Elasticity Elasticity 10 10 2013 Measure of the responsiveness of Quantity to a change in Price o Price elasticity of demand o Price elasticity of supply o Cross price elasticity of demand Income elasticity of demand is a measure of the responsiveness of Quantity to a change in income Price Elasticity of Demand Law of demand states that as the price of an item increases the quantity demanded goes down o Doesn t answer how much QD goes down due to change in price Measures and quantifies the extent to which quantity demanded will change in response to change Proportional Changes o Very Responsive Elastic o Not Very Responsive Inelastic A scenario Price Elasticity of Demand change in QD change in P How much QD responds to change in P Loosely speaking it measures the price sensitivity of buyers demand Example Price of Elasticity of Demand Said to be Elastic if price elasticity of demand is 1 Means that change in QD is than the change in P Numerator denominator Refer to Price elasticity of demand in Absolute Value Calculating Percentage Changes End Value Start Value Midpoint x 100 Midpoint Method Going from A to B change in P equals o 250 200 225 22 2 Example o Using midpoint method change in P equals The Market for Hotel Rooms P 70 QD 5000 P 90 QD 3000 Use Midpoint Method o change in QD 5000 3000 4000 50 o change in P 90 70 80 25 o Price Elasticity of Demand 50 25 ANSWER 2 0 Price Elasticity of Demand Price Elasticity is Higher o Luxury Goods Necessity Goods o Narrowly Defined Goods Broadly Defined Goods o Long Run Short Run Price Elasticity of Demand Depends on o Market Definition o The extent to which close substitutes are available Elasticity of Demand and the Demand Curve The Price Elasticity of Demand is closely related to slope of the demand curve Rule of Thumb o Flatter the curve the bigger the elasticity o Steeper the curve the smaller the elasticity Perfectly Inelastic Demand One Extreme Case More Realistic Example Unit Elastic Demand Another Example of Elastic Perfectly Elastic Demand Extreme Example Elasticity Midpoint Method Change in Qd Change in P o End Value Start Value Midpoint x 100 Elasticity of a Linear Demand Curve 10 10 2013 Continuing our scenario if you raise your Price from 200 to 250 Price Elasticity and Total Revenue would your revenue rise or fall o Revenue P x Q A Price increase has 2 effects o Higher P means more revenue o But you sell fewer units Lower Q due to Law of Demand If demand is elastic o Price elast of demand 1 change in Q change in P o Revenue Falls If demand is inelastic o Price elast of demand 1 change in Q change in P o Revenue Rises Example Chart Inelastic Increases Rise in TR Elastic Increase Fall in TR Elastic Decrease Rise in TR Price TR have direct relationship w Inelasticity Price TR have indirect relationship w Elasticity Inelastic Decreases Fall in TR Income Elasticity of Demand Change in Qd Change in Income Normal Goods Increase in Income Increase in D for Normal Good o Income Elasticity 0 o Ex Automobiles Furniture Inferior Goods o Income Elasticity 0 o Ex Margarine Public Transportation Cross Price Elasticity of Demand change in Qd of good 1 change in Price of good 2 Very High Positive CP Elasticity Small Positive CP Elasticity goods are not good substitutes If negative CP they re compliments goods are strong substitutes Price Elasticity of Supply change in Qs change in P Measures price sensitivity of sellers supply Apply Midpoint Method Elastic 1 Inelastic 1 Elasticity Taxes 10 10 2013 Elasticity and Tax Incidence Case 1 o Supply is more elastic than demand o sellers is true response o If buyers price elasticity sellers price elasticity buyers can more easily leave the market when the tax is imposed so buyers will bear a smaller share of the burden of the tax than o If sellers price elasticity buyers price elasticity the reverse o Incidence of tax falls on side of market with more inelastic o If demand curve is inelastic demand is not responsive to a change in price Tax will fall more heavily on buyers o If supply curve is inelastic sellers will bear the burden of the tax Deadweight Loss from a Tax With a tax o CS A o PS F Tax Revenue o B D Tax Surplus o A B D F Tax causes total surplus to fall by o C E Deadweight Loss o C E Elasticity and Deadweight Loss loss is desirable DWL and Elasticity Inelastic supply small tax DWL The size of the deadweight loss is determined by elasticity s Goal is efficiency taxing the goods with the smallest deadweight Elastic supply larger tax DWL Inelastic demand small tax DWL Elastic Demand larger tax DWL Why Elasticity Affects DWL Size Tax distorts the market outcome o Consumers buy less and producers sell less so EQ is below the surplus maximizing Q Elasticity measures how much buyers and sellers respond to o Therefore determines how much tax distorts the market changes in price outcome Equity vs Efficiency The gov must raise tax revenue to pay for schools etc To do this it can either tax groceries or meals at fancy restaurants Which should it tax o A tax on groceries would be more efficient smaller DWL than a tax on restaurant meals o But it would hurt people with lower incomes than people with If you make over 357 700 per year 35 cents of every dollar earned higher incomes The Debate Over Income Tax is taxed What is effect of this high tax rate o Biggest source of gov revenue What does Income Tax Do Lowers real wages providing incentives to reduce work hours which inhibits productivity If labor supply is elastic then the high marginal tax rate will cause people to reduce their work hours Some economists believe that labor is not very responsive to changes in income this tax is small supply is inelastic o They argue that labor supply is inelastic then the DWL from If most workers work full time even if the tax rate is high labor Other economists believe that the tax on labor is highly distorting because some groups of workers have elastic supply o Many workers can adjust their hours o Many families have a 2nd earner with discretion over whether and how much to work o Many elderly choose when to retire based on the wage they o Some people work in the underground economy to evade earn high taxes Evidence In Countries with higher taxes people tend to work fewer hours Effects of Changing the Size of the Tax Policymakers often change taxes raising some and lowering others What happens to DWL and tax revenue when taxes change DWL and Size of Tax Initially the tax is T per unit Doubling the tax
View Full Document
Unlocking...