Price Elastic Demand

Report
Chapter 4
Elasticity and
Taxation
Slides created by Dr. Amy Scott
©2010  Worth Publishers
More Precious than
a Flu Shot
The U.S. supply of the flu vaccine for the 2004–2005 flu
season was suddenly cut in half
As news of it spread, there was a rush to get the shots.
Some pharmaceutical distributers detected a profit - making
opportunity in the frenzy.
Consumers of the vaccine were relatively unresponsive to
price;

that is, the large increase in the price of the vaccine
left the quantity demanded by consumers relatively
unchanged.
In this chapter we will show how the price elasticity of
demand is calculated and why it is the best measure of how
the quantity demanded responds to changes in price.
Chapter Objectives
1. What is elasticity?
A.
B.
C.
D.
Price elasticity of demand
Cross-price elasticity of demand
Income elasticity of demand
Price elasticity of supply
2. The effects of taxes on supply and demand
3. What determines who bears the burden of a tax
4. The costs and benefits of taxes, and why taxes impose
a cost that is larger than the tax revenue they raise
Defining and Measuring Elasticity
 The
price elasticity of demand is the ratio of the
percent change in the quantity demanded to the
percent change in the price as we move along the
demand curve
%∆Q
%∆P
 Drop the minus sign - Price elasticity of demand
is always negative because of the inverse
relationship between price and quantity demandedso drop the minus sign and use Absolute Value
The Price Elasticity of Demand
Demand for Vaccinations
Price of vaccination
When price rises to $21 per
barrel, world demand falls
to 9.9 million barrels per
day (point B).
B
$21
A
20
D
0
9.9 10.0
Quantity of vaccinations (millions)
Calculating the Price Elasticity of Demand
1)
2)
3)
The Midpoint Method
Percentage
change can vary depending on
which variables are used to measure. To
alleviate this problem:
 The
midpoint method is a technique for
calculating the percent change using averages of
starting and final values (midpoints).
Midpoint Method
Using the Midpoint Method
The price of strawberries falls from $1.50 to $1.00 per carton
and the quantity demanded goes from 100,000 to 200,000
cartons. Using the midpoint method, the price elasticity of
demand is:
1.
2.
3.
4.
1.7.
0.6.
67.
40.
At the present level of consumption, 4,000 movie tickets,
and at the current price, $5 per ticket, the price elasticity
of demand for movie tickets is 1. Using the midpoint
method, calculate the percentage by which the owners of
movie theaters must reduce price in order to sell 5,000
tickets.
1.
2.
3.
4.
16%
32%
18%
22%
The price elasticity of demand for ice-cream sandwiches is 1.2 at the current
price of $0.50 per sandwich and the current consumption level of 100,000
sandwiches. Calculate the change in the quantity demanded when price rises
by $0.05.
Use Equations 5-1 and 5-2 to calculate percent changes, and Equation 53 to relate price elasticity of demand to the percent changes.
1.
2.
3.
4.
quantity
quantity
quantity
quantity
demanded increases by 12,000
demanded decreases by 12,000
demanded increases by 15,000
demanded decreases by 15,000
Estimating Elasticities
Assumption: It’s easy to estimate price elasticities of demand from
real-world data
Fact: Changes in price aren’t the only thing affecting changes in
the quantity demanded. Other factors include:
changes in income
changes in population
changes in the prices of other goods
To estimate price elasticities of demand, economists must use
careful statistical analysis to separate the influence of these
different factors, holding other things equal.
Some Estimated Price Elasticities of Demand
Good
Inelastic demand




Eggs
Beef
Stationery
Gasoline
Elastic demand




Housing
Restaurant meals
Airline travel
Foreign travel
Price elasticity
0.1
0.4
0.5
0.5
1.2
2.3
2.4
4.1
Price elasticity of
demand<1
Price elasticity of
demand>1
Interpreting Price Elasticity of Demand
Extreme Cases of Price Elasticity of Demand:

Demand is perfectly inelastic when the
quantity demanded does not respond at all to
changes in the price


demand curve is a vertical line.
Demand is perfectly elastic when any price
increase will cause the quantity demanded to
drop to zero.

