LECTURE NOTES CH 4 ELASTICITY

Learning Outcomes Understand the meaning of e asticit! of demand Understand that e asticit! of demand can "e #ith res$ect to income% other $rices or o#n $rices Simi ar ! understand the meaning of e asticit! of su$$ !% the determinants of su$$ ! e asticit! and the e asticit! of su$$ ! in short and ong run Understand that a ta& can ha'e different incidence on demanders and su$$ iers de$ending on the e asticit! of demand or su$$ ! Understand norma and inferior goods "! e&amining their income e asticit! Understand su"stitutes and com$ ements "! e&amining their cross $rice e asticit!

ELASTICITY O( )E*AN) Refers to res$onsi'eness of demand to changes in o#n $rice% or other determinants of demand +or factors that affect demand,Own price elasticity of demand responsiveness of demand to changes in own price Cross price elasticity of demand responsiveness of demand to changes in prices of other products.(substitutes or complements) Income elasticity of demand responsiveness of demand to changes in income . / change in 0uantit!1 / change in $rice Ca cu ating / changes and the im$ortance of a'erage 'a ue of 2 in ca cu ating e asticit! of demand for 2 The discussion "e o# e&$ ains that #hen !ou ta3e / change% !ou can end u$ #ith t#o ans#ers% "ut !ou can get a uni4ue ans#er for / change if !ou ta3e the change from the a'erage 'a ueSa! 25. 67 and it increases to 26.87- 9hat is / change in 2: It can "e +87;67,187 . 518 if #e ta3e the change #ith res$ect to ne# 'a ue of 2 i-e- 87It can "e +87;67,167. < if #e ta3e the change #ith res$ect to initia 'a ue of 2 i-e67To a'oid this am"iguit! #e ta3e / change #ith res$ect to a'erage 'a ue of 2 +i-ethe a'erage of the initia and fina 'a ues of &,-

In our e&am$ e% a'erage 'a ue of 2 is +initia 'a ue = ne# 'a ue,16 . +67=87,16.6> No# after finding a'erage 'a ue #e can ca cu ate a uni4ue 'a ue for ? / change in 2 . +ne# 'a ue of 2;o d 'a ue of 2,1A' 'a ue of 2 . +87;67,1 6>. 5716> Ta" e 4-5 Commodit! Cheese T Shirts C) @ a!ers Reduction in @rice +Cents, 47c $er 3g 47c $er shirt 47c $er cd $ a!er Increase in 0t! )emanded +$er month, A>77 3g >777 shirts 577 C) $ a!ers

Note that the change in $rice is the same in a"so ute terms for a $roducts i-e- 47 cents- The data is incom$ ete as it does not te us #hat #as the origina $rice or the origina 4uantit! demanded; a it te s us is that #hat ha$$ens to demand #hen $rice fa s "! 47 cents Ta" e 4-6 @roduct Unit Origina @rice +B, 5 8-47 5C-67 E7-67 Ne# @rice +B, 6 8-77 5>-E7 AF-E7 A' @rice +B, 8.+5=6,16 8-67 5C-77 E7-77 Origina Ne# A' 0uantit! 0uantit! 0uantit! 4 55C6>7 5FA>77 FF>7 > 568A>7 676>77 577>7 C.+4=>,16 567777 677777 57777

Cheese T shirts C) @ a!ers

Dg Shirt @ a!er

In ta" e 4-6 #e start off #ith origina $rices and 4uantities and see #hat ha$$ens to them once $rices fa "! 47 c ; 55C6>7=A>77.568A>7 Ta" e 4-8 @roduct / fa in $rice +5, 56-> 6-> 7-> / increase in 0t! +6, C-6> 6->7 5-77 E asticit! of demand + , +8,.615 7-> 5-7 6-7

Cheese T shirts C) @ a!ers

/ change in $rice? +8-4;8,18-6.7-418-6.7-56>.56->/ / change in 4t!? +55C6>7;568A>7,1567777.7-C6>.C-6>/ E asticit!. C-6>156->.7-> Inter$reting e asticities

