Econ 2 Files
Econ 2 Lecture
Notes
Lecture 12: Applications of Elasticity
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Economics 2 |
Lecture 12: Applications of Elasticity
determinants of the price elasticity of demand
elasticity and total revenue
price discrimination
tax incidence
other elasticities
Determinants of Price Elasticity of Demand
- existence of substitutes: the more substitutes, the more elastic the demand
- importance of the product in the consumer's total budget: the greater the portion of the consumer's budget, the more elastic the demand
- time period under consideration: the longer the time period, the more elastic
- luxury or a necessity: the demand for luxuries is relatively elastic
- definition of the market: the more broadly defined the market, the more inelastic the demand, e.g. food vs. chicken
Elasticity and Total Revenue
Total revenue (TR) is equal to price times quantity sold.
- if demand is elastic, a rise in price causes a fall in TR
- if demand is inelastic, a rise in price causes TR to increase
- if demand is unit elastic, TR does not change when price changes
Price Discrimination
Price discrimination refers to charging different customers different prices for the same product, e.g. senior citizens discounts on movie tickets. Firms can increase their revenues and profits by charging a higher price to customers with inelastic demand and a lower price to customers with demand that is elastic.
Tax Incidence
Suppose that the equilibrium price initially is $1.00 and that a sales tax of 25¢ per unit sold is collected from sellers. The tax shifts up the supply curve by the amount of the tax. For the relatively elastic demand curve the equilibrium price rises to $1.10. The rise in price from $1.00 to $1.10 is the amount of the tax paid by buyers. So, buyers pay 10¢ of the tax. Sellers used to receive and keep $1.00 per unit sold. Now, with the tax sellers receive $1.10 but keep just 85¢ after paying the 25¢ tax. So, sellers pay 15¢ of the tax. For the relative inelastic demand, buyers pay 20¢ of the tax while sellers pay the remaining 5¢. Two things: (1) regardless of who the tax is nominally collected from, buyers and sellers typically both pay a portion of the sales tax and (2) the more inelastic the demand, the more of the tax paid by by buyers.
Other Elasticities
Cross Price Elasticity of Demand
percentage change in the quantity demanded for good A
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percentage change in the price of good B
When the cross price elasticity of demand is positive, goods A and B are substitutes. A negative elasticity indicates that A and B are complements.
Income Elasticity of Demand
percentage change in the quantity demanded for good A
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percentage change in income
The income elasticity of demand is greater than zero for normal goods and less than zero for inferior goods.
Elasticity of Supply
percentage change in quantity supplied
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percentage change in price
Supply is elastic when the elasticity of supply is greater than 1 and inelastic when the elasticity is less than 1. The elasticity of supply depends on the ability of firms to change production techniques or switch from producing one good to another, for example, a bakery versus an automaker.
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