demand curve is a horizontal line.
Interpreting Price Elasticity of Demand
(continued)
 Demand
is elastic if the price elasticity of demand
is greater than 1
 Price Elasticity of Demand > 1
 Demand is inelastic if the price elasticity of
demand is less than 1
 Price Elasticity of Demand < 1
 Demand is unit-elastic if the price elasticity of
demand is exactly 1
 Price Elasticity of Demand = 1
Two Extreme Cases of Price Elasticity of Demand
Perfectly Inelastic Demand: Price Elasticity of Demand = 0
Price of shoelaces
(per pair)
D
1
$3
An increase in
price…
$2
… leaves the
quantity
demanded
unchanged.
0
1
Quantity of shoelaces (billions of pairs per year)
Two Extreme Cases of Price Elasticity of Demand
Price Elastic Demand: Price Elasticity of Demand = ∞
Price of pink tennis balls
(per dozen)
At any price above $5,
quantity demanded is
zero
$5
At exactly $5,
consumers
will buy any
quantity
D
2
At any price below
$5, quantity
demanded is infinite
0
Quantity of tennis balls (dozens per year)
Unit-Elastic Demand, Inelastic Demand, and Elastic Demand
Demand is unit-elastic if the price elasticity of demand is exactly 1
Price of crossing
Unit-Elastic Demand:
Price Elasticity of Demand = 1
B
A 20%
increase in
the price . . .
$1.10
A
0.90
D
0
900
1,100
. . . generates a 20% decrease in
the quantity of crossings
demanded.
1
Quantity of crossings
(per day)
Unit-Elastic Demand, Inelastic Demand, and Elastic Demand
Demand is inelastic if the price elasticity of demand is less than 1
Price of crossing
Inelastic Demand: Price Elasticity
of Demand = 0.5
B
A 20% increase
in the price . . .
$1.10
A
0.90
D
0
950
1,050
. . . generates a 10% decrease in the
quantity of crossings demanded.
2
Quantity of crossings
(per day)
Unit-Elastic Demand, Inelastic Demand, and Elastic Demand
Demand is elastic if the price elasticity of demand is greater than 1
Elastic Demand: Price Elasticity of
Demand = 2
Price of crossing
B
$1.10
A 20%
increase in
the price . . .
A
0.90
D
0
800
1,200
… generates a 40%
decrease in the quantity of
crossings demanded.
3
Quantity of crossings
(per day)
Why Does It Matter Whether Demand is
Unit-Elastic, Inelastic, or Elastic?



Because this predicts how changes in the price
of a good will affect the total revenue earned by
producers from the sale of that good.
The total revenue is defined as the total value of
sales of a good or service, i.e.
Total Revenue = Price × Quantity Sold
Total Revenue by Area
Total Revenue = Price × Quantity Sold
Price of crossing
$0.90
Total revenue = price x
quantity = $990
0
D
1,100
Quantity of crossings (per day)
Elasticity and Total Revenue
 When a seller raises the price of a good, there are
two effects in action (except in the rare case of a
good with perfectly elastic or perfectly inelastic
demand):
 A price effect: After a price increase, each
unit sold sells at a higher price, which tends to
raise revenue.
 A quantity effect: After a price increase,
fewer units are sold, which tends to lower
revenue.
Figure 5.4b Effect of a Price Increase on Total
Revenue
Price of crossing
Price effect of price increase:
higher price for each unit sold
Quantity effect of
price increase:
fewer units sold
$1.10
C
0.90
B
0
A
900
D
1,100
Quantity of crossings (per day)
Elasticity and Total Revenue
demand for a good is elastic (the price elasticity of
demand > 1), an increase in price reduces total revenue.
 The quantity effect is stronger than the price effect.
 If
Price
TR
 If demand for a good is inelastic (the price elasticity of
demand < 1), a higher price increases total revenue.
 The price effect is stronger than the quantity effect.
Price
TR
 If demand for a good is unit-elastic (the price elasticity of
demand = 1), an increase in price does not change total
revenue.

