Question

Good A has a price elasticity of demand of .27, while good B has a price elasticity of demand of 2.9. To raise the most tax revenue, the government should:

1) place a unit tax on good A.
2) place a unit tax on good B.
3) raise the price elasticity of demand for good A.
4) subsidize the production of good B.
5) cut its spending for various social programs

Answer 1

The government should place a unit tax on Good A with a price elasticity of demand of 0.27, because a more inelastic demand leads to higher tax revenue, unlike Good B which has a high elasticity and will result in a greater decrease in quantity demanded and lower tax revenue.

Step-by-step explanation:

To raise the most tax revenue, the government should place a unit tax on the good with the inelastic demand, which in this case is Good A with a price elasticity of demand of 0.27. The concept of price elasticity of demand indicates how much the quantity demanded of a good responds to a change in its price.

Tax revenue is larger the more inelastic the demand is, because consumers are less sensitive to price changes and will continue to buy relatively the same amount even when the price increases.

Therefore, a unit tax on Good A will lead to higher tax revenue as compared to Good B, which has a high elasticity of demand (2.9), meaning consumers will significantly reduce their quantity demanded in response to a price increase, leading to lower tax revenue.