In most cases, the fact that one of the market curves is perfectly inelastic is not sufficient to conclude that a per-unit tax in that market is efficient. A tax on land rents is an exception. Can you explain why?

Question

What will be an ideal response?

Answer 1

In goods markets, supply curves are never perfectly inelastic. In the short run, they are formed by the upward sloping marginal cost curves of firms, and in the long run they are determined by entry and exit (and thus tend to be fairly or completely elastic). The demand curve in goods markets arises from the consumer model where substitution and income effects are both included, and the inefficiency arises from the substitution effect. Thus, we would need a perfectly inelastic compensated demand curve for there to be no inefficiency on the consumer side.


In labor and capital markets, the demand curve arises from firms -- and must be downward sloping because of diminishing marginal product in the short run and greater elasticity in the long run. The supply curves in those markets, on the other hand, arise from the consumer model where once again substitution and wealth effects are both included in market curves but only substitution effects are relevant for deadweight losses.


The case of a land market is unique because the inelastic supply curve does not arise from the consumer model and therefore does not conflate income and substitution effects. When the tax is then passed entirely to land owners, there is no impact on consumers and thus no deadweight loss on the consumer side. And since there are no substitution effects on the supply side, there is no deadweight loss.