Determinants of Elasticity

1. Determinants of Elasticity • Availability of substitutes • Necessities vs. Luxuries • Importance in the Buyer’s Budget • Time Horizon • The demand is more price elastic: • close substitutes are easy to find • The less of a “necessity” (luxurious) • The more of total budgets spent on good • The longer the time horizon

2. Two Practical Examples • Elasticity and Mass Transit • long-run demand for mass transit is inelastic • An increase in fares • would increase revenue • would decrease ridership • Elasticity and an Oil Crisis • to bring about 1% percent decrease in world oil demand • oil prices would have to rise by 6.67%

3. Income Elasticity of Demand • Percentage change in quantity demanded divided by the percentage change in income • percentage increase in quantity demanded for each 1% rise in income

4. Income Elasticity of Demand • Differences • Price elasticity of Demand • sensitivity of demand to price as we move along a demand curve • virtually always negative • Income elasticity of Demand • relative shift in demand curve • positive or negative

5. Cross-Price Elasticity of Demand • Percentage change in quantity demanded of one good (x) caused by a 1% change in the price of another good (y) • Substitutes: Exy >0 • Complements: Exy <0

6. Price Elasticity of Supply • Percentage change in quantity of a good supplied, caused by a 1% change in the price of the good • The more easily suppliers can switch from/to alternate goods, the more elastic the supply

7. Taxes and Market Equilibrium • Excise tax - tax on a specific good • to raise the price and discourage the use • A tax collected from sellers • shifts the supply curve upward by the amount of the tax • A tax collected from buyers • shifts the demand curve downward

8. An Excise Tax on Sellers - Airlines • Figure 7 A Tax on Sellers Shifts the Supply Curve Upward SAfter Tax Price per Ticket S1 $360 A’ with a $60 tax, the airlines must get $60 more than before to supply any given number of tickets. 300 A Millions of Tickets per Year 10

9. An Excise Tax on Sellers - Airlines • Figure 8 The Effect of an Excise Tax Imposed on Sellers Price per Ticket After the tax Buyers pay $40 of the tax Sellers pay $20 of the tax Safter tax $360 340 B S1 300 A Before the tax D 7.5 Millions of Tickets per Year 10

10. An Excise Tax on Buyers • Figure 9 A Tax on Buyers Shifts the Demand Curve Downward with a $60 tax imposed on buyers they must be charged $60 less than before to demand any given number of tickets. Price per Ticket A $300 A’ 240 D1 D After Tax Millions of Tickets per Year 10

11. An Excise Tax on Buyers • Figure 10 The Effect of an Excise Tax Imposed on Buyers Price per Ticket Buyers pay $40 of the tax Sellers pay $20 of the tax S $340 $340 A Before the tax 300 C 280 280 After the tax D1 D After Tax Millions of Tickets per Year 7.5 10

12. Incidence of tax The incidence of a tax is the same no matter the tax is imposed on buyers or imposed on sellers The incidence of a tax depends on the elasticity of demand and supply. • The more elastic side will take less of the tax burden, and vice versa • Because the elastic side has more options. (switch to substitute or alternative good)

13. The War on Drugs • Figure 11(a) - Market for drug without government intervention • Figure 11(b) - Result of government efforts to restrict supply (current policy) • Price rises; • Total expenditure increases • Figure 11(c) - Results of an effective policy of reducing demand • Price falls; • Total expenditure falls

14. Price per Unit Quantity The War on Drugs • Figure 11a The War on Drugs S1 A P1 D1 Q1

15. Price per Unit Quantity The War on Drugs • Figure 11b The War on Drugs S2 B S1 P2 A P1 D1 Q2 Q1

16. Price per Unit Quantity The War on Drugs • Figure 11c The War on Drugs S1 A P1 C P3 D1 D2 Q3 Q1