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ELASTICITIES OF DEMAND AND
SUPPLY
ECO 2023
Principles of Microeconomics
Dr. McCaleb
Elasticities of Demand and Supply
1
TOPIC OUTLINE
I.
Price Elasticity of Demand
II. Application: Elasticity and the Demand for
Smoking
III. Price Elasticity of Supply
IV. Cross Elasticity and Income Elasticity
V.
Application: Tax Incidence and Efficiency
Elasticities of Demand and Supply
2
Price Elasticity of Demand
Elasticities of Demand and Supply
3
PRICE ELASTICITY OF DEMAND
 Price Elasticity of Demand
Definition
The price elasticity of demand is the ratio of the percentage change
in the quantity demanded to the percentage change in price.
Price elasticity of
=
demand
Percentage change in quantity demanded
Percentage change in price
It is a measure of the extent to which the quantity demanded of a
good changes when the price of the good changes.
Elasticities of Demand and Supply
4
PRICE ELASTICITY OF DEMAND
 Calculating the Price Elasticity of Demand
Problem
Suppose Starbucks raises the price of a latte from $3 to $5 a cup. The
price increase is 66.67 percent of the initial $3 price.
Now, suppose Starbucks lowers the price from $5 to $3. The price
decrease is 40 percent of the initial $5 price.
The same price change, $2, over the same interval, $3 to $5, is a
different percentage change depending on whether the price rises or
falls.
Elasticities of Demand and Supply
5
PRICE ELASTICITY OF DEMAND
 Calculating the Price Elasticity of Demand
Solution
We need a measure of percentage change that does not depend on the
direction of the price change.
We use the average of the initial price and the new price to measure
the percentage change in price.
Similarly, we use the average of the initial quantity and the new
quantity to measure the percentage change in quantity.
This is called the midpoint method for computing the elasticity.
Elasticities of Demand and Supply
6
PRICE ELASTICITY OF DEMAND
 The Midpoint Method
Calculating the percentage change in quantity
demanded
To calculate the percentage change in quantity demanded divide the
change in the quantity demanded by the average quantity demanded
and then multiply by 100. The average quantity demanded is at the
midpoint between the initial quantity and the new quantity.
Percent change
in quantity =
New quantity ΠInitial quantity
(New quantity + Initial quantity)Φ 2
Elasticities of Demand and Supply
x 100
7
PRICE ELASTICITY OF DEMAND
 The Midpoint Method
Calculating the percentage change in price
To calculate the percentage change in price, divide the change in the
price by the average price and then multiply by 100. The average price
is at the midpoint between the initial price and the new price.
New price ΠInitial price
Percent change in price
=
x 100
(New Price + Initial Price) Φ 2
Elasticities of Demand and Supply
8
PRICE ELASTICITY OF DEMAND
Calculating Demand
Elasticity: Example
If Starbucks raises the price of a
latte from $3 to $5 a cup, the
quantity demanded decreases from
15 to 5 cups per hour.
The quantity decrease is 100% of
the average quantity.
The price increase is 50% of the
average price.
The price elasticity of demand
equals 100% divided by 50%, or 2.
Elasticities of Demand and Supply
9
PRICE ELASTICITY OF DEMAND
 Comment
Minus sign
Because of the Law of Demand, when the price rises, the quantity
demanded decreases. Price and quantity demanded always change in
opposite directions.
Therefore, the elasticity of demand calculated by the midpoint
formula is always negative. So we ignore the minus sign and use
absolute values.
Elasticities of Demand and Supply
10
PRICE ELASTICITY OF DEMAND
 Elastic and Inelastic Demand
Based on the coefficient of elasticity, the demand for
any good can be classified into one of five categories
•
•
•
•
•
Elastic
Unit elastic
Inelastic
Perfectly elastic
Perfectly inelastic
Elasticities of Demand and Supply
11
PRICE ELASTICITY OF DEMAND
 Elastic and Inelastic Demand
Demand is elastic if
• the percentage change in quantity demanded is greater than
the percentage change in price
• the coefficient of the elasticity of demand is greater than 1.
