Elasticity and Taxes: Videos & Practice Problems

The incidence of tax on consumers and producers is influenced by the price elasticity of demand and supply. When demand is inelastic and supply is elastic, consumers bear a higher tax burden. Conversely, if supply is inelastic and demand is elastic, sellers pay more tax. In extreme cases, perfectly elastic demand results in sellers bearing the entire tax burden, while perfectly inelastic demand leads to buyers absorbing the full tax. Understanding these dynamics is crucial for analyzing market responses to taxation and the distribution of tax burdens.

Elasticity and Taxes

Now let's discuss how the elasticity of the curves relates to taxes. Alright, so the way we're going to split the tax, right? The tax incidence to the consumer and the tax incidence to the producer is going to be based on the price elasticity of the curves, right? So remember when we were talking about price elasticity, if we're talking about price elasticity of demand, that was when we had the percentage change in quantity demanded over the percentage change in price, right? And with supply, it was quantity supplied on top. So this idea of elasticity, it helped us determine what the shape of the curve was going to look like, right? How steep the curves are going to be, right? So remember from our earlier discussion about taxes is that the party paying the tax does not necessarily bear the burden, right? Just because the buyer is paying the tax doesn't mean that they're going to take the whole burden. It's going to be split in some way and that split is going to be based on these elasticities.

So let's look at a couple of examples. First, let's look at a situation where we have an elastic supply and an inelastic demand, right? Demand is more inelastic. Let's look at the graph and talk about this. We've got our price and quantity axes and this is our downward demand and our supply curve, right? It tells us that the supply is elastic which we know because it's crossing through the price axis, right? And the other thing that tells me that it's elastic is that it's very close to laying down. Remember when we're perfectly elastic, we're laying down, and the supply curve is pretty close to that laying down, so it's pretty elastic there. How about the demand curve, right? That's pretty close to perfectly inelastic where we're standing straight up, it's just a little bit over to the side, so that one's quite inelastic. Look what happens to our tax in this situation. So remember, we're going to impose some tax that's going to create a difference between the prices the buyers pay up here and the price the seller receives down here, right? There's now this difference because of the tax, and we're going to be able to say who paid more of the tax based on who has more of the line, right? So if this was our original p star right here, right and I'll draw it in black this whole line to divide that tax. The amount below the line is the part that goes to the supplier, and you can see it's a little tiny piece right? This little red piece right there, that's going to the supplier, and that big chunk is going to the buyer, right. So, in this case, you're going to see that the buyer pays more tax.

Now let's talk about the opposite situation where we have an inelastic supply and an elastic demand. So once again, we've got our price and quantity axes and our demand downward and our supply upward. And again, let's confirm whether we're inelastic or elastic, right? So the supply is inelastic when it crosses the quantity axis, which we see there, but we also can confirm because it's almost perfectly inelastic, right? It's getting close to that standing straight up, and we've got elastic demand, right? It's getting pretty close to that perfectly elastic laying down. That is our elastic demand that we see there. And now what happens? So, there's this tax imposed, right? And we're going to have this difference where the price of the buyer is right here, and the price of the seller is down here, right, and there's that tax in the middle. So just like we did before, let's see who's paying more of the tax in this situation, right? So the portion of the tax going to the buyer in this case is a little bit, on the top is small, right, compared to this large amount to the seller, right? So, in this case, the seller is paying more. They have the higher tax incidence. Seller pays more tax.

What conclusion can we draw here, right? In both cases, in the first case, we had inelastic demand and the buyer was paying more tax. In the second case, we had inelastic supply, and the seller was paying more tax, right? So we're going to make this conclusion: whoever is more inelastic, represents the group that will have more tax incidents, right? The idea here is when we're inelastic, our quantity demanded is not going to react so much to a price change, right? We're usually inelastic as consumers for something that we really need, right? Maybe like some sort of life-saving drug, or if we're addicted to cigarettes, right? Cigarettes would be an inelastic demand that even if the price went up, we would still buy them. So that would be an inelastic product, and you can imagine if you're inelastic and the price is changing, you can't really get out of the market. But if you're elastic and now you're seeing this higher price, you're going to get out of the market, and that's exactly what we're seeing. So whoever's more inelastic is more tied to the market and is going to have to suffer through that tax incidence. So, if the demand curve is more inelastic, consumers have a higher tax incidence. Consumers pay more tax, and if the supply curve is more inelastic, the sellers pay more tax. What if they're both elastic or they're both inelastic? In that case, when they're both elastic or both inelastic, you're going to get something closer to a fair share, right? Where they're going to be splitting it more evenly. But remember, it's the one that's more inelastic that's going to pay more. So even if they're both elastic, one might be more inelastic than the other. And in that case, they're going to pay more of the tax, right? And usually, you're not going to be able to decide that, usually, it's going to be some sort of visual thing like we can see on this graph here, right? More inelastic, more tax incidence. In the next video, let's go through a couple of special cases, like the idea of having perfectly elastic demand or perfectly inelastic demand, and let's see what happens with tax incidence in those cases. Alright, let's do that now.

