Question

(Related to Solved Problem 18.3 on page 616 ) Explain whether you agree with the following statement: "For a given demand curve, the excess burden of a tax will be greater when supply is less price elastic than when it is more price elastic." Illustrate your answer with a demand and supply graph.

Short answer

Yes, one would agree with the statement. For a given demand curve, when supply is less price elastic (inelastic), the excess burden of a tax or deadweight loss is indeed greater. This is because, with an inelastic supply, sellers bear a larger share of the tax burden and significantly decrease their production, leading to a larger welfare loss to society than when supply is more price-elastic.

Step-by-step solution

Understand Basic Concepts

The demand curve in economics shows how the quantity of a good or service varies with its price. Elasticity refers to a measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants. Excess burden of tax, also known as deadweight loss, refers to the cost to society created by market inefficiency.

Analyze the Statement

Now, let's analyze the given statement: 'For a given demand curve, the excess burden of a tax will be greater when supply is less price elastic than when it is more price elastic.' It means if the supply is inelastic (less responsive to price changes), then the deadweight loss of a tax is larger.

Reasoning the Statement

A tax imposed on a market with inelastic supply will distort the market outcome more, resulting in a larger deadweight loss to society. The tax creates a wedge between the price buyers pay and the price sellers receive, regardless of elasticity. However, when supply is inelastic, sellers bear a larger share of the tax burden and decrease their production significantly. This reduces total welfare by more.

Illustration

To illustrate this, draw two graphs showing demand and supply before and after tax. In the case of inelastic supply, the supply curve will be steeper, and the area representing the deadweight loss (excess burden) will be larger compared to more elastic supply.

Key concepts

Demand Curve

Understanding the demand curve is fundamental when studying the impacts of taxation on a market. It represents the relationship between the price of a goods or service and the quantity demanded by consumers at various price levels. Typically, the curve slopes downwards, reflecting the law of demand: as the price of a product decreases, consumers are willing to purchase more, and vice versa.

In the context of taxation, the demand curve helps us analyze how consumer behavior might change in response to a tax imposed on a good, influencing the overall quantity demanded within the market. This relationship is crucial for evaluating the excess burden of a tax, as taxes can lead to a decrease in the quantity demanded, which in turn affects market efficiency and welfare.

Price Elasticity

Price elasticity is a measure of how much the quantity demanded or supplied of a good responds to a change in its price. Specifically, it gauges the sensitivity of consumers or producers to price adjustments. Price elasticity is categorized as either elastic, inelastic, or unitary.

Elastic demand or supply means that the quantity demanded or supplied changes significantly due to price changes. In contrast, inelastic demand or supply indicates that the quantity is relatively unresponsive to price. This concept is pivotal when analyzing tax incidence and deadweight loss because the elasticity of supply and demand will influence how the tax affects market outcomes and distribution of economic welfare.

Deadweight Loss

Deadweight loss is a critical concept in economics, representing the loss of economic efficiency when the equilibrium for a good or service is not achieved or is unachievable. Taxes can cause markets to become inefficient by creating a discrepancy between the consumers' willingness to pay and the producers' costs, leading to a reduction in the overall quantity traded.

When a tax is levied, it can result in a deadweight loss especially if the market is distorted significantly from its equilibrium. For instance, when a good with inelastic supply is taxed, the quantity traded could drop substantially, resulting in a larger deadweight loss as the tax severely affects production and consumption decisions, deviating from the optimal market outcome.

Market Inefficiency

Market inefficiency occurs when resources are not allocated optimally, leading to missed opportunities for gains in trade. In an efficient market, every transaction would maximize buyer and seller satisfaction without any unexploited opportunities for further exchange. Taxes, however, can introduce inefficiencies by preventing markets from reaching this optimal allocation of resources.

The excess burden of a tax is a direct result of such inefficiencies. It measures the cost to society in lost utility or economic welfare, as taxes can both decrease consumer surplus, which is the benefit obtained from purchasing a good or service, and producer surplus, which is the benefit sellers receive from selling the good.

Tax Incidence

Tax incidence examines which group, consumers or producers, bears the burden of a tax. It doesn't solely depend on who legally pays the tax but rather on the relative elasticities of demand and supply. When supply is inelastic, producers find it harder to pass the tax onto consumers, and therefore bear most of the tax burden. In contrast, when demand is inelastic, consumers tend to bear a greater share of the tax.

The distribution of tax incidence has significant implications for equity and market outcomes. By understanding who is most affected by taxes, policy makers can make informed decisions about taxation strategies and anticipate potential changes in market behavior that result from new or adjusted taxes.