The sales effect and price effect exactly offset each other.
Price Elasticity of Demand and Total Revenue
Demand Schedule and Total Revenue
Price
Elastic
$10
9
8
7
6
5
4
3
2
1
Unit-elastic
Inelastic
D
0
1
2
3
4
5
6
7
8
9 10
Quantity
Total
revenue
$25
24
21
16
Demand Schedule and Total Revenue
for a Linear Demand Curve
Quantity
Total
Price
demanded
Revenue
$0
10
$0
1
9
9
2
8
16
3
7
21
4
6
24
5
5
25
6
4
24
7
3
21
8
2
16
9
1
9
10
0
0
9
0
0
1
2
3
Demand is
elastic: a higher
reduces total
revenue
4
5
6
7
8
9 10
Quantity
Demand is inelastic: a
higher price increase
total revenue
The price elasticity of demand changes
along the demand curve
What Factors Determine the Price Elasticity
of Demand?
Price Elasticity of Demand is determined by:

Whether Close Substitutes Are Available

Whether the Good Is a Necessity or a Luxury

Share of Income Spent on the Good

Time
How Mad?
Responding to your tuition bill




For years tuition has been rising faster than the overall cost of living,
but does rising tuition keep people from going to college?
A 1988 study found that a 3% increase in tuition led to an
approximately 2% fall in the number of students enrolled at fouryear institutions, giving a price elasticity of demand of 0.67 (2%/3%)
and 0.9 for two-year institutions.
Enrollment decision for students at two-year colleges was
significantly more responsive to price than for students at four-year
colleges. The result: students at two-year colleges are more likely to
forgo getting a degree because of tuition costs than students at four
year colleges.
A 1999 study confirmed this pattern.
For each case that follows choose the condition that best characterizes
demand: elastic demand, inelastic demand or unit-elastic demand
Total revenue decreases when price increases.
1.
2.
3.
elastic demand
inelastic demand
unit-elastic demand
For each case that follows choose the condition that best characterizes
demand: elastic demand, inelastic demand or unit-elastic demand
The additional revenue generated by an increase in quantity sold is
exactly offset by revenue lost from the fall in price received per unit.
1.
2.
3.
elastic demand
inelastic demand
unit-elastic demand
For each case that follows choose the condition that best characterizes
demand: elastic demand, inelastic demand or unit-elastic demand
Total revenue falls when output increases.
1.
2.
3.
elastic demand
inelastic demand
unit-elastic demand
For each case that follows choose the condition that best characterizes
demand: elastic demand, inelastic demand or unit-elastic demand
Producers in an industry find they can increase their total revenues
by working together to reduce industry output.
1.
2.
3.
elastic demand
inelastic demand
unit-elastic demand
For each case that follows, would you expect demand to be elastic or
inelastic?
Demand by a snake-bite victim for an antidote
elastic
inelastic
1.
2.
Demand by students for green erasers
1.
2.
elastic
inelastic
Cross-Price Elasticity
The cross-price elasticity of demand between two goods
measures the effect of the change in one good’s price on the quantity
demanded of the other good.
Equal to the percent change in the quantity demanded of one good
divided by the percent change in the other good’s price.
The Cross-Price Elasticity of Demand between Goods A and B
Cross-Price Elasticity


Goods are substitutes when the crossprice elasticity of demand is positive.
Goods are complements when the crossprice elasticity of demand is negative.
Income Elasticity of Demand
The income elasticity of demand is the percent
change in the quantity of a good demanded when a
consumer’s income changes divided by the percent
change in the consumer’s income.
Normal Goods and Inferior Goods


When the income elasticity of demand is positive,
the good is a normal good
 that is, the quantity demanded at any given
price increases as income increases.
When the income elasticity of demand is negative,
the good is an inferior good
 that is, the quantity demanded at any given
price decreases as income increases.
Where Have All the Farmers Gone?
Why do so few people now live and work on farms in
the United States?


