ElasticityMeasure of the responsiveness of Quantity to a change in PricePrice elasticity of demandPrice elasticity of supplyCross price elasticity of demandIncome elasticity of demand is a measure of the responsiveness of Quantity to a change in incomePrice Elasticity of DemandLaw of demand states that as the price of an item increases, the quantity demanded goes downDoesn’t answer how much QD goes down due to change in priceMeasures and quantifies the extent to which quantity demanded will change in response to changeProportional ChangesVery Responsive ElasticNot Very Responsive InelasticA scenario…Price Elasticity of Demand% change in QD / % change in PHow much QD responds to change in PLoosely speaking, it measures the price-sensitivity of buyers’ demandExample)Price of Elasticity of DemandSaid to be Elastic if price elasticity of demand is > 1Means that % change in QD is > than the % change in PNumerator > denominatorRefer to Price elasticity of demand in Absolute ValueCalculating Percentage ChangesEnd Value – Start Value/Midpoint x 100% (Midpoint Method)Going from A to B, % change in P equals…($250-$200)/$225=22.2%Example)Using midpoint method, % change in P equals…The Market for Hotel RoomsP = $70, QD = 5000P = $90, QD = 3000Use Midpoint Method% change in QD(5000-3000)/4000=50%% change in P($90-$70)/$80=25%Price Elasticity of Demand50%/25%ANSWER = 2.0Price Elasticity of DemandPrice Elasticity is Higher…Luxury Goods > Necessity GoodsNarrowly Defined Goods > Broadly Defined GoodsLong Run > Short RunPrice Elasticity of Demand Depends on…Market DefinitionThe extent to which close substitutes are availableElasticity of Demand and the Demand CurveThe Price Elasticity of Demand is closely related to slope of the demand curveRule of Thumb:Flatter the curve, the bigger the elasticitySteeper the curve, the smaller the elasticityPerfectly Inelastic DemandOne Extreme CaseMore Realistic ExampleUnit Elastic DemandAnother Example of ElasticPerfectly Elastic DemandExtreme ExampleMidpoint Method% Change in Qd / % Change in PEnd Value – Start Value / Midpoint x 100%Elasticity of a Linear Demand CurvePrice Elasticity and Total RevenueContinuing our scenario, if you raise your Price from $200 to $250, would your revenue rise or fall?Revenue = P x QA Price increase has 2 effectsHigher P means more revenueBut you sell fewer units (Lower Q) due to Law of DemandIf demand is elastic…Price elast. of demand > 1% change in Q > % change in PRevenue FallsIf demand is inelastic…Price elast. of demand < 1% change in Q < % change in PRevenue RisesExample ChartElasticIncreaseFall in TRInelasticIncreasesRise in TRElasticDecreaseRise in TRInelasticDecreasesFall in TRPrice & TR have direct relationship w/ InelasticityPrice & TR have indirect relationship w/ ElasticityIncome Elasticity of Demand% Change in Qd / % Change in IncomeIncrease in Income = Increase in D for Normal GoodNormal GoodsIncome Elasticity > 0Ex) Automobiles, FurnitureInferior GoodsIncome Elasticity < 0Ex) Margarine , Public TransportationCross-Price Elasticity of Demand% change in Qd of good 1 / % change in Price of good 2Very High & Positive CP Elasticity = goods are strong substitutesSmall & Positive CP Elasticity = goods are not good substitutesIf negative CP, they’re complimentsPrice Elasticity of Supply% change in Qs / % change in PMeasures price sensitivity of sellers’ supplyApply Midpoint MethodInelastic < 1Elastic > 1Elasticity and Tax IncidenceCase 1Supply is more elastic than demandIf 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 sellersIf sellers’ price elasticity > buyers price elasticity, the reverse is true.Incidence of tax falls on side of market with more inelastic responseIf demand curve is inelastic, demand is not responsive to a change in priceTax will fall more heavily on buyersIf supply curve is inelastic, sellers will bear the burden of the taxDeadweight Loss from a TaxWith a taxCS = APS = FTax RevenueB + DTax SurplusA + B + D + FTax causes total surplus to fall byC + EDeadweight LossC + EElasticity and Deadweight LossThe size of the deadweight loss is determined by elasticity’sGoal is efficiency, taxing the goods with the smallest deadweight loss is desirableDWL and ElasticityInelastic supply = small tax DWLElastic supply = larger tax DWLInelastic demand = small tax DWLElastic Demand = larger tax DWLWhy Elasticity Affects DWL SizeTax distorts the market outcomeConsumers buy less and producers sell less, so EQ is below the surplus-maximizing Q.Elasticity measures how much buyers and sellers respond to changes in priceTherefore determines how much tax distorts the market outcomeEquity vs. EfficiencyThe 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?A tax on groceries would be more efficient (smaller DWL) than a tax on restaurant meals.But it would hurt people with lower incomes than people with higher incomesThe Debate Over Income TaxIf you make over $357,700 per year, 35 cents of every dollar earned is taxedWhat is effect of this high tax rate?Biggest source of gov revenueWhat does Income Tax Do?Lowers real wages, providing incentives to reduce work hours which inhibits productivityIf labor supply is elastic, then the high marginal tax rate will cause people to reduce their work hoursSome economists believe that labor is not very responsive to changes in incomeThey argue that labor supply is inelastic, then the DWL from this tax is smallIf most workers work full time even if the tax rate is high, labor supply is inelasticOther economists believe that the tax on labor is highly distorting because some groups of workers have elastic supplyMany workers can adjust their hoursMany families have a 2nd earner with discretion over whether and how much to workMany elderly choose when to retire based on the wage they earnSome people work in the “underground economy” to evade high taxesEvidenceIn Countries with higher taxes, people tend to work fewer hoursEffects of Changing the Size of the TaxPolicymakers often change taxes, raising some and lowering othersWhat happens to DWL and tax revenue when taxes change?DWL and Size of TaxInitially the tax is T per unitDoubling the tax causes the DWL to more than doubleTripling the tax would cause
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