112 ❖ Chapter 6/Supply, Demand, and Government Policies
E. Elasticity and Tax Incidence
1. When supply is elastic and demand is inelastic, the largest share of the tax burden falls on
consumers.
2. When supply is inelastic and demand is elastic, the largest share of the tax burden falls on
producers.
3. In general, a tax burden falls more heavily on the side of the market that is less elastic.
consuming this product.
b. A small elasticity of supply means that sellers do not have good alternatives to producing
this particular good.
4.
Case Study: Who Pays the Luxury Tax?
a. In 1990, Congress adopted a new luxury tax.
b. The goal of the tax was to raise revenue from those who could most easily afford to pay.
c. Because the demand for luxuries is often relatively more elastic than supply, the burden
of the tax fell on producers and their workers.
Go through this material slowly. Make sure that students can see how to find the
burden of the tax paid by consumers and the burden of the tax paid by producers
before discussing the effects of elasticity on tax incidence. If you rush through this
material, you will lose them.
Figure 9
Chapter 6/Supply, Demand, and Government Policies ❖ 113
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. A price ceiling is a legal maximum on the price at which a good can be sold. Examples of
ceiling leads to a shortage, if the ceiling is binding, because suppliers will not produce
2. With no tax, as shown in Figure 1, the demand curve is
D
1 and the supply curve is
S
. The
equilibrium price is
P
1 and the equilibrium quantity is
Q
1. If the tax is imposed on car buyers,
shift in the demand curve leads to a decline in the price received by sellers to
P
2 and a
decline in the equilibrium quantity to
Q
2. The price received by sellers declines by
P
1 –
P
2,
shown in the figure as
P
S. Buyers pay a total of
P
2 + $1,000, an increase in what they pay
of
(
P
2 + $1,000) –
P
1, shown in the figure as
P
B.
Figure 1 Figure 2
the amount of the tax ($1,000) to
S
2. The upward shift in the supply curve leads to a rise in
by buyers increases by
P
2 –
P
1, shown in the figure as
P
B. Sellers receive
P
2 – 1,000, a
decrease in what they receive by
P
1 – (
P
2 – $1,000), shown in the figure as
P
S.
Questions for Review
1. An example of a price ceiling is the rent control system in New York City. An example of a price floor
114 ❖ Chapter 6/Supply, Demand, and Government Policies
2. A shortage of a good arises when there is a binding price ceiling. A binding price ceiling is one that is
exceeds quantity supplied. See Figure 3.
Figure 3
3. When the price of a good is not allowed to bring supply and demand into equilibrium, some
shortage of a good as in the case of a binding price ceiling, sellers can ration the good according to
4. Economists usually oppose controls on prices because prices have the crucial job of coordinating
hurt those they are trying to help.
5. Removing a tax paid by buyers and replacing it with a tax paid by sellers raises the price that buyers
6. A tax on a good raises the price buyers pay, lowers the price sellers receive, and reduces the quantity
sold.
7. The burden of a tax is divided between buyers and sellers depending on the elasticities of demand
and supply. Elasticity represents the willingness of buyers or sellers to leave the market, which in
turns depends on their alternatives. When a good is taxed, the side of the market with fewer good
alternatives cannot easily leave the market and thus bears more of the burden of the tax.
Quick Check Multiple Choice
1. d
2. c
3. a
4. a
5. d
6. d
Chapter 6/Supply, Demand, and Government Policies ❖ 115
Problems and Applications
1. If the price ceiling of $40 per ticket is below the equilibrium price, then quantity demanded exceeds
quantity supplied, so there will be a shortage of tickets. The policy decreases the number of people
who attend classical music concerts, because the quantity supplied is lower because of the lower
price.
2. a. The imposition of a binding price floor in the cheese market is shown in Figure 4. In the absence
of the price floor, the price would be
P
1 and the quantity would be
Q
1. With the floor set at
P
f,
which is greater than
P
1, the quantity demanded is
Q
2, while quantity supplied is
Q
3, so there is a
surplus of cheese in the amount
Q
3 –
Q
2.
Figure 4
price, so total revenue would decline.
c. If the government purchases all the surplus cheese at the price floor, producers benefit and
taxpayers lose. Producers would produce quantity
Q
3 of cheese, and their total revenue would
the same position as before. Taxpayers lose because they would be financing the purchase of the
surplus cheese through higher taxes.
b. With a price floor of $10, the new market price is $10 because the price floor is binding. At that
price, only two million Frisbees are sold, because that is the quantity demanded.
c. If there’s a price ceiling of $9, it has no effect, because the market equilibrium price is $8, which
116 ❖ Chapter 6/Supply, Demand, and Government Policies
4. a. Figure 5 shows the market for beer without the tax. The equilibrium price is
P
1 and the
producers,
P
1.
Figure 5 Figure 6
P
2 – $2. The difference between the price paid by consumers and the price received by producers
5. Raising the payroll tax paid by firms and using part of the extra revenue to reduce the payroll tax
paid by workers would not make workers better off, because the division of the burden of a tax
would be worse off.
6. The price will rise by less than $500. The burden of any tax is shared by both producers and
consumersthe price paid by consumers rises and the price received by producers falls, with the
difference between the two equal to the amount of the tax. The only exceptions would be if the
exactly $500.
Chapter 6/Supply, Demand, and Government Policies ❖ 117
7. a. It does not matter whether the tax is imposed on producers or consumersthe effect will be the
the tax is imposed on producers, the supply curve shifts left by the amount of the tax (50 cents)
to
S
2. Then the equilibrium quantity is
Q
2, the price paid by consumers is
P
2, and the price
consumers, the demand curve shifts left by the amount of the tax (50 cents) to
D
2. The leftward
again, the equilibrium quantity is
Q
2, the price paid by consumers is
P
2 (including the tax paid to
Figure 7 Figure 8
demand curve, while demand curve
D
2 is more inelastic. The tax will cause a greater decline in
the quantity sold when demand is elastic.
d. Workers in the oil industry are hurt by the tax as well. With a lower quantity of gasoline being
produced, some workers may lose their jobs. With a lower price received by producers, wages of
workers might decline.
118 ❖ Chapter 6/Supply, Demand, and Government Policies
8. a. Figure 9 shows the effects of the minimum wage. In the absence of the minimum wage, the
imposed above
w
1, the market wage is
w
m, the number of employed workers is
Q
2, and the
number of workers who are unemployed is
Q
3 −
Q
2. Total wage payments to workers are shown
Figure 9
c. The increase in the minimum wage would increase unemployment. The size of the rise in
unemployment depends on both the elasticities of supply and demand. The elasticity of demand
determines the change in the quantity of labor demanded, the elasticity of supply determines the
change in the quantity of labor supplied, and the difference between the quantities supplied and
d. If the demand for unskilled labor were inelastic, the rise in the minimum wage would increase
total wage payments to unskilled labor. With inelastic demand, the percentage decline in
employment would be lower than the percentage increase in the wage, so total wage payments
increase. However, if the demand for unskilled labor were elastic, total wage payments would
increase in the wage.
Chapter 6/Supply, Demand, and Government Policies ❖ 119
9. Since the supply of seats is perfectly inelastic, the entire burden of the tax will fall on the team’s
owners. Figure 11 shows that the price the buyers pay for the tickets will fall by the exact amount of
the tax.
Figure 11
price received by sellers is
P
S and the effective price paid by consumers is
P
D, which equals
P
S
increases to
Q
2.
Figure 12