Question

The Yankee Soda Co. currently produces two carbonated beverages with identical cost curves. Reggie Cola which has highly elastic demand and Yankee Root Beer which has highly inelastic demand. Both products currently sell for 40 cents per can and sell approximately 20 million cans per year. If the government wishes to impose a 4 cent per can tax on one of these two products, which would it choose to maximize revenue?

Short answer

To maximize revenue, the government should impose the 4 cent per can tax on Yankee Root Beer since it has a highly inelastic demand, meaning that the demand will not decrease significantly when the price increases due to the tax. This will result in higher revenue compared to taxing the highly elastic Reggie Cola.

Step-by-step solution

Understanding elasticity of demand

Price elasticity of demand measures the responsiveness of consumers to a change in price. If the demand for a product is highly elastic, it means that consumers are very sensitive to price changes, and a small increase in price will cause a significant decrease in demand. On the other hand, if the demand is highly inelastic, consumers are less sensitive to price changes, and the demand will not significantly decrease even if the price increases.

Analyzing the effect of a tax on demand

A tax on a product will increase the product's price for consumers. In this case, we have a 4 cent per can tax on either Reggie Cola or Yankee Root Beer. Since Reggie Cola has highly elastic demand, if we increase the price by imposing the tax, there would likely be a significant drop in demand. In contrast, putting the tax on the Yankee Root Beer will not decrease its demand as much since it has a highly inelastic demand.

Choosing the product to maximize revenue

Now that we know the effect of the tax on demand, we should choose the product that will generate more revenue when taxed. Since the demand for Yankee Root Beer is highly inelastic, placing the tax on this product will result in a smaller decrease in demand compared to Reggie Cola. Thus, if the government imposes a 4 cent per can tax on Yankee Root Beer, it will generate more revenue for the government than taxing Reggie Cola.

Conclusion

To maximize revenue, the government should choose to impose the 4 cent per can tax on Yankee Root Beer as its highly inelastic demand means that the demand will not decrease significantly when the price increases due to the tax. This will result in higher revenue compared to taxing the highly elastic Reggie Cola.

Key concepts

Elastic Demand

The concept of elastic demand relates to how sensitively buyers respond to price changes of a product. When we say that a product like Reggie Cola has elastic demand, we mean that consumers will significantly cut back on their purchase quantities or switch to alternative products if the price were to rise even marginally. For instance, if the price of Reggie Cola goes up by 4 cents per can, a large number of consumers might stop buying it. The necessity of businesses to be highly competitive with pricing is emphasized with products that exhibit elastic demand, as modest price increases can lead to a disproportionate decrease in the quantity sold.

• A steep drop off in purchases with a price increase illustrates high elasticity.
• Competitor prices greatly influence consumer choice.
• Marketers should cautiously evaluate price changes to avoid losing sales volumes.

Inelastic Demand

Conversely, inelastic demand characterizes a situation where the price changes have a relatively small effect on the quantity demanded. Products like Yankee Root Beer, in this context, hold a strong foothold in consumers' preferences. Inelasticity indicates that people will continue to buy the product despite increases in prices, often due to a lack of close substitutes, necessity, or brand loyalty. Therefore, businesses with products that have inelastic demand can implement price increases - like a tax - with minimal fear of losing significant sales volume.

• Price increases lead to a less than proportionate drop in quantity demanded.
• Products are often necessities or have few substitutes.
• Companies can raise prices with less risk of losing customers.

Tax Incidence

Tax incidence refers to the analysis of the effect of a tax on the distribution of economic welfare. It shows which group - consumers or producers - will ultimately bear the cost of a tax. For example, if the government decides to tax Yankee Root Beer, the tax incidence would depend on the relative elasticity of demand and supply. Since Yankee Root Beer has inelastic demand, the tax incidence would likely fall more heavily on consumers, who are less responsive to price increases and will still pay for the drink despite the tax, ensuring steady revenue for the government.

• Tax burden can fall more on consumers or producers depending on elasticity.
• Inelastic goods often pass the tax burden onto consumers.
• Understanding tax incidence helps governments maximize revenue without significant loss of demand.

Consumer Responsiveness

Consumer responsiveness is fundamentally tied to the elasticity of demand - it measures how consumers alter their purchasing behavior in response to price changes. Products like Reggie Cola, with high responsiveness, see consumers quickly changing their consumption as prices change; this may be due to the availability of close substitutes or a lack of strong brand loyalty. Recognizing consumer responsiveness is vital for businesses and governments to anticipate the outcomes of pricing strategies, including taxation, discounts, or price increases.

• High responsiveness means consumers are price-sensitive.
• Understanding responsiveness aids in strategic pricing decisions.
• Government tax policies consider responsiveness to maintain or increase tax revenues without deterring consumers.