Elasticities of Demand and Supply
12
PRICE ELASTICITY OF DEMAND
Elastic Demand
When the price of a Sony
Playstation rises by 10%, . . .
the quantity demanded decreases by
20%.
The decrease in quantity demanded
is greater than the increase in price.
Therefore, demand for Sony
Playstations is elastic.
Elasticities of Demand and Supply
13
PRICE ELASTICITY OF DEMAND
 Elastic and Inelastic Demand
Demand is unit elastic if
• the percentage change in quantity demanded is the same as the
percentage change in price
• the coefficient of the elasticity of demand equals 1.
Elasticities of Demand and Supply
14
PRICE ELASTICITY OF DEMAND
Unit Elastic Demand
When the price of a trip rises by
10%, . . .
the quantity demanded of trips
decreases by 10%.
The decrease in quantity demanded
is the same as the increase in price.
Therefore, the demand for trips is
unit elastic.
Elasticities of Demand and Supply
15
PRICE ELASTICITY OF DEMAND
 Elastic and Inelastic Demand
Demand is inelastic if
• the percentage change in quantity demanded is smaller than the
percentage change in price
• the coefficient of the elasticity of demand is less than 1.
Elasticities of Demand and Supply
16
PRICE ELASTICITY OF DEMAND
Inelastic Demand
When the price of gum rises by
20%, . . .
the quantity demanded decreases by
10%.
The decrease in quantity demanded
is smaller than the increase in price.
Therefore, the demand for gum is
inelastic.
Elasticities of Demand and Supply
17
PRICE ELASTICITY OF DEMAND
 Elastic and Inelastic Demand
Demand is perfectly elastic if
• the quantity demanded changes by a very large percentage in
response to an almost zero percentage change in price.
• the coefficient of the elasticity of demand is infinite (the
numerator is very large and the denominator is infinitesimally
small).
Elasticities of Demand and Supply
18
PRICE ELASTICITY OF DEMAND
Special Case: Perfectly
Elastic Demand
For even a very small change in the
price of spring water, . . .
the quantity demanded of spring
water changes by a very large
amount.
The change in the quantity
demanded is much (infinitely)
larger than the change in price.
Therefore, the demand for spring
water is perfectly elastic.
Elasticities of Demand and Supply
19
PRICE ELASTICITY OF DEMAND
 Elastic and Inelastic Demand
Demand is perfectly inelastic if
• the percentage change in quantity demanded is zero when the
price changes.
• the coefficient of the elasticity of demand equals 0.
Elasticities of Demand and Supply
20
PRICE ELASTICITY OF DEMAND
Special Case: Perfectly
Inelastic Demand
When the price rises, . . .
the quantity demanded does not
change.
There is no change in the quantity
demanded when price changes.
Therefore, demand is perfectly
inelastic.
Elasticities of Demand and Supply
21
PRICE ELASTICITY OF DEMAND
 Comments
Elasticity is independent of units of measurement
Elasticity is independent of the units used to measure price and
quantity.
Because it is the ratio of two percentages, it is a number with no
units. For example, the elasticity of demand for latte is simply 2.
Elasticity allows us to compare the demands for different goods. For
example, we can compare the elasticity of demand for latte with the
elasticity of demand for baseball tickets.
Elasticities of Demand and Supply
22
PRICE ELASTICITY OF DEMAND
 Comments
Elasticity is not the same as slope
Unlike elasticity, slope depends on the units of measurement of price
and quantity. For example, the slope of the demand curve for latte
has the units “dollars per cup”.
Slope cannot be used to compare the demands for different goods
because the slopes have different units.
Elasticities of Demand and Supply
23
PRICE ELASTICITY OF DEMAND
Elasticity and Slope:
Example
Along a linear (straight-line)
demand curve, the slope is constant
but the elasticity decreases as the
price falls.
At any price above the midpoint,
demand is elastic.
At the midpoint, demand is unit
elastic.
At any price below the midpoint,
demand is inelastic.
