Question 6 Flashcards
The elasticity of demand plays a crucial role in determining the incidence of tax between buyers and sellers, explain.
The elasticity of demand plays a crucial role in determining the incidence of tax between buyers and sellers. Explain with proper diagram(s). While taxes are an important source of revenue for the government, taxes decrease both supply and demand in the market as buyers have to pay a higher price and sellers receive a lower price for their product. Sometimes the government tries to divide the burden of tax, such as the federal government does with the payroll tax requiring both employee and employer to pay half of the tax. However do employees and employers actually pay half the tax? From considering supply and demand and elasticities, the actual tax incidence depends on the respective elasticities of both supply and demand eg consider a 20% tax on a can of soda. • As higher prices decrease demand, regardless of the reason, sellers will share some of the burden. • How much of the burden is determined by the elasticity of supply and demand of the product. • Only if either demand or supply was either completely elastic or inelastic will the tax burden fall completely on either the buyer or the seller. Between the two extremes tax incidence varies continuously from perfectly inelastic supply or perfectly elastic demand, where the seller assumes the entire burden of the tax, to the perfectly inelastic demand where the buyers bear the entire burden. As per the diagrams, tax burden will fall more on the buyer if demand is inelastic or supply is elastic, but will fall more on the seller if demand is elastic or supply is inelastic. Note: in the 4 diagrams below a tax on a particular product increases its price and decreases the quantity supplied, since supplies are getting less revenue for their product. The assessed tax, shifts the supply curve upward from S to S*, the price increases from P to Pt and the quantity declines from Q to Qt. But how the tax burden is shared between buyer and seller depends on the elasticity of both supply and demand.
What are the key things to remember?
Buyer=demand inelastic/supply elastic Seller=demand elastic/supply inelastic
What is unit elasticity
if a price change, quantity demanded will change in the same amount
what is inelastic demand?
if a price change, quantity demanded will not change
what is elastic demand?
if a price change, quantity demanded will change
Demand and supply elasticity
