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Economics explained


microeconomic policies

Incidence of tax and elasticity

Incidence of tax and elasticity

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Incidence of tax and elasticity

The extent to which the producer is able to pass on the tax by raising the price depends on the price elasticity of demand and supply for the product.

In each of the diagrams, the size of the tax is the same: the supply curve shifts upwards by the same amount.

The rise in price from P1 to P2 multiplied by the number of goods sold (Q2) (the blue area) represents the consumers’ share of the tax.

The producer's share of the tax (pink area) is the amount by which the producers’ share net price (P2 − t) is below the original price (P1) multiplied by Q2.

The following conclusions can be drawn:

Inelastic demand and Inelastic supply= More government revenue

Tax revenue for the government will be greater, the less elastic are demand and supply
(cases (1) and (3)).

Inelastic demand and Elastic supply = Larger consumer share of the tax

The consumers’ share of the tax will be larger, the less elastic is demand and the more elastic is supply
(cases (1) and (4)).

Elastic demand and Inelastic supply = Larger producer share of the tax

The producers’ share will be larger, the more elastic is demand and the less elastic is supply
(cases (2) and (3))

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