Elasticities of Demand and Supply
24
PRICE ELASTICITY OF DEMAND
 Variables That Influence the Price Elasticity of
Demand
Influences on the price elasticity of demand include
• Substitution effects
• Time
• Income effects
Elasticities of Demand and Supply
25
PRICE ELASTICITY OF DEMAND
 Variables That Influence the Price Elasticity of
Demand
Substitution effects
If a substitute for a good is easy to find, then ceteris paribus, the
demand for the good tends to be more elastic or less inelastic.
If a substitute for a good is hard to find, then ceteris paribus, the
demand for the good tends to be more inelastic or less elastic.
Elasticities of Demand and Supply
26
PRICE ELASTICITY OF DEMAND
 Variables That Influence the Price Elasticity of
Demand
Time
As time passes after a price change, consumers find it easier to make
substitutions among goods.
Therefore, the longer the time elapsed since the price change, ceteris
paribus, the more elastic is the demand for the good.
Elasticities of Demand and Supply
27
PRICE ELASTICITY OF DEMAND
 Variables That Influence the Price Elasticity of
Demand
Income Effects
The greater the proportion of income spent on a good, ceteris paribus,
the more elastic is the demand for the good.
The smaller the proportion of income spent on a good, ceteris paribus,
the more inelastic is the demand for the good.
Elasticities of Demand and Supply
28
PRICE ELASTICITY OF DEMAND
 Total Revenue and Price Elasticity of Demand
Total revenue or total expenditure
The amount spent on a good by consumers and received by sellers. It
equals the price of the good multiplied by the quantity of the good
sold:
TR(or TE) = P x Q.
Total revenue and total expenditure are the same thing. The amount
received by sellers is the same as the amount spent by buyers.
Elasticities of Demand and Supply
29
PRICE ELASTICITY OF DEMAND
 Total Revenue and Price Elasticity of Demand
Relationship between price elasticity of demand and
total revenue
There is a unique relationship between the price elasticity of demand
and total revenue (or total expenditure).
This relationship is valid for the price elasticity of demand only. It is
not valid for any other elasticity (income elasticity of demand, price
elasticity of supply, or cross-elasticities).
Elasticities of Demand and Supply
30
PRICE ELASTICITY OF DEMAND
 Total Revenue and Price Elasticity of Demand
Elastic demand
Total revenue changes in the opposite direction to price.
When price increases, the percentage decrease in quantity demanded
is larger than the percentage increase in price. Therefore, total
revenue decreases.
When price decreases, the percentage increase in quantity demanded
is larger than the percentage decrease in price. Therefore, total
revenue increases.
Elasticities of Demand and Supply
31
PRICE ELASTICITY OF DEMAND
 Total Revenue and Price Elasticity of Demand
Unit elastic demand
Total revenue does not change when price changes.
When price increases, the percentage decrease in quantity demanded
just equals the percentage increase in price. They are exactly
offsetting. Therefore, total revenue is unchanged.
When price decreases, the percentage increase in quantity demanded
just equals the percentage decrease in price. They are exactly
offsetting. Therefore, total revenue is unchanged.
Elasticities of Demand and Supply
32
PRICE ELASTICITY OF DEMAND
 Total Revenue and Price Elasticity of Demand
Inelastic demand
Total revenue changes in the same direction as price.
When price increases, the percentage decrease in quantity demanded
is smaller than the percentage increase in price. Therefore, total
revenue increases.
When price decreases, the percentage increase in quantity demanded
is smaller than the percentage decrease in price. Therefore, total
revenue decreases.
Elasticities of Demand and Supply
33
PRICE ELASTICITY OF DEMAND
 Total Revenue and Price Elasticity of Demand
Determining elasticity from changes in price and total
revenue
• If price and total revenue (or total expenditure) change in opposite
directions, demand is elastic.
• If a price change leaves total revenue (or total expenditure)
unchanged, demand is unit elastic.
• If price and total revenue (or total expenditure) change in the same
direction, demand is inelastic.
Elasticities of Demand and Supply
34
PRICE ELASTICITY OF DEMAND
Total Revenue and Elastic
Demand
At $3 a cup, the quantity demanded
is 15 cups an hour.
