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Lecture

Week4.Elasticity.2009.doc

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Department
Business
Course
BU357
Professor
Irene Cheung
Semester
Fall

Description
Week 4 – Elasticity, Tax Incidence and Tax Burden A key characteristic of demand and supply curves! – Elasticity 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%. (Why “about”?) Terminology: Demand is elastic if E D 1 Demand is inelastic if E D 1 Demand is unit(ary) elastic if E D 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 D 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 P A B C Demand Curve Q 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): P A B C Demand Curve Q When demand is inelastic P A B C Demand Curve Q When demand is unit elastic P A B C Demand Curve 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 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. 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 excise tax)? 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). Economics – 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 and sellers. 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 sheets… Price $60 $50 $40 Tax (per unit amount) $25 Original Dema $15 nd (D) Net-of-tax Demand
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