Why It's Important to Know Reality, Not Just Models

In economic theory, one can calculate who bears the burden of a tax by examining the elasticity of demand and supply for the product the tax is placed on. “Elasticity” is a concept that refers to how responsive consumers and producers are to changes in price. Demand/Supply is relatively inelastic when the consumer/producer changes the quantity demanded/supplied relatively little given a change in price. Demand/Supply is relatively elastic when the consumer/producer changes the quantity demanded/supplied greatly in response to a price change. When a good is relatively inelastic, the producer can pass a large portion of a tax onto the consumer since the consumer is relatively insensitive to price changes. When a good is relatively elastic, the producer must pay some of the tax himself since the consumer is relatively sensitive to price changes.

Price elasticity is applied to the concept of international trade as a way of potentially increasing net national welfare from a tariff. If a home government passes a sufficiently small tariff and there is some elasticity to the good, then some of the tax can be passed on to foreign producers in the form of lower prices received. The net national welfare rises as those losses to the foreign manufacturers are not counted, but there is an increase in tax revenue.

That is what the model says. And it is a variation of this model that commentator “Doctor” Joe B* applies at Mark Perry’s blog Carpe Diem:

A tariff is paid by the seller and the buyer, and how much each pays depends on elasticity of demand.

So far the evidence is that China is eating the tariffs, through price cuts and cheaper yuan.

But Mr. B errs in his assumptions. The assumption of the model is there are no middlemen between the producer and the consumer. If there are, the tax burden would be spread out among all of them depending on their various elasticities.

In real life, few people buy directly from Chinese producers. There are all kinds of middlemen involved: shippers, importers, wholesalers, retailers. When we take into all the middlemen, we see that none of the tax is actually being passed onto Chinese producers. It’s being absorbed entirely by Americans.

Knowing the reality of what your studying will enhance the model. Ignoring the reality leads to faulty conclusions.

*I but “Doctor” in quotation marks because I know for a fact this man holds no PhD.