"Price Theory Lecture 2: Supply & Demand"

1. Over the past few days, we appear to have been making a bit of progress on the topic of how the price sensitivity (a much better word than 'elasticity' to be honest) of demand for [something] dictates whether higher input costs or a tax on [something] lead to higher prices or lower profit margins.

2. Perhaps I'm being optimistic here, but commenters now appear to accept what I thought was basic economics general knowledge:

- if demand is price sensitive (discretionary goods or large budget share), higher input costs or a tax lead to lower profit margins, and

- if demand is price insensitive (necessities or very small budget share) higher input costs or a tax lead to higher prices.

3. That is only half the picture of course: the price sensitivity of supply is just as important and even more important than that is the relative price sensitivity of supply and demand. This explains why there is so often a difference between the legal and economic incidence of a tax - in practical terms, for example, it makes not the slightest difference whether the purchaser or the vendor of land and buildings is legally responsible for paying the Stamp Duty Land Tax, so there is little point even discussing it.*

4. Just to reassure you that this is not something I just made up for the fun of it, I hereby link to yet another fine article on supply and demand. It covers all the related topics like the effect of price caps, price floors and so on, well worth a read. Section IX covers Elasticity and the final section X covers Tax Incidence**:

So why is elasticity important? Many reasons, but here is one: it determines the distribution of the burden of taxes. Tax incidence is the study of how the burden of a tax is distributed over different groups. Consider the following statements:

"If we raise the tax on cigarettes, tobacco companies will just pass the tax on to consumers." This statement implies that consumers bear the entire burden of a sales tax, even if the government requires firms to pay the tax.

"The Social Security tax is divided between the employer and the employee. The employer must pay half of the tax, and the employee must pay the other half." This statement implies that the government can decide how the burden of the tax will be distributed.

So which point of view is correct? As a general rule, neither. Consumers do not bear the entire burden of a tax in most cases, but neither can the government decide who pays how much. The distribution of the burden depends on the elasticity of supply and demand.

The key to understanding tax incidence is to realize that a sales tax (in fact, almost any kind of tax) is not a tax on a person -- it's a tax on a transaction. If there is a $1 tax on cigarettes, what that means is that there has to be a $1 difference between what the buyer pays and what the seller gets. It doesn't really matter who sends the check to the government.

It might appear from the graph above that the tax is distributed evenly between consumers and producers, but that need not be true. It depends on the elasticity of supply and demand. Suppose that demand is very inelastic (consumers are unresponsive to price changes), and supply is very elastic (producers are very responsive to price changes). Then we get a picture like the one below. Here, it should be apparent that the consumers are bearing the bulk of the tax burden, while the producers' burden is very small...

On the other hand, what if the supply were very inelastic and the demand were very elastic? In that case, the producers would bear most of the burden. The general result is that when demand is more elastic than supply, producers bear the larger burden, and when supply is more elastic than demand, consumers bear the larger burden.

Consider again our examples. In the case of cigarettes, do you think the demand is relatively elastic or relatively inelastic? Given the addictive quality of cigarettes, it seems like demand is probably inelastic. If that's true, then a sales tax on cigarettes is likely to be borne mainly by the consumers.

In the case of the Social Security tax, do you think the supply of labor is relatively elastic or relatively inelastic? It's probably fairly inelastic (people need to have their jobs, and almost all legal jobs are taxed), so the suppliers (i.e. the employees) probably bear most of the burden.

5. It seemed a bit cheeky to copy their charts, but this is exactly how I explained it myself, with charts, to contrast the same two extremes cases as in that article:

- Price insensitive demand and price sensitive supply (e.g. cigarettes). The consumer bears the tobacco duty in higher prices.

- Price sensitive demand and price insensitive supply. I used land as an example rather than wages, as the supply of land is fixed and hence entirely unresponsive to price changes. The supplier bears the tax. Land owners bear all the costs in their entirety (be they repair or insurance costs, interest or taxes) and cannot glibly pass any of them on to their tenants (or purchasers) because the rental value of their land is completely out of their control and is decided by the market. This is this much the same reason that employees bear most of the burden of Employer's National Insurance contributions.

* H/t Fraggle. The comment thread is a hoot - it's the usual battle between Home-Owner-Ists churning out their easy lies and Land Value Taxers fighting back with the rather lengthy but correct facts and reasoning.

** On Tax Incidence, Wiki says exactly the same: "Where the tax incidence falls depends (in the short run) on the price elasticity of demand and price elasticity of supply. Tax incidence falls mostly upon the group that responds least to price (the group that has the most inelastic price-quantity curve). If the demand curve is inelastic relative to the supply curve the tax will be disproportionately borne by the buyer rather than the seller. If the demand curve is elastic relative to the supply curve, the tax will be born disproportionately by the seller." Note the use of "relative to".