)emand e asticit! #i a #a!s ha'e a negati'e 'a ue +"ecause of o$$- signs of $rice and 4uantit! in e asticit! formu a, Gut #e a #a!s ta3e $ositi'e 'a ue +thatHs an age o d con'ention,- The higher the 'a ue the more e astic +res$onsi'e, the demand #hen $rices changeSee Ta" e E&tensions in theor! 4-5 in LIR +The same 3no# edge is re$resented "e o# in a ternate #ords, 0- 9hat 'a ue can the e asticit! coefficient +i-e- o#n $rice e asticit! coefficient, ta3e: A- Ja ue of is "et#een 7 and infinit! 9hen / change in 0 is greater than / change in @% demand is said to "e e astic ; #i ta3e on 'a ue of greater than 5 to infinit! 9hen / change in 0 is ess than / change in @% demand is said to "e ine astic ; #i ta3e on 'a ue of ess than 5 or more $recise ! "et#een 7 and 5 9hen 0 does not change at a and @ changes e asticit! is 7 +Note that #hi e e asticit! can "e =infinit!% it cannot "e infinit! or ess than Kero, 9hen / change in 0 . / change in @% demand is said to "e unitar! e astic 0- 9ou d #e o"ser'e a constant o#n $rice e asticit! of demand a ong a demand cur'e: A- )e$ends on the s o$e of the demand cur'e; If ) cur'e is a st ine demand cur'e its e asticit! changes as #e mo'e a ong the cur'e +See fig 4;6, If ) is horiKonta or 'ertica e asticit! is infinite or Kero +see fig 4;8, If ) cur'e is a h!$er"o a it #i ha'e unitar! e asticit!% .5% ++See (ig 4;8, )eterminants of E asticit! of )emand ;;;;)e$ends on a'ai a"i it! of su"stitutes; if 'er! c ose su"stitutes are a'ai a" e for 2% changes in $rices of those goods #i ha'e a arger effect on 4uantit! consumed of 2; Thus a $roduct #ith c ose su"stitutes tends to ha'e an e astic demand and a $roduct #ith no c ose su"stitutes tends to ha'e an ine astic demand ;;;;;)e$ends on ho# much time is a'ai a" e to su"stitute; in SR not man! $roducts can "e $roduced or introduced in mar3et "ut o'er onger run man! su"stitutes can "e de'e o$ed "! su$$ iers; Thus LR demand for a $roduct is more e astic than SR demand +$eo$ e change their method of trans$ortation o'er time hence demand for gaso ine is ess e astic in SR than in LR,

0- 9ou d O@EC oi @roducers e&$erience a gain in re'enues if the! restricted the carte s su$$ ! of oi and there"! increased $rices: A- )e$ends on #hether demand for oi is e astic or ine astic; their re'enues #i on ! increase if demand is ine astic and re'enues #ou d fa if demand is e astic0- Can farmers increase their re'enues "! dro$$ing $rices: A- Yes on ! if demand is e astic +fa in $rice shou d generate huge increase in demand such that @ & 0 increases- If demand is ine astic and 0 does not increase #ith fa in $rice% the tota re'enue to farmers @ & 0 #ou d fa #ith a fa in $riceThese ideas can "e seen in (ig 8;> #hich sho#s re ationshi$ L"et#een tota re'enue of firms +#hich is tota e&$enditure of consumers, and 4uantit! demanded-Note that tota e&$enditure of consumers +#hich is the same as tota re'enue of firms $roducing those $roducts, first rises #ith increase in 4uantities $urchased and then starts fa ing des$ite the fact that more 4uantities are sti "eing $urchasedNote that u$ to 57%777 units of demand the e&$enditure is rising and then after 57777 units it starts to fa and goes to Kero at 67777 units of consum$tion demand0- 9h! ma! this "e so: A- The e&$enditure @0 is com$osed of $rices and 4uantities therefore TE. @ & 0- A ong the demand cur'e $rices are throughout fa ing and 4uantities are throughout rising so direction of change of TE is inderminate- Ho#e'er% the ans#er ies in understanding that e asticit! of demand +or res$onse of demand to changes in $rice, is different o'er the initia range +to$ LHS, of the demand cur'e as com$ared to the atter $art +"ottom RHS, of the ) cur'eInitia ! the increase in demand is much more than the fa in $rice so that TE rises; in other #ords o'er the initia range of the demand cur'e demand is more e astic +i-e- change in demand is more than change in $rice,- 9e note that TEs continua ! increase ti @.6 and ).57777% "ut after that further fa in $rices does not ead to much arger increase in demand +i-e- fa in @ is greater than increase in )% therefore TE.@0 fa s,Note that in a"so ute 'a ue demand is continua ! increasing #ith fa in $rices "ut at $rices ess than @.6% the incrementa increase in demand is ess than the incrementa decrease in $rice- In other #ords at @ ess than 6 )emand 3ee$s "ecoming more and more ine astic- The effect of this demand ine asticit! is that TE e'entua ! "ecomes Kero #hen ).67%777 units-

