Question

How do changes in market prices relate to scarcity? Why do economists typically not favor price controls?

What is tax incidence? How does it relate to price elasticity of supply/demand? How might understanding tax incidence be important when evaluating public policy proposals?

Answer 1

Every resource, be it financial or natural, is scarce. There is no resource that is unlimited.

As the scarcity of a product increases, its market price also increases. For example, diamonds are very scarce, and hence they are very costly.

Scarcity is the inherent property that assigns value to products.

Economists feel that the demand and supply of a product should determine its price. There should be no external intervention in this. If a product is scarce, its price automatically rises. For a product that is abundant, the price should fall.

By interfering in this process, the economic process of price discovery is hindered. Therefore economists do not prefer price controls, unless a market failure has taken place. If the free market has failed to solve the problem, then price controls are needed. For example, the government may set price floors for farmers' produce.

By following the principle of no intervention, the ideal outcome for a market is the free market equilibrium. Here, the product is allocated as per demand and supply, and no external force is present.

Any deviation from equilibrium implies that the basic allocation as per scarcity is being violated.

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Tax incidence refers to the manner in which the burden of a tax is shared. When a tax is imposed, it doesn't matter who pays it first. It may be imposed on buyers or sellers.

Ultimately, the burden of the tax will get shared between buyers and sellers. This will be on the basis of how much they are able to shift their demand or supply.

This shifting depends on elasticity of demand and supply.

If elasticity of demand is greater than elasticity of supply, the sellers bear the burden.

If elasticity of supply is greater than elasticity of demand, the buyers bear the burden.

In general, the burden of the tax falls on the inelastic side of the market. This is because they don't have easy substitutes available.

Policy makers should set a tax on the inelastic side of the market, so that tax revenues are maximized. Of course, necessities should not be taxed heavily.

For example, in most countries, cigarettes, petrol / diesel, entertainment, electronic items, and so on, are taxed heavily. This is because demand for such products is not too elastic. The government makes a lot of revenue out of such taxes.

The diagram shows an example of inelastic demand. The vertical red line between D and S, is the tax. It can be seen how a major part of the tax is imposed on buyers, since they have no choice.