1

Determinants of Elasticity

1. Availability of substitutes2. Necessities vs. Luxuries3. Importance in the Buyer’s Budget4. Time Horizon• The demand is more price elastic:

– close substitutes are easy to find– The less of a “necessity” (luxurious)– The more of total budgets spent on

good– The longer the time horizon

2

Two Practical Examples

1. Elasticity and Mass Transit• long-run demand for mass transit is

inelastic• An increase in fares

– would increase revenue– would decrease ridership

2. Elasticity and an Oil Crisis• to bring about 1% percent decrease in

world oil demand• oil prices would have to rise by 6.67%

3

Income Elasticity of Demand

• Percentage change in quantity demanded divided by the percentage change in income–percentage increase in quantity demanded for each 1% rise in income

Income

QE DY

%

%

4

Income Elasticity of Demand

• Differences– Price elasticity of Demand

• sensitivity of demand to price as we move along a demand curve

• virtually always negative

– Income elasticity of Demand• relative shift in demand curve • positive or negative

5

Cross-Price Elasticity of Demand

• Percentage change in quantity demanded of one good (x) caused by a 1% change in the price of another good (y)

y

Dxy P

QE x

%

%

• Substitutes: Exy >0

• Complements: Exy <0

6

Price Elasticity of Supply

• Percentage change in quantity of a good supplied, caused by a 1% change in the price of the good

P

QE SS

%

%

• The more easily suppliers can switch from/to alternate goods, the more elastic the supply

7

Taxes and Market Equilibrium

• Excise tax - tax on a specific good – to raise the price and discourage the use – A tax collected from sellers

• shifts the supply curve upward by the amount of the tax

– A tax collected from buyers• shifts the demand curve downward

8

An Excise Tax on Sellers - Airlines• Figure 7 A Tax on Sellers Shifts the Supply Curve Upward

S1

SAfter Tax

$360

300

10

Price per

Ticket

Millions of

Tickets per Year

A

A’

with a $60 tax, the

airlines must get $60 more

than before to supply any

given number of tickets.

9

An Excise Tax on Sellers - Airlines• Figure 8 The Effect of an Excise Tax Imposed on Sellers

S1

Safter tax$360

300

10

Price per

Ticket

Millions of

Tickets per Year

A

B

Before the tax

After the tax

Buyers pay $40 of the tax

Sellers pay $20 of the tax

340

D

7.5

10

An Excise Tax on Buyers• Figure 9 A Tax on Buyers Shifts the Demand Curve Downward

$300

240

10

Price per

Ticket

Millions of

Tickets per Year

A’

A

D1

D After Tax

with a $60 tax imposed on buyers

they must be charged $60 less

than before to demand any

given number of tickets.

11

An Excise Tax on Buyers• Figure 10 The Effect of an Excise Tax Imposed on Buyers

300

10

Price per

Ticket

Millions of

Tickets per Year

A

D1

D After Tax

Before the tax

S

C280

$340

7.5

After the tax

Buyers pay $40 of the tax

Sellers pay $20 of the tax

280

$340

Incidence of tax

• The incidence of a tax is the same no matter the tax is imposed on buyers or imposed on sellers

• The incidence of a tax depends on the elasticity of demand and supply. – The more elastic side will take less of the tax

burden, and vice versa– Because the elastic side has more options.

(switch to substitute or alternative good)

12

13

The War on Drugs

• Figure 11(a) - Market for drug without government intervention

• Figure 11(b) - Result of government efforts to restrict supply (current policy)– Price rises; – Total expenditure increases

• Figure 11(c) - Results of an effective policy of reducing demand– Price falls; – Total expenditure falls

14

The War on Drugs

P1

Q1

D1

A

S1

Quantity

Price per Unit

• Figure 11a The War on Drugs

15

The War on Drugs

B

Q1

S2

P2

Q2

P1

D1

S1

Quantity

Price per Unit

A

• Figure 11b The War on Drugs

16

The War on Drugs

P1

Q1

D1

A

S1

Quantity

Price per Unit

C

D2

Q3

P3

• Figure 11c The War on Drugs