Chapter 6: Elasticity

Taxes create a wedge between the price paid by buyers and the price received by sellers, causing the quantity exchanged to fall below the competitive equilibrium level. The fundamental principle determining incidence is the relative elasticity of supply and demand curves: when demand is relatively inelastic compared to supply, consumers absorb a larger share of the tax burden, while elastic demand shifts more of the burden to sellers. Graphical analysis illustrates how taxation generates deadweight loss by eliminating mutually beneficial trades that would occur at equilibrium, thereby reducing total economic surplus. The magnitude of efficiency loss depends directly on the elasticities involved, with more elastic markets experiencing greater deadweight loss at any given tax rate because quantity reductions are proportionally larger. The chapter explores revenue considerations for government policymakers, explaining that total tax revenue depends on both the tax rate and the quantity sold after taxation. The Laffer curve demonstrates that extremely high tax rates can paradoxically decrease government revenue by substantially reducing market activity and economic incentives. Practical applications illustrate these principles through real-world examples including excise taxes on gasoline and cigarettes, payroll taxes on wages, and luxury taxes on high-value goods, each demonstrating distinct incidence patterns based on supply and demand elasticities. The chapter also addresses how governments use corrective or sin taxes as policy tools to internalize negative externalities and reduce consumption of harmful products. Additional considerations include the administrative burden of tax collection and the trade-offs policymakers face between efficiency objectives and equity concerns when designing tax systems. This comprehensive analysis enables students to predict how specific tax policies affect market outcomes, government revenue collection, economic efficiency, and the distribution of economic burden across different populations.