Question

Consider the market for white athletic socks, which consumers consider to be identical products. If the demand is very elastic and the supply is very inelastic, how would the burden of a new tax on athletic socks be shared between consumers and producers? What if the situation were reversed – a very inelastic demand and a very elastic supply? How would that change the way consumers and producers share the burden of the new tax? Justify your answer.

Answer 1

Consider the market for white athletic socks, which consumers consider to be identical products. If the demand is very elastic and the supply is very inelastic, how would the burden of a new tax on athletic socks be shared between consumers and producers?

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The burden of tax is called the tax incidence. Tax incidence tells us how the tax will be shared between buyers and sellers. It doesn't matter who pays the tax initially - tax incidence depends on the elasticity of demand and supply.

If demand is very elastic and supply is very inelastic, the tax burden will fall more upon the producers. The consumers will be able to escape the effects of the tax, till the extent that their demand is elastic. Elasticity of demand means that consumers will be able to find substitutes, or postpone the purchase, or even cancel it altogether.

In the diagram, the red line indicates the tax. Due to different elasticities, the tax burden falls more upon the sellers.

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What if the situation were reversed – a very inelastic demand and a very elastic supply? How would that change the way consumers and producers share the burden of the new tax? Justify your answer.

In case demand is inelastic and supply is elastic, the major burden of the tax will now fall upon the consumers. Consumers will not be able to find substitutes or change their consumption, and will have to end up paying a higher price due to the tax. Producers will happily be able to sell more of the product at the higher price.

In the diagram, the red line indicates the tax. Due to different elasticities, the tax burden falls more upon the buyers.

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In general, whichever part of the market is inelastic, bears the major burden of the tax.