Question

The incidence of a unit tax depends on the elasticities of supply and demand. By assuming that a unit tax is levied on suppliers and the demand is elastic, with the aid of diagrams, explain the incidence when:

1. Supply is perfectly inelastic.
2. Supply is perfectly elastic.

Answer 1

i ii

P_B is the price paid by the buyers, P_S is the price received by the sellers and P is the equilibrium market price.

Q1 is the equilibrium quantity befor tax. After imposition of unit tax equilibrium quantity falls to Q2.

(P_B-P_S) is the tax per unit of the good  

i. As shown in the diagram, we observe that when the supply of the good relatively more inelastic than demand for the good, there is a greater incidence of taxation on the suppliers. A+B is the total tax revenue collected from the consumers and producers respectively. Area of B is greater than area of A as producers or suppliers have to pay greater tax per transaction of the particular good. This is because, when the supply of the good is relatively more inelastic than demand for the good, then producers ability to evade transaction of the good is less than that of the consumers. Thus he has to pay greater tax per unit.

ii. Now as the the supply of the good is perfectly elastic, suppliers have infinite ability to evade the transaction. Hence they do not pay any tax. Entire burden of taxation is on the consumers. We observe here B is missing, the entire tax revenue is A, and producers receive the market price. Consumers are paying entire tax which is (P_B-P) over and above the price of the good P, and A is the entire tax revenue of the government  collected from the consumers.

Note: A tax burden falls more heavilly on the side of the market which is less elastic. This is because elaticity measure the willingness and ability of buyeres and sellers to leave the market when market conditions become unfavourable. Lower elasticity means lower opportunity to leave the market.