ELASTICITIES (CONTINUEDâ€¦â€¦â€¦â€¦.):Short Run and Long Run, Incidence of Taxation

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Introduction to Economics ECO401

Lesson 3.3

ELASTICITIES (CONTINUED.............)

If the sign of income elasticity of demand is positive, the good is normal and if sign is negative,

the good is inferior.

Determinants of Income Elasticity of Demand:

The determinants of income elasticity of demand are:

· Degree of necessity of good.

The rate at which the desire for good is satisfied as consumption increases

The level of income of consumer.

Short Run and Long Run:

Short run is a period in which not all factors can adjust fully and therefore adjustment to

shocks can only be partial.

Long run is a period over which all factors can be changed and full adjustment to shocks can

take place.

Incidence of Taxation:

A tax results in a vertical shift of the supply curve as it increases the cost of producing the

taxed product.

The incidence of taxation relates to how much of the tax's burden is being borne by

consumers and producers. The more inelastic the demand, the more of the tax's burden will

fall on consumers. The more inelastic the supply, the more of the tax's burden will fall on

producers.

Terms of trade means the `real' terms at which a nation sells its exports and buys its import.

OPEC: Organization of Petroleum Exporting Countries.

Introduction to Economics ECO401

END OF UNIT 3 EXERCISES

Why will the price elasticity of demand for a particular brand of a product (e.g. Shell) be

greater than that for the product in general (e.g. petrol)? Is this difference the result of a

difference in the size of the income effect or the substitution effect?

The price elasticity of demand for a particular brand is more elastic than that for a product in

general because people can switch to an alternative brand if the price of one brand goes up. No

such switching will take place if the price of the product in general (i.e. all brands) goes up. Thus

the difference in elasticity is the result of a difference in the size of the substitution effect.

Will a general item of expenditure like food (or clothing) have a price-elastic or inelastic

demand? Discuss in the context of income and substitution effects.

The income effect will be relatively large (making demand relatively elastic). The substitution

effect will be relatively small (making demand relatively inelastic). The actual elasticity will

depend on the relative size of these two effects.

Demand for oil might be relatively elastic over the longer term, and yet it could still be

observed that over time people consume more oil (or only very slightly less) despite

rising oil prices. How can this apparent contradiction be explained?

Because, there has been a rightward shift in the demand curve for oil. This is likely to be the

result of rising incomes. Car ownership and use increase as incomes increase. Also tastes may

have changed so that people want to drive more. There may also have been a decline in

substitute modes of transport such as rail transport and buses. Finally, people may travel longer

distances to work as a result of a general move to the suburbs.

Assume that demand for a product is inelastic. Will consumer expenditure go on

increasing as price rises? Would there be any limit?

So long as demand remains inelastic with respect to price, then consumer expenditure will go on

rising as price rises. However, if the price is raised high enough, demand always will become

elastic.

Can you think of any examples of goods which have a totally inelastic demand (a) at all

prices; (b) over a particular price range?

a) No goods fit into this category, otherwise price could rise to infinity with no fall in demand

but people do not have infinite incomes!

b) Over very small price ranges, the demand for goods with no close substitutes, oil, water

(where it is scarce) may be totally inelastic.

What will the demand curve corresponding to the following table look like?

If the curve had an elasticity of 1 throughout its length, what would be the quantity

demanded (a) at a price of £1; (b) at a price of 10p; (c) if the good were free?

Total

P (£)

Expenditure

(£)

2.5

400

1000

200

1000

100

1000

The curve will be a `rectangular hyperbola': it will be a smooth curve, concave to the origin

which never crosses either axis (Qd = 1000/P).

Introduction to Economics ECO401

a. 1000 units.

b. 10 000 units.

c. There would be infinite demand!

Referring to the following table, use the mid-point (arc) formula to calculate the price

elasticity of demand between (a) P = 6 and P = 4; (b) P = 4 and P = 2. What do you

conclude about the elasticity of a straight-line demand curve as you move down it?

Price Quantity Demanded

Using the formula: (ΔQ/mid Q) ÷ (ΔP/mid P) gives the following answers:

(a) 10/25 ÷ 2/5

= 10/25 × 5/2

= 50/50

= 1 (which is unit elastic)

(b) 10/35 ÷ 2/3

= 10/35 × 3/2

= 30/70

= 0.43 (which is inelastic)

The elasticity decreases as you move down a straight-line demand curve.

Given Qd = 60 15P + P², calculate the (point) price elasticity of demand at a price of:

a. 5

b. 2

c. 0.

