- Introduction to price elasticity of demand
- Price elasticity of demand using the midpoint method
- More on elasticity of demand
- Determinants of price elasticity of demand
- Determinants of elasticity example
- Price Elasticity of Demand and its Determinants
- Perfect inelasticity and perfect elasticity of demand
- Constant unit elasticity
- Total revenue and elasticity
- More on total revenue and elasticity
- Elasticity and strange percent changes
- Price elasticity of demand and price elasticity of supply
- Elasticity in the long run and short run
- Elasticity and tax revenue
- Determinants of price elasticity and the total revenue rule
Read about how elasticity affects tax revenue.
- Tax incidence is the manner in which the tax burden is divided between buyers and sellers.
- The tax incidence depends on the relative price elasticity of supply and demand. When supply is more elastic than demand, buyers bear most of the tax burden. When demand is more elastic than supply, producers bear most of the cost of the tax.
- Tax revenue is larger the more inelastic the demand and supply are.
The burden of tax
Depending on the circumstance, the burden of tax can fall more on consumers or on producers.
In the case of cigarettes, for example, demand is inelastic—because cigarettes are an addictive substance—and taxes are mainly passed along to consumers in the form of higher prices.
The analysis, or manner, of how the burden of a tax is divided between consumers and producers is called tax incidence.
Elasticity and tax incidence
Typically, the incidence, or burden, of a tax falls both on the consumers and producers of the taxed good. But if we want to predict which group will bear most of the burden, all we need to do is examine the elasticity of demand and supply.
In the tobacco example above, the tax burden falls on the most inelastic side of the market. If demand is more inelastic than supply, consumers bear most of the tax burden. But, if supply is more inelastic than demand, sellers bear most of the tax burden.
Think about it this way—when the demand is inelastic, consumers are not very responsive to price changes, and the quantity demanded remains relatively constant when the tax is introduced. In the case of smoking, the demand is inelastic because consumers are addicted to the product. The seller can then pass the tax burden along to consumers in the form of higher prices without much of a decline in the equilibrium quantity.
When a tax is introduced in a market with an inelastic supply—such as, for example, beachfront hotels—sellers have no choice but to accept lower prices for their business. Taxes do not greatly affect the equilibrium quantity. The tax burden in this case is on the sellers. If the supply were elastic and sellers had the possibility of reorganizing their businesses to avoid supplying the taxed good, the tax burden on the sellers would be much smaller, and the tax would result in a much lower quantity sold instead of lower prices received. You can see the relationship between tax incidence and elasticity of demand and supply represented graphically below.
In diagram A, above on the left, the supply is inelastic and the demand is elastic—as it was in the beachfront hotels example. While consumers may have other vacation choices, sellers can’t easily move their businesses. By introducing a tax, the government essentially creates a wedge between the price paid by consumers,
, and the price received by producers, . In other words, of the total price paid by consumers, part is retained by the sellers and part is paid to the government in the form of a tax. The distance between and is the tax rate. The new market price is , but sellers receive only per unit sold since they pay to the government. Since a tax can be viewed as raising the costs of production, this could also be represented by a leftward shift of the supply curve. The new supply curve would intercept the demand at the new quantity . For simplicity, the diagram above omits the shift in the supply curve.
The tax revenue is given by the shaded area, which is obtained by multiplying the tax per unit by the total quantity sold,
. The tax incidence on the consumers is given by the difference between the price paid, , and the initial equilibrium price, . The tax incidence on the sellers is given by the difference between the initial equilibrium price, , and the price they receive after the tax is introduced, .
In diagram A, above on the left, the tax burden falls disproportionately on the sellers, and a larger proportion of the tax revenue—the shaded area—is due to the resulting lower price received by the sellers than by the resulting higher prices paid by the buyers.
On the other hand, if we go back to our example of cigarette taxes, the situation would look more like diagram B—above on the right—where the supply is more elastic than demand. The tax incidence now falls disproportionately on consumers, as shown by the large difference between the price they pay,
, and the initial equilibrium price, . Sellers receive a lower price than before the tax, but this difference is much smaller than the change in consumers’ price.
