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Introduction to Economics –ECO401
VU Lesson 08
ELASTICITIES (CONTINUED) INCOME ELASTICITY OF DEMAND The relative response of a change in demand to a relative change in income. More specifically the income elasticity of demand can be defined as the percentage change in demand due to a percentage change in buyers' income. The income elasticity of demand quantitatively identifies the theoretical relationship between income and demand. Єdy = ∆ Q ÷ ∆ Y Y Less income elastic Єdy < 1 ) Y ( e m o c n I
More income elastic Єdy > 1
Quantity demanded (Q)
!f the sign of income elasticity of demand is positive" the good is normal and if sign is negative" the good is inferior. Table: Quan!" Deman#e# Income (Rs) (un!s) #$$$$ #$$ #%$$$ #$& YЄd = ∆ ÷ ∆ Y Y = & %$$$ #$$ #$$$$ = $.%& The (ood is normal )the sign is positive*. +ut its demand is income inelastic o, - Є - , #. DETERMINANTS OF INCOME ELASTICITY OF DEMAND The determinants of income elasticity of demand are • /egree of necessity of good. • The rate at which the desire for good is satisfied as consumption increases • The level of income of consumer. S$o% Run an# Lon& Run 0hort run is a period in which not all factors can ad1ust fully and therefore ad1ustment to shoc2s can only be partial. 3ong run is a period over which all factors can be changed and full ad1ustment to shoc2s can ta2e place.
CROSS+RICE ELASTICITY OF DEMAND ;ross price elasticity of demand is the percentage change in quantity demanded of a specific good" with respect to the percentage change in the price of another related good. b*#a , - Qa ÷ Qa
- b b
Table Deman# o% A
%!ce o .
#$$ #5$
#$ #%
8bЄda = ∆ a ∆ 8b a 8b = 5$ % #$$ #$ = % (oods are substitutes )sign is positive*. /emand is cross price elastic - B - C #. DETERMINANTS OF CROSS RICE ELASTICITY OF DEMAND • T!me /e%!o# The longer the time period" the more will be the elasticity" • Tases an# /%ee%ences Taste and preferences can change.
INCIDENCE OF TA0ATION A taD results in a vertical shift of the supply curve as it increases the cost of producing the taDed product. The incidence of taDation relates to how much of the taDEs burden is being borne by consumers and producers. The more inelastic the demand" the more of the taDEs burden will
fall on consumers. The more inelastic the supply" the more of the taDEs burden will fall on producers. Terms of trade means the FrealE terms at which a nation sells its eDports and buys its import. G86; GrganiHation of 8etroleum 6Dporting ;ountries. T1REE CORE RULES OF ELASTICTY RULE 2 34
E0ERCISES 8$" 9!ll $e /%!ce elas!c!" o #eman# o% a /a%!cula% b%an# o a /%o#uc (e& S$ell) be &%eae% $an $a o% $e /%o#uc !n &ene%al (e& /e%ol); Is $!s #!e%ence $e %esul o a #!e%ence !n $e s!e oo# (o% clo$!n&) $a?e a /%!ce+elas!c o% !nelas!c #eman#; D!scuss !n $e cone= o !ncome an# subs!u!on eecs The income effect will be relatively large )ma2ing demand relatively elastic*. The substitution effect will be relatively small )ma2ing demand relatively inelastic*. The actual elasticity will depend on the relative siHe of these two effects. Deman# o% o!l m!