Total revenue is $45 an hour.
When the price rises to $5 a cup, the
quantity demanded decreases to 5
cups an hour.
Total revenue decreases to $25 an
hour.
Demand is elastic.
Elasticities of Demand and Supply
35
PRICE ELASTICITY OF DEMAND
Total Revenue and Inelastic
Demand
At $50 a book, the quantity
demanded is 5 million books.
Total revenue is $250 million.
When the price rises to $75 a book,
the quantity demanded decreases to
4 million books.
Total revenue increases to $300
million.
Demand is inelastic.
Elasticities of Demand and Supply
36
Application: Elasticity and the Demand for
Smoking
Elasticities of Demand and Supply
37
ELASTICITY AND THE DEMAND FOR
SMOKING
In November 1996, residents of
Oregon approved a ballot measure
increasing the excise tax on sellers
of cigarettes by $0.30 per pack.
The average price per pack
increased from $1.75 to $2.05.
Annual per capita consumption
decreased from 92 packs to 86
packs.
Price per pack
Example: Oregon’s AntiSmoking Campaign
$6.50
$6.50
$6.00
$6.00
$5.50
$5.50
$5.00
$5.00
$4.50
$4.50
$4.00
$4.00
$3.50
$3.50
$3.00
$3.00
$2.50
$2.50
$2.00
$2.00
$1.50
$1.50
$1.00
$1.00
$0.50
$0.50
$0.00
$0.00
S+tax
S+tax
SS
D
0
Elasticities of Demand and Supply
20 40
40 60
60 80
20
80 100
100 120
120
Annual Packs
Annual
Packsper
perCapita
Capita
38
ELASTICITY AND THE DEMAND FOR
SMOKING
10% of the additional tax revenue
was allocated to the Oregon Health
Division (OHD) to develop and
implement a tobacco-use prevention
program.
Because of the fall in demand,
annual per capita consumption
decreased by an additional 4
packs, from 86 to 82.
Price per pack
Example: Oregon’s AntiSmoking Campaign
$6.50
$6.50
$6.00
$6.00
$5.50
$5.50
$5.00
$5.00
$4.50
$4.50
$4.00
$4.00
$3.50
$3.50
$3.00
$3.00
$2.50
$2.50
$2.00
$2.00
$1.50
$1.50
$1.00
$1.00
$0.50
$0.50
$0.00
$0.00
S+tax
S+tax
S
D
D'
D'
0
Elasticities of Demand and Supply
20 40
40 60
60 80
20
80 100
100 120
120
Annual Packs
Annual
Packsper
perCapita
Capita
39
ELASTICITY AND THE DEMAND FOR
SMOKING
 Addiction and Elasticity
Nonusers
Nonusers’ demand for addictive substances is elastic. For example,
the estimated elasticity of demand for cigarettes among teenage
nonusers is 1.2.
Therefore, a moderately higher price leads to a substantially smaller
number of people trying a drug.
Elasticities of Demand and Supply
40
ELASTICITY AND THE DEMAND FOR
SMOKING
 Addiction and Elasticity
Users
Existing users’ demand for addictive substances is inelastic. For
example, the estimated elasticity of demand for cigarettes among
adult smokers is 0.4.
Therefore, a substantial price rise brings only a modest decrease in
the quantity demanded. Even addicted users, however, may reduce
their consumption at the margin so demand is not perfectly inelastic.
Elasticities of Demand and Supply
41
Price Elasticity of Supply
Elasticities of Demand and Supply
42
PRICE ELASTICITY OF SUPPLY
 Price Elasticity of Supply
Definition
The price elasticity of supply is the ratio of the percentage change in
the quantity supplied to the percentage change in price.
Price elasticity of
=
supply
Percentage change in quantity supplied
Percentage change in price
It is a measure of the extent to which the quantity supplied of a good
changes when the price of the good changes.
Elasticities of Demand and Supply
43
PRICE ELASTICITY OF SUPPLY
Calculating Supply
Elasticity: Example
If the price of a bunch of roses
increases from $40 to $80, the
quantity supplied increases from 6
to 24 million bunches per month.
