What determines how the burden of the tax is shared between buyers and sellers?

• wedge shortcut: the most important effect of a tax is to drive a tax wedge between the price paid by buyers and the price received by sellers

  • Instead of shifting curves, start with a tax of $1 and “push” the vertical “tax wedge” into the diagram until the top of the wedge just touches the supply curve

  • The top of the wedge gives the price paid by the buyers, and the bottom of the wedge gives the price received by sellers, and the quantity at which the wedge “sticks” is the number on the x-axis

Using the wedge shortcut, shows whether buyers or sellers pay a tax is determined by relative elasticities of demand and supply

• Elasticity of demand measures how responsive the quantity demanded is to a change in price and the elasticity of supply measures how responsive quantity supplied is to a change in price

• When demand is more elastic than supply, demanders pay less of the tax than sellers

• When supply is more elastic than demand, suppliers pay less of the tax than buyers

An elastic demand curve means that demanders have a lot of substitutes and you can’t tax someone that has a good substitute because they’ll just buy the substitute

• When demand is elastic, sellers will just end up paying most of the tax

An elastic supply curve means that the workers and capital in the industry can easily find work in another industry

• If you try to tax an industry with an elastic supply curve, the industry inputs will escape to other industries

Elasticity = escape

• Whether buyers or sellers pay more depends on who can escape the best (which curve is more elastic)