&$ be %ela!?el" elas!c o?e% $e lon&e% e%m@ an# "e ! coul# s!ll be obse%?e# $a o?e% !me /eo/le consume mo%e o!l (o% onl" ?e%" sl!&$l" less) #es/!e %!s!n& o!l /%!ces 1o9 can $!s a//a%en con%a#!c!on be e=/la!ne#; +ecause" there has been a rightward shift in the demand curve for oil. This is li2ely to be the result of rising incomes. ;ar 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. 7inally" people may travel longer distances to wor2 as a result of a general move to the suburbs. Assume $a #eman# o% a /%o#uc !s !nelas!c 8!ll consume% e=/en#!u%e &o on !nc%eas!n& as /%!ce %!ses; 8oul# $e%e be an" l!m!; 0o long as demand remains inelastic with respect to price" t hen consumer eDpenditure will go on rising as price rises. Jowever" if the price is raised high enough" demand always will become elastic. Can "ou $!n> o an" e=am/les o &oo#s 9$!c$ $a?e a oall" !nelas!c #eman# (a) a all /%!ces (b) o?e% a /a%!cula% /%!ce %an&e; a* Io goods fit into this category" otherwise price could rise to infinity with no fall in demand K but people do not have infinite incomesL b* Gver very small price ranges" the demand for goods with no close substitutes" oil" water )where it is scarce* may be totally inelastic. 8$a 9!ll $e #eman# cu%?e co%%es/on#!n& o $e ollo9!n& able loo> l!>e; I $e cu%?e $a# an elas!c!" o B4 $%ou&$ou !s len&$@ 9$a 9oul# be $e uan!" #eman#e# (a) a a /%!ce o 4 (b) a a /%!ce o 43/ (c) ! $e &oo# 9e%e %ee; P (£)
Q
%.& & #$ %$ 5$
5$$ %$$ #$$ &$ %&
Total Expenditur e (£) #$$$ #$$$ #$$$ #$$$ #$$$
The curve will be a Frectangular hyperbolaE it will be a smooth curve" concave to the origin which never crosses either aDis ) d = #$$$8*. a. #$$$ units. b. #$ $$$ units. c. There would be infinite demandL
Ree%%!n& o $e ollo9!n& able@ use $e m!#+/o!n (a%c) o%mula o calculae $e /%!ce elas!c!" o #eman# be9een (a) , an# , (b) , an# , 5 8$a #o "ou conclu#e abou $e elas!c!" o a s%a!&$+l!ne #eman# cu%?e as "ou mo?e #o9n !; %!ce Quan!" Deman#e# 53 G 5G 73 7 7G 5 3 Nsing the formula ) ∆mid * ÷ )∆8mid 8* gives the following answers )a* #$%& ÷ K%& = #$%& × &K% = &$K&$ = K# )which is unit elastic* )b* #$?& ÷ K%? = #$?& × ?K% = ?$KO$ = K$.5? )which is inelastic* The elasticity decreases as you move down a straight4line demand curve. '!?en Q# , 3 B 4G 6 H@ calculae $e (/o!n) /%!ce elas!c!" o #eman# a a /%!ce o: a G b 5 c 3 (iven that d = :$ K #&8 P 8Q Then" dd8 = K#& P %8. Thus using the formula" P εd = dQdP × P Q" the elasticity at the each of the above price points 6quals )a* )K#& P )% × &** × )& ):$ K )#& × &* P &Q** = K& × &#$ = B5G )b* )K#& P )% × %** × )% ):$ K )#& × %* P %Q** = K## × %?5 = B3G )c* )K#& P )% × $** × )$ ):$ K )#& × $* P $Q** = K#& × $:$ = 3 As "ou mo?e #o9n a s%a!&$+l!ne #eman# cu%?e@ 9$a $a//ens o elas!c!"; 8$"; !t decreases. 8 gets less and less" but dd8 remains constant. '!?en $e ollo9!n& su//l" sc$e#ule: % 5 : 9 #$ P Q $ #$ %$ ?$ 5$ a D%a9 $e su//l" cu%?e b Us!n& $e a%c me$o# calculae /%!ce elas!c!" o su//l": ! .e9een , 5 an# , !!.e9een , an# , 43 c Us!n& $e /o!n me$o# calculae /%!ce elas!c!" o su//l" a , # Does $e elas!c!" o $e su//l" cu%?e !nc%ease o% #ec%ease as an# Q !nc%ease; 8$"; e 8$a 9oul# be $e ans9e% o (#) ! $e su//l" cu%?e $a# been a s%a!&$ l!ne bu !ne%sec!n& $e $o%!