@rice E asticit! of Su$$ ! (ig 4;C

*easures the e asticit! of su$$ ! of goods #ith res$ect to changes in mar3et $rices-

It is denoted s .

/ change in 4uantit! su$$ ied / change in mar3et $rice

The sign of s is $ositi'e "ecause "oth numerator and denominator are a #a!s $ositi'e- The reason that numerator and denominator are "oth $ositi'e is that #e are considering the su$$ ! cur'es #hich ha'e $ositi'e s o$esHo#e'er% there are s$ecia cases of su$$ ! cur'es #hose s o$es ma! not "e $ositi'e; the! cou d "e 'ertica or horiKonta - A 'er! stee$ S cur'e means that a unit increase +decrease, in $rice has a 'er! sma increase +increase, in 0 su$$ ied- It means stee$er S cur'e is ess e astic or ine astic-

Jertica S cur'e has s . 7% stee$er S cur'es #i ha'e sma 'a ues of e asticit! of su$$ ! HoriKonta S cur'e;has s . % f atter S cur'es #i ha'e arge 'a ues of e asticit! of su$$ ! S$ecia case of S cur'e??? An! $ositi'e ! s o$ed S cur'e $assing through origin #i ha'e s . 5Loo3 at sma er triang e and arger triang e;their ang es are e4ua +simi ar triang es, therefore ratios of their sides are e4ua $14. $1 4 and #e 3no# from definition that

s .

414 $1$ 41 $ - $14

.
Su"stitute for $14

. 41 $ - $1 4 . 5 +means that the / change in 4uantit! su$$ ied e4ua s the / change in $rice, )eterminants of Su$$ ! E asticit!: )e$ends on ho# eas! it is to su"stitute factors of $roduction to#ards the $rodn of those goods #hose $rice has risen-

Natura ! #e #i not see this su"stitution in 'er! di'erse $roducts cars and ca""ages etc% rather c ose $roducts e-g different 3inds of detergents or soa$s or other 'er! c ose su"stitutes; Ho# 4uic3 ! S res$onds to increase the $rodn of the $roduct #hose @ has risen de$ends on #hether the costs #i a so rise as su"stitution in $rodn is made; if thatHs the case then su$$ ! ma! not "e res$onsi'e to increase in $riceMenera ! in SR su$$ ! is not that res$onsi'e as com$ared to LR #hen costs can "e "etter contro ed and factors of $rodn can "e "etter com"ined to $roduce the $roduct #hose $rice has risen- Therefore SR S cur'es are re ati'e ! ine astic com$ared to LR S cur'es- +see (ig 4;A, An E&am$ e 9here E asticit! *atters +$g E5, (ig 4;E 9e are interested to find out #ho "ears a higher "urden #hen a ta& is im$osed i-e- the consumers or the se ers9hen #e sa! higher "urden #e mean #ho "ears the oss #hen a ta& is im$osed- (or e&am$ e ho# much of the ta& can "e $assed on to consumers and ho# much is a"sor"ed #i determine #ho e'entua ! "ears the "urden of the ta&The more ine astic the demand cur'e re ati'e to the su$$ ! cur'e the more "urden of a ta& #i "e "orne "! consumers This fact is demonstrated in (ig 4;F% "ut ideas $ertaining to Nse er $riceO% Nconsumer $riceO and Nshift of su$$ ! cur'eO due to e&cise ta& shou d first "e understood through fig 4;EE&$ anation of (ig 4;F In (ig 4;F +i, Su$$ ! is e astic and demand is ine astic +re ati'e e asticities matter,

