Today zIncome elasticity of demand. zPrice elasticity of supply. zExcise taxes and tax incidence

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’

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’

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 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’

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 the relationship between tax incidence on the 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?

0.50 Elastic Demand & Gas Tax Incidence 1,000 Gal. of gas Price/Gal. zUse this graph & the 2 earlier ones from lecture to fill in the table on the next slide. zHint: To get price elasticity of D, use numbers along D curve. D S S’

Table for Gas Tax Price Elasticity of D Gov’t Revenue Producers’ lost revenue Consumers’ extra payment Inelastic D (2 nd ex.) $2,300 First Ex.1.0$2,000$1,000 Elastic D (3 rd ex.) $805$345

Questions about Tax Incidence zDoes your table confirm or refute the statement made in lecture about the relationship between price elasticity of D and tax incidence? zWhat is the relationship between price elasticity of D and gov’t revenue from the gas tax?