We used supply and demand to explain the effects of taxes and subsidies. Using the wedge shortcut, you should be able to show that taxes decrease the quantity traded, subsidies increase the quantity traded, and both taxes and subsidies create a deadweight loss. Surprisingly, we showed that the burden of a tax and the benefit of a subsidy do not depend on who sends or receives the government check. Instead, who bears the burden of a tax and who receives the benefit of a subsidy depend on the relative elasticities of supply and demand. In particular, if you remember that elasticity = escape, then you will know that the side of the market (buyers or sellers) with the more elastic curve will escape more of the tax.

We also showed that elasticities of demand and supply determine the deadweight loss of a tax. The more elastic either the demand or the supply curve is, the more a tax deters trade, and the more trades that are deterred, the greater the deadweight loss (for a given amount of tax revenue). As a result, it is better to tax goods with inelastic demands. Equal-revenue taxes on broad-based goods (for example, food) tend to have lower deadweight loss than taxes on narrowly based goods (for example, apples) because broad-based goods have more inelastic demands.

The tools of supply and demand are very powerful. In this chapter, we have shown how we can use these tools to understand taxes and subsidies