Ta& e'ied ? Consum$tion or demand fa s and @ rises- @re'ious ! Consumer #as s$ending @707 and no# @c05 S fa s too; $re'ious ! su$$ iers #ere earning @707 no# the! earn @c05; "ecause $rice Pum$s from $7 to $c and ) fa s from 47 to 45Note that consumersH e&$enditure has increased much more due to huge rise in $rice and ess dro$ in 4uantities; thatHs "ecause their demand is ine astic for cigarettes- On the other hand the $rice for su$$ iers does not fa as much "ecause of the arger e asticit! of their su$$ ! cur'es% hence their ne# re'enue @s05 is not much ess than $re'ious re'enue +$747, Conc usion? )ue to ine astic ) cur'e% the $rice rises much more for consumer and 4uantit! fa s ess% therefore the consumer ends u$ $a!ing much more for their consum$tion thus in other #ords the "urden of the e&cise ta& fa s more on the consumerIn (ig 4;F +ii, a ta& of Bt $er $ac3 of cigarettes shifts u$ the S cur'e "! Bt for each and e'er! 4uantit! of cigarette $ac3s- At the higher $rice of $c consumers on ! demand 45 $ac3s of cigarettes- (irms are #i ing to su$$ ! 45 demand at $rice of $s- Note that in the case of e astic ) for consumers +it must "e the case that the! ha'e more su"stitution $ossi"i ities, the! are a" e to drastica ! reduce their )emand and cut do#n cons$n to 45 from 47So #hi e $rices $er $ac3 ha'e increased "! the same amount in case +i, and +ii, QHo#: Note that the ta& in case +i, is the same as ta& in case +ii, the shift u$ of the S cur'e is the sameR% the arger reduction in 4uantit! )emanded in case +ii, $re'ents the consumers "i from going u$ too much; Note that in case +i, #hen demand #as ine astic +$erha$s not man! su"stitutes #ere a'ai a" e to consumer,% the consumer #as not a" e to

reduce demand much in res$onse to the e&cise ta& $er $ac3 of cigarettes- Conse4uent ! his tota "i % @-0 #ent u$ +/reduction in 4uantit! #as ess than the / increase in $rices,; thus in case +i, the "urden of the ta& #as higher than in case +ii,Conc usion? )ue to e astic )emand 4uantit! fa s much more and $rice rises much ess% therefore ess "urden fa s on consumer@a!ro Ta&es; A$$ !ing Eco Conce$ts 4;6 $ E4 LIR @a!ro ta&es are deducted from a $ersons income- @a!ro ta& different from income ta& #hich #e $a! at the end of fisca !ear for ta& assessment $ur$oses to Re'enue Canada- @a!ro ta&es are deducted from each sa ar! s i$ "! em$ o!erThis ta& is then de$osited "! em$ o!er to Re'enue Canada9ho gains and #ho oses "! thee $a!ro ta&es: The effects of this ta& + i3e e&cise ta&, #i "e on "oth $rices and 4uantities- In this case the 4uantit! is 4uantit! of em$ o!ment and $rices are #ages +hour ! #ages, of #or3ersA $a!ro ta& deducted "! em$ o!er dri'es a #edge "et#een the #age $aid "! firm +9f, and #age recei'ed "! #or3er +9#,9hen there #as no $a!ro ta& the em$ o!ment #as E7 and #age #as #79ith $a!ro ta&% firms ha'e to $a! Bt1hr to go't- in addition to #hat the! $a! to #or3ers9hat ha$$ens to em$ o!ment: Note that #ith a rise in #ages from #7 to #f +#f;#7 is rise in firms net cost $er hour $er #or3er,% firms #ou d hire on ! E5 #or3ers +a ong their )emand cur'e for a"or,- It can "e seen that the em$ o!ment has fa en from E7 to E5In this e&am$ e #ho "ears most of the "urden of the ta&; firms or a"or: The "urden of the ta& is determined "! ho# much the #age fa s for #or3ers as com$ared to the increase in the #age +net cost $er #or3er, for firms- 9ith an ine astic Su$$ ! cur'e for a"or% #or3ers do not ha'e much o$tion% "ut to 3ee$ #or3ing- Hence at o#er em$ o!ment of E5% the #age recei'ed "! #or3ers fa s a ot from the $re'ious e'e of 9o +note that if S #as e astic #age #ou d not ha'e fa en as much #hen firms reduced their demand for a"or,- Thus "urden of $a!ro ta& is

