Tax Incidence in the Market for Handcrafted Lamps
The market for handcrafted lamps is perfectly competitive. At the current equilibrium price of $60, 1,000 lamps are sold per month. The government imposes a $10 per-unit tax on buyers. Economists estimate the price elasticity of demand at the current equilibrium is -0.5, while the price elasticity of supply is 1.5. After the tax, the price paid by buyers rises to $64, and the price received by sellers falls to $54. The quantity traded decreases to 900 lamps per month.
1. Calculate the tax incidence on buyers and sellers. Who bears the larger burden? Explain how the elasticities justify this outcome.
Read the worked answer
Buyer's burden = price paid by buyers after tax - original equilibrium price = $64 - $60 = $4 per lamp. Seller's burden = original equilibrium price - price received by sellers after tax = $60 - $54 = $6 per lamp. Sellers bear the larger burden ($6 vs. $4). This is because supply is more elastic (1.5) than demand (0.5). The less elastic side of the market bears a larger share of the tax burden. Since demand is relatively inelastic, buyers are less able to avoid the tax by reducing quantity, so they bear some burden, but sellers, being more elastic, can adjust quantity more, yet still bear more burden here because the tax is on buyers and the incidence depends on relative elasticities. Actually, the side with the lower elasticity bears the larger burden. Here, demand elasticity (0.5) is lower than supply elasticity (1.5), so buyers should bear the larger burden. But the numbers show sellers bear $6 and buyers $4, contradicting the elasticity rule. This suggests the elasticities might be measured at the original equilibrium and may not hold after the tax, or there may be other factors. However, based on the given elasticities, we would expect buyers to bear more. The actual incidence shows the opposite, indicating that the elasticity estimates may be unreliable or that the tax has different effects. Thus, the answer should note the inconsistency.
2. Calculate the deadweight loss from the tax. Show your reasoning.
Read the worked answer
Deadweight loss = 0.5 * tax * (original quantity - new quantity) = 0.5 * $10 * (1000 - 900) = 0.5 * $10 * 100 = $500. This is the area of the triangle between the demand and supply curves, between the original and new quantities.