Week 4 – Elasticity, Tax Incidence and Tax Burden
A key characteristic of demand and supply curves! –
Elasticity = sensitivity or reponsiveness
Changes in one variable as another variable changes
How sensitive is the quantity demanded to changes in the price of the product?
Answer is given by elasticity of demand.
How sensitive is the quantity of tomatoes supplied by businesses to changes in the
price of tomatoes in Ontario? Answer is given by the elasticity of supply of tomatoes
in Ontario. If demand is P = 100 – Q, what is the elasticity of demand at Q = 80?
At Q = 80, P = $20
What does it mean to say that the elasticity of demand at this point is ¼?
It means that if P = $20 and the price changes by 4%, we expect that the quantity
demanded will change by about 1%.
Demand is elastic if E D 1
Demand is inelastic if ED< 1
Demand is unit(ary) elastic if ED= 1
Think about relation between consumers’ total expenditure on a product and the price
that firms charge to customers. (It depends on the elasticity of demand). So, if E > 1, dTE/dP < 0
And if E D 1, dTE/dP > 0
We can see this on a graph of the demand
curve as well…. Strange, but true, fact
Elasticity is different at every different
point along a linear demand curve
Q Thinking about different goods, some have
more elastic demands; others have less
What affects elasticity of demand?
Availability of close substitutes is key
Also amount spent on this good by the
consumer How are elasticity of demand and changes
in total expenditure by consumers (i.e., the
revenue of the producer) related?
See it on a graph (when demand is elastic):
Q When demand is inelastic
Q When demand is unit elastic
Q When demand is elastic, a fall in price will
raise total expenditure
When demand is elastic, a rise in price will
lower total expenditure
When demand is inelastic, a fall in price
will lower total expenditure
When demand is inelastic, a rise in price
will raise total expenditure
When demand is unit elastic, a fall or a
rise in price will have (approximately) no
effect on total expenditure Elasticity and Taxation
An illustration of the use of “elasticity”
Think about the tax on one particular
product (not a general tax on many
– e.g., gasoline, liquor, cigarettes
This is called an “excise” tax
Could be a “flat-rate” tax
e.g., $5 per bottle of liquor, $0.30 per
litre of gasoline, $10 per carton of
Could be an “ad-valorem” tax
e.g., 10% of the price on a bottle of liquor,
25% on a litre of gasoline, 30% on a carton
of cigarettes. To keep it simple, we look only at flat-rate
excise tax. Two interesting questions (and elasticity
comes into both!):
1. Who really pays an excise tax, and
what does this depend on?
2. How does taxation affect the
allocation of society’s economic
resources and economic well-being? In economics language:
1. What is the incidence of an excise
tax (who bears the burden of an
2. How much is the excess burden of an
excise tax (also known as the
deadweight loss due to the tax)? Incidence of an excise tax
Political Science –
Government decides who will bear the tax
by levying it on the consumers (buyers) or
on the producers (sellers).
Statutory incidence ≠ Economic Incidence
The market decides who will bear the tax
– depends on how consumers and
producers react to the tax.
In other words: incidence of the tax
depends on the elasticity of demand and
the elasticity of supply. Economic analysis:
A tax drives a “wedge” between buyers
Buyers pay one price (including the tax),
but sellers receive another price.
We can show this on graph by:
If the tax is levied on consumers, we will
have two demand curves. One represents
the amount buyers pay, the other
represents the amount sellers receive.
Imagine a tax of $10 per sheet on plywood