Question

When demand is perfectly elastic, a tax increase is borne (LO7) a) only by the buyer c) mostly by the buyer b) only by the seller d) mostly by the seller

Short answer

In the case of perfectly elastic demand, the burden of a tax increase falls entirely on the sellers, as buyers are highly responsive to price changes and any price increase would lead to an infinite drop in quantity demanded. Thus, the short answer is: b) only by the seller

Step-by-step solution

Understand Perfectly Elastic Demand

Perfectly elastic demand refers to a market situation where the quantity demanded of a good or service is responsive to any change in its price. In this case, even a small change in the price will lead to an infinite change in the quantity demanded. Graphically, this can be represented as a horizontal demand curve.

Analyze the Impact of Tax Increase

When a tax is imposed on a good, it leads to an increase in the price, which affects both buyers and sellers. The incidence of a tax (or how much of the tax burden is carried by the buyer and the seller) depends on the responsiveness of the quantity demanded and supplied to the price changes, or the elasticity of demand and supply.

Determine the Tax Burden on Buyers and Sellers

In the case of perfectly elastic demand, buyers are highly responsive to price changes. When a tax is imposed, sellers try to pass it on to the buyers by increasing the price. However, because the demand is perfectly elastic, any increase in price will cause the quantity demanded to drop infinitely. As a result, sellers cannot increase the price without losing all their customers. This implies that the burden of the tax falls entirely on the sellers, due to the highly responsive nature of the demand. Therefore, the correct answer to this question is: b) only by the seller

Key concepts

Tax Incidence

When we talk about **tax incidence**, we're referring to the division of the tax payment between consumers and producers. It's about figuring out who really bears the cost of the tax. This is not always shared equally and depends heavily on the elasticity of demand and supply.

In a perfectly elastic demand scenario, the demand curve is horizontal. This means consumers will only pay the same price, and any increase will lead them to stop their purchases entirely.
As a result, sellers cannot pass any of the tax onto buyers through higher prices, because raising prices would mean losing all their customers. Thus, sellers end up bearing the full burden of the tax.
Understanding who pays the tax helps businesses and policymakers make informed decisions about tax policy and its potential impacts on markets and economic welfare.

Elasticity of Demand

**Elasticity of demand** measures how much the quantity demanded of a good responds to changes in its price. If the demand is highly elastic, even a tiny change in price leads to a large shift in the quantity demanded.

Let's say you have a perfectly elastic demand, depicted by a straight horizontal line. In this case, any increase in price causes the quantity demanded to drop to zero because consumers refuse to pay a higher price—they'll simply switch to alternatives.
This makes perfectly elastic demand a special case where supply bears all the tax burden. Thus, understanding demand elasticity is crucial for figuring out tax incidence and other market behaviors.

Price Responsiveness

**Price responsiveness** is a key concept that reflects how much the quantity demanded or supplied reacts to changes in price. When we say a demand is price responsive, it means that any change in price will lead to a noticeable change in the quantity demanded.

In the context of perfectly elastic demand, price responsiveness is at its peak. Even a small price increase causes demand to vanish completely. This total responsiveness forces sellers to absorb any additional costs, such as taxes, without transferring them to consumers.

Understanding price responsiveness can help businesses plan their pricing strategies effectively, ensuring they stay competitive and manage their financial impacts effectively.