Suppose that all consumers view red pencils and blue pencils...

Suppose that all consumers view red pencils and blue pencils as perfect substitutes. Suppose that the supply curve for red pencils is upward sloping. Let the price of red pencils and blue pencils be $p_{r}$ and $p_{b}$. What would happen if the government put a tax only on red pencils?

Key Concepts

Perfect Substitutes

Perfect substitutes are goods that consumers view as interchangeable; when the price of one increases even slightly relative to the other, consumers will switch entirely to the cheaper alternative. This concept is key in understanding consumer behavior in competitive markets where no product differentiation exists except price.

Tax Incidence

Tax incidence refers to the analysis of the effect of a tax on the distribution of economic welfare between buyers and sellers. In a market with perfect substitutes, the burden of a tax on one product tends to shift away due to consumer substitution, minimizing the effective tax incidence on that product.

Substitution Effect

The substitution effect explains how consumers react to changes in relative prices; when the price of a taxed good increases, consumers substitute it with a cheaper alternative. This effect is particularly strong among perfect substitutes, leading to significant changes in market demand patterns.

Supply Curve Dynamics

An upward sloping supply curve indicates that producers require higher prices to supply additional quantities. When a tax is imposed on one type of good, the effective price received by producers changes, influencing their willingness to supply that good, and potentially shifting market equilibrium.

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