Department

Economics for Management StudiesCourse Code

MGEA02H3Professor

Gordon ClevelandLecture

4This

**preview**shows pages 1-3. to view the full**9 pages of the document.**Week 4 – Elasticity, Tax Incidence and Tax Burden

A key characteristic of demand and supply curves! – Elasticity

Elasticity = sensitivity or responsiveness

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.

Elasticity of Demand

ED = dQ/dP x P/Q = (dQ / Q) / (dP / P)

ED = percentage change in quantity demanded

percentage change in price

….how consumers respond to a change in market price

Elasticity of Supply

ES = dQ/dP x P/Q

ES = percentage change in quantity supplied

percentage change in price

…how producers respond to a change in market price

If demand is P = 100 – Q, what is the elasticity of demand at Q = 80?

At Q = 80, P = $20

ED = dQ/dP x P/Q = 1/(-1) x 20/80 = ¼

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%.

(Why “about”?)

Terminology:

Demand is elastic if ED > 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).

Consider dTE/dP. TE = P x Q

Both are functions of P

Use product rule.

dTE/dP = (dP/dP x Q) + (dQ/dP x P) = Q + dQ/dP x P

Multiply by Q/Q = Q(Q/Q + dQ/dP x P/Q)

So dTE/dP = Q(1 – ED)

So, if ED > 1, dTE/dP < 0

And if ED < 1, dTE/dP > 0

We can see this on a graph of the demand curve as well….

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Strange, but true, fact

Elasticity is different at every different point along a linear demand curve

Thinking about different goods, some have more elastic demands; others have less elastic demands.

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):

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When demand is inelastic

When demand is unit elastic

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 products)

– 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 cigarettes

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.

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