Taxes and perfectly elastic demand | Microeconomics | Khan Academy

Summary

This video explains the effects of a tax on a product with highly elastic demand, using the example of flags made in China. The narrator highlights that even a small price increase will drastically reduce the quantity demanded as buyers can easily switch to substitutes. The introduction of a $5 tax raises the supply curve, reducing the quantity sold from 25,000 to 18,000 flags. The tax burden falls primarily on producers due to the almost perfectly elastic demand, leading to deadweight loss and diminished producer surplus, while consumers experience no surplus loss.

Takeaways

• 📉 The product in question is a flag made in China, with an equilibrium price of $70 and a quantity of 25,000 units demanded per year.
• 🔄 The demand for this product is highly elastic, meaning small changes in price lead to large changes in the quantity demanded.
• 🌍 If the price increases slightly, consumers will substitute with similar products made in Taiwan, Mexico, or the U.S., causing demand for the Chinese-made flag to drop sharply.
• 💸 A $5 tax per flag is proposed, shifting the supply curve upward and increasing the price seen by consumers.
• ⚖️ Despite the tax, the equilibrium price remains around $70, but the quantity demanded decreases significantly to 18,000 flags per year.
• 📊 The tax revenue generated is $5 per flag multiplied by 18,000 flags, representing the government's earnings from the tax.
• 💼 The producer bears the bulk of the tax burden due to the highly elastic demand, as most of the tax is taken from the producer's surplus.
• 📉 The tax causes a deadweight loss, which is the lost producer surplus not recovered by either the government or consumers.
• 🔍 With almost perfectly elastic demand, there's little to no consumer surplus, meaning consumers are not benefiting from paying less than their maximum willingness to pay.
• 🧮 In this scenario, the entirety of the tax and the loss in surplus is absorbed by the producer, while the consumer remains unaffected in terms of surplus.

Q & A

What happens when the price of the Chinese-made flags increases slightly?

If the price of the Chinese-made flags increases even slightly, consumers will switch to substitutes, such as flags made in Taiwan, Mexico, or the U.S., as they are indistinguishable from a distance. This results in a significant drop in the quantity demanded.

How does the demand curve for Chinese-made flags behave in the scenario described?

The demand curve for Chinese-made flags is described as almost perfectly elastic. A small change in price leads to a large change in the quantity demanded.

What is the initial equilibrium price and quantity for the Chinese-made flags?

The initial equilibrium price is $70 per flag, and the quantity demanded is 25,000 flags per year.

What effect does a tax on Chinese-made flags have on the supply curve?

A tax on Chinese-made flags shifts the supply curve upwards by the amount of the tax. For example, a $5 tax per flag shifts the supply curve upward by $5 at every price point.

How does the tax affect the equilibrium quantity and price?

After the tax is applied, the equilibrium quantity decreases from 25,000 to approximately 18,000 flags per year. The equilibrium price remains around $70, as the demand is highly elastic.

Who bears the burden of the tax in this scenario?

In this scenario with almost perfectly elastic demand, the producer bears the burden of the tax. The tax reduces the producer surplus, as there is little to no consumer surplus in this case.

How is tax revenue calculated in this example?

The tax revenue is calculated by multiplying the quantity of flags sold (18,000) by the tax amount ($5 per flag), resulting in $90,000 in tax revenue.

What is deadweight loss in this context, and how is it represented?

Deadweight loss refers to the loss of economic efficiency when the equilibrium quantity is reduced due to the tax. It is represented as the area between the original supply curve and the supply plus tax curve.

What happens to consumer surplus in the case of perfectly elastic demand?

In the case of perfectly elastic demand, there is no consumer surplus because the marginal benefit to the consumer is always equal to the price they pay. Thus, no surplus exists to be reduced by the tax.

Why does the producer bear the brunt of the tax instead of the consumer?

Since the demand is almost perfectly elastic, any increase in price causes a significant reduction in the quantity demanded, meaning consumers can easily switch to substitutes. As a result, the producer cannot pass the tax onto the consumer and must absorb it, leading to a reduction in producer surplus.

Outlines

00:00

📉 Understanding Elastic Demand and Its Effects on Pricing

This paragraph discusses the impact of a tax on a product when the demand is highly elastic. Using the example of flags made in China, it explains how even a small price increase can lead to a sharp drop in demand as consumers will quickly switch to substitutes like flags made in Taiwan, Mexico, or the U.S. The discussion illustrates how the elasticity of demand means that a slight price hike will cause demand to plummet, while a small price cut would significantly increase sales. The speaker emphasizes that in this case, the demand is almost perfectly elastic, meaning a minor change in price results in a significant shift in the quantity demanded. The scenario also sets the stage for exploring the impact of a $5 tax per flag, showing how this tax affects the supply curve, prices, and quantities sold.

05:00

🏷️ Tax Impact and Deadweight Loss on Producer Surplus

The second paragraph explains how the imposed $5 tax impacts the producer's surplus. Since the demand is almost perfectly elastic, the entire tax burden falls on the producer, reducing their surplus. The tax reduces the quantity of flags sold, and the resulting tax revenue is represented by the area between the new supply curve and the old supply curve. This shift also creates a deadweight loss, as a portion of the producer surplus is lost. The paragraph concludes by emphasizing that when demand is perfectly elastic, the producer bears the full tax burden, with no consumer surplus to absorb any of it.