Given that:

Qd = 60 15P + P²

Then,

dQ/dP = 15 + 2P.

Thus using the formula, Pεd = dQ/dP × P/Q, the elasticity at the each of the above price points

Equals:

(a) (15 + (2 × 5)) × (5/ (60 (15 × 5) + 5²))

= 5 × 5/10 = 2.5

(b) (15 + (2 × 2)) × (2/ (60 (15 × 2) + 2²))

= 11 × 2/34 = 0.65

= 15 × 0/60 = 0

As you move down a straight-line demand curve, what happens to elasticity? Why?

It decreases. P/Q gets less and less, but dQ/dP remains constant.

Given the following supply schedule:

Introduction to Economics ECO401

a. Draw the supply curve.

b. Using the arc method calculate price elasticity of supply:

i. Between P = 2 and P = 4;

ii. Between P = 8 and P = 10

c. Using the point method calculate price elasticity of supply at P = 6.

d. Does the elasticity of the supply curve increase or decrease as P and Q

increase? Why?

e. What would be the answer to (d) if the supply curve had been a straight line but

intersecting the horizontal axis to the right of the origin?

a. The supply curve will be an upward sloping straight line crossing the vertical axis

where P = 2.

b. Using the formula ΔQ/average Q ÷ ΔP/average P, gives:

10/5 ÷ 2/3= 3

10/35 ÷ 2/9= 1.29

c. Using the formula dQ/dP × P/Q, and given that dQ/dP = 5 (= 10/2), gives:

5 × 6/20= 1.5

d. The elasticity of supply decreases as P and Q increase. It starts at infinity where the

supply curve crosses the vertical axis (Q = 0 and thus P/Q =∞).

e. No. At the point where it crossed the horizontal axis, the elasticity of supply would be

zero (P = 0 and thus P/Q = 0). Thereafter, as P and Q increased, so would the

elasticity of supply.

Which are likely to have the highest cross elasticity of demand: two brands of tea, or

tea and coffee?

Two brands of tea, because they are closer substitutes than tea and coffee.

Supply tends to be more elastic in the long run than in the short run. Assume that a tax

is imposed on a good that was previously untaxed. How will the incidence of this tax

change as time passes? How will the incidence be affected if demand too becomes

more elastic over time?

As supply becomes more elastic, so output will fall and hence tax revenue will fall. At the

same time price will tend to rise and hence the incidence will shift from the producer to the

consumer.

As demand becomes more elastic, so this too will lead to a fall in sales. This, however, will

have the opposite effect on the incidence of the tax: the burden will tend to shift from the

consumer to the producer.

If raising the tax rate on cigarettes raise more revenue and reduce smoking, are there

any conflict between the health and revenue objectives of the government?

There may still be a dilemma in terms of the amount by which the tax rate should be raised.

To raise the maximum amount of revenue may require only a relatively modest increase in the

tax rate. To obtain a large reduction in smoking, however, may require a very large increase

in the tax rate. Ultimately, if the tax rate were to be so high as to stop people smoking

altogether, there would be no tax revenue at all for the government!

You are a government minister; what arguments might you put forward in favour of

maximising the revenue from cigarette taxation?

That it is better than putting the taxes on more socially desirable activities. That there is the

beneficial spin-off from reducing a harmful activity. (You would conveniently ignore the option

of putting up taxes beyond the point that maximises revenue and thus cutting down even more

on smoking.)

Introduction to Economics ECO401

You are a doctor; why might you suggest that smoking should be severely restricted?

What methods would you advocate?

That the medical arguments concerning damage to health should take precedence over

questions of raising revenue. You would probably advocate using whatever method was most

effective in reducing smoking. This would probably include a series of measures from large

increases in taxes, to banning advertising, to education campaigns against smoking. You

might even go so far as to advocate making smoking tobacco illegal. The problem here, of

course, would be in policing the law.

Why is the supply curve for food often drawn as a vertical straight line?

It is because; the supply of food is virtually fixed in the short run. Once a crop is grown and

harvested, then it is of a fixed amount. (In practice, the timing of releasing crops on to the

market can vary, given that many crops can be stored. This does allow some variation of

supply with price.)

The income elasticity of demand for potatoes is negative (an `inferior' good). What is

the implication of this for potato producers?

Potato producers would expect to earn less as time goes past, given that national income rises

over time. Thus if the incomes of individual potato producers are to be protected, production

should be reduced (with some potato dairy farmers switching to other foodstuffs or away from

food production altogether).

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