Question

3. The price elasticity of demand for wine is estimated to be 1 at all possible quantities. Currently, 200 million gallons of wine are sold per year, and the price averages $6 per bottle. Assuming that the price elasticity of supply of wine is 1 and the current tax rate is $1 per bottle, calculate the current excess burden of the tax on wine. Suppose the tax per bottle is increased to $2 per bottle. What will happen to the excess burden of the tax as a result of the tax increase

Answer 1

The excess burden would quadruple to $33,333

Step-by-step explanation:

In order to calculate the excess burden as a result of the tax increase, we first calculate the excess burden at current tax rate which is $1 per bottle. Excess burden is calculated using the following formulae:

W = 1/2(T)²(Q/P) x (Es x Ed / (Es - Ed))

where:

T = Tax per unit

Q = Total Quantity

P = Price per unit

Es = Elasticity of Supply

Ed = Elasticity of Demand

W = 1/2(1)² (200,000/6) x (1 x 1 / (1 - (-1)))

W = 1/2 (33.333) x (1/2)

W = $8,333

Now after-tax rate goes up to $2, the excess burden would as follow:

W = 1/2(2)² (200,000/6) x (1 x 1 / (1 - (-1)))

W = 2 (33.333) x (1/2)

W = $33,333 per year

Hence, the excess burden is $33,333 after the increase in tax.