The income elasticity of demand for food is much less than 1—it is
income inelastic. As consumers grow richer, other things equal,
spending on food rises less than income  as the U.S. economy has
grown, the share of income it spends on food—and therefore the share
of total U.S. income earned by farmers—has fallen.
Agriculture has been a technologically progressive sector for
approximately 150 years in the U.S., with steadily increasing yields
over time. Competition among farmers means that technological
progress leads to lower food prices. Meanwhile, the demand for food is
price-inelastic, so falling prices of agricultural goods, other things
equal, reduce the total revenue of farmers  progress in farming has
been good for consumers but bad for farmers.
Food’s Bite in World Budgets
Spending on food
(% of income)
80%
Sri Lanka
60
40
Mexico
United
States
Israel
20
0
20
40
60
80
100%
Income (% of U.S. income per capital)
Spending It




The Bureau of Labor Statistics
captures data on spending.
A classic result of their surveys is that the income elasticity of
demand for ‘food eaten at home’ is considerably less than 1. As a
family’s income rises, the share of income spent on food consumed
at home falls, and vice a versa as family income falls.
In 1950, 19% of U.S. income was spent on food consumed at
home compared with 7% now. Over the same time period, the
share of U.S. income spent on food away from home has stayed
constant at 5%.
An example of an inferior good is rental housing. As family income
rises demand for rental housing decreases since higher income
families are likely to own their homes.
After Chelsea’s income increased from $12,000 to $18,000 a year, her
purchases of CDs increased from 10 to 40 CDs a year. Calculate
Chelsea’s income elasticity of demand for CDs using the midpoint
method.
1.
2.
3.
4.
3
.333
1
7
Expensive restaurant meals are income-elastic goods for most people,
including Sanjay. Suppose his income falls by 10% this year. What can you
predict about the change in Sanjay’s consumption of expensive restaurant
meals?
1.
2.
3.
4.
Sanjay’s consumption of
fall by 10%.
Sanjay’s consumption of
rise by 10%.
Sanjay’s consumption of
fall by more than 10%.
Sanjay’s consumption of
rise by more than 10%.
expensive restaurant meals will
expensive restaurant meals will
expensive restaurant meals will
expensive restaurant meals will
As the price of margarine rises by 20%, a manufacturer of baked goods
increases its quantity of butter demanded by 5%. Calculate the crossprice elasticity of demand between butter and margarine. Are butter and
margarine substitutes or complements for this manufacturer?
1.
2.
3.
4.
Cross price elasticity
substitutes.
Cross price elasticity
substitutes.
Cross price elasticity
complements.
Cross price elasticity
complements.
is 0.50 and the goods are
is 0.25 and the goods are
is -0.50 and the goods are
is -0.25 and the goods are
Price Elasticity of Supply
The price elasticity of supply is a measure of the
responsiveness of the quantity of a good supplied to
the price of that good.
It is the ratio of the percent change in the quantity
supplied to the percent change in the price as we
move along the supply curve.
Two Extreme Cases of Price Elasticity of
Supply
Perfectly Inelastic Supply:
Price Elasticity of Supply = 0
Perfectly Elastic Supply: Price
Elasticity of Supply = ∞
Price of cell phone frequency
Price of
pizza
S
1
An increase
in price…
At any price above
$12, quantity
supplied is infinite.
$3,000
$12
2,000
0
At exactly $12,
producers will
produce any
quantity
… leaves
the quantity
supplied
unchanged
100
Quantity of cell
phone frequencies
At any price
below $12,
quantity
supplied is
zero.
0
S2
Quantity of pizzas
Measuring the Price Elasticity of Supply

Supply is perfectly inelastic when the price
elasticity of supply is zero. When changes in
the price have no effect on the quantity
supplied


Supply curve is a vertical line
Supply is perfectly elastic when price
elasticity of supply is infinite. When any price
change will lead to very large changes in the
quantity supplied

Supply curve is a horizontal line
What Factors Determine Price Elasticity of
Supply?
 The
Availability of Inputs: The price elasticity of
supply tends to be large when inputs are
readily available and can be shifted into and out
of production at a relatively low cost. It tends to be
small when inputs are difficult to obtain.
 Time:
The price elasticity of supply tends to grow
larger as producers have more time to
respond to a price change. This means that the
long-run price elasticity of supply is often higher
than the short-run elasticity.
European Farm Surpluses