more on #or3ers and ess on firms due to the re ati'e ine asticit! of a"or su$$ ! as com$ared to a"or demand "! firmsConc usion? @a!ro ta&es increase net cost of hiring for firms and reduce net #ages for a"or; natura ! #ith higher #ages firms hire ess% than #ou d "e the case #ithout an! $a!ro ta&es-

9hat )etermines Income E asticit! +discussion of income consum$tion cur'es,

Y = change in !uantity demanded change in income

" Y # " $ %%% for normal goods& therefore Y ' ( " Y # ) $ %%% for inferior goods& therefore Y * ( Income elasticity of +ormal ,oods will definitely be positive (greater than () but can be greater than unity (elastic) or less than unity (inelastic) depending on whether the change in - demanded is greater or less than the change in income.. If Y is greater than 5% #e sa! that demand is income e astic If Y is ess than 5% #e sa! that demand is income ine astic )efining Inferior and Norma Moods in terms of E asticit! +See ta" e 4;4 for e&am$ es of such goods and their em$irica ! o"ser'ed e asticities, Inferior Moods ha'e Norma Moods #hich are ine astic ha'e Norma Moods #hich are e astic ha'e Income Consum$tion Cur'es +(ig 4;57, (ig 4;57 sho#s the effects of change of income on 4uantit! demanded; these cur'es can ha'e different sha$es de$ending on their income e asticit! Y ess than Kero Y "et#een Kero and one Y greater than one

E&$ anation of (ig 4;57? Norma goods increase in 4uantit! as income increases s o$e is rising u$#ards (ig 4;57 +i, Lu&ur! goods +#hich are a so norma goods as o$$osed to "eing inferior goods, a so increase in 4uantit! as income rises; ho#e'er there is a difference "et#een norma goods #hich are necessities and norma goods #hich are u&uries- In the case of necessities% 4uantit! increases no dou"t "ut at a decreasing rate +Ho# much necessities can !ou ha'e #ith high income,% ho#e'er in the case of u&uries the higher the income increases thee more #e consume u&uriesS hence the ICC #i ha'e an increasing s o$e +note thatHs the case after I5 income,- See (ig 4;57 +ii, In the case of inferior goods 4uantit! reduces "e!ond a certain income; thus a commodit! ma! "e a necessit! at o#er incomes +sa! $otatoes, "ut "ecomes an inferior good at higher incomes% and after #e ha'e achie'ed that income e'e #e reduce its consum$tion- See (ig 4;57 +iii,

Cross E asticit! of )emand &! . / change in 0 demanded of 2;;; / change in $rice of good Y ; T &! T
If cross e asticit! is U7 itHs a su"stitute that is V in $rice of Y eads to V in ) for 2 )emand cur'e of 2 #i shift right

If cross e asticit! is W7 itHs a com$ ement that is V in $rice of Y eads to Xin ) for 2 )emand cur'e of 2 #i shift eft