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Relation between Elasticitys and DWL (Regarding to Government Tax Policy)

A tax has a deadweight loss because it induces buyers and sellers to change their behavior. The tax raises the price paid by buyers, so they consume less. At the same time, the tax lowers the price received by sellers, so they produce less. Because of these changes in behavior, the size of the market shrinks below the optimum. The elasticitys of supply and demand measure how much sellers and buyers respond to the changes in the price and, therefore, determine how much the tax distorts the market outcome. Hence, the greater the elasticitys of supply and demand, the greater the deadweight loss of a tax. Elastic Demand of Good X (i) Higher responsive to price, i.e., higher change in quantity demanded (i.e., transaction) (ii) Higher change in transaction means higher deadweight loss (DWL). (iii) When Govt imposes tax on buyers, they lower the quantity demanded significantly, and greater DWL is created. (iv) Hence, govt should not impose tax on buyers of good X, or should think twice before imposing tax on them. Inelastic Demand of Good X (i) Lower responsive to price ,i.e., lower change in quantity demanded (i.e., transaction) (ii) Lower change in transaction means lower deadweight loss (DWL). (iii) When Govt imposes tax on buyers, they lower the quantity demanded (but not significantly), and smaller DWL is created. (iv) Hence, govt can impose tax on buyers of good X. (But, govt should also see elasticity of supply).

Elastic Supply of Good X (i) Higher responsive to price ,i.e., higher change in quantity supplied (i.e., transaction). (ii) Higher change in transaction means higher deadweight loss (DWL.) (iii) When Govt imposes tax on sellers, they lower the quantity supplied significantly, and greater DWL is created. (iv) Hence, govt should not impose tax on sellers of good X, or should think twice before imposing tax on them.

Inelastic Supply of Good X (i) Lower responsive to price ,i.e., lower change in quantity supplied (i.e., transaction) (ii) Lower change in transaction means lower deadweight loss (DWL). (iii) When Govt imposes tax on sellers, they would not lower the quantity supplied significantly, and smaller DWL is created. (iv) Hence, govt can impose tax on sellers of good X. (But, govt should also see elasticity of demand).

Tax Should be Imposed on Buyers or Sellers?


It does not matter whether a tax on a good is levied on buyers or sellers of the good. When a tax is levied on buyers, the demand curve shifts downwards by the size of the tax; when it is levied on sellers, the supply curve shifts upwards by that amount. In either case, when the tax is enacted, the price paid by buyers rises, and the price received by sellers falls. In the end, the elasticities of supply and demand determine how the tax burden is distributed between producers and consumers. This distribution is the same, regardless of how it is levied. It can be illustrated by an example.

Suppose market demand for tires (in millions) is given by the equation QD = 12 - P. Tires are supplied according to the market supply equation QS = 2P. (i) Calculate equilibrium price and quantity. (ii) Calculate price and quantity at new equilibrium when tax of Rs 3 per unit is imposed on sellers. Also calculate burden of tax on buyers, and sellers. (iii) Calculate price and quantity at new equilibrium when tax of Rs 3 per unit is imposed on buyers. Also calculate burden of tax on buyers, and sellers. Solution: (i) Without tax Given that QD = 12 P (i) QS = 2P (ii) Solving (i) and (ii), Q = 8 , and P = 4 (ii) When tax Rs 3 is imposed on sellers, Demand function remains same, but supply curve shifts upwards by 3 units. From (ii), QS = 2P Or, P = QS/2 After imposing tax of Rs 3 per unit on sellers, New supply function is P 3 = QS/2 ..(iii) Solving (i) and (iii), we get P = 6, and Q = 6 Price paid by buyers = Rs 6 per unit (i.e., buyers pay Rs 2 more) Price received by sellers = Rs 6 Rs 3 = Rs 3 (i.e., sellers receive Re 1 less)

(iii) When tax Rs 3 is imposed on buyers Supply function remains same, but demand curve shifts downwards by 3 units. From (i), QD = 12 P Or, P = 12 - Qd After imposing tax of Rs 3 per unit on buyers, New demand function is P + 3 = 12 - Qd P = 9 - Qd (iv) Solving (ii) and (iv), we get P = 3, and Q = 6 Price paid by buyers = Rs 3 + 3 = Rs 6 per unit (i.e., buyers pay Rs 2 more) Price received by sellers = Rs 3 (i.e., sellers receive Re 1 less) We get the same results by imposing tax either on sellers or on buyers.

Note :Some more results:


Tax revenue is also same in both cases. Tax revenue = 6 3 = Rs 18. Incidence of tax is also same in both cases. Tax incidence on sellers = 6 1 = Rs 6 Tax incidence on buyers = 6 2 = Rs 18 Note : You may draw a diagram to for confidence build up, and clarification. (i) (ii)