Keywords

💡Elasticity of Demand

Elasticity of demand measures how much the quantity demanded of a product changes in response to a change in its price. In this video, it is noted that the demand for flags is highly elastic, meaning that even a small change in price can lead to a significant change in the quantity demanded. This elasticity impacts how consumers react to a tax imposed on Chinese-made flags.

💡Substitute Goods

Substitute goods are products that consumers can use in place of one another. The video discusses how American flags made in Taiwan or Mexico are substitutes for those made in China. Due to the high elasticity of demand, if the price of Chinese-made flags rises slightly, consumers may switch to these substitutes, as they are perceived to be nearly identical from a distance.

💡Equilibrium Price

The equilibrium price is the price at which the quantity of goods demanded by consumers equals the quantity supplied by producers. Here, the equilibrium price for the flags is about seventy dollars, where demand and supply intersect. The video examines how a tax affects this price point and shifts the market dynamics.

💡Tax

A tax is a financial charge imposed by the government on goods, services, or transactions. In this case, a $5 tax is imposed on flags imported from China. The video analyzes how this tax shifts the supply curve and ultimately impacts both the quantity of flags sold and the burden borne by producers.

💡Producer Surplus

Producer surplus is the difference between what producers are willing to accept for a good and what they actually receive. In the video, it is shown that the tax primarily impacts the producer surplus because the demand is highly elastic, meaning producers must absorb most of the tax burden without raising prices much.

💡Consumer Surplus

Consumer surplus is the difference between what consumers are willing to pay for a good and what they actually pay. In a perfectly elastic demand scenario, such as the one described, there is virtually no consumer surplus, as consumers will only buy the flag at the market price and will turn to substitutes if prices increase.

💡Deadweight Loss

Deadweight loss represents the lost economic efficiency when the equilibrium outcome is not achieved due to market distortions like taxes. The video describes how the tax on Chinese flags results in deadweight loss, which is represented by a reduction in producer surplus and the overall decrease in market activity.

💡Supply Curve

The supply curve is a graph showing the relationship between the price of a good and the quantity supplied. The video details how the tax shifts the supply curve upward by five dollars per flag, representing the additional cost imposed by the tax. This shift affects the equilibrium quantity and overall market supply.

💡Perfectly Elastic Demand

Perfectly elastic demand implies that any slight change in price leads to an infinite change in quantity demanded. In this context, the demand curve for flags is almost perfectly elastic, which means consumers will not tolerate any price increase and will switch to substitutes immediately if the price goes up.

💡Tax Revenue

Tax revenue is the income that the government generates from taxing goods or services. Here, it is calculated as the tax rate multiplied by the quantity sold after the tax is imposed. The video calculates the tax revenue generated from the $5 tax on flags and highlights how this revenue primarily comes at the expense of producer surplus.

Highlights

The demand for the product (a flag made in China) is highly elastic, meaning small changes in price cause large changes in the quantity demanded.

At the equilibrium price of $70 per flag, 25,000 flags are demanded annually.

If the price rises even slightly above $70, consumers will switch to substitutes like flags made in Taiwan, Mexico, or the US.

If the price decreases slightly, consumers will opt for Chinese flags over substitutes, increasing demand significantly.

The demand curve is almost perfectly elastic, meaning it's very sensitive to price changes.

A tax of $5 per flag is imposed, shifting the supply curve upward by $5, which changes the equilibrium.

The new equilibrium price remains around $70, but the equilibrium quantity falls to 18,000 flags per year.

Tax revenue is calculated as the $5 tax multiplied by the 18,000 flags sold, resulting in $90,000 in tax revenue.

The tax burden falls entirely on the producer, reducing the producer surplus significantly.

The original producer surplus included the area under the supply curve up to the equilibrium price, but this is reduced due to the tax.

Deadweight loss occurs as a result of the tax, representing inefficiency in the market.

In a perfectly elastic demand scenario, the consumer surplus is effectively zero since the price paid equals the marginal benefit for each unit.

The producer bears the entire tax burden, with no consumer surplus available to reduce.

In a perfectly elastic demand curve, even a small tax leads to a significant reduction in quantity and producer surplus.

The overall impact of the tax is a reduction in market efficiency, as indicated by the deadweight loss and the drop in quantity sold.

Transcripts

Let's think about how a tax on a product might affect it,

if the demand for it is very, very, very elastic.

So what I've done here -- We're going to think about flags --

the market for a certain type of flag that's made in China.

And to think about this flag -- think about it this way.

If the price -- the price right now -- the equilibrium price between

where the supply and the demand intersect --

the supply curve and the demand curve intersect --

is right about seventy dollars per flag.

So this is a pretty nice flag. It's right at seventy dollars per flag.

And the quantity demanded, in thousands per year,

it looks like it's about twenty five thousand

flags are demanded per year.

Now if at the price were to go slightly above

that equilibrium price,what's going to happen?

