1.1.14 price elasticity

Price elasticity describes the impact of a decrease/increase in the prices of the amount. That's nothing really sophisticated, although we find a lot of mathematical infotainment related to this issue. Every merchant makes this kind of calculation. If the unit costs don't depend on the amount, he will try to maximise the turnover. (If they change, the calculation is a little bit more complicated, but the basic idea is the same.)

He can sell more at a lower price or less at a higher price. He will try to find the combination where the turnover is maximal. He can sell 12 units for 3 dollars or 10 units for 4 dollars.

The elasticity, the impact of a change in prices on the amount, is critical for some taxes. If the elasticity is very low, little impact of a change in prices on the amount, or zero, it is, for instance, the consumer who will pay the value added tax or similar taxes.

Cigarette addicts, for instance, won't reduce the quantity they smoke if there is an extra tax on cigarettes. They will perhaps save money on food in order to buy cigarettes. In this case, a tax imposed by the government will be paid by the smokers. The merchant will add the tax on the price, collect the money and forward it to the tax office. That's one extreme case.

The other extreme is that a little increase in the price would lead to complete renunciation of the product. For this extreme case, it 's hard to find examples. That can only happen if there is a very similar if not identical substitute. When the EU imposed custom duties on American bananas 20 years ago  in order to protect "European bananas", actually, bananas from the old European colonies, the American bananas disappeared from the market from one day to another.

Between these two extreme positions, there is no impact on the amount at all and a complete renunciation of the product there are a wide range of situations. In general, there is an effect on the amount and the tax is paid by both the merchant and the consumer.

Adam Smith makes some special assumptions, which can be interpreted as special cases of the concept of elasticity. In this case, both parties, the demand side and the supply side have no choice. The first one have to buy the product at any price; this can be the case for food in times of starvation, and the second, the merchants, earns just enough to survive so that they have to add the tax on the price by 100 percent or give up. In the terms of elasticity, we have total inelasticity on the demand side, and people buy the same amount at any price, and total elasticity on the supply side is zero if the supplier has more costs. This case is obviously not very typical.

Adam Smith assumes that the retailer earns so little money that it is just enough for survival. If the government imposes a tax on his turnarounds, he can't bear it himself and due to the assumption that all retailers are in the same condition, they must and can increase the prices.

That's a typical problem of the classic theory because the classic theory assumes the same cost structure. We will see that again in the chapter about David Ricardo. Only in one sector, food production, the different suppliers get a rent, because land is scarce and can't move. Capital and labour are assumed to be perfectly flexible. The same error we find in the work of Léon Walras.

Actually, only Alfred Marshall saw that producer surplus exists everywhere. Every time we have differences in the performance of the different companies; we have producer surplus. (Consumer surplus is the same principle as the Ricardian rent.)

The marginal revolution of the neoclassic theory never happened, because the idea of marginality is already included in the concept of the natural price / market price of Adam Smith. What is actually new, at least in theory of Alfred Marshall, is the idea of the producer surplus. The idea exists already in the Ricardian theory, but is restricted to the land.

Adam Smith assumes, under very special conditions, that retailers can (and must) charge the consumers with any indirect taxes. There is no explicit reason given for this assumptions. Only from a half-sentence, we can deduce whom he got to this conclusion.

In some countries, extraordinary taxes are imposed upon the profits of stock; sometimes when employed in particular branches of trade, and sometimes when employed in agriculture. Of the former kind, are in England, the tax upon hawkers and pedlars, that upon hackney-coaches and chairs, and that which the keepers of ale-houses pay for a licence to retail ale and spiritous liquors. During the late war, another tax of the same kind was proposed upon shops. The war having been undertaken, it was said, in defence of the trade of the country, the merchants, who were to profit by it, ought to contribute towards the support of it. A tax, however, upon the profits of stock employed in any particular branch of trade, can never fall finally upon the dealers (who must in all ordinary cases have their reasonable profit, and, where the competition is free, can seldom have more than that profit), but always upon the consumers, who must be obliged to pay in the price of the goods the tax which the dealer advances; and generally with some overcharge. A tax of this kind, when it is proportioned to the trade of the dealer, is finally paid by the consumer, and occasions no oppression to the dealer. When it is not so proportioned, but is the same upon all dealers, though in this case, too, it is finally paid by the consumer, yet it favours the great, and occasions some oppression to the small dealer. The tax of five shillings a-week upon every hackney coach, and that of ten shillings a-year upon every hackney chair, so far as it is advanced by the different keepers of such coaches and chairs, is exactly enough proportioned to the extent of their respective dealings. It neither favours the great, nor oppresses the smaller dealer. The tax of twenty shillings a-year for a licence to sell ale; of forty shillings for a licence to sell spiritous liquors; and of forty shillings more for a licence to sell wine, being the same upon all retailers, must necessarily give some advantage to the great, and occasion some oppression to the small dealers.

