Taxes and elastcity

“If you put the federal government in charge of the Sahara Desert, in 5

years there'd be a shortage of sand.”

Milton FriedmanNobel Laureate, Economics

(1912 – 2006)

TAXES ON BUYERS AND SELLERS

Tax Incidence

Tax incidence is the division of the burden of a tax between the buyer and the seller.

When a good is taxed, it has two prices:• A price that includes the tax• A price that excludes the tax

Buyers respond to the price that includes the tax.

Sellers respond to the price that excludes the tax.


The tax is like a wedge between the two prices.

Suppose that the government puts a $10 tax on MP3 players.

• How does the price paid by the buyer change?• How does the price received by the seller change?• How is the burden of a tax shared between the

buyer and the seller?

1. With no tax, the price is $100 and 5,000 players are bought.

2. A $10 tax on buyers shifts the demand curve to D – tax.

What happens when the government taxes buyers of the MP3 players?


3. The buyer’s price rises to $105—an increase of $5 a player.

4. The seller’s price falls to $95—a decrease of $5 a player.

5. The quantity decreases to 2,000 players a week.

6. The government’s tax revenue is $20,000.


1. With no tax, the price is $100 and 5,000 players a week are bought.

2. A $10 tax on sellers of MP3 players shifts the supply curve to S + tax.

Shows what happens when the government taxes sellers of the MP3 players.


3. The buyer’s price rises to $105—an increase of $5 a player.

4. The seller’s price falls to $95—a decrease of $5 a player.

5. The quantity decreases to 2,000 players a week.

6. The government’s tax revenue is $20,000.


A tax places a wedge between the buyers’ price (marginal benefit) and the sellers’ price (marginal cost).

The equilibrium quantity is less than the efficient quantity and a deadweight loss arises.

Taxes and Efficiency


The market is efficient with marginal benefit equal to marginal cost.

Shows the inefficiency of taxes.

Total surplus—the sum of2. Consumer surplus and3. Producer surplus—is maximized.


A $10 tax shifts the supply curve to S + tax.

3. Consumer surplus and4. Producer surplus shrink.

Shows how taxes create inefficiency.

5. The government collectsits tax revenue.

6. A deadweight loss arises.

1. Marginal benefit exceeds 2. Marginal cost.


The loss of consumer surplus and producer surplus is the burden of the tax.

The burden of the tax equals the tax revenue plus the deadweight loss.


Excess burden is the deadweight loss from a tax.

The excess burden is (3,000 $10 2), which equals $15,000.

Excess burden is the amount by which the burden of a tax exceeds the tax revenue received by the government.


Incidence, Inefficiency, and Elasticity

The incidence of a tax and its excess burden depend on the elasticites of demand and supply:

• For a given elasticity of supply, the buyer pays a larger share of the tax, the more inelastic is the demand for the good.

• For a given elasticity of demand, the seller pays a larger share of the tax, the more inelastic is the supply of the good.

• Excess burden is smaller, the more inelastic is demand or supply.



Tax Incidence, Inefficiency, and Elasticity of Demand

Perfectly Inelastic Demand: Buyer Pays and Efficient

Perfectly Elastic Demand: Seller Pays and Inefficient

Shows tax incidence in a market with perfectly inelastic demand—the market for insulin.

A tax of 20¢ a dose raises the price by 20¢, and the buyer pays all the tax.

Marginal benefit equals marginal cost, so the outcome is efficient.


Shows tax incidence in a market with perfectly elastic demand—the market for pink pens.

A tax of 10¢ a pink pen lowers the price received by the seller by 10¢, and the seller pays all the tax.

A deadweight loss arises, so the outcome is inefficient.



Tax Incidence, Inefficiency, and Elasticity of Supply

Perfectly Inelastic Supply: Seller Pays and Efficient

Perfectly Elastic Supply: Buyer Pays and Inefficient

Shows tax incidence in a market with perfectly inelastic supply—the market for spring water.

A tax of 5¢ a bottle does not change the price paid by the buyer but lowers the price received by the seller by 5¢.

Marginal benefit equals marginal cost, so the outcome is efficient.

The seller pays the entire tax.


Figure 7.4(b) shows tax incidence in a market with perfectly elastic supply—the market for sand.

A tax of 1¢ a pound increases the price by 1¢ a pound, and the buyer pays all the tax.

A deadweight loss arises, so the outcome is inefficient.


Elasticity and Tax Incidence

CASE 1: Supply is more elastic than demand

P

QD

S

Tax

Buyers’ share of tax burden

Sellers’ share of tax burden

Price if no tax

PB

PS

In this case, buyers bear most of the burden of the tax.

In this case, buyers bear most of the burden of the tax.

S-tax

Elasticity and Tax Incidence

CASE 2: Demand is more elastic than supply

P

Q

D

S

Tax

Buyers’ share of tax burden

Sellers’ share of tax burden

Price if no tax

PB

PS

In this case, sellers bear most of the burden of the tax.

In this case, sellers bear most of the burden of the tax.

S-tax

Taxes and elastcity

Education

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