Well, if the price goes slightly above that

equilibrium price, people are going to say,

"Well, I can go by the American flags made in Taiwan,

or even the ones made in America, or made in Mexico,

or made some place else. [Because...]

"People won't be able to tell the difference from a distance."

So I'm going to buy one of the substitutes --

[because] especially the ones from Taiwan or Mexico

or wherever else. are identical to the ones made in China.

So if the price for slightly -- even slightly higher,

the quantity demanded would be much, much, much lower.

And if the price were even a little bit lower,

then people say, "I'm not going to buy the Mexican flag--

or the Taiwanese [or] American flags.

I'm going to buy the ones that were made in China."

And then the quantity demanded would be much larger.

And so what you have here is a very large,

a high elasticity of demand.

So this right over here, this is almost perfectly elastic.

If it was perfectly elastic, it would be completely horizontal.

So this is almost almost almost perfectly --

perfectly elastic -- elastic demand.

A very small change in price leads to a huge change in quantity.

In particular a very small percentage change in price

leads to a huge percent change in quantity.

So let's say that -- that some government

official decides, "You know what? [I] don't like the

idea of American flags being made in China."

So they decide to tax American flags made in China.

So what they do is that they place a tax, they place a tax --

And once again I'll do a fixed dollar tax.

It could be a percentage and if a percentage then it'll change the sup -- the supply

plus tax curve It'll be -- the shift will will be a percentage change

instead of a fixed change.

But the fixed change is a little bit easier to draw,

so I'll do that.

So let's say that there is a tax --

Let me do that in a different color Let's say that there's a tax placed of ten dollars --

ten dollars per flag.

Ten dollars, actually -- Let's do an even a smaller amount.

Let's say that there is a tax placed of of one dollar per flag -- one dollar per flag.

I'll make it a little bit larger. Let's say it's five dollars per flag --

five dollars per flag.

So now what is the supply plus tax curve? So the supplier / just to make the flags in

China and ship them to United States and get the

story here even to get that first flag done

even if is that in the most efficient way possible

looks do you need at least looks like around fifty to fifty three dollars now

Now they're going now they're still going to need that

plus there's going to be a five dollar tax

on it So supply plus tax is going to be that plus

five dollars is going to be right around there

Over here, you add five dollars.

So at any given point, we're gonna add fivedollars to essentially what the consumer would have to see.

\\So you would have a curve that looks something

like this you would have a curve that looks something

like this you would have a curve that looks something

like this. That dotted line right over there is our supply

is our supply plus tax.

This right over here was just our supply --was just our supply.

So you're essentially -- So let's think about what happens here.

Your equilibrium price was at seventy before. Now our equilibrium price is still --

Our equilibrium price is still pretty much at seventy.

But our equilibrium quantity has gone down dramatically.

Our equilibrium quantity has gone down to --

our equilibrium quantity has gone down to --

I don't know. It looks like about eighteen thousand.

Eighteen thousand flags per year.

So who bore -- who bore the bulk of this right over here?

So let's think about the tax revenue So the tax revenue in this situation is going

to be eighteen thousand times the five dollars.

So this is the five dollars right over here. That is five dollars -- and then times eighteen

thousand -- times eighteen thousand.

So this right over here is the tax revenue. That right over there is a tax revenue.

Actually, let me draw a little bit more carefully so the tax revenue is

This is going to be between this line right over here and five dollars.

So just like that. So that's all the tax revenue.

And notice. It all came out of the producer surplus.

The original producer surplus -- the original producer surplus was --

Especially if we assume perfect elasticity --

The original producer surplus was this green rectangle plus this and plus this.

Now this is going to be -- This little area right over here is going

to be dead weight loss -- dead-weight loss.

And all of that came from the producer's surplus.

And then the all the tax revenue, also -- If you especially if you assume this top-line

was horizontal -- also came out of the producer surplus.

So in this situation where you had almost where you

We could say, if if you do have perfect elasticity if you have perfect elasticity of demand for

the product, The person who's going to bear the the brunt

of the tax -- so -- is going to be the producer.

The producer surplus is going to be eaten into from the tax.

Bears -- bears the Actually that's not -- that's not

(I'm not talking about the animal, "bears.") The producer, --

You know -- I'm not -- well -- The producer gets the burden the producer

The producer gets the burden in that situation.

And this is an interesting thing to think about.

Because when you have almost perfectly elastic demand --

so a -- almost -- or if you said perfectly elastic demand --

a flat -- a flat demand curve right over here --

there's -- there's actually no consumer surplus,

because the marginal benefit, even the incremental marginal or --

(I'm -- I'm being redundant with the words incremental and marginal.)

But the marginal benefit at any point for the consumer for -- that -- for that next

unit is equal to the price they're paying, when you have --

There's no -- There's -- Especially if the the especially if the demand

curve is perfectly elastic -- and it's perfectly horizontal --

There is no area between the demand curve and the price paid.

So there's actually -- There's isn't any -- even any consumer surplus

to take any -- to take any of the -- to take -- to eat into.

It all gets eaten out of the out of the producer surplus.