Imposition of a price floors to support the incomes of farmers has created
“butter mountains” and “wine lakes” in Europe.
Were European politicians unaware that their price floors would create huge
surpluses?
They probably knew that surpluses would arise, but underestimated the
price elasticity of agricultural supply.
They thought big increases in production were unlikely since there was little
new land available in Europe for cultivation. However, farm production
could expand by adding other resources, especially fertilizer and pesticides,
which were readily available
So although farm acreage didn’t increase much, farm production did!
An Elasticity Menagerie
Using the midpoint method, calculate the elasticity of supply for webdesign services when the price per hour rises from $100 to $150 and
the number of hours transacted increases from 300,000 hours to
500,000. Is supply elastic, inelastic, or unit-elastic?
1.
2.
3.
4.
1.75, elastic
1 unit-elastic
0.75, inelastic
1.25 elastic
True or False? If the demand for milk were to rise, then, in
the long run, milk-drinkers would be better off if supply
were elastic rather than inelastic.
1.
2.
True
False
True or False? Long-run price elasticities of supply are generally larger
than short-run price elasticities of supply. Therefore the short-run
supply curves are generally flatter than the long-run supply curves.
1.
2.
True
False
True or False? When supply is perfectly elastic, changes in
demand have no effect on price
1.
2.
True
False
Table 5.3 An Elasticity Menagerie (continued)
Tax Incidence – Putting It Together
 When
the price elasticity of demand is higher than
the price elasticity of supply, an excise tax falls
mainly on producers.
 When
the price elasticity of supply is higher than
the price elasticity of demand, an excise tax falls
mainly on consumers.
 So
elasticity—not who officially pays the tax—
determines the incidence of an excise tax.
The Revenue from an Excise Tax
The tax revenue collected is:
Tax revenue = $40 per room × 5,000 rooms =
$200,000
Price of hotel $140
room
120
A
S
100
Excise tax = $40
per room
80
60
D
B
The area of the shaded rectangle is:
Area = Height × Width = $40 per room × 5,000
rooms = $200,000
40
20
0
E
Area = tax
revenue
6
5,000
10,000
15,000
Quantity of hotel rooms
The Revenue from an Excise Tax
The general principle is:
The revenue collected by an excise tax is
equal to the area of the
rectangle(Area = Height x Width) whose
height is the tax wedge between the
supply and demand curves and whose
width is the quantity transacted under the
tax.
Tax Rates and Revenue



A tax rate is the amount of tax people are
required to pay per unit of whatever is being
taxed.
In general, doubling the excise tax rate on a
good or service won’t double the amount of
revenue collected, because the tax increase will
reduce the quantity of the good or service
transacted.
In some cases, raising the tax rate may actually
reduce the amount of revenue the government
collects.
Tax Rates and Revenue
(a) An excise tax of $20
(b) An excise tax of $60
Price of
$140
hotel
room
120
Price of
hotel
room
120
90
80
70
E
Area = tax
revenue
D
Excise
tax =
$60 per
room
80
Area = tax revenue
110
S
Excise
tax =
$20 per
room
$140
S
E
D
50
40
40
20
20
0
6,000
7,500 10,000
15,000
Quantity of hotel rooms
0
2,500 5,000
10,000
15,000
Quantity of hotel rooms
The Laffer Curve




In 1974. during a conversation with WSJ writer, Jude Wanniski,
and the then Deputy White House chief of staff, Dick Cheney,
economist Auther Laffer drew a drew a diagram that was intended
to explain how tax cuts could sometimes lead to higher tax
revenues.
According to Laffer, raising tax rates initially increases revenue but
beyond a certain level, revenue will fall as tax rates rise.
In 1981 Ronald Regan used Laffer Cure to argue that his proposed
tax cuts would not reduce government tax revenues.
Is there a Laffer Curve? Yes, as a theoretical proposition but very
few economists believe that there exists such a high tax rate that
reducing it leads to an increase in revenue.
The Costs of Taxation




A fall in the price of a good generates a gain
in consumer surplus.
Similarly, a rise in the price generates a loss in
consumer surplus .
Excise tax raises the price paid by
consumers causing a loss.
Meanwhile, the fall in the price received by
producers leads to a fall in producer
surplus.
 Thus a tax reduces both the CS and the PS.
A Tax Reduces Consumer and Producer
Surplus
Fall in consumer surplus
due to tax
iprice
P
C
A
Excise tax =
T
P
B
E
E
F
C
P
S
P
Fall in producer surplus
due to tax
Q
T
Q
E
D
Quantity
The Deadweight Loss of a Tax
Consumers and producers are hurt by the tax, but the
government gains revenue.
 The revenue the government collects is equal to the
tax per unit sold, T, multiplied by the quantity sold,
QT.


