hello and welcome back to the foundation course in managerial economics uh we had uh started
our discussion on how to understand the effect of different policies of the government in
the demand supply framework the very simple demand supply framework that uh we uh started
with and we are looking at the impact of different policies of the government whether it is a
price control or a tax and we are trying to understand what happens in such kinds of policy
interventions by the government into a free market equilibrium
so a free market equilibrium basically gives us a intersection between the demand and supply
curve and it gives us the equilibrium price in the market and the equilibrium quantity
in the market uh which leaves both the consumers and the producer satisfied and no one is left
in the market who is looking for a good at the existing price and he is not getting it
so uh and we discussed that the government sometimes intervenes in the market where the
market fails due to various kinds of reasons and we were discussing about taxes uh in the
last class we discussed about uh we looked at what happens when a tax is imposed on a
buyer or on a seller and what we saw was it does not matter whether the tax is on the
buyer or the seller because in both the situations the buyer and the seller are going to distribute
the tax between themselves and the amount of tax burden that the buyer bears and the
amount of tax burden that the seller bears that does not change if the tax is imposed
on the buyer or the seller that is it is irrespective of which party
the tax is imposed on it is distributed in the same way in both cases between the buyer
and the seller so uh next thing uh and we we left the discussion uh looking at the typical
example that we took and in our example we saw that the buyer in both the cases whether
the tax was on the seller or the buyer in both the cases buyer was bearing major part
of the tax we discussed about the example where the tax
was 1.5 rupees per unit of product sold and we saw that the buyer was bearing 1 rupee
out of that 1.5 rupees and the seller was bearing a tax a 0.5 rupees or 50 paise out
of that entire tax of 1.5 per unit of good and we saw that it did not change whether
it was on the buyer or the seller so the question that we left are uh last discussion
with was what determines is it that always the buyer bears the major part of the tax
or what is going to determine how much part of the tax the buyer is going to bear and
how much part of the tax the seller is going to bear and uh today we are going to see that
the answer lies in our uh understanding of elasticity that we did a few lectures back
so we are going to discuss about elasticity and what impact elasticity or rather price
elasticity of demand and supply has on the incidence of taxes so we are going to talk
about elasticity and impact of taxes . we are going to show that if supply is more
elastic than demand buyers bear most of the tax burden so if supply is more elastic than
demand buyers bear most of the tax burden and uh let me illustrate through an example
let me show on the board why that is so . so we are talking about a case is one is supply
is
so supply is more elastic than demand supply is more elastic than demand so we draw a so
we draw a supply curve which is more elastic means the supply curve is flatter so we draw
a very flat supply curve and a steep demand curve so supply is more elastic than demand
and this is the equilibrium price equilibrium quantity so this is what happens before taxes
now say a tax is imposed of amount t so the first thing that we can do when when uh we
are trying to find out the impact of a tax through this kind of a diagram uh what you
can do is you can imagine a tax of t and straightaway draw the amount of the tax between the demand
and the supply curve so this is the amount of tax that has to be
paid to the government and we know that uh whether it is the tax is imposed on the supply
or on the seller or the buyer the tax is going to be distributed in the same way in both
the cases and so this tax has to be paid by the seller and the buyer and so this is the
amount this is the price that the seller is going to pay on the supply curve this is the
price that the buyer is going to pay on the demand curve and uh so now what i am doing
here is slightly different from the way i was illustrating the tax in the previous lecture
so it is follow me through uh so this is the equilibrium price and the tax has been imposed
so we imagine a tax of this size between the demand and the supply curve so this is this
is t so let me uh colour it so this green line is the tax of amount t so this tax is
to be split between the supplier or the seller and the buyer and the buyer now the buyer
pays a higher price of p b and the seller gets a lower price of p s than the equilibrium
price so this is how the tax is uh distributed between
the two and if you are interested to know uh how the how the diagram can be completed
uh looking at the new demand curve looking at the new supply curve etc it is very easy
to do that uh if the tax is on the seller what happens the supply curve basically shifts
up so if it is on seller if it is on the seller then the supply curve is going to be a parallel
