Elasticity and Incidence by Jeff Traczynski, 9/3/07

Elasticity
Elasticity: the percentage change in a variable in response to a given percentage change
in another variable
Elasticity is a !eas"re of the sensitivity of one variable to changes in another variable
#ost often, elasticity is "se$ to $escribe $e!an$ c"rves, tho"gh %e&ll see that the
concept has so!e applicability to s"pply c"rves as %ell There are !any types of
elasticity, each na!e$ for the variables involve$ 'e also have point elasticity an$ arc
elasticity, t%o separate for!"las %hich %e "se $epen$ing on %hether %e&re calc"lating
the elasticity at a given point or bet%een t%o given points (o %hile it !ay see! like
there are a lot of for!"las here, the patterns %ill beco!e clear, so it&s not too !"ch to
!e!orize 'e&ll start %ith the !ost fre)"ently "se$ type of elasticity, the price elasticity
of $e!an$
*rice Elasticity of +e!an$
P P
Q Q
/
/

=
, -.percentage change in )"antity $e!an$e$/ / .percentage change in price/-
The price elasticity of $e!an$ .0/ sho%s ho% !"ch the )"antity $e!an$e$ of a goo$
changes as its o%n price changes That is, %hen the price of a goo$ increases 102, ho%
!"ch $oes the )"antity $e!an$e$ fall3 The price elasticity of $e!an$ is of partic"lar
interest to pro$"cers %ho are atte!pting to $eter!ine ho% to set the price of their
pro$"cts if they raise their price slightly, %ill cons"!ers b"y nearly as !"ch as before
or %ill they t"rn to co!peting pro$"cts3 4t is also %orth pointing o"t that %e al%ays
report price elasticity of $e!an$ as a positive n"!ber .note the absol"te val"e signs in
the above for!"la/, even tho"gh %e kno% fro! o"r st"$y of the 5a% of +e!an$ that as
price goes "p, )"antity $e!an$e$ sho"l$ go $o%n
(o, here are the t%o for!"las to "se %hen co!p"ting price elasticity of $e!an$:
*oint Elasticity 6rc Elasticity

=
A
A
Q
P
slope
1

=
C B
C B
C B
C B
P P
P P
Q Q
Q Q

The point elasticity for!"la allo%s "s to $eter!ine the elasticity at point 6 , .76, *6/,
%hile the arc elasticity for!"la gives "s the responsiveness of )"antity $e!an$e$ to the
change in price bet%een points 8 , .78, *8/ an$ 9 , .79, *9/
5et&s try to !ake things a little !ore clear by %orking thro"gh an e:a!ple 9onsi$er the
$e!an$ c"rve +: * , 30 ;7 %ith points 6, 8, an$ 9 as pict"re$ belo%:
'e see that 6 , .1, <;/, 8 , .3, 1;/, 9 , .;, ;/, an$ the slope of o"r $e!an$ c"rve is =;
'e %ill no% co!p"te the point elasticity at each of these three points, as %ell as the arc
elasticity bet%een each pair of points
;
1
<;
;
1
=

=
A

,
1
3
1;
;
1
=

=
B

, an$
; / 1
;
;
;
1
=

=
C

are o"r point

elasticities, %hile
<
>
1
<
1
1; <;
1; <;
3 1
3 1
=

=
AB

,
< / 1
<
1
>
1
; 1;
; 1;
; 3
; 3
=

=
BC

, an$
1
3
<
3
<
; <;
; <;
; 1
; 1
=

=
AC

are o"r arc elasticities
?o" !ight notice that the point elasticity at point 8 an$ the arc elasticity bet%een 6 an$
9 are both 1, an$ that 8 is e:actly half%ay bet%een 6 an$ 9 This is not a coinci$ence
4n$ee$, the arc elasticity bet%een any t%o points %ill al%ays be e)"al to the point
elasticity of the point half%ay bet%een the! To see this, %e %ill co!p"te the point
elasticities at the points .<, <0/ .half%ay bet%een 6 an$ 8/ an$ .>, 10/ .half%ay bet%een
8 an$ 9/
<
<
<0
;
1
/ <0 , < .
=

