The federal government decides to require that automobile...

The federal government decides to require that automobile manufacturers install new anti-pollution equipment that costs $2,000 per car. Under what conditions can carmakers pass almost all of this cost along to car buyers? Under what conditions can carmakers pass very little of this cost along to car buyers?

Key Concepts

Elasticity of Demand

Elasticity of demand measures how responsive consumers are to changes in price. When demand is inelastic, consumers are less sensitive to price increases, meaning that most or all of a cost increase, such as the additional equipment cost, can be passed on to them in the form of higher prices. Conversely, if demand is elastic, a price increase can significantly reduce the quantity demanded, forcing manufacturers to absorb more of the cost.

Elasticity of Supply

Elasticity of supply gauges how responsive sellers are to changes in price. If supply is elastic, producers can easily adjust production levels in response to price changes, which in turn shifts more of the cost burden onto consumers when demand is inelastic. However, if supply is inelastic, producers cannot adjust production levels quickly, which may limit the extent of cost pass-through to consumers.

Tax Incidence

Tax incidence refers to the way the burden of a tax is shared between buyers and sellers in the market. It depends on the relative elasticities of supply and demand, not on who is legally responsible for paying the tax. If one side is more inelastic, that side will bear a larger share of the tax burden because their quantity demanded or supplied changes less in response to price changes.

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