Applications of demand and supply elasticity

1. APPLICATIONS OF DEMAND & SUPPLY
ELASTICITY
SEM I
Managerial Economics

2. ELASTICITY & TAX INCIDENCE
 Tax incidence shows how the burden of tax on a commodity is
distributed between seller and buyer
 Commodity tax (sales tax, excise duty) is imposed on the seller who
shifts either a part or all of the tax on to buyers through the
medium of price
 Burden on the buyer is the amount by which the price rises
 Burden on seller is fall in revenue after paying tax
Tax incidence depends on relative elasticity of demand & supply

3. CASE 1- DEMAND IS INELASTIC, SUPPLY IS ELASTIC
ED<ES
• Original Price = $10
• Equilibrium Quantity at $10 = 88 units
• Tax per unit sold = $ 6
• Imposition of tax shifts the supply curve inwards
from S1 to S2
• The vertical distance between the two supply curves is
the tax per unit of output
• New Price = $14
• New Quantity = 80 units
• Increase in Price = Tax incidence on buyer = $4
• Tax incidence on seller = $2
 Greater incidence on tax on buyer than seller because
demand is more inelastic than supply
 When demand is relatively inelastic, seller can
increase price without much reduction in quantity

4. CASE I1- DEMAND IS ELASTIC, SUPPLY IS INELASTIC
ED>ES
• Tax per unit sold = $ 6
• Imposition of tax shifts the supply curve inwards
from S1 to S2
• Price increases from $13 to $14
• Quantity falls from 80 units to 50
• Increase in Price = Tax incidence on buyer = $1
• Tax incidence on seller = $5
 Greater incidence on tax on seller than buyer
because
demand is more elastic than supply
 When demand is relatively elastic, seller cannot
increase price much as it leads to a more than
proportionate fall in quantity demanded

5. CASE 111 – ELASTICITY OF DEMAND = ELASTICITY
OF SUPPLY
• Imposition of tax shifts the supply curve inwards
from S to S+ tax
• Original Price = P
• New Price = P1
• Increase in Price = Tax incidence on buyer =PP1
• Tax incidence on seller = PX
• PP1 = PX
 Equal incidence on tax on seller and buyer

6. DEMAND ELASTICITY & TAX BURDEN
 When demand is perfectly
inelastic, price rises by the full
amount of the tax
 Price rises from P0 to P1
 Full incidence is on the buyer
 When demand is perfectly elastic,
there is no rise in price
 Full incidence is on the seller
Perfectly Inelastic Demand Perfectly Elastic Demand

7. ELASTICITY OF SUPPLY & TAX INCIDENCE
Perfectly Elastic Supply
• Price rises by the full amount of the tax
• Full incidence on buyer
Perfectly Inelastic Supply
• No increase in price
• Full incidence on seller

8. CALCULATING TAX INCIDENCE ON BUYER & SELLER
Tax incidence on Buyer
The fraction of tax borne by the
buyer =
𝐸𝑠
𝐸𝑠+ 𝐸𝑑
Tax incidence on Seller
The fraction of tax borne by the
seller =
𝐸𝑑
𝐸𝑠+𝐸𝑑
𝐸𝑠 is elasticity of supply
𝐸𝑑 is elasticity of supply
We consider here absolute value for 𝐸𝑑
If price elasticity of demand is -0.4 and price elasticity of supply is 0.5, the incidence on the buyer is
0.5
0.5+0.4
= 0.56 = 56%
The incidence on the seller is 44%

9. SOLVE
A firm has following demand and supply function:
Demand: Qd = 40 – 1/2P
Supply: Qs = -20 +1/2P
A. From the above functions, find the equilibrium price.
B. If the government imposes specific sales tax of Rs. 10, what would be
the new equilibrium price?
C. Show the same with the help of a diagram and incidence of tax on
buyer and seller.
If the government imposes lumpsum tax of Rs. 1000, what would be the
equilibrium price of the good?

10. PARADOX OF POVERTY AMIDST PLENTY

11. BUMPER CROP – BAD NEWS FOR FARMERS?
 A good weather, good monsoon, technological improvements can
cause supply of farm products to increase substantially
 Price falls
 Most agricultural goods have inelastic demand, hence demand
does not rise proportionally
 Total revenue earned by producers fall
 Large harvest tends to bring low revenue to the farmers
A bumper crop, instead of raising farm incomes, reduces it

12. BUMPER HARVEST PARADOX
 As supply of agricultural produce rises,
prices drop more sharply for items with
inelastic demand
(staples, perishables, etc.)
 At the higher price of Rs.100,
(equilibrium point A), farmers are able to
earn a revenue of Rs. 7,000
 With a fall in price, revenue falls to Rs.
4,000
 The more inelastic the demand curve,
lower will be the revenue earned with a
fall in price
 This paradox is the reason why
government provide support in the form
of Minimum Support Price

13. WHY DID OPEC FAIL TO KEEP PRICE OF OIL HIGH
AFTER THE 1980
 In the 1970s, countries forming the OPEC decided to raise the oil
price by jointly deciding to reduce supply
 In 1973 & 1974, oil price increased by more than 50% creating
worldwide energy crisis
 Supply was further reduced and price rose in 1979(14%), 1980
(34%) & 1981 (34%)
 After 1981, it failed to maintain high prices
 Between 1982-1985, oil price fell by 50%

14. DEMAND ELASTICITY, SUPPLY ELASTICITY, TIME
HORIZON & OIL PRICE

15. DEMAND & SUPPLY OF OIL MORE ELASTIC IN LONG
RUN
 Buying habits of consumers take time to adjust. Short run demand
is inelastic
 In the long run, consumers respond to high oil price by attempting
to conserve oil – use of fuel efficient cars, use of public transport,
car pooling, etc.
 Supply of oil also is more elastic in long run
 Producers outside OPEC also increased production and oil
extraction capacities
 New energy sources were identified and used