But a portion of the loss to producers and
consumers from the tax is not offset by a gain to the
government.
The deadweight loss caused by the tax represents
the total surplus lost to society because of the
tax—that is, the amount of surplus that would have
been generated by transactions that now do not
take place because of the tax.
The Deadweight Loss of a Tax
S
Price
Deadweight loss
P
Excise tax = T
P
P
C
E
E
P
D
Q
T
Q
E
Quantity
Cost of Collecting Taxes



The administrative costs of a tax are the
resources used by government to collect the
tax, and by taxpayers to pay it, over and above
the amount of the tax, as well as to evade it.
The total inefficiency caused by a tax is the
sum of its deadweight loss and its
administrative costs.
The general rule for economic policy is that,
other things equal, a tax system should be
designed to minimize the total inefficiency it
imposes on society.
Deadweight Loss and Elasticities
(b)
(a) Elastic Demand
Price
Price
Inelastic Demand
S
S
Deadweight loss
is larger when
demand is elastic
P
C
Excise
tax = T
P
C
P
E
E
Excise
tax = T
P
E
P
P
E
D
Deadweight loss
is smaller when
demand is
inelastic
P
P
D
Q
T
Q
E
Quantity
Q Q
T E
Quantity
Figure 5.11 Deadweight Loss and
Elasticities
(d)
Inelastic Supply
(c) Elastic Supply
Deadweight
loss is larger
when supply is
elastic
Price
P
C
Price
S
P
C
Excise
tax = T
P
E
P
P
S
E
Excise
tax = T
P
E
E
Deadweight
loss is smaller
when supply
is inelastic
P
P
D
Q
T
Q
E
D
Quantity
Q Q
T E
Quantity
Deadweight Loss and Elasticities


To minimize the efficiency costs of
taxation, one should choose to tax only
those goods for which demand or
supply, or both, is relatively
inelastic.
For such goods, a tax has little effect on
behavior because behavior is relatively
unresponsive to changes in the price.
Deadweight Loss and Elasticities