shift like this this is s 1 and if it is on the buyer if the tax is on the buyer then
the demand curve shifts downwards that is there is less demand now and you can imagine
a this to be the new demand curve this can be the new demand curve
so either it is the new supply curve or it is the new demand curve in both the cases
in both the situations the uh the price the the new prices are going to be p b and p s
and so even without drawing the shift in the demand or the supply curve we can actually
say how much of what is going to be the new price in the both cases
so now we can see that this is how the tax is divided between the two so this is the
the green line is the amount of tax that has to be split up between the two and earlier
both were the price that the p b was equal to p s was earlier before tax p b was equal
to p s was equal to p e after tax p s is the price that the seller receives which is less
than p e and buyer pays a price which is higher than p e and the tax is split between the
two so p b minus p e p b minus p e is equal to p b minus p e is the amount paid by the
amount of tax paid by buyer plus p e minus p s this is the amount of tax paid by the
seller this is actually not paid by the seller but
this is a reduction in price that the seller now receives so its like the incidence of
tax has fallen on the seller also so the total amount that is equal to now t so that is equal
to t and so that is equal to p b minus p s and that is equal to t so t is now split up
between the two now coming back to our original question that
how much of the tax should the buyer pay and how much of the tax should the seller pay
now in this situation we can clearly see that when we have drawn a flat supply curve and
a steep demand curve we can see that the amount of tax paid by the buyer is much higher than
the amount of tax or the incidence of tax that falls on the seller
so here we can clearly see that this is the amount of uh this is the amount of tax paid
by buyer and this this is the small amount this is the amount of tax paid by seller this
is the tax paid by seller or its is a more correct way of saying it is the incidence
of tax that falls on the seller because the tax has been imposed the the seller ends up
receiving a smaller price than than what he was receiving earlier so it is like he has
uh split up the amount of tax with the buyer so uh so whether it is the tax has been imposed
or the seller or the buyer in both the cases uh we see in this situation that the buyer
ends up paying more major part of the tax and the seller the incidence or the burden
tax burden is less on the seller so this is what we see in the case where supply is more
elastic than demand now this is what we illustrated through this
is what we illustrated through diagram but what is the what is the intuition behind it
why does it happen this way so i am sure many of you have already figured that out or the
logic would be working in your brain already that uh supply is more flexible so when supply
is more elastic that means what when supply is more elastic that means that
supply is more flexible and so it is easier for suppliers to leave the market than consumers
so it is easier for suppliers to leave the market than consumers so whenever there is
uh tax in the market on any good whether it is on the seller or the buyer that means the
market is not very friendly to either of them because the price has been increased forcibly
by the government and there is a tax on the product
so so in such a situation the one of the buyer and the seller the party which is more rigid
or which is more inflexible he that party has to bear the major part of the burden of
the case so in this case demand is steeper which means the people probably probably this
is the kind of necessity necessary good or there are no substitutes or uh people are
uh there are no substitute of this product so people cannot change their habits or consumption
requirements so easily so even if the price increases of or the the market is not very
friendly still the buyer stick to the market so in that case obviously who the the party
which uh party which is more flexible that is the party which can leave the market which
can decide not to produce since its its not uh the the price has the cost has gone up
for the seller so the seller might just decide that i am going to produce less or i am going
to uh really not i am not interested in paying so much of tax so i am going to produce less
for unit of output i am going to pay less tax
so in that case uh the supplier is more flexible so he can manage to get away with a lower
by bearing a lower part of the tax and the party the buyer who has a very inelastic demand
curve and cannot change his consumption requirement so easily that party has to bear the major
part of the tax next we are going to show that when demand
is more elastic than supply sellers bear most of the tax burden so again its just a matter
of showing it uh graphically what happens or in the through diagram what happens when
uh demand is more elastic than supply but again i am sure that uh the logic has already
worked in your minds that uh what happens when demand is more elastic than supply so
lets just draw the diagram and see what happens .