=
, an$
< / 1
>
10
;
1
/ 10 , > .
=

=
, so AB
=
/ <0 , < . an$ BC
=
/ 10 , > .
This little trick can help save yo" so!e %ork really, yo" $on&t nee$ the arc elasticity
for!"la if yo" can correctly fin$ the half%ay point an$ apply the point elasticity for!"la
Econo!ists "se the price elasticity of $e!an$ to $ivi$e a $e!an$ c"rve into three
regions, as ill"strate$ belo%:
+e!an$ is calle$ elastic at a point if the price elasticity of $e!an$ at that point is strictly
greater than 1 .0 @ 1/, inelastic if 0 A 1, an$ "nit elastic if 0 , 1 6 linear $e!an$ c"rve
has e:actly one "nit elastic point, %hich is locate$ right in the !i$$le of the line 4n o"r
above e:a!ple, %e sa% that 0 , 1 at point 8 , .3, 1;/, an$ 8 is the center of the line
+e!an$ is elastic at all points above the "nit elastic point, like point 6 fro! o"r previo"s
e:a!ple 'e verifie$ this $irectly %hen %e sho%e$ that at point 6, 0 , ; (i!ilarly,
$e!an$ is inelastic at all points belo% the "nit elastic point, B"st as %e sa% that 0 , 1/; at
point 9
'hat&s the point of $ivi$ing the $e!an$ c"rve into these regions3 'ell, recall that %e
earlier !entione$ ho% kno%ing the price elasticity of $e!an$ %o"l$ be "sef"l for
pro$"cers beca"se it %o"l$ help the! set the price for their pro$"cts These regions of
the $e!an$ c"rve help "s $ra% the i!portant links bet%een elasticity an$ total reven"e
Cirst, let&s note that the reven"e of the seller !"st e)"al the e:pen$it"re of the cons"!er
That is, ho%ever !"ch !oney the seller receives !"st be e)"al to the a!o"nt of !oney
cons"!ers spen$ on the pro$"ct Do%, ho% !"ch $o cons"!ers spen$ on the pro$"ct3
Cort"nately, the $e!an$ c"rve gives "s this infor!ation, as the $e!an$ c"rve sho%s "s
the )"antity the cons"!ers %ant to b"y at any given price per "nit, an$ total e:pen$it"re
on the goo$ is e)"al to the price pai$ per "nit ti!es the n"!ber of "nits bo"ght
'e %ill ill"strate o"r arg"!ent by "sing the sa!e e:a!ple as above, so let o"r $e!an$
c"rve be given by +: * , 30 ;7, an$ consi$er the points 6=E as $ra%n belo%:
9onsi$er a !arket %here the price is E<; 'e kno% that cons"!ers only $e!an$ 1 "nit,
an$ %e are at point 6 on the $e!an$ c"rve Total reven"e for the seller is E<; : 1 , E<;,
the area highlighte$ in re$ Fo%ever, if the seller lo%ers his price to E<0 .point 8/, he
%ill sell < "nits for a total reven"e of E<0 : < , E>0, the area highlighte$ in light bl"e 4n
this case, the seller has increase$ his reven"e by lo%ering his price Gf co"rse, this %ill
not be tr"e for every price 9onsi$er a !arket %here the price is E10 .point +/ Do%, the
seller has reven"e of E10 : > , E>0, the area highlighte$ in pink 4f he lo%ers his price to
E; .point E/, then his reven"e beco!es E; : ; , E<;, the area highlighte$ in bl"e
'henever $e!an$ is elastic, total reven"e rises %hen the price falls an$ falls %ith the
price rises 'henever $e!an$ is inelastic, total reven"e rises %hen the price rises an$
falls %hen the price falls Gf co"rse, %hen %e p"t these t%o state!ents together, %e
realize that on a linear $e!an$ c"rve, reven"e is at its !a:i!"! at the "nit elastic point
.point 9, total reven"e , HE1; : 3I , E>;/ 4n$ee$, %e can see that the grey highlighte$
area is larger than any of the others it contains 9 bo:es, %hile the others contain either J
or ; #a:i!izing reven"e is one of the !ost i!portant applications of the price elasticity
of $e!an$
4nco!e Elasticity of +e!an$
The other types of elasticity %e %ill $isc"ss are very si!ilar to the price elasticity of
$e!an$, an$ are also closely relate$ to the $eter!inants of $e!an$ %hich %e previo"sly
covere$ The inco!e elasticity of $e!an$ is given by
I I
Q Q
I

=
, .percentage change in )"antity $e!an$e$/ / .percentage change in inco!e/
Fere, %e are intereste$ in ho% !"ch the )"antity $e!an$e$ of a goo$ changes %hen the
cons"!er&s inco!e changes The first thing to notice abo"t this for!"la is that there is
no absol"te val"e sign, so 04 can be either positive or negative Cor inco!e elasticity, %e
generally $o not "se the point elasticity for!"la, so here&s the arc elasticity for!"la:

