Elasticity and Taxation

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Eugene Watts
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1 Elasticity and Taxation Important Knowledge Elasticity is the measure of responsiveness of one thing to another Price Elasticity of Demand is the measure of responsiveness of price to a change in quantity. PED= %Change in Quantity %Change in Price Price Elasticity of Supply is the measure of responsiveness of price to a change in Supply. PED= %Change in Supply %Change in Price Income Elasticity of Demand is the measure of responsiveness of Income to a change in quantity. PED= %Change in Quantity %Change in Income. Elasticity Absolute Value Elastic >1 Inelastic <1 Unitary Elastic 1 Perfectly Elastic Infinity Perfectly Inelastic 0 Greater PED and lesser PES mean a greater burden of tax on producer. Greater PES and lesser PED mean a greater burden of tax on consumer. (Note: the same applies to subsidy The sum of consumer surplus and producer surplus is the total surplus. A decrease in total surplus due to taxes is referred to as welfare loss. PED= Perfectly inelastic or PED=0 DD Price DD PED= Perfectly Elastic or Inifite PED

2 PES= Perfectly inelastic or PES=0 SS Price SS PES= Perfectly Elastic or Inifite PES Quantity In a downward sloping demand curve, the top half is inelastic while the bottom half is elastic. A supply curve is elastic if it starts from the y axis, inelastic is it starts from the x axis and unitary elastic if it starts from the origin. Summary of Questions to be Asked: 1. Calculate the Point and Arc Elasticity of demand i) Point Elasticity of Demand = Change in Q* P Change in P* Q ii) Arc Elasticity of Demand/Mid- point Method [Q2- Q1]*[Q2+Q1/2] [P2- P1]*[P1+P2/2] 2. What would be the incidence of taxation if: i) PED=O/PES=Infinity All of the burden of the tax would go to the consumer because demand is irresponsive to change in price (PED) The burden goes on the consumer because producers are extremely sensitive to costs and supply will decrease to zero if the burden of tax falls on them (PES) ii) PED=Infinity/ PES=0 The entire burden falls on the Producer. iii) PED=1/PES=1 The burden is shared equally between the producer and consumer. (General Rule: The inelastic party gets most of the burden).

3 Common Exam Questions: 2012 Short Answer Question 3 Why is elasticity not constant along a linear demand function even though the slope is constant? Answer: Elasiticity is (1/slope) * original price/original q. If slope is more, elasticity is less and if slope is less, elasticity is more Multiple Choice Question 1 If per capita incomes increased by 10% and household expenditures on fur coats increased by 15%, one can conclude that the price elasticity of demand for fur coats is a. positive b. not determinable from the given information c. elastic d. unit elastic e. inelastic Answer: Not determinable since we need change in price and change in quantity for PED, but those are not given 2011 Multiple Choice Question 2 Which of the following is true at equilibrium for the Buyers share of a per/unit tax on a commodity that has perfectly elastic demand and relatively elastic supply? a. The buyers share of the tax is zero b. The buyers share of the tax is more than zero, but less than the seller s share of tax c. The buyers share of the tax is greater than the seller s share of tax d. The buyers share is equal to the total amount of the per unit tax e. None of the above Answer: Perfectly elastic demand means demand will be zero if there is even a slight increase in price. Hence, producers are forced to take all the burden and buyer's share is zero.

4 2009 Multiple Choice Question 3 If demand on Canadian exports is unit elastic, which of the following statements is true? a. An increase in price increases total revenue from exports b. An increase in price decreases total revenue from exports c. An decrease in price increases total revenue from exports d. an increase in price will not change total revenue from export e. none of the above f. Answer: Unit elastic means equally proportional change in opposite directions of price and Qd. Hence, as revenue is Qd*P, total revenue remains constant Multiple Choice Question 6 Suppose that 700 units of a commodity sell at $28 and 900 units sell at $23. Which of the following is the equation for demand? a. P = Q b. P = Q c. P = Q d. P = Q e. P = Q f. P = Q g. P = Q h. P = Q i. P = Q j. none of the above Answer: Elastic demand and inelastic supply means the producer takes all the benefit. So seller's price is equilibrium market price - subsidy.

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Chapter 3 Quantitative Demand Analysis

Chapter 3 Quantitative Demand Analysis EX1: Suppose a 10 percent price decrease causes consumers to increase their purchases by 30%. What s the price elasticity? EX2: Suppose the 10 percent decrease in