so now we are discussing case 2 where demand is more elastic than supply so demand is more
elastic than supply that means we have a very flat demand curve and we have a steep supply
curve so so demand is more elastic than supply again you have a equilibrium price p e and
equilibrium quantity of q e now again a tax of amount t imposed and so
this is the almost the same amount of tax that we have been drawing so this is let this
be the tax that is tax t so this amount of tax is imposed and so immediately we draw
the amount of tax between the demand and the supply curve and we get the the after tax
prices so now along the demand curve the buyer is
going to pay a price of p b which is higher than the equilibrium price and the along the
supply curve the seller is going to receive a price of p s which is less than the equilibrium
price and this is the incidence of tax that is happening on the uh incidence of tax that
is the seller is bearing so this is now the tax creates a wedge which
is split up between the seller and the buyer and these are the prices that the price that
the seller gets and this is the price that the buyer pays and the difference is basically
the amount of the tax now here we can clearly see that the amount
of tax that the buyer is paying that is this amount this very small amount this is the
amount of tax the buyer is actually paying no matter if if the say say the tax the amount
of tax has been imposed on the buyer then what happens the demand curve basically shifts
down by this amount so the demand curve has made a huge shift
downwards but the tax that the buyer actually ends up paying is this very small amount this
is the part of the tax paid by buyer and the seller ends up foregoing this amount of price
per unit of the output so earlier he was receiving p e now he is receiving p s and this is the
amount which he is uh which is the amount he gets less than what he was getting in during
equilibrium so this is the amount that is part of the
tax shared by the shared by the seller so this is the part of the tax shared by the
seller and in this case we clearly see that since demand is more elastic than supply what
is happening is the amount of tax burden that the seller is bearing is now much more than
the amount of tax burden that the buyer has to bear and again the again the reason is
again the same now demand is more flexible that is buyers
have more choice and can shift away more easily so so basically demand is flat or it is a
very elastic demand curve means that uh demand is more flexible that is probably the buyers
have choices in the market and when they see it does not it is not too attractive to buy
this product in the market with all these taxes they will quickly shift their demand
to a probably a substitute good or probably they will stop consuming this good altogether
or reduce their consumption of this good because its not so much of necessity to them
so in such a situation and we can see that the amount by which the curve shifts in each
of the cases if you look at the earlier diagram also you will see that the amount by which
it shifts depends on how flat or steep it is so if the demand if this is the amount
of tax the demand curve has made a huge shift that means the demand is flexible and it has
made a huge shift on the other hand supply is steep and say if the tax had been on the
supplier . in that case what is what would have happened
in that case supply would have shifted this this to the left or to the upward and this
would have been the new supply curve this would have been the new supply curve and we
can clearly see that the shift in the supply curve is also very small which shows that
uh which is basically happening because the intuition is that supply is probably inflexible
at least in the short run or in the given circumstances supply does not adjust so easily
so the supplier is willing to bear major part of the tax than the buyers .
so lets uh discuss some examples lets look at some examples what happens in case of a
luxury tax what happens in case of a luxury tax often during the budget we hear that the
tax on luxury goods has been increased uh say say tax on uh branded high end products
or taxes on uh room room rents in hotels or say say taxes on luxury cars high end cars
uh the the tax has gone up and sometimes even it happens that the tax is on the uh buyer
we feel kind of happy that okay the rich are paying more taxes now and theyll be paying
theyll have to top up more money for every unit of luxury product that they consume but
does it happen that way what have we learnt from the exercises that
we did right now what kind of supply or demand curve does does the luxury product have now
a luxury look at looking at demand curve luxury product is not a necessary product and uh
sometimes luxury products have lot of lot of substitutes in the market also .