=
1 <
1 <
1 <
1 <
I I
I I
Q Q
Q Q
I

, 6rc 4nco!e Elasticity of +e!an$

'e "se this for!"la %hen a cons"!er e:periences a change in inco!e fro! 41 to 4< an$
therefore changes his )"antity $e!an$e$ of the goo$ fro! 71 to 7<
6s %e kno% fro! o"r $isc"ssion of $eter!inants of $e!an$, a cons"!er&s )"antity
$e!an$e$ of a goo$ can go "p or $o%n %hen his inco!e increases $epen$ing on %hat
type of goo$ it is Cor nor!al goo$s, the cons"!er $e!an$s !ore %hen his inco!e
increases, an$ the opposite is tr"e for inferior goo$s 'ith the inco!e elasticity of
$e!an$, the $istinction bet%een these t%o types is reflecte$ in the sign of 04 4f 04 @ 0,
then the goo$ is nor!al, an$ if 04 A 0, then the goo$ is inferior
1
6 n"!erical e:a!ple is
%orke$ o"t belo%
E:: Jen receives a raise in her allo%ance fro! E10/%eek to E1;/%eek, an$ she also
increases the n"!ber of san$%iches she p"rchases fro! >/%eek to J/%eek 'hat is Jen&s
inco!e elasticity of $e!an$ for san$%iches, an$ are san$%iches a nor!al or inferior
goo$ for Jen3
'ell, let&s apply the above for!"la an$ see %hat %e get:
3 / ;
;
1
3
1
10 1;
10 1;
> J
> J
1 <
1 <
1 <
1 <
=

=
I I
I I
Q Q
Q Q
I

, so san$%iches are a nor!al goo$ for Jen

9ross=*rice Elasticity of +e!an$
B B
A A
B A
P P
Q Q

=
,

, .2 change in )"antity $e!an$e$ of goo$ 6/ / .2 change in price of

goo$ 8/
'e $on&t "se the point elasticity for!"la %ith cross=price elasticities, so here&s the arc
elasticity for!"la:

=
1 <
1 <
1 <
1 <
,
B B
B B
A A
A A
B A
P P
P P
Q Q
Q Q

, 6rc 9ross=*rice Elasticity of +e!an$

1
(o!e books also !ake the follo%ing $istinction: if 04 @ 1, then the goo$ is income-elastic or a luxury .like
a E"ropean vacation/, an$ if 1 @ 04 @ 0, then the goo$ is income-inelastic or a necessity .like foo$/
'e "se this for!"la %hen goo$ 8 changes price fro! *1 to *<, ca"sing o"r cons"!er to
change his )"antity $e!an$e$ of goo$ 6 fro! 71 to 7<
6gain, %e recall o"r $eter!inants of $e!an$ an$ note that if the prices of other goo$s
an$ services .say, goo$ 8/ change, the $e!an$ for goo$ 6 !ay also change 'e %o"l$
certainly e:pect that if 8"rger King lo%ere$ the price of its ha!b"rgers, then $e!an$ for
#c+onal$&s ha!b"rgers %o"l$ probably fall 4f an increase in the price of 8 ca"ses
$e!an$ for 6 to rise, then 6 an$ 8 are s"bstit"tes, %hile if an increase in the price of 8
ca"ses $e!an$ for 6 to fall, 6 an$ 8 are co!ple!ents 6n$ again, this $istinction
bet%een the types is reflecte$ in the sign of 06,8 4f 06,8 @ 0, then 6 an$ 8 are s"bstit"tes,
an$ if 06,8 A 0, then 6 an$ 8 are co!ple!ents 6 n"!erical e:a!ple is %orke$ o"t belo%
E:: Jen b"ys both 9+s an$ +L+s 5ast %eek, the price of a 9+ increase$ fro! E> to EM,
an$ Jen respon$e$ by p"rchasing M +L+s instea$ of her "s"al 10 'hat is Jen&s cross=
price elasticity of $e!an$ bet%een 9+s an$ +L+s, an$ are 9+s an$ +L+s co!ple!ents
or s"bstit"tes for Jen3
5et&s try the for!"la, since that techni)"e %orke$ so nicely for the last e:a!ple:
> / ;
;
1
>
1
> M
> M
10 M
10 M
1 <
1 <
1 <
1 <
,
=