Book V, Chapter II

The central sentence is "... who must in all ordinary cases have their reasonable profit, and, where the competition is free, can seldom have more than that profit...". If this is the case and if ALL the retailers just earn what they need to survive, the taxes will be passed to the consumer.

However, the situation is more complicated and to untangle the situation we need the more sophisticated theory of Alfred Marshall. Adam Smith talks of profits and assumes that this profits are the same in the whole economy and are just high enough to survive. Under this special assumptions his assertions are true.

The problem is, that these assumptions are not true. The cost structure of the companies are different and their earnings are therefore different and therefore a tax on PROFITS can not be passed to the consumer.

This is a crucial point, that should be understood. If a company earns 500 dollars and another company 1000 and they pay a tax on profits of let's say 10 percent, then the first company would pass 50 dollar to the consumer, the second company 100. That's not possible, if these companies compete with each other, because then the second company would be obliged to raise the prices more than the first one, something impossible if there is competition.

In other words, a distinction is to be made between taxes to pay independently from the profit and taxes that depends on the profit.

For taxes depending on the profit cannot be passed to the consumer. The price is determined by the less efficient supplier who is still, given a certain demand, able to enter the market. (If the demand increases, more inefficient suppliers can enter.)

This "marginal supplier" makes, simpifying a bit, no profit at all and therefore he doesn't pay a tax on profit and the price doesn't increase. If the price doesn't increase, the other companies can't raise the prices and have to pay the taxes themselves.

The situation is different in the case of a tax on the turnover. In this case, even the marginal supplier has to pay the tax, the price raises and therefore the other companies can raise the price as well.

In this case, the situation is similar as a rise in costs. If for instance the price for a raw material increases, the marginal supplier has to raise the prices and therefore the other companies can raise the prices as well. (Actually, the topic is a little bit more complicated because even in the case that prices can rise, there will be an impact on the amount. If the marginal supplier raises the price, some marginal consumer will reduce the amount they buy and consume.)

We see that concerning this point the concepts of Alfred Marshall, as we will see later on, are really helpful. The concept of consumer surplus and producer surplus is not clearly understood in classic theory. That is the difference between classic and neoclassic theory and NOT the "marginal revolution", because the concept of marginality is already included in the concept of natural price/market price.

The big difference is the consumer/producer surplus, although this is not a neoclassic concept. Léon Walras and Vilfredo Pareto share the error of classical thinking that the cost structure is the same everywhere. The term neoclassic theory doesn't make sense, see neoclassic theroy. If the terms used are so wrong that it takes more time to correct the errors than to explain what they actually mean, it is time to forget them.

Adam Smith mixes a tax on profits with taxes that are actually costs. Concerning an increase of the licence price he is right. If the same amount of money is paid for a license independently from the turn over, the companies with little turn over are disadvanted. Proportionally the costs are higher and if they have to compete with companies with a bigger turnover they can't pass these costs to the consumer.

This kind of errors is typical for economic thinking. Some basic errors leads to a lot of other errors. Adam Smith, as well as David Ricardo and some neoclassical authors like Léon Walras, assume that the (monetary) marginal product of productive factor is the same in any use. Actually, a market economy only tends to equalise that (monetary) marginal product, but this equalisation is never completely achieved. Otherwise we wouldn't have a producer surplus.

This wrong conception leads to the obviously erroneous idea that it doesn't make any difference whether the tax is imposed on the profit or imposed on something that doesn't depend on the profit.

David Ricardo is on the right way, but the obsession that the (monetary) marginal product of capital and labour is the same everywhere, impedes him to get to right conclusions. He realised that there is a producer surplus in the agricultural sector, that’s what he calls a rent, but didn't realise, that this is true for capital and labour as well. Therefore, he committed similar errors than Adam Smith. We will return to the topic when talking about David Ricardo.

At the end, Adam Smith discusses elasticity without using the term. A change in price has an impact on the amount and this impact can be so strong, that it outweighs the price effect.

High taxes, sometimes by diminishing the consumption of the taxed commodities, and sometimes by encouraging smuggling frequently afford a smaller revenue to government than what might be drawn from more moderate taxes. When the diminution of revenue is the effect of the diminution of consumption, there can be but one remedy, and that is the lowering of the tax.

Book V, Chapter II

The final effect of add value tax is difficult to evaluate. If the demand is completely elastic, a small increase in price lead to a reduction of the amount to zero, to take an extreme example, the companies has to pay the add value tax. This reduces its profits and therefore the tax revenue from the taxes on profit will decrease. If the tax on profit is fifty percent, the revenue from the add value taxed will only increase by 50 percent in this extreme case.

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Taxes on profits can not be passed to the consumer

Concerning the taxes on the turnover or taxes on productive factors it depends on the
elasticity of the demand

Adam Smith discusses a special case. If the cost structure is the same everywhere and profit is on the level of vital minimal, even taxes on the value added can be passed to the consumer

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