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Income elasticity of demand.
Price elasticity of supply.
Excise taxes and tax incidence
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.
What determines income
elasticity?
How “basic” the item is.
What the current level of income is.
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
%P
Generally 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
P
 S = 0.
QS is fixed, will
not increase with
rising demand.
Level of D
determines price.
When applicable?
S
Q
Perfectly Elastic Supply
P
S
Q
 S = .
Suppliers will
supply whatever
Q is demanded at
this price.
Increases in D do
not increase
price.
(Applies to LR for
some markets.)
Elasticity of Supply: SR &
LR
P
SSR
SSR
SSR
SLR
Q
Supply is more
elastic in the LR
than in the SR.
Why?
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.
Excise tax on Gasoline-50¢
S’
Price/Gal.
0.50 S
1.50
1.25
1.00
0.75
D
4
5
6
S shifts up by
50¢ b/c sellers
need 50¢ more
to sell each
quantity.
Why doesn’t P
rise by 50¢?
1,000 Gal. of gas
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.
Excise tax on Gasoline-50¢
S’
Price/Gal.
0.50
S
1.25
Price paid by
consumers is
$1.25
Price kept by
producers is
$0.75.
1.00
0.75
D
4
5
6 1,000 Gal.
of gas
What happens
to the rest?
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 5050. Will that always be true?
Inelastic Demand
S’
Price/Gal.
0.50
S
1.40
0.90
Price paid by
consumers
rises 40¢
Price kept by
producers falls
10¢
1.00
D
5
4.6
1,000 Gal.
of gas
QD doesn’t fall
as much.
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.
Coming Up
Next Time: Review for exam.
One week from today: First midterm
exam.
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
Income
1999
2000
$26,000
$30,000
QD of Soda per
Year
50 gallons
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
$30,000
$1,000
$45,000
$1,700
% of inc. spent on
rest. meals
• Calculate the % of income spent on
restaurant meals at each income level.
• Is this good normal or inferior? A necessity
or a luxury good?
Elastic Demand & Gas Tax
Incidence
S’
Price/Gal.
0.50
Use this graph &
the 2 earlier
ones from
lecture to fill in
the table on the
next slide.
S
1.15
1.00
0.65
 Hint: To get
price elasticity of
D, use numbers
along D curve.
1,000 Gal.
D
2.3
5
of gas
Table for Gas Tax
Price
Consumers’
Gov’t
Producers’
Elasticity
extra
Revenue lost revenue
of D
payment
Inelastic D
(2nd ex.)
First Ex.
Elastic D
(3rd ex.)
$2,300
1.0
$2,000
$1,000
$1,000
$805
$345
Questions about Tax
Incidence
Does your table confirm or refute the
statement made in lecture about the
relationship between price elasticity of D
and tax incidence?
What is the relationship between price
elasticity of D and gov’t revenue from the
gas tax?