Question

When demand is perfectly elastic, a tax increase is bornc (L.O7) a) only by the buyer c) mostly by the buyer b) only by the seller d) mostly by the seller

Short answer

In a market with perfectly elastic demand, any tax increase cannot be passed on to the buyers, as they are unwilling to pay a higher price. Therefore, the burden of the tax increase falls entirely on the seller, not on the buyer. The correct answer is (b) only by the seller.

Step-by-step solution

Understanding the Concept of Perfectly Elastic Demand

Perfectly elastic demand refers to a market scenario where the quantity demanded by consumers responds to an infinite extent to any change in price. In other words, consumers would buy as much of a product as possible at a certain price but if the price were to increase, even by a very small amount, the quantity demanded would drop to zero. This can be visualised as a horizontal demand curve on a price-quantity graph.

Impact of a Tax Increase on the Seller and Buyer

When a tax is imposed, it increases the price of goods or services. If a seller tries to pass on this extra cost to the buyers by increasing the price of the product, in a scenario of perfectly elastic demand, the buyers would stop purchasing that product or service. This means the seller cannot pass on the tax burden to the buyers.

Who Bears the Tax Burden?

Given that the demand is perfectly elastic, and buyers are not willing to pay a higher price, it would mean that any tax increase cannot be passed on to the buyers. Therefore, the burden of the tax increase falls entirely on the seller, not on the buyer. So, the correct answer is (b) only by the seller.

Understanding the Implication

This scenario suggests that in a market with perfectly elastic demand, a seller must absorb any additional costs from a tax increase to maintain sales. The firm might have to look at reducing costs elsewhere to remain profitable.

Key concepts

Tax Burden

In economics, understanding who bears the tax burden is vital in determining market dynamics. The tax burden refers to the economic responsibility placed on either the buyer or the seller when a tax is imposed. In a perfectly elastic demand scenario, buyers are extremely sensitive to price changes. Even a slight increase in price would lead to buyers refusing to purchase the product entirely.

This characteristic means sellers cannot pass on any tax increase to consumers. Instead, they will have to absorb the full cost of the tax themselves. To reiterate, when the demand is perfectly elastic, sellers bear the entire tax burden. Buyers continue paying the initial price because any increase would reduce the quantity demanded to zero. As a result, sellers may need to explore strategies for cost reduction or efficiency improvements to mitigate the financial impact of the tax.

Demand Curve

A demand curve is a graphical representation illustrating the quantity of a product consumers are willing and able to purchase at various price levels. In the context of perfectly elastic demand, this curve is exceptionally unique.

• The demand curve is a horizontal line.
• This signifies that consumers will buy any amount of the product at the set market price.
• Increasing prices even slightly will see the quantity demanded drop instantly to zero.

This horizontal demand curve emphasizes the need for sellers to maintain competitive pricing. In markets characterized by perfectly elastic demand, consumer loyalty is often non-existent because if offered a better price, consumers will immediately switch to another provider. Thus, maintaining market price is critical for sellers.

Price-Quantity Graph

A price-quantity graph is an important tool for visualizing the relationship between the price of a good and the quantity demanded or supplied.

In a typical graph, the x-axis represents quantity, while the y-axis represents price. In the case of perfectly elastic demand, the graph shows a unique scenario:

• The demand line is completely horizontal, indicating that any increase in price leads to zero demand.
• This starkly contrasts with inelastic or unit elastic demand, where some adjustments are visible with price changes.

Using a price-quantity graph helps illuminate why sellers cannot increase prices in a perfectly elastic market. Any deviation from the market equilibrium price leads to losing all potential buyers, as displayed by the flat demand line. Hence, it visually demonstrates the critical importance of price stability for sellers in maintaining consumer demand.