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

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

3. Pricing parking spaces in a parking lot zYou 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. zSuppose 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 zHow responsive Q D is to changes in income. zOften use “Y” to repr. income. z  Y = %  Q D / %  Y z  Y may be positive or negative, depending on whether this good is normal or inferior. zNormal if  Y > 0. zInferior if  Y < 0.

What determines income elasticity? zHow “basic” the item is. zWhat the current level of income is.

Categories of income elasticity, normal goods z0 <  Y < 1 yIncome inelastic, “necessity” y%  Q D < %  Y yAs income rises, Q D rises but a smaller percentage of income is spent on these goods.

Categories of income elasticity, cont’d. z  Y > 1 yIncome elastic, “luxury” y%  Q D > %  Y yAs income rises, Q D rises and a larger percentage of income is spent on these goods. zThe terms necessity and luxury shouldn’t be taken literally. zA good’s income elasticity of demand depends on current income.

Example: Meat zAt very low levels of income, meat is a luxury good and  Y > 1. zAt moderate levels of income, meat is a necessity and  Y < 1. zAt high levels of income, people don’t want more meat, and  Y is near zero. zConclusion: The income elasticity of meat depends on the initial level of income.

Price Elasticity of Supply zHow responsive Q S is to a change in price.  S = %  Q S %  P zGenerally expected to be a positive number. (Why?) zUsed when demand is changing while S is fixed.

Evaluating Price Elasticity of Supply zInelastic supply: When 0 <  S < 1. yQuantity supplied is not particularly responsive to changes in price. zUnit elastic supply: When  S = 1. yQuantity supplied and price change by equal percentages. zElastic supply: When 1 <  S. yQuantity supplied responds more than proportionately to changes in price.

Perfectly Inelastic Supply z  S = 0. zQ S is fixed, will not increase with rising demand. zLevel of D determines price. zWhen applicable? Q PS

Perfectly Elastic Supply z  S = . zSuppliers will supply whatever Q is demanded at this price. zIncreases in D do not increase price. z(Applies to LR for some markets.) Q P S

S LR Elasticity of Supply: SR & LR zSupply is more elastic in the LR than in the SR. zWhy? Q P S SR

Application: Tax incidence zExcise tax: Tax on the sale of a particular good. zCommonly used on gasoline, cigarettes, alcoholic beverages. zTax 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. zS shifts up by 50¢ b/c sellers need 50¢ more to sell each quantity. zWhy 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 zThe price of the taxed good will go up, but not by the full amount of the tax. zWhen sales of a good are taxed, less is sold. zGeneral 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. zPrice paid by consumers is \$1.25 zPrice kept by producers is \$0.75. zWhat happens to the rest? D S S’ 1.00 5 0.75 4 1.25 6

Tax Incidence zThe gov’t collects \$0.50(4,000) =\$2,000 in tax revenue. zProducers lose \$0.25(4,000) = \$1,000 in revenue. zConsumers pay \$0.25(4,000) = \$1,000 extra.

Question zIn 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. zPrice paid by consumers rises 40¢ zPrice kept by producers falls 10¢ zQ D doesn’t fall as much. D S S’ 1.00 5 0.90 4.6 1.40

Tax Incidence & Demand Elasticity zThe tax incidence falls more on consumers (& less on producers) when demand is inelastic relative to supply. zCheck for yourself what happens when you change the price elasticity of supply, leaving D the same.

Coming Up zNext Time: Review for exam. zOne week from today: First midterm exam.

Group Work zProblems on income elasticity of demand zProblem on price elasticity of demand.

Income elasticity of demand for soda Income Q D of Soda per Year 1999\$26,00050 gallons 2000\$30,00063 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 zThere 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.” zYou, however, convince the water authority to raise prices by 30 percent, predicting a 25 percent reduction in consumption. zWhat price elasticity of demand did you use in your calculation?

Water Problem, Cont’d. zOne month after the new rates are implemented, the water company reports that consumption has fallen 3 percent, and water officials are greatly discouraged. zWhat is the price elasticity of demand, as indicated by the experience of this water company so far? Show your work. zWere you necessarily wrong? [Hint: Will the situation be the same six months from now?]

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