The quantity increase is 120% of
the average quantity.
The price increase is 66.67% of the
average price.
The price elasticity of supply equals
120% divided by 66.67%, or 1.8.
Elasticities of Demand and Supply
44
PRICE ELASTICITY OF SUPPLY
 Elastic and Inelastic Supply
Supply is elastic if
• the percentage change in quantity supplied is greater than the
percentage change in price
• the coefficient of the elasticity of supply is greater than 1.
Elasticities of Demand and Supply
45
PRICE ELASTICITY OF SUPPLY
Elastic Supply
A 10% rise in the price of a book, . . .
increases the quantity supplied by
20%.
The increase in quantity supplied is
greater than the increase in price.
Therefore, the supply of books is
elastic.
Elasticities of Demand and Supply
46
PRICE ELASTICITY OF SUPPLY
 Elastic and Inelastic Supply
Supply is unit elastic if
• the percentage change in quantity supplied is the same as the
percentage change in price
• the coefficient of the elasticity of supply equals 1.
Elasticities of Demand and Supply
47
PRICE ELASTICITY OF SUPPLY
Unit Elastic Supply
A 10 % rise in the price of fish, . . .
increases the quantity supplied of
fish by 10%.
The increase in quantity supplied is
the same as the increase in price.
Therefore, the supply of fish is unit
elastic.
Elasticities of Demand and Supply
48
PRICE ELASTICITY OF SUPPLY
 Elastic and Inelastic Supply
Supply is inelastic if
• the percentage change in quantity supplied is smaller than the
percentage change in price
• the coefficient of the elasticity of supply is less than 1.
Elasticities of Demand and Supply
49
PRICE ELASTICITY OF SUPPLY
Inelastic Supply
A 20% rise in the price of a hotel
room, . . .
increases the quantity supplied of
hotel rooms by 10%.
The increase in quantity supplied is
smaller than the increase in price.
Therefore, the supply of hotel
rooms is inelastic.
Elasticities of Demand and Supply
50
PRICE ELASTICITY OF SUPPLY
 Elastic and Inelastic Supply
Supply is perfectly elastic if
• the quantity supplied changes by a very large percentage in
response to an almost zero percentage change in price.
• the coefficient of the elasticity of supply is infinite (the numerator
is very large and the denominator is infinitesimally small).
Elasticities of Demand and Supply
51
PRICE ELASTICITY OF SUPPLY
Special Case: Perfectly
Elastic Supply
Even a very small rise in the the
price, . . .
increases the quantity supplied by a
very large amount.
The change in the quantity supplied
is much (infinitely) larger than the
change in price. Supply is perfectly
elastic.
Elasticities of Demand and Supply
52
PRICE ELASTICITY OF SUPPLY
 Elastic and Inelastic Supply
Supply is perfectly inelastic if
• the percentage change in quantity supplied is zero when the price
changes.
• the coefficient of the elasticity of supply equals 0.
Elasticities of Demand and Supply
53
PRICE ELASTICITY OF SUPPLY
Special Case: Perfectly
Inelastic Supply
A small rise in the price of a
beachfront lot, . . .
increases the quantity supplied by
0%.
There is no change in quantity
supplied when price changes.
Therefore, the supply of beachfront
lots is perfectly inelastic.
Elasticities of Demand and Supply
54
PRICE ELASTICITY OF SUPPLY
 Variables That Influence the Price Elasticity of
Supply
Influences on the price elasticity of supply include
• Substitution possibilities
• Time
Elasticities of Demand and Supply
55
PRICE ELASTICITY OF SUPPLY
 Variables That Influence the Price Elasticity of
Supply
Substitution possibilities
If producers have good substitution possibilities for their resources,
then the good can be produced at a constant or very gently rising opportunity
cost, and the supply of the good is relatively elastic.
If the resource substitution possibilities are not good, then the
opportunity cost of producing the good increases rapidly, and the supply of
the good is relatively inelastic.
At the extreme, if there are no resource substitution possibilities, the
good can be produced only in a fixed quantity, and the supply of the good is
perfectly inelastic.
