Junk Food Tax Case Study

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Navajo Nation has decided to apply an indirect tax of a 2% on the price of junk food, an inelastic product. Junk food is a demerit good with negative externalities and therefore the government wants to decrease the quantity demanded. In this case the tax applied is an Ad Valorem tax as it is a percentage of the price.

Introduction to the theory:

An indirect tax changes the structure of a market provoking an increase in prices and a decrease in the quantity demanded and supplied. However the effect of the tax varies depending on the price elasticity of demand. The aim of the tax is to solve a market failure situation, in which there is overconsumption of a product with negative externalities.

Analysis:

Junk food is a demerit good. This means that it’s a product which its consumption has a negative effect on the consumers themselves. Furthermore this product has negative externalities in consumption meaning that it has a negative effect upon a third part. In this situation fast food is being
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The MPB is higher than the MSB and the difference between the two is the negative externality. From a social point of view the MSC should be equal to the MSB (decrease in consumption), reaching an optimum equilibrium in which there is no negative externalities. Moreover we can see the welfare loss provoked by the overconsumption of fast food.

The government wants to solve this market failure situation by applying an Ad valorem indirect tax of a 2% on junk food that would provoke a decrease in the consumption. The tax is an extra cost for suppliers and so they will decide to decrease the amount of junk food supplied moving the supply curve to the left. If the supply decrease there will be excess of demand and there will be an increase in prices leading to a decrease in the demand till a new equilibrium is reached. Furthermore there will be a division on the payment of the

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