so if the tax goes up on the luxury product that basically means that uh
so luxury product is so in case of a luxury product first looking at demand first looking
at demand is it elastic or inelastic so luxury product is not a necessary product its not
that uh people really really need to consume it immediately even if the price has gone
up so people can move to other substitutes and so basically demand is highly elastic
so demand is highly elastic what about supply what about supply what about the elasticity
of supply of luxury goods now in most cases you can imagine if the luxury good is uh say
as i said if it is a high end five star hotel rooms or it is high end cars uh really luxurious
cars supply is going to be inelastic at least in the short run why
supply is inelastic at least in the short run because that most supplying these kinds
of products in in incur a lot of cost like say for example if there is a five star hotel
for the maintenance of the rooms the hotels the taxes that they pay for uh having the
the im not talking about the per unit tax but im saying that the the all the cost that
are incurred uh by the uh by the by the hotels they are quite high and they cannot be reduced
they are not so flexible in the short run later we we are going to talk about variable
cost and fixed cost and we are going to see that uh in these hotels the fixed costs are
very high so basically hotels or even high end cars the plants the manufacturing units
everything has been set so all of a sudden because the prices are
high the supplier cannot reduce the supply or cannot uh all of a sudden decide that i
am not going to uh produce any more cars or im going to cut down on the production of
cars because they already have created a enormous (capa) capacity or even if not enormous they
had created certain capacity uh with some uh with some plan about production in the
near future and all of a sudden he cannot just cut back on production
so basically supply is inelastic so supply is inelastic at least in the at least in the
short run so in such a situation this is going to happen this is going to happen demand is
more elastic than supply and part of the tax paid by the buyer is going to be very very
small and most part of the tax incidence is is going to be would have to be borne by the
supplier so is that a good policy or bad now uh since
we already said that the from our understanding of elasticity that we discussed in the earlier
classes now income elasticity of demand or price elasticity of demand of luxury goods
is very high its a very elastic demand so in that case the revenue of suppliers or sellers
is going to increase if they can reduce the prices if they cut uh if they if they reduce
cost there there will be enormous increase in output sold and the opposite is going to
happen if they try if they raise the prices so the government is basically discouraging
this sector if it is imposing ya if it is imposing taxes on this sectors consumption
so if it is discouraging this sector then what will happen is when the peoples income
grow or when the when they try to be more cost efficient or when they try to uh reduce
their cost i mean they will not have any incentive to reduce or they will not have much incentive
to uh grow this sector in that case the revenue from the entire sector is going to fall
so it at the end of the day it is not a very uh attractive proposition for the overall
growth of the economy because this is the sector the luxury sector uh again going as
per our understanding of elasticity that we have been discussing since the last classes
uh since elasticity of demand for luxury products is very high it makes sense to encourage this
sector to grow and be more efficiently and to reduce the prices cost and prices so that
their overall revenue grow grows in the sector so this was about luxury tax and demand is
more elastic than supply and suppliers bear most of the tax burden
on the other hand what happens when there is a tax on cigarettes when there is a tax
on cigarettes supply is more elastic than demand so supply is more elastic than demand
because cigarette is mostly addictive and to the consumers or to the smokers probably
they are not going to be able to change their habits habits at least in the short run
so uh and even unlikely to change their habits in the long run so supply is very uh demand
is very inelastic and on the other hand supply is more elastic than demand it is possible
for a cigarette company to just uh start producing less cigarettes or they can just some of if
they feel that its unattractive to be in this market they can quit the market so smokers
bear most of the tax burden in this case so these 2 examples show us uh what kind of
issues the policymaker needs to keep in mind when he is deciding who to impose the tax
on when i say who to it does not mean whether the buyer or the seller but on which sector
so because we have already seen that imposing a tax on the buyer or the seller does not
make any difference as per as incidence of tax is concerned so we are going to discuss
about uh efficiency of uh efficiency of a market equilibrium in the next class thank
you