indirect tax on consumers & firms
differs depending on PED & PES.
Plot demand & supply curves from linear
functions and calculate the effects of a
specific tax on the market (consumers,
producers, producer revenue, government
revenue, consumer & producer surplus).

Incidence of Taxation
Examines the amount a specific tax has on the
consumer, producer and government.
Three cases:
1. PED similar to PES
2. PED > PES
3. PED < PES

What we know...
Consumer Surplus: The price a consumer is willing
and able to pay minus the actual amount they paid.
Above price equilibrium below the Demand curve.
Producer Surplus: The price a producer is willing
to supply a good to the market minus the price they
actually receive. Below price equilibrium and above
the supply curve.

Consumer & Producer Surplus

Additional term
Total Welfare Loss (TWL):
The consumer and producer surplus lost due to
disequilibrium existing in the market.
The market is said to not be allocatively
efficient.

Tax Incidence: PED similar to PES

With a specific tax added:
1.
2.
3.
4.
5.
6.

7.

Price increases R0 - R1
Quantity decreases
Consumer Surplus decreases
Producer Surplus decreases
Total Welfare Loss (shaded
triangle).
Consumers & Producers
equally share the incidence of
the tax.
Government Revenue =
Consumers & Producers share.

Government Intervention - Specific tax

Creates disequilibrium in the market

In summary...
1. When PED is similar to PES
the Consumer & Producer
burden of the tax is shared
evenly.

2. When a tax is applied, the

market is allocatively inefficient
creating a total welfare loss.

Tax Incidence:

PED > PES

With a specific tax added to a

good with elastic demand:
1. Consumer burden of tax
a. (P1 - P) x Q
2. Producer burden of tax
a. (P - X) x Q
3.

Government Revenue
a. (P1 - X) x Q

With Elastic Demand, the Producers burden

of tax is greater than the consumers burden.
Market is allocatively inefficient.

Tax Incidence: PED < PES

With a specific tax added to a good
with elastic demand:
The incidence of taxation for
consumers is greater than the
incidence for producers.
From the graph, try and explain
why this is...

Your turn...
With your knowledge of the incidence of
taxation on elastic and inelastic demand,
explain how the incidence of taxation affects
Consumers & Producers when PES varies:
Supply is elastic (PES < 1)
Supply is inelastic (PES > 1)