Final answer:
The direct burden of an excise tax, when supply is perfectly elastic, falls entirely on consumers, as depicted by the price increase from P3 to P4, which represents the tax rate. The shaded area under the demand curve in the supply and demand diagram represents the tax revenue generated. Tax incidence analysis helps to determine which market side (consumers or producers) will bear the majority of the tax burden.
Step-by-step explanation:
When an excise tax raises the price of a good from P3 to P4 and the supply is perfectly elastic, the direct burden of the tax falls onto the consumers. The tax creates a wedge between the price consumers pay (Pc) and the price producers receive (Pp). The actual tax revenue generated for the government is illustrated by the shaded area in the supply and demand diagram, calculated as the tax per unit times the total quantity sold (Qt). If the supply is perfectly elastic, the supply curve is horizontal, indicating that producers are willing to supply any quantity at price P3. When a tax is imposed, the entire burden falls on consumers, shown by the increase in price they pay, which moves from P3 to P4 without affecting the price received by the sellers, as they continue to receive P3.
The determination of the tax incidence—how the burden of a tax is distributed between buyers and sellers—depends on the relative elasticities of supply and demand. When the demand is more elastic than supply, as in the example of beachfront hotels where supply is inelastic, a larger portion of the tax is paid by sellers. Conversely, when supply is more elastic, as in the case of a tobacco excise tax, consumers carry a larger share of the tax burden. In a perfectly elastic supply scenario, sellers are not affected by the tax; consumers bear the full burden, leading to an increase from P3 to P4, which is equivalent to the tax rate.