Question

Consider a firm in a market with rising production costs. Using a supply-demand graph and briefly explaining in words, explain why this firm would be less hurt if demand is inelastic than if demand is elastic.

Answer 1

The rising production cost imply that the firm has an upward sloping supply curve.

The first panel in the graph shows an inelastic demand curve such that the slope of the demand curve is such that it is steeper and almost vertical. What we see in the first panel is that any external effect such as a tax that tend to shift the supply curve upward, will have a higher impact on the consumer side and not on producer side. This is because the inelastic demand curve imply that whatever comes, the demand will not change too much so when the supply curve shifts upward and the price of the good increase more for the consumers than it falls for the firm. This imply that the most part of the tax is bore by the consumers who have inelastic demand. The portion of tax bore by the firm = (pc-p) while the price fall only by (P-Ps). From the figure it is obvious that(Pc-P)> (P-Ps). Thus firm is hurt less.

Inthe second panel we have an elastic or an almost horizontal demand curve. This imply that as the price change the change in quantity demanded is maximum. Thus when due to an effect of tax, the supply curve shifts upwards, the price changes for suppliers more than consumers implying that the suppliers bear most of the burden of tax. Here (P-Ps)> (Pc-P), implying the firm is hurt more by a tax when the demand is more elastic.