Introduction to Economics –ECO401
VU
Nsing the formula ∆average ÷ ∆8average 8" gives #$& ÷ %?= 7 #$?& ÷ %<= 45J c. Nsing the formula dd8 × 8" and given that dd8 = & )= #$%*" gives & × :%$= 4G d. The elasticity of supply decreases as 8 and increase. !t starts at infinity where the supply curve crosses the vertical aDis ) = $ and thus 8 = ∞*. e Io. At the point where it crossed the horiHontal aDis" the elasticity of supply would be Hero )8 = $ and thus 8 = $*. Thereafter" as 8 and increased" so would the elasticity of supply. 8$!c$ a%e l!>el" o $a?e $e $!&$es c%oss elas!c!" o #eman#: 9o b%an#s o ea@ o% ea an# coee; Two brands of tea" because they are closer substitutes than tea and coffee. Su//l" en#s o be mo%e elas!c !n $e lon& %un $an !n $e s$o% %un Assume $a a a= !s !m/ose# on a &oo# $a 9as /%e?!ousl" una=e# 1o9 9!ll $e !nc!#ence o $!s a= c$an&e as !me /asses; 1o9 9!ll $e !nc!#ence be aece# ! #eman# oo becomes mo%e elas!c o?e% !me; As supply becomes more elastic" so output will fall and hence taD 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 taD the burden will tend to shift from the consumer to the producer. I %a!s!n& $e a= %ae on c!&a%ees %a!se mo%e %e?enue an# %e#uce smo>!n&@ a%e $e%e an" conl!c be9een $e $eal$ an# %e?enue obKec!?es o $e &o?e%nmen; There may still be a dilemma in terms of the amount by which the taD rate should be raised. To raise the maDimum amount of revenue may require only a relatively modest increase in the taD rate. To obtain a large reduction in smo2ing" however" may require a very large increase in the taD rate. Nltimately" if the taD rate were to be so high as to stop people smo2ing altogether" there would be no taD revenue at all for the governmentL You a%e a &o?e%nmen m!n!se% 9$a a%&umens m!&$ "ou /u o%9a%# !n a?ou% o ma=!m!s!n& $e %e?enue %om c!&a%ee a=a!on; That it is better than putting the taDes on more socially desirable activities. That there is the beneficial spin4off from reducing a harmful activity. )You would conveniently ignore the option of putting up taDes beyond the point that maDimiHes revenue and thus cutting down even more on smo2ing.* You a%e a #oco% 9$" m!&$ "ou su&&es $a smo>!n& s$oul# be se?e%el" %es%!ce#; 8$a me$o#s 9oul# "ou a#?ocae; That the medical arguments concerning damage to health should ta2e precedence over questions of raising revenue. You would probably advocate using whatever method was most effective in reducing smo2ing. This would probably include a series of measures from large increases in taDes" to banning advertising" to education campaigns against smo2ing. You might even go so far as to advocate ma2ing smo2ing tobacco illegal. The problem here" of course" would be in policing the law. 8$" !s $e su//l" cu%?e o% oo# oen #%a9n as a ?e%!cal s%a!&$ l!ne; !t is becauseR the supply of food is virtually fiDed in the short run. Gnce a crop is grown and harvested" then it is of a fiDed amount. )!n practice" the timing of releasing crops on to the mar2et can vary" given that many crops can be stored. This does allow some variation of supply with price.* T$e !ncome elas!c!" o #eman# o% /oaoes !s ne&a!?e (an !ne%!o% &oo#) 8$a !s $e !m/l!ca!on o $!s o% /oao /%o#uce%s; 8otato producers would eDpect 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 b.
