Question

The same amount on one of two previously untaxed goods, good A and good B. Good A and B currently trade at the same price and quantity in their respective markets.

a. Assume both the demand and supply of good A are more price elastic than demand and supply for good B. If the finance minister wants to maximize tax revenue, which good should she tax? If the finance minister wants to minimize deadweight loss, which good should she tax? Explain briefly, you can use a graph to explain.

Answer 1

Maximize tax revenue by taxing the good with more inelastic demand and supply (good B), and minimize deadweight loss by taxing the good with more elastic demand and supply (good A).

Step-by-step explanation:

If the finance minister wants to maximize tax revenue, she should tax the good with more inelastic demand and supply, which in this case would be good B.

A tax on a more inelastic good results in a smaller decline in the quantity sold, so the government can collect more revenue as changes in price will not lead to significant changes in quantity traded.

On the other hand, if the finance minister wants to minimize deadweight loss, she should tax the good with more elastic demand and supply, which is good A. When a good is taxed, the market deviates from the efficient level of trade, causing a deadweight loss.

Since elastic goods have a larger potential change in quantity traded in response to price changes, the relative deadweight loss would be smaller compared to that of an inelastic good where the quantity changes are minimal but the price changes are significant.

Therefore, the selection of which good to tax depends on whether the focus is on maximizing revenue or minimizing economic inefficiency.

Understanding the elasticity of demand and supply is crucial in making this decision.