Elasticity  and  Taxation  Important  Knowledge    

• Elasticity  is  the  measure  of  responsiveness  of  one  thing  to  another  • Price  Elasticity  of  Demand  is  the  measure  of  responsiveness  of  price  to  a  change  in  

quantity.  PED=  %Change  in  Quantity                             %Change  in  Price      

• Price  Elasticity  of  Supply  is  the  measure  of  responsiveness  of  price  to  a  change  in  Supply.  PED=  %Change  in  Supply                         %Change  in  Price      

• Income  Elasticity  of  Demand  is  the  measure  of  responsiveness  of  Income  to  a  change  in  quantity.  PED=  %Change  in  Quantity                               %Change  in  Income  .  Elasticity   Absolute  Value  Elastic   >1  Inelastic   <1  Unitary  Elastic   1  Perfectly  Elastic   Infinity  Perfectly  Inelastic   0  

 • Greater  PED  and  lesser  PES  mean  a  greater  burden  of  tax  on  producer.  • Greater  PES  and  lesser  PED  mean  a  greater  burden  of  tax  on  consumer.  

(Note:  the  same  applies  to  subsidy    • The  sum  of  consumer  surplus  and  producer  surplus  is  the  total  surplus.  A  decrease  in  

total  surplus  due  to  taxes  is  referred  to  as  welfare  loss.    

                                    PED=  Perfectly  inelastic  or  PED=0                                                         DD    Price   DD                                                                                             PED=  Perfectly  Elastic  or  Inifite  PED              

                                    PES=  Perfectly  inelastic  or  PES=0                                                         SS    Price   SS                                                                                             PES=  Perfectly  Elastic  or  Inifite  PES                                                                                                                               Quantity    

• In  a  downward  sloping  demand  curve,  the  top  half  is  inelastic  while  the  bottom  half  is  elastic.  

• A  supply  curve  is  elastic  if  it  starts  from  the  y  axis,  inelastic  is  it  starts  from  the  x  axis  and  unitary  elastic  if  it  starts  from  the  origin.  

 Summary  of  Questions  to  be  Asked:  1. Calculate  the  Point  and  Arc  Elasticity  of  demand  

i) Point  Elasticity  of  Demand  =  Change  in  Q*  P                                                 Change  in  P*  Q  

ii) Arc  Elasticity  of  Demand/Mid-­‐point  Method  [Q2-­‐Q1]*[Q2+Q1/2]     [P2-­‐P1]*[P1+P2/2]  

2. What  would  be  the  incidence  of  taxation  if:  i) PED=O/PES=Infinity  

All  of  the  burden  of  the  tax  would  go  to  the  consumer  because  demand  is  irresponsive  to  change  in  price  (PED)  The  burden  goes  on  the  consumer  because  producers  are  extremely  sensitive  to  costs  and  supply  will  decrease  to  zero  if  the  burden  of  tax  falls  on  them  (PES)  

ii) PED=Infinity/  PES=0  The  entire  burden  falls  on  the  Producer.  

iii) PED=1/PES=1  The  burden  is  shared  equally  between  the  producer  and  consumer.  (General  Rule:  The  inelastic  party  gets  most  of  the  burden).  

Common Exam Questions: 2012 Short Answer Question 3 Why is elasticity not constant along a linear demand function even though the slope is constant? Answer: Elasiticity is (1/slope) * original price/original q. If slope is more, elasticity is less and if slope is less, elasticity is more. 2012 Multiple Choice Question 1 If per capita incomes increased by 10% and household expenditures on fur coats increased by 15%, one can conclude that the price elasticity of demand for fur coats is a. positive b. not determinable from the given information c. elastic d. unit elastic e. inelastic

Answer: Not determinable since we need change in price and change in quantity for PED, but those are not given 2011 Multiple Choice Question 2 Which of the following is true at equilibrium for the Buyers’ share of a per/unit tax on a commodity that has perfectly elastic demand and relatively elastic supply? a. The buyers share of the tax is zero b. The buyers share of the tax is more than zero, but less than the seller’s share of tax c. The buyers share of the tax is greater than the seller’s share of tax d. The buyers share is equal to the total amount of the per unit tax e. None of the above Answer: Perfectly elastic demand means demand will be zero if there is even a slight increase in price. Hence, producers are forced to take all the burden and buyer's share is zero.

2009 Multiple Choice Question 3 If demand on Canadian exports is unit elastic, which of the following statements is true? a. An increase in price increases total revenue from exports b. An increase in price decreases total revenue from exports c. An decrease in price increases total revenue from exports d. an increase in price will not change total revenue from export e. none of the above f. Answer: Unit elastic means equally proportional change in opposite directions of price and Qd. Hence, as revenue is Qd*P, total revenue remains constant. 2009 Multiple Choice Question 6 Suppose that 700 units of a commodity sell at $28 and 900 units sell at $23. Which of the following is the equation for demand? a. P = 28 - 0.02Q b. P = 28 - 0.025Q c. P = 28 - 0.04Q d. P = 45.5 - 0.02Q e. P = 45.5 - 0.025Q f. P = 45.5 - 0.04Q g. P = 51 - 0.02Q h. P = 51 - 0.025Q i. P = 51 - 0.04Q j. none of the above Answer: Elastic demand and inelastic supply means the producer takes all the benefit. So seller's price is equilibrium market price - subsidy.

2009 Problem Format Question 4 and 5

2011 Problem Format Question 4 and 5

2012 Problem Format Question 4 and 5