Income Elasticity of Demand
How responsive QD is to changes in income.Often use “Y” to repr. income.
Y = % QD/ %Y
Y may be positive or negative, depending on whether this good is normal or inferior.
Normal if Y > 0.
Inferior if Y < 0.
Categories of income elasticity, normal goods
0 < Y < 1 Income inelastic, “necessity” % QD < % Y
As income rises, QD rises but a smaller percentage of income is spent on these goods.
Categories of income elasticity, cont’d.
Y > 1 Income elastic, “luxury” % QD > % Y
As income rises, QD rises and a larger percentage of income is spent on these goods.
The terms necessity and luxury shouldn’t be taken literally.
A good’s income elasticity of demand depends on current income.
Example: Meat
At very low levels of income, meat is a luxury good and Y > 1.
At moderate levels of income, meat is a necessity and Y < 1.
At high levels of income, people don’t want more meat, and Y is near zero.
Conclusion: The income elasticity of meat depends on the initial level of income.
Price Elasticity of Supply
How responsive QS is to a change in price.
S = % QS
% PGenerally expected to be a positive
number. (Why?)Used when demand is changing while S
is fixed.
Evaluating Price Elasticity of Supply
Inelastic supply: When 0 < S < 1. Quantity supplied is not particularly responsive
to changes in price.
Unit elastic supply: When S = 1. Quantity supplied and price change by equal
percentages.
Elastic supply: When 1 < S . Quantity supplied responds more than
proportionately to changes in price.
Perfectly Inelastic Supply
S = 0.
QS is fixed, will not increase with rising demand.
Level of D determines price.
When applicable?
Q
P S
Perfectly Elastic Supply
S = .Suppliers will
supply whatever Q is demanded at this price.
Increases in D do not increase price.
(Applies to LR for some markets.)
Q
P
S
SLR
Elasticity of Supply: SR & LR
Supply is more elastic in the LR than in the SR.
Why?
Q
P
SSRSSRSSR
Application: Tax incidence
Excise tax: Tax on the sale of a particular good.
Commonly used on gasoline, cigarettes, alcoholic beverages.
Tax 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. S shifts up by 50¢ b/c sellers need 50¢ more to sell each quantity.
Why doesn’t P rise by 50¢?D
S
S’
1.00
5
0.75
4
1.25
6
1.50
Basic results of excise tax
The price of the taxed good will go up, but not by the full amount of the tax.
When sales of a good are taxed, less is sold.
General 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. Price paid by consumers is $1.25
Price kept by producers is $0.75.
What happens to the rest?
D
S
S’
1.00
5
0.75
4
1.25
6
Tax Incidence
The gov’t collects $0.50(4,000) =$2,000 in tax revenue.
Producers lose $0.25(4,000) = $1,000 in revenue.
Consumers pay $0.25(4,000) = $1,000 extra.
Question
In our example, the consumers and the producers “split” the cost of the tax 50-50. Will that always be true?
0.50
Inelastic Demand
1,000 Gal. of gas
Price/Gal. Price paid by consumers rises 40¢
Price kept by producers falls 10¢
QD doesn’t fall as much.
D
S
S’
1.00
5
0.90
4.6
1.40
Tax Incidence& Demand Elasticity
The tax incidence falls more on consumers (& less on producers) when demand is inelastic relative to supply.
Check for yourself what happens when you change the price elasticity of supply, leaving D the same.
Group Work
Problems on income elasticity of demand
Problem on the relationship between tax incidence on the price elasticity of demand.
Income elasticity of demand for soda
IncomeQD of Soda per
Year
1999 $26,000 50 gallons
2000 $30,000 63 gallons
• Calculate the income elasticity of demand for soda.
• Is this good normal or inferior? A necessity or a luxury good?
Income elast of demand for restaurant meals
Income$ 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. Use this graph
& the 2 earlier ones from lecture to fill in the table on the next slide.
Hint: To get price elasticity of D, use numbers along D curve.
D
S
S’
1.00
5
0.65
2.3
1.15
Table for Gas Tax
Price Elasticity
of D
Gov’t Revenue
Producers’ lost revenue
Consumers’ extra
payment
Inelastic D(2nd ex.)
$2,300
First Ex. 1.0 $2,000 $1,000 $1,000
Elastic D(3rd ex.)
$805 $345