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PED and taxation

Syllabus: Examine the significance of PED for government in relation to indirect taxes.


The imposition of an indirect tax (tax on a good shifts supply curve upwards by the amount of the tax) usually means that the price increases. However, the amount of the price increase will depend on the price elasticity of demand PED. Compare Figures 1 and 2 to see the difference.

tax_d_el

Figure 1 Tax imposed on a good with elastic demand

tax_d_inel

Figure 2 Tax imposed on a good with inelastic demand

question

1

Tax revenue

If you aimed as a government solely to reduce the consumption of the good, which type of good would you be taxing?

a)
b)
Yes - if the sole intention was to reduce demand then this would be most effective if the good is elastic in demand. The tax would increase the price and reduce demand by proportionately more.No - if the sole intention was to reduce demand of the good then this will be less effective if the good was inelastic in demand. However, if the good has damaging external costs, then the government may nevertheless want to tax the good.Your answer has been saved.
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2

Tax revenue (2)

If you aimed as a government to tax goods simply to raise tax revenue, which type of good would you tax?

a)
b)
Yes - if demand is inelastic, then firms are able to increase the price without demand falling very much. This will mean that the revenue raised will be relatively greater than for a good with elastic demand.No, that's not right. If the demand is elastic, then little revenue will be raised. The tax will put the price up, but this will lead to a proportionately greater decrease in demand and the revenue raised from the tax will be lower.Your answer has been saved.
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So, for a government wishing to raise revenue from indirect taxation, they will always tend to impose the taxes on goods with relatively inelastic demand. The more inelastic the demand, the more the price will rise and therefore the more of the tax will be passed on to the consumer.

Are tobacco, alcohol, petrol PED elastic or inelastic? Are they taxed highly or not taxed?