Elasticities of Demand and Supply
56
PRICE ELASTICITY OF SUPPLY
 Variables That Influence the Price Elasticity of
Supply
Substitution possibilities and storage
Storage provides producers with a way of substituting future sales for
current sales. The lower the cost of storing a good, ceteris paribus,
the more elastic is its supply.
On the other hand, the supply of a non-storable good is highly
inelastic.
Elasticities of Demand and Supply
57
PRICE ELASTICITY OF SUPPLY
 Variables That Influence the Price Elasticity of
Supply
Time
As time passes after a price change, producers find it easier to change
their production plans.
Therefore, the longer the time elapsed since the price change, ceteris
paribus, the more elastic is the supply of the good.
Elasticities of Demand and Supply
58
Cross Elasticity and Income Elasticity
Elasticities of Demand and Supply
59
CROSS ELASTICITY AND INCOME
ELASTICITY
 Cross Elasticity of Demand
Definition
The ratio of the percentage change in quantity demanded of a good to
the percentage change in the price of another good that is a substitute
or a complement.
It is a measure of the extent to which the demand for a good changes
when the price of a substitute or complement changes, other things
remaining the same.
Elasticities of Demand and Supply
60
CROSS ELASTICITY AND INCOME
ELASTICITY
 Cross Elasticity of Demand
Cross elasticity
=
of demand
Percentage change in quantity demanded of a
good
Percentage change in the price of one of its
substitutes or complements
Elasticities of Demand and Supply
61
CROSS ELASTICITY AND INCOME
ELASTICITY
 Cross Elasticity of Demand
Example 1
Suppose that when the price of a burger falls by 10 percent, the
quantity of pizza demanded decreases by 5 percent.
Cross elasticity of
demand for pizza
Π 5 percent
=
Π10 percent
Elasticities of Demand and Supply
=
0.5
62
CROSS ELASTICITY AND INCOME
ELASTICITY
 Cross Elasticity of Demand
Substitutes
The cross elasticity of demand for a substitute is positive.
A fall in the price of a substitute brings a decrease in the quantity
demanded of the good.
The quantity demanded of a good and the price of its substitute
change in the same direction.
Elasticities of Demand and Supply
63
CROSS ELASTICITY AND INCOME
ELASTICITY
 Cross Elasticity of Demand
Example 2
Suppose that when the price of a soda falls by 10 percent, the quantity
of pizza demanded increases by 2 percent.
Cross elasticity of
demand for pizza
2 percent
=
– 10 percent
Elasticities of Demand and Supply
=
-0.2
64
CROSS ELASTICITY AND INCOME
ELASTICITY
 Cross Elasticity of Demand
Complements
The cross elasticity of demand for a complement is negative.
A fall in the price of a complement brings an increase in the quantity
demanded of the good.
The quantity demanded of a good and the price of its complement
change in opposite directions.
Elasticities of Demand and Supply
65
CROSS ELASTICITY AND INCOME
ELASTICITY
Cross Elasticity of Demand
Pizzas and burgers are substitutes.
Cross elasticity is positive.
Pizzas and soda are complements.
Cross elasticity is negative.
Elasticities of Demand and Supply
66
CROSS ELASTICITY AND INCOME
ELASTICITY
 Income Elasticity of Demand
Definition
The ratio of the percentage change in quantity demanded to the
percentage change in income.
It is a measure of the extent to which the demand for a good changes
when income changes, other things remaining the same.
Elasticities of Demand and Supply
67
CROSS ELASTICITY AND INCOME
ELASTICITY
 Income Elasticity of Demand
Percentage change in quantity demanded
Income elasticity
of demand
=
Percentage change in income
The income elasticity is
• greater than 1 for a normal good in elastic demand.
• between 1 and 0 for a normal good in inelastic demand.
• between 0 and -1 for an inferior good in inelastic demand.
• smaller than -1 for an inferior good in elastic demand.
Elasticities of Demand and Supply
68
Application: Tax Incidence
Elasticities of Demand and Supply
69
APPLICATION: TAX INCIDENCE
 Tax Incidence
Definition
The division of the burden of a tax between the buyer and the seller.