Using this type of analysis, we can also predict whether a tax is likely to create a large revenue or not. The more elastic the demand curve, the easier it is for consumers to reduce quantity instead of paying higher prices. The more elastic the supply curve, the easier it is for sellers to reduce the quantity sold instead of taking lower prices. In a market where both the demand and supply are very elastic, the imposition of an excise tax generates low revenue.
People often think that excise taxes hurt mainly the specific industries they target. But ultimately, whether the tax burden falls mostly on the industry or on the consumers depends simply on the elasticity of demand and supply.
Under which circumstances does the tax burden fall entirely on consumers?
In a market where the supply curve is perfectly inelastic, how does an excise tax affect the price paid by consumers and the quantity bought and sold?
Want to join the conversation?
- What would be the elasticity of a product that is technically unlimited, such as a software download or an ebook? And how would that affect who would pay the taxes?(7 votes)
- The quantity supplied will be the same regardless of price as there is no additional burden on the supplier (except for bandwidth or hosting/downloading costs), hence inelastic. Taxes will fall predominantly on supplier(6 votes)
- Assume the government wishes to reduce alcohol consumption by considering a higher excise tax on alcohol products. Collect information on estimates for the price elasticity of demand for alcohol products. Based on these elasticity estimates illustrate using a demand/supply diagram(s) who bears the burden of the higher excise tax, consumers or producers.
As an alternative for reducing alcohol consumption assume the government is also considering the imposition of a minimum price on alcohol products. Using a demand/supply diagram illustrate the consequences of imposing a minimum price on alcohol for the consumption of alcohol products.
Provide comment on the relative merits of increasing excise taxes compared to imposing a minimum price on alcohol products for reducing alcohol consumption.(3 votes)
- Quota rent is won by quota holders, ie mfrs. Excise tax the goverment collects the difference in price. This would reduce purchasing and benefit the government.(1 vote)
- Suppose that the government imposes a per-unit tax on the producers of a good that has a perfectly inelastic demand. After the tax, the price and quantity of the good sold would change in which of the following ways?(2 votes)
- I don't understand why equilibrium quantity is not affected much when the tax is introduced when supply is inelastic and demand is elastic. Since the increase in tax could be represented as the leftward shift in supply, shouldn't there be a low increase in price and a big decrease in quantity? Also, why do sellers lower the price in this case?(2 votes)
- The supply is inelastic so the quantity supplied will not change much no matter the price. However, since the demand is elastic, a small increase in price will result in a large decrease in quantity demanded, and since the firms want to maximize profits, they must bear most of the burden of the tax or else demand will significantly decrease. This results in the consumers paying a similar price while the suppliers still supply a similar quantity (because of inelastic supply).(1 vote)
- Could someone give me a different example other than beachfront hotels? Thanks(1 vote)
- Imagine you are a highly specialized in the production of computer chips: if taxes on computer chips are raised, you can't just produce something else, because you don't have the technology, the machines etc.
If you are highly specialized or invested heavily on something (a house, machines, a degree...), usually you can't just turn around and do something else. You are stuck with what you are doing at least for some time.(3 votes)
- do the videos cover the written parts, or they have different ideas?(1 vote)
- The absolute value of the price elasticity of demand for eggs is 3.5 and the price elasticity of supply of eggs
is 0.5. The price of eggs is $5 per carton before a $2 tax is placed on eggs. Which of the following is true based on the information above
The producer's tax burden per unit will be more than $2
b. The producer's tax burden per unit will be less than $2 but more than $1
c. The producer's tax burden per unit will be $2
d. The producer's tax burden will be less than $1(1 vote)
- Please give some examples where cross elasticity is positive and almost equal to zero. And also post some examples where cross elasticity is negative and of high magnitude.(1 vote)
- Why are producers usually unable to pass the whole tax on to consumers?(1 vote)
- Are there any goods for which the elasticity of the demand and supply are equal? I'm guessing so, but I have been unable to find any viable real-world examples.(1 vote)