Elasticity and Taxes: Videos & Practice Problems

The relationship between elasticity and tax incidence is crucial for understanding how the burden of a tax is distributed between consumers and producers. Elasticity measures how responsive the quantity demanded or supplied is to changes in price. Specifically, the price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price, while the price elasticity of supply is the percentage change in quantity supplied over the percentage change in price. The steeper the curve, the more inelastic it is, indicating that quantity changes little with price changes.

When a tax is imposed, the division of the tax burden depends on the relative elasticities of demand and supply. If demand is inelastic and supply is elastic, consumers will bear a larger share of the tax burden. For instance, in a scenario where the demand curve is steep (inelastic) and the supply curve is relatively flat (elastic), the price consumers pay increases significantly, while the price received by producers decreases only slightly. This results in a larger tax incidence on consumers.

Conversely, if supply is inelastic and demand is elastic, producers will shoulder more of the tax burden. In this case, the supply curve is steep, indicating that producers cannot easily reduce the quantity supplied in response to price changes, while the demand curve is flat, showing that consumers can easily adjust their purchasing behavior. Thus, the price received by producers decreases significantly, while the price consumers pay increases only slightly, leading to a higher tax incidence on producers.

In summary, the group that is more inelastic—whether consumers or producers—will bear a greater share of the tax burden. This is because inelastic groups are less responsive to price changes and are therefore more likely to continue purchasing or supplying despite the tax. If both demand and supply are elastic or both are inelastic, the tax burden will be shared more evenly, but the more inelastic group will still pay a larger portion of the tax. Understanding these dynamics is essential for analyzing the effects of taxation in various markets.

In economics, understanding the concepts of perfectly elastic and perfectly inelastic demand is crucial for analyzing how taxes affect market behavior. Perfectly elastic demand is characterized by consumers' willingness to buy any quantity at a specific price, but not above it. This means that if a tax is imposed on suppliers, shifting the supply curve to the left, the entire tax burden falls on the suppliers. Since consumers will not purchase at a higher price, the price they pay remains unchanged, while the price received by suppliers decreases by the full amount of the tax.

Conversely, perfectly inelastic demand represents a scenario where consumers will buy a good regardless of its price, often seen with essential items like life-saving medications. In this case, if a tax is levied on suppliers, consumers bear the full burden of the tax. Since they are willing to pay any price, the suppliers can pass the entire tax onto the consumers without losing sales.

These two extremes illustrate a fundamental principle in tax incidence: the more inelastic the demand or supply, the greater the burden of the tax on that side of the market. In the case of perfectly elastic demand, suppliers absorb the tax burden entirely, while with perfectly inelastic demand, consumers take on the full burden. This relationship highlights the importance of elasticity in determining who ultimately pays the tax, reinforcing the idea that the side of the market that is less responsive to price changes will bear a larger share of the tax burden.