Explain how the concept of price elasticity can be useful to the government in its determination of taxation policy.  

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detroitted eNotes educator| Certified Educator

The question asks how the concept of price elasticity can be useful to the government in its determination of taxation policy. First, let’s review the concept of price elasticity. It is defined as the percent change in quantity demanded or supplied divided by the percent change in price which caused the change in quantity. Note that it applies to both the supply and demand curves. Finally, it is related to the slope of the curve in question, but it is not identical.

 

Fundamentally, elasticity measures the sensitivity of quantity to price changes. Taxes have the effect of adding an additional cost to an item on top of what the supplying firm charges. That is, they have the effect of changing the price of the item or service, ceteris paribus. Therefore, if demand is highly elastic (relatively flat demand curve), small tax increases will cause large declines in quantity demanded. This in turn may cause suppliers to lower price to compensate for this effect, that is to attempt to increase the quantity demanded back toward the previous equilibrium. In essence, the suppliers have then absorbed some of the tax increase, because the overall price paid by the consumer does not go up by the full amount of the tax increase. Conversely, if demand is highly inelastic, the quantity demanded will change little due to the tax increase and the consumer’s price will go up by almost the full amount of that increase.

These examples illustrate that the concept of price elasticity will define how the burden of taxes is spread between consumers and suppliers. Additionally, this analysis can be used to estimate where the new equilibrium quantity will be. This in turn will affect both the total value of goods produced (with effects on employment, etc.) and the amount of tax revenue collected. For example, it does little good to dramatically increase tax rates on something if the result is to crush the market for that good, thus eliminating tax revenues from it.