• If the price rises by the full amount of the tax, then the burden
of the tax falls entirely on the buyer.
• If the price doesn’t change, then the burden of the tax falls
entirely on the seller.
• If the price rises by a lesser amount than the tax, then the
burden of the tax falls partly on the buyer and partly on the
seller.
Elasticities of Demand and Supply
70
APPLICATION: TAX INCIDENCE
 Tax Incidence
Legal incidence and economic incidence
The tax legislation defines the legal incidence of a tax. The legal
incidence specifies the individuals who are legally liable for payment
of the tax to the government, who bear the initial burden of the tax.
If the individuals who bear the legal incidence can shift the burden of
the tax to others, the economic incidence is different from the legal
incidence. The economic incidence is determined by the elasticities
of demand and supply. It is independent of the legal incidence.
Elasticities of Demand and Supply
71
APPLICATION: TAX INCIDENCE
Economic Incidence of a
Tax on CD Players (1)
With no tax, the price of a CD
player is $100 and 5,000 CD
players a week are bought.
A $10 tax per CD player imposed
on sellers of CD players shifts the
supply curve to S + tax.
Elasticities of Demand and Supply
72
APPLICATION: TAX INCIDENCE
Economic Incidence of a
Tax on CD Players (2)
The equilibrium price rises to
$105—an increase of $5 a CD
player. The equilibrium quantity
decreases to 2,000 CD players a
week.
Sellers receive $95 after payment of
the tax—a decrease of $5 per CD
player.
Elasticities of Demand and Supply
73
APPLICATION: TAX INCIDENCE
Economic Incidence of a
Tax on CD Players (3)
The government collects tax
revenue of $20,000 a week—the
purple rectangle.
The burden of the tax is split
equally between the buyer and the
seller—each pays $5 per CD player.
Elasticities of Demand and Supply
74
APPLICATION: TAX INCIDENCE
 Tax Incidence and Price Elasticities of Demand
and Supply
Economic incidence depends on elasticities of demand
and supply
The economic incidence of a tax is not always equally divided
between buyers and sellers.
In general, the distribution of the economic incidence between
buyers and sellers depends on the price elasticities of demand and
supply.
Elasticities of Demand and Supply
75
APPLICATION: TAX INCIDENCE
Tax Incidence in a Market
with Perfectly Elastic
Supply—The Market for
Sand
A tax of 1¢ a pound increases the
price by 1¢ a pound, and the buyer
pays all the tax.
Elasticities of Demand and Supply
76
APPLICATION: TAX INCIDENCE
Tax Incidence in a Market
with Perfectly Inelastic
Demand—The Market for
Insulin
A tax of 20¢ a dose raises the price
by 20¢, and the buyer pays all the
tax.
Elasticities of Demand and Supply
77
APPLICATION: TAX INCIDENCE
Tax Incidence in a Market
with Perfectly Elastic
Demand—The Market for
Pink Marker Pens
A tax of 10¢ a pen lowers the price
received by the seller by 10¢, and
the seller pays all the tax.
Elasticities of Demand and Supply
78
APPLICATION: TAX INCIDENCE
Tax Incidence in a Market
with Perfectly Inelastic
Supply—The Market for
Spring Water
A tax of 5¢ a bottle lowers the price
received by the seller by 5¢, and the
seller pays all the tax.
Elasticities of Demand and Supply
79
APPLICATION: TAX INCIDENCE
 Tax Incidence and Price Elasticities of Demand
and Supply
Elasticities and tax incidence: summary
Holding the elasticity of supply constant, the price rises more when
the elasticity of demand is lower (more inelastic or less elastic).
Therefore, the buyer pays a larger share of the tax the lower is the
elasticity of demand for the good.
Holding the elasticity of demand constant, the price rises less when
the elasticity of supply is lower (more inelastic or less elastic).
Therefore, the seller pays a larger share of the tax the lower is the
elasticity of supply of the good.
