Lecture # 6 -- Elasticity/Taxes

Transcription

1 Lecture # 6 -- Elasticity/Taxes I. Elasticity Elasticity tells us the percentage change that will ccur in ne variable due t a ne percent change in anther variable. It is a unit-free measure f cmparisn. Price elasticity f demand measures the sensitivity f quantity demanded t price changes. It tells us the percentage change in quantity demanded fr a 1% change in price. εp = % change quantity demanded/% change price Elastic vs. inelastic abslute value > 1 = elastic abslute value < 1 = inelastic Demand curves are steeper when demand is inelastic Inelastic demand is a steep demand curve Quantity demanded des nt change much, even fr large changes in price. An extreme case is perfectly inelastic demand: quantity demanded is the same at any price:

2 Elastic demand is a flat demand curve. Even small changes in price result in large changes in quantity demanded. An extreme case is perfectly elastic demand: the price is the same fr any quantity demanded.

3 Elastic vs. inelastic abslute value > 1 = elastic abslute value < 1 = inelastic Elasticity and revenue: When price is inelastic, price and revenue mve tgether. An increase in price raises revenue. Intuitin: if demand is inelastic, cnsumers will nt respnd much t a change in price. Mst peple still purchase the gd, and they pay mre t d s. When price is elastic, price and revenue mve in the ppsite directin. Revenues fall when the price is raised. Intuitin: if demand is elastic, cnsumers respnd strngly t a change in price. The drp in quantity dminates the increased price. Crss-price elasticity f demand -- the percentage change in quantity demanded f gd x due t a 1% change in price f gd y. exy< 0 implies cmpliments (e.g. cffee and sugar) exy> 0 implies substitutes (e.g. hney and sugar) Incme elasticity f demand -- the percentage change in quantity demanded due t a ne percent change in incme. ey< 0 is an inferir gd ey> 0 is a nrmal gd ey> 1 is a luxury ey between 0 and 1 is a necessity Althugh the abve examples are fr demand, nte that we can d the same thing fr supply. II. Shrt-run vs. Lng-run elasticities Factrs influencing elasticity include: Availability f substitutes Need: hw imprtant is the gd t cnsumers Time: cnsumers are mre flexible when they have mre time t change (mre n this belw) Expenditure as a percentage f incme Price changes matter mre when the gd uses up a larger share f yur incme In this sectin, we fcus n the rle f time. Shrt- vs. lng-run elasticity Fr mst gds, demand is mre inelastic in the shrt run than the lng run Mre pprtunities t change behavir are available in the lng run. Fr example, when gas prices rise, peple can't d much right away, but eventually they can buy mre fuel-efficient cars.

4 Fr durable gds, demand is mre elastic in the shrt run. Durable gds are gds that last a lng time, such as cars. When prices rise, peple can put ff buying a new car. Hwever, eventually they will need t buy ne, s demand becmes mre inelastic as time passes. The New Yrk Times example n husing prices illustrates differences between the shrt and lng run. In the shrt-run, supply is very inelastic. Thus, as demand increases, prices rise sharply. This als affects lng-time residents f a cmmunity, as the value f their hmes (and their prperty taxes) als increase. In respnse, sme lcalities are giving a break n prperty taxes t lcal residents. This wrks because nly thse wh have lived in the hme fr a lng time can benefit. It des nt increase demand acrss the brader market, althugh it des lwer the supply f hmes available fr sale t new residents (since fewer peple mve ut). The plicy may cause ther distrtins, hwever, such as lng-time residents unable t dwnsize t a smaller hme because they will lse their tax break.

5 III. Taxes Taxes can be represented by a shift f the supply curve r the demand curve. Only ne curve shifts. The shift represents the amunt f the tax. Nte that the difference between what cnsumers pay and suppliers receive is the tax That is, PC = PS + tax, r PS= PC - tax Only shift the curve fr the party that faces the legal incidence. That is the grup frm which the gvernment cllects the tax. The new curve represents the curve faced by the ther party. Example: If a tax is placed n sellers, supply shifts up and in. This new supply curve is the supply faced by cnsumers. In this case, the new supply curve represents PC = PS + tax, which is the amunt f mney cnsumers will have t pay t seller. Equilibrium is where the shifted demand (supply) curve intersects the supply (demand) curve. Intuitin: the riginal curve represents the cnsumers tastes. It tells us hw much they are willing t pay fr the gd. Cnsumers dn't care abut whether they pay mney t the gvernment r the supplier -- all that matters is the ttal amunt they pay. Suppliers, n the ther hand, nly care abut the mney that they receive after taxes are paid. When there is a tax n cnsumers, part f what cnsumers pay ges t the gvernment. The shifted demand curve represents what is left t g t suppliers after the tax is paid.

6 The graph belw illustrates the case when shifting supply. Quantity falls after the tax. Cnsumers pay mre -- their new price is PC. Because suppliers use sme f that mney t pay the tax, they keep less. They nly get t keep PS. The difference between PC and PS is the amunt f the tax.

7 Similarly, we culd represent the tax by shifting demand instead. Here, the new demand curve represents PS = PC tax. It is hw much mney suppliers will get frm cnsumers after cnsumers pay the tax. That is because cnsumers nly care abut the ttal amunt they pay. They dn't care wh they pay the mney t. Quantity falls after the tax. Cnsumers pay mre -- their new price is PC. Because cnsumers use sme f that mney t pay the tax, they give less t the seller. Sellers nly get t keep PS. The difference between PC and PS is the amunt f the tax. Nte that in bth cases, the new price fr cnsumers cmes frm the riginal demand curve, and the new price fr sellers frm the riginal supply curve.