Elasticity and Taxes:Perfectly Elastic Demand and Perfectly Inelastic Demand

Alright, so now let's talk about these special cases: perfectly elastic and perfectly inelastic. Right, so first, we have a perfectly elastic demand, right? It's laying down entirely. It's super elastic. It's laying down. It's so comfy, right? And we've got our supply curve just kind of a standard supply curve, right? So what happens if, let's say, there's a tax here, right? Let's put the tax on suppliers and shift the supply curve to the left. And let's think about what happens here. So this is S2, this was S1, right? So now when demand is perfectly elastic, they're willing to buy any quantity, right, but they're only willing to buy it at a specific price. They're not going to pay more for this than this price that we see here. So what's going to happen to this tax burden? If the supplier tries to shift any of the burden to the consumers, they're not going to have it, they're not going to buy anymore, right? At a different price, they wouldn't purchase any. So in this case, the supplier is going to have to bear the entire burden of the tax. The seller bears the entire burden of the tax. So the price to the buyers is going to stay the same, and the price to the seller is going to decrease by the full amount of the tax. So let's talk about the other situation. What about when we have perfectly inelastic demand and just a regular supply curve there? So now we're talking about that situation where it's like a life-saving drug or something that we need to have no matter what the price, right? So now in this case, let's say there was a tax on the supplier, right? Just to keep it simple. Now what's going to happen is that since it's perfectly inelastic, the buyers are willing to pay any price, and they are going to take the full burden of the tax themselves, right? So in this case, the buyer takes the full burden, and this makes sense back to our previous conclusion where the more inelastic curve pays more tax. In the first case, who was more inelastic? Well, demand was perfectly elastic. You couldn't get any more elastic. So anything is going to be more inelastic than that, right? So the supply curve was more inelastic, and they paid more of the tax. In this case, it's the extreme example that they paid all of it. How about the other side? Here, we have perfectly inelastic demand, right? You can't get any more inelastic than perfectly inelastic, and in that case, they're more inelastic than the other one, right? And so that's what we're seeing here. Since the demand is more inelastic and in this case perfectly inelastic, they're going to have more of the tax burden, and in this case, all of the tax burden. Alright, so our conclusion stays the same even at these extremes, it's just that the entire burden is being put on 1 person. Alright, so that's about it for these special cases, let's go ahead to the next video.

A tax imposed on consumers of a good:

• A. Creates a loss only for consumers
• B. Creates a loss only for producers
• C. Creates a deadweight loss for society as a whole
• D. Creates a net gain for society as a whole

Answer: (C)

Suppose that a unit tax of $2 is imposed on producers with initial equilibrium of $10. If the demand curve is vertical and the supply curve is upward-sloping, what will be the price faced by consumers after the tax?

• A. $8
• B. $10
• C. $12
• D. There is not enough information.

Answer: (C)

Here’s what students ask on this topic:

How does price elasticity of demand affect tax incidence?

Price elasticity of demand significantly influences tax incidence. When demand is inelastic, consumers are less sensitive to price changes, meaning they will continue to buy the product even if the price increases due to a tax. As a result, consumers bear a higher tax burden. Conversely, if demand is elastic, consumers are more sensitive to price changes and will reduce their quantity demanded if the price rises. In this case, producers cannot pass the tax onto consumers and must absorb more of the tax burden themselves. Understanding this relationship helps in predicting how taxes will impact different markets.

What happens to tax incidence when supply is perfectly inelastic?

When supply is perfectly inelastic, producers cannot change the quantity supplied regardless of price changes. In this scenario, producers bear the entire tax burden. This is because the quantity supplied remains constant, and producers cannot pass any of the tax onto consumers through higher prices. The price received by producers decreases by the full amount of the tax, while the price paid by consumers remains unchanged. This situation is an extreme case illustrating how inelastic supply leads to producers absorbing the full tax burden.

Why do consumers bear more tax when demand is inelastic?

Consumers bear more tax when demand is inelastic because their quantity demanded does not significantly decrease with price increases. Inelastic demand means that consumers need or strongly desire the product, such as essential goods or addictive products. As a result, when a tax is imposed, producers can pass most of the tax onto consumers through higher prices without losing many sales. This leads to consumers shouldering a larger portion of the tax burden. The inelastic nature of their demand makes them less responsive to price changes, thus absorbing more of the tax.

How does perfectly elastic demand impact tax incidence?

With perfectly elastic demand, consumers are highly sensitive to price changes and will only buy the product at a specific price. If a tax is imposed, producers cannot pass any of the tax onto consumers because even a slight price increase would result in zero sales. Therefore, producers must bear the entire tax burden. The price paid by consumers remains the same, while the price received by producers decreases by the full amount of the tax. This extreme case demonstrates how perfectly elastic demand forces producers to absorb the entire tax.

What is the relationship between elasticity and tax burden distribution?

The relationship between elasticity and tax burden distribution is crucial in determining who bears the tax. If demand is more inelastic than supply, consumers bear a larger share of the tax burden because their quantity demanded is less responsive to price changes. Conversely, if supply is more inelastic than demand, producers bear a larger share of the tax burden because their quantity supplied is less responsive to price changes. In cases where both demand and supply are equally elastic or inelastic, the tax burden is more evenly distributed. The more inelastic side of the market always bears a greater share of the tax burden.