Elasticities of Demand and Supply
80
APPLICATION: TAX INCIDENCE
 Example: Incidence of the Payroll Tax
Legal Incidence
Social security and Medicare are financed by a payroll tax. The total
tax is 15.3% of an employer’s payroll.
The legal incidence of the payroll tax is divided equally between the
employer and the employee. The employer pays 7.65% of each
worker’s pay and the employee has 7.65% deducted from his or her
pay.
Who really pays the payroll tax?
Elasticities of Demand and Supply
81
APPLICATION: TAX INCIDENCE
 Example: Incidence of the Payroll Tax
Economic Incidence
Empirical evidence shows that the supply of labor of primary
workers (usually, but not always, male) is very inelastic.
With a very inelastic supply, the economic incidence of a tax is
mostly on the supplier. The workers or employees are the suppliers of
labor.
Therefore, no matter how the legal incidence is divided between
employers and workers, the economic incidence of the tax is mostly
on workers. The net wage received by workers is approximately
15.3% lower than it would be if there were no payroll tax.
Elasticities of Demand and Supply
82
APPLICATION: TAX INCIDENCE
 Example: Incidence of Taxes on Business
Legal Incidence
Businesses do not pay taxes in any real economic sense. Only people
pay taxes. All of a business’s revenues are derived from people
(consumers) and ultimately become income to other people
(employees, suppliers of other resources, owners and shareholders).
Even though the legal incidence of a tax may be on business, the
economic incidence must rest on people.
Elasticities of Demand and Supply
83
APPLICATION: TAX INCIDENCE
 Example: Incidence of Taxes on Business
Economic Incidence: What Are the Possibilities?
Just because the legal incidence of a tax is on business income or
profits does not necessarily mean that profits are lower by the amount
of the tax. The tax may instead raise prices or reduce wages or lower
the prices paid to other resource suppliers.
Elasticities of Demand and Supply
84
APPLICATION: TAX INCIDENCE
 Example: Incidence of Taxes on Business
Consumers
If consumer demand for the goods produced by the business is
relatively inelastic, then the economic incidence of a tax on business
rests at least in part on consumers. They pay higher prices than they
would if there were no tax and the tax on business is really a tax on
consumers .
Elasticities of Demand and Supply
85
APPLICATION: TAX INCIDENCE
 Example: Incidence of Taxes on Business
Workers
If workers’ supply of labor to the business is relatively inelastic, then
the economic incidence of a tax on business rests at least in part on
the business’s employees. They receive a lower net wage than they
would if there were no tax, and the tax on business is really a tax on
the incomes of workers.
Elasticities of Demand and Supply
86
APPLICATION: TAX INCIDENCE
 Example: Incidence of Taxes on Business
Suppliers of other resources
If the supply of other factors of production (physical capital, land) is
relatively inelastic, then the economic incidence of a tax on business
rests at least in part on the owners of these other factors. They
receive a lower price than they would if there were no tax, and the
tax on business is really a tax on the incomes of suppliers of other
factors.
Elasticities of Demand and Supply
87
APPLICATION: TAX INCIDENCE
 Example: Incidence of Taxes on Business
Investors, entrepreneurs and suppliers of financial
capital
If the supply of financial capital and entrepreneurship to the business
is relatively inelastic, then the economic incidence of a tax on
business rests at least in part on the business’s owners and
shareholders. They receive a lower net return on their investment
than they would if there were no tax. Only in this case is a tax on
business truly a tax on the profits of owners and shareholders.
Elasticities of Demand and Supply
88
APPLICATION: TAX INCIDENCE
 Example: Incidence of Taxes on Business
Who ultimately bears the economic incidence of a tax
on business?
Legislators have no influence over the economic incidence of taxes
on business. Economics, not politics, determines where the ultimate
burden of taxes on business rests.
Because the supply of labor is very inelastic and consumer demand is
often less elastic than the supply of capital or entrepreneurship, a
large part of any broad-based tax on business is likely to rest on
workers and consumers, not on owners and shareholders. Taxes on
business are more likely to be paid by consumers or workers than by
owners and investors.
Elasticities of Demand and Supply
89