AS Level Economics 9708: Elasticity, a Specific Tax and Consumer/Producer Surplus

A small pottery studio makes hand-painted ceramic mugs. Each mug is thrown and painted individually by the studio's small team of trained artisans, so the studio cannot increase the number of mugs it supplies very quickly in response to a change in price. At the same time, buyers can choose from many close substitutes for these mugs (factory-made mugs, glass mugs, and hand-painted mugs from other craft studios) so they can switch away fairly easily if this studio's mugs become noticeably more expensive.

The local authority then imposes a specific (per-unit) tax of $1.50 on every mug the studio sells, paid by the studio.

(a) Explain why this tax causes a shift of the supply curve for the studio's mugs, rather than a movement along it, and state the direction of the shift. [3]

(b) Explain the effect of this shift on the equilibrium price and quantity of the studio's mugs, and on consumer surplus and producer surplus in this market. [3]

(c) Discuss the extent to which the burden of this $1.50 tax is likely to fall on buyers of the mugs rather than on the pottery studio, using the relative price elasticities of demand and supply described above. [4]

Part (a): Why this is a shift, not a movement

The tax is paid by the studio on every mug it sells, so at any given selling price the studio now keeps less of that price than before (effectively raising the cost of supplying each mug. A change in the cost of production (here, caused by a tax) is a non-price determinant of supply, so it shifts the whole supply curve; it is not a movement along the curve, because nothing has directly changed the mug’s own selling price itself) that price is only determined afterwards, at the new equilibrium.

Direction: the supply curve shifts left (supply decreases). To be willing to supply any given quantity of mugs, the studio now needs to receive a higher selling price than before, high enough to cover both its normal costs and the $1.50 tax.

Part (b): Effect on equilibrium and on consumer/producer surplus

With the demand curve unchanged and the supply curve shifting left:

Equilibrium price rises: buyers must now pay more for each mug.
Equilibrium quantity falls: fewer mugs are bought and sold than before.

Effect on surplus:

Consumer surplus falls. Consumer surplus is the area below the demand curve and above the price paid; since price paid rises and quantity falls, this area shrinks.
Producer surplus also falls. Producer surplus should be measured using the price the studio actually keeps after paying the tax (which is lower than the new market price), not the higher price buyers pay. Since the studio receives a lower net price per mug than before the tax, and sells a smaller quantity, its surplus shrinks too.

So, unlike a simple shift in demand (where one surplus typically rises as the other falls), a tax that shifts supply left tends to reduce both consumer surplus and producer surplus at the same time. Part of what buyers and the studio both lose becomes tax revenue for the local authority, and part is lost altogether as fewer mutually beneficial trades take place.

Part (c): Discussing where the burden of the tax falls

The economic burden of a tax does not necessarily fall on whichever side of the market physically pays it to the government, it depends on the relative price elasticities of demand and supply. The general principle is: the side of the market that is more price inelastic, less able to adjust the quantity it demands or supplies in response to a price change. Ends up bearing the larger share of the burden, because it has less scope to avoid the tax by changing its behaviour.

Applying this here:

Supply is relatively price inelastic. The studio relies on a small, fixed team of trained artisans, so it cannot quickly expand (or easily maintain) the quantity of mugs it supplies if the price it receives changes.
Demand is relatively price elastic. Buyers have many close substitutes (factory-made mugs, glass mugs, and mugs from other craft studios) so if the studio tries to pass on most of the $1.50 tax through a higher price, quantity demanded is likely to fall substantially as buyers switch away.

Because demand can escape a price rise fairly easily (many substitutes) while supply cannot easily escape a price fall (fixed artisan capacity), the pottery studio should be expected to absorb the larger share of the $1.50 tax, in the form of a lower net price received per mug, while only a small part of the tax is passed on to buyers as a higher price. This is the opposite outcome to a market where demand is inelastic and supply is elastic, which illustrates that it is the relative elasticities on each side of a specific market, not any general rule about who legally pays the tax, that determine how its burden is actually shared.

Final answers

(a) The tax shifts the supply curve left (supply decreases), because it changes the studio’s cost of supplying at every price, not the mug’s own selling price.
(b) Equilibrium price rises, equilibrium quantity falls; both consumer surplus and producer surplus fall.
(c) Because supply is relatively inelastic (fixed artisan capacity) and demand is relatively elastic (many substitutes), the pottery studio bears the larger share of the $1.50 tax, with only a small part passed on to buyers.