When demand is perfectly inelastic (vertical demand
curve), the quantity demanded is unchanged by the
imposition of the tax. As a result, the tax imposes no
deadweight loss.
Similarly, if supply is perfectly inelastic (vertical
supply curve), the quantity supplied is unchanged by
the tax and there is no deadweight loss.
If the goal is to minimize deadweight loss, then
taxes should be imposed on goods and services that
have the most inelastic response—goods and
services for which consumers or producers will change
their behavior the least in response to the tax.
Taxing the Marlboro Man
One of the most important excise taxes in the United States is the tax
on cigarettes.
The table above shows the results of big increases in cigarette taxes.
In each case, sales fell, just as our analysis predicts.
The tax revenue rose in each case because cigarettes have a low price
elasticity of demand.
The accompanying table shows five consumers’ willingness to pay for
one can of diet soda as well as five producers’ cost of selling one can
of diet soda. The government asks your advice about the effects of an
excise tax of $0.40 per can of soda. Assume there are no
administrative costs from the tax.
Without the excise tax, what is the equilibrium price and
quantity of soda transacted?
1. $0.70, 1
2. $0.50, 2
3. $0.40, 4
4. $0.30, 5
The excise tax raises the price paid by consumers to $0.60 and
lowers the price received by producers post-tax to $0.20. With
the tax, what is the quantity of soda transacted?
1. 1
2. 2
3. 4
4. 5
Without the excise tax, how much individual consumer surplus
does each of the consumers gain? How much with the tax? How
much total consumer surplus is lost as a result of the tax?
1. $1.00, $.20, $.80
2. $.60, $.10, $0.70
3. $.60, $.10, $0.50
4. $0.40, $.20, $.40
Without the excise tax, how much producer surplus does each of
the producers gain? How much with the tax? How much total
producer surplus is lost as a result of the tax?
1. $1.00, $.20, $.30
2. $.60, $.10, $0.70
3. $.60, $.10, $0.50
4. $0.40, $.20, $.40
How much government revenue does the excise tax
create?
1. $1.00
2. $0.80
3. $0.50
4. $0.40
What is the deadweight loss from the imposition of this
excise tax?
1. $0.80
2. $0.50
3. $0.40
4. $0.20
You would expect a tax on gasoline to have a ________
deadweight loss.
1.
2.
Small
Large
You would expect a tax on milk chocolate bars to have a
________ deadweight loss.
1.
2.
Small
Large
Summary
1.
2.
3.
1 of 5
Elasticity is a general measure of responsiveness
The price elasticity of demand—the percent change in the
quantity demanded divided by the percent change in the price
(dropping the minus sign)—is a measure of the responsiveness
of the quantity demanded to changes in the price.
The responsiveness of the quantity demanded to price can
range from perfectly inelastic demand, where the quantity
demanded is unaffected by the price, to perfectly elastic
demand, where there is a unique price at which consumers will
buy as much or as little as they are offered. When demand is
perfectly inelastic, the demand curve is a vertical line; when it is
perfectly elastic, the demand curve is a horizontal line.
Summary
4.
5.
6.
2 of 5
The price elasticity of demand is classified according to whether
it is more or less than 1. If it is greater than 1, demand is
elastic; if it is less than 1, demand is inelastic; if it is exactly
1, demand is unit-elastic. This classification determines how
total revenue, the total value of sales, changes when the price
changes.
The price elasticity of demand depends on whether there are
close substitutes for the good, whether the good is a necessity
or a luxury, the share of income spent on the good, and the
length of time that has elapsed since the price change.
The cross-price elasticity of demand measures the effect of
a change in one good’s price on the quantity of another good
demanded.
Summary
7.
8.
3 of 5
The income elasticity of demand is the percent change in
the quantity of a good demanded when a consumer’s income
changes divided by the percent change in income. If the income
elasticity is greater than 1, a good is income elastic; if it is
positive and less than 1, the good is income-inelastic.
The price elasticity of supply is the percent change in the
quantity of a good supplied divided by the percent change in
the price. If the quantity supplied does not change at all, we
have an instance of perfectly inelastic supply; the supply
curve is a vertical line. If the quantity supplied is zero below
some price but infinite above that price, we have an instance of
perfectly elastic supply; the supply curve is a horizontal line.
Summary
9.
10.
11.
4 of 5
The price elasticity of supply depends on the availability of
resources to expand production and ontime. It is higher when
inputs are available at low cost and the longer the time since
price change.
“Excise taxes” (taxes on the purchase/sale of a good) raise
the price paid by consumers and reduce the price received by
producers, driving a wedge between the two. The incidence of
the tax (how burden of tax is divided between consumers and
producers) does not depend on who officially pays the tax.
The incidence of an excise tax depends on the price elasticities
of supply and demand. If the price elasticity of demand is
higher than the price elasticity of supply, the tax falls mainly on
producers; if the price elasticity of supply is higher than the
price elasticity of demand, the tax falls mainly on consumers.
Summary
12.
13.
5 of 5
The tax revenue generated by a tax depends on the tax rate
and on the number of units transacted with the tax. Excise
taxes cause inefficiency in the form of deadweight loss because
they discourage some mutually beneficial transactions. Taxes
also impose administrative costs—resources used to collect
the tax.
An excise tax generates revenue for the government, but lowers
total surplus. The loss in total surplus exceeds the tax revenue,
resulting in a deadweight loss to society. This deadweight loss is
represented by a triangle, the area of which equals the value of
the transactions discouraged by the tax. The greater the
elasticity of demand or supply, or both, the larger the
deadweight loss from a tax. If either demand or supply is
perfectly inelastic, there is no deadweight loss from a tax.
The End of Chapter 5
Coming attraction
Chapter 6:
Behind the Supply Curve:
Inputs and Costs

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