Elastic or Inelastic Demand - Who Pays How Much of the Tax? [Virtual Economy]

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Theories about how VAT affects demand when it is elastic and inelastic.

VAT Theories - Elastic or Inelastic Demand - Who pays how much?

The burden of an indirect tax is very important, and will vary according to the elasticity of demand for the product it is imposed on. If the demand for the good is very elastic (very responsive to price changes), then the price will not increase very much when the tax is imposed, but the quantity will fall significantly. The diagram below shows this:

Elastic demand

In this case, we can see that the price has only risen a little compared with the amount of the tax. The main burden of the tax has therefore fallen on the firm. It has to pay the full amount of the tax but is only compensated by a relatively small increase in price. The consumer has only suffered a fairly small price increase from P1 to P2. It is for this reason that indirect taxes are generally not levied on goods with elastic demand, as the tax revenue would be relatively small.

In the case of goods with inelastic demand, the picture is very different. Because consumers are much less sensitive to price changes of these goods, the bulk of the tax can be passed on by the firm, as the diagram below shows:

Inelastic demand

Here the quantity has only fallen very slightly and the price has risen almost by the full amount of the tax. In fact, if the demand for the good had been perfectly inelastic, then all the tax could have been passed on as a price increase. So when the demand for a product is inelastic, the burden of the tax will fall on the consumer.

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