Today zReview question #3 from last lecture zIncome elasticity of demand. zPrice elasticity of supply. zExcise taxes and tax incidence.

Today

Review question #3 from last lectureIncome elasticity of demand.Price elasticity of supply.Excise taxes and tax incidence

3. Pricing parking spaces in a parking lot

You think that if you reduce prices then you will be able to fill more spots and therefore earn more money. Your friend says that you should raise prices and thereby increase revenue even if fewer people park there.

Suppose you find out that the elasticity of demand (at your current price) is equal to 0.80. How can this information settle your debate?

Income Elasticity of Demand

How responsive QD is to changes in income.Often use “Y” to repr. income.

Y = % QD/ %Y

Y may be positive or negative, depending on whether this good is normal or inferior.

Normal if Y > 0.

Inferior if Y < 0.

What determines income elasticity?

How “basic” the item is.What the current level of income is.

Categories of income elasticity, normal goods

0 < Y < 1 Income inelastic, “necessity” % QD < % Y

As income rises, QD rises but a smaller percentage of income is spent on these goods.

Categories of income elasticity, cont’d.

Y > 1 Income elastic, “luxury” % QD > % Y

As income rises, QD rises and a larger percentage of income is spent on these goods.

The terms necessity and luxury shouldn’t be taken literally.

A good’s income elasticity of demand depends on current income.

Example: Meat

At very low levels of income, meat is a luxury good and Y > 1.

At moderate levels of income, meat is a necessity and Y < 1.

At high levels of income, people don’t want more meat, and Y is near zero.

Conclusion: The income elasticity of meat depends on the initial level of income.

Price Elasticity of Supply

How responsive QS is to a change in price.

S = % QS

% PGenerally expected to be a positive

number. (Why?)Used when demand is changing while S

is fixed.

Evaluating Price Elasticity of Supply

Inelastic supply: When 0 < S < 1. Quantity supplied is not particularly responsive

to changes in price.

Unit elastic supply: When S = 1. Quantity supplied and price change by equal

percentages.

Elastic supply: When 1 < S . Quantity supplied responds more than

proportionately to changes in price.

Perfectly Inelastic Supply

S = 0.

QS is fixed, will not increase with rising demand.

Level of D determines price.

When applicable?

Q

P S

Perfectly Elastic Supply

S = .Suppliers will

supply whatever Q is demanded at this price.

Increases in D do not increase price.

(Applies to LR for some markets.)

Q

P

S

SLR

Elasticity of Supply: SR & LR

Supply is more elastic in the LR than in the SR.

Why?

Q

P

SSRSSRSSR

Application: Tax incidence

Excise tax: Tax on the sale of a particular good.

Commonly used on gasoline, cigarettes, alcoholic beverages.

Tax incidence: refers to how much the tax affects buyers versus sellers.

0.50

Excise tax on Gasoline-50¢

1,000 Gal. of gas

Price/Gal. S shifts up by 50¢ b/c sellers need 50¢ more to sell each quantity.

Why doesn’t P rise by 50¢?D

S

S’

1.00

5

0.75

4

1.25

6

1.50

Basic results of excise tax

The price of the taxed good will go up, but not by the full amount of the tax.

When sales of a good are taxed, less is sold.

General result: When the government taxes an activity, people do less of it.

0.50

Excise tax on Gasoline-50¢

1,000 Gal. of gas

Price/Gal. Price paid by consumers is $1.25

Price kept by producers is $0.75.

What happens to the rest?

D

S

S’

1.00

5

0.75

4

1.25

6

Tax Incidence

The gov’t collects $0.50(4,000) =$2,000 in tax revenue.

Producers lose $0.25(4,000) = $1,000 in revenue.

Consumers pay $0.25(4,000) = $1,000 extra.

Question

In our example, the consumers and the producers “split” the cost of the tax 50-50. Will that always be true?

0.50

Inelastic Demand

1,000 Gal. of gas

Price/Gal. Price paid by consumers rises 40¢

Price kept by producers falls 10¢

QD doesn’t fall as much.

D

S

S’

1.00

5

0.90

4.6

1.40

Tax Incidence& Demand Elasticity

The tax incidence falls more on consumers (& less on producers) when demand is inelastic relative to supply.

Check for yourself what happens when you change the price elasticity of supply, leaving D the same.

Coming Up

Next Time: Review for exam.One week from today: First midterm

exam.

Group Work

Problems on income elasticity of demand

Problem on price elasticity of demand.

Income elasticity of demand for soda

IncomeQD of Soda per

Year

1999 $26,000 50 gallons

2000 $30,000 63 gallons

• Calculate the income elasticity of demand for soda.

• Is this good normal or inferior? A necessity or a luxury good?

Income elast of demand for restaurant meals

Income$ spent on

restaurant meals% of inc. spent on

rest. meals

$30,000 $1,000

$45,000 $1,700

• Calculate the % of income spent on restaurant meals at each income level.

• Is this good normal or inferior? A necessity or a luxury good?

Water authority wants usage to fall during drought

There is a meeting to consider raising the price. One person says, “You can increase the price of water, but since it is a necessity, people won’t cut back.”

You, however, convince the water authority to raise prices by 30 percent, predicting a 25 percent reduction in consumption.

What price elasticity of demand did you use in your calculation?

Water Problem, Cont’d.

One month after the new rates are implemented, the water company reports that consumption has fallen 3 percent, and water officials are greatly discouraged.

What is the price elasticity of demand, as indicated by the experience of this water company so far? Show your work.

Were you necessarily wrong? [Hint: Will the situation be the same six months from now?]