Application of Price Elasticity of Demand

Application of Price Elasticity of Demand: The Case of Incidence of Tax

Taxation is one of the main sources of government revenue, as well as an instrument of government fiscal policy, in every modern economy. Government’s indirect taxes on goods and services such as Value-Added Tax (VAT), excise tax, and sales tax usually affect both the producers and the consumer. The economists use the concept of incidence of tax to describe how the burden of tax on a good (or service) is shared between the producers and the consumers. One of the factors which determine the incidence of tax is the price elasticity of demand for the commodity or service in question.

The incidence of tax on commodities with various degrees of price elasticity of demand is discussed below.

1. Elastic Demand: If the demand for a commodity is price elastic, both the producer and the consumer will share the burden of tax, but the greater burden will fall on the producer.

2. Inelastic Demand: Both the producers and consumers will share the burden of tax, but the greater burden will fall on the consumer.

3. Unit Elastic Demand: The burden of tax will be shared equally between the producers and the consumers.

4. Perfectly Elastic Demand: The entire burden of tax will fall on the producers.

5. Perfectly Inelastic Demand: The entire burden of tax will fall on the consumers. The price will increase by the full amount of tax.