=
B B
B B
A A
A A
B A
P P
P P
Q Q
Q Q

, so these are co!ple!ents for Jen

*rice Elasticity of ("pply
P P
Q Q
S S
S
/
/

=
, .percentage change in )"antity s"pplie$/ / .percentage change in price/
4ncl"$e$ here for co!pleteness, the price elasticity of s"pply is rarely $irectly calc"late$
in practice The !ost i!portant thing to re!e!ber is that it is co!p"te$ in e:actly the
sa!e %ay as the price elasticity of $e!an$, so %e can "se the sa!e for!"las as above:
*oint Elasticity 6rc Elasticity

=
A
A
S
Q
P
slope
1

=
C B
C B
SC SB
SC SB
S
P P
P P
Q Q
Q Q

Fo%ever, %e $on&t have regions of the s"pply c"rve, nor $o %e have notions of elastic
an$ inelastic goo$s on the s"pply si$e *erhaps the only note%orthy thing abo"t
n"!erical val"es of 0( is that if the s"pply c"rve r"ns thro"gh the origin, then 0( , 1 at all
points
6 final %or$ abo"t elasticity: tho"gh %e&ve B"st spent so!e ti!e talking abo"t ho%
$e!an$ c"rves have elastic an$ inelastic regions, %e haven&t sai$ %hy the $e!an$ .or
s"pply/ of so!e goo$s is !ore elastic than others There are three !ain characteristics of
pro$"cts %hich affect the elasticity of $e!an$ an$ s"pply:
Elasticity of +e!an$:
1/ E:istence of close s"bstit"tes if the price of $ecaffeinate$ green tea rises, %e !ight
think that people are %illing to s%itch to caffeinate$ green tea even if the price increase is
s!all, so %e %o"l$ e:pect the $e!an$ for $ecaffeinate$ green tea to be highly elastic
</ Decessity vs 5":"ry foo$ is certainly a necessity, %hile a laptop is not Th"s, the
$e!an$ for foo$ sho"l$ be !"ch !ore inelastic than for laptops
3/ Ti!efra!e $e!an$ is less elastic in the short r"n than in the long r"n, as !ore ti!e
gives people !ore opport"nities to fin$ alternatives Cor e:a!ple, if yo" live ;0 !iles
fro! yo"r Bob an$ the price of gas rises to!orro%, yo"&re pretty !"ch st"ck paying the
ne% higher price 8"t over the ne:t year, yo" co"l$ fin$ another Bob, !ove closer to yo"r
c"rrent Bob, start a car pool, fig"re o"t the p"blic transportation syste!, b"y a hybri$ car
all of %hich lo%er yo"r $e!an$ for gas
Elasticity of ("pply:
1/ 6lternative "ses for inp"ts if the price of shirts falls, a co!pany %hich !akes shirts
%o"l$ probably fin$ its !achines an$ labor %ell=s"ite$ to !aking pants Fo%ever, a
co!pany %hich !akes airplanes !ight not be able to easily s%itch to !aking another
pro$"ct Th"s, %e e:pect the s"pply c"rve for shirts to be relatively elastic, %hile the
s"pply c"rve for airplanes is inelastic
</ 6vailability of inp"ts the inp"ts for !aking orange B"ice are rea$ily available, so if
there is a s!all increase in the price of orange B"ice, fir!s can )"ickly get !ore inp"ts
an$ e:pan$ pro$"ction 6s inp"ts beco!e easier to obtain, s"pply beco!es !ore elastic
3/ Ti!efra!e B"st as %ith $e!an$, as !ore ti!e passes, s"pply beco!es !ore elastic
4nci$ence
*erhaps the !ost i!portant application of elasticity co!es %hen $ealing %ith e:cise
ta:es 4nci$ence refers to the Nb"r$enO of a ta: %hen the govern!ent i!poses a ta: on
a !arket, %ho pays it3 There are t%o types of inci$ence The legal inci$ence of a ta:
falls on the gro"p $esignate$ by the govern!ent to act"ally pay the !oney to the
govern!ent Cor e:a!ple, it !ay be the responsibility of cons"!ers to pay the
govern!ent, as in the case of a sales ta: .%hich is al%ays separately tacke$ onto yo"r
bill/ The econo!ic inci$ence of a ta: is the a!o"nt of cons"!er an$ pro$"cer s"rpl"s
lost $"e to the i!position of the ta: Econo!ic inci$ence is often e:presse$ as a
percentage to $enote %hat portion of the ta: is being pai$ by cons"!ers vers"s
pro$"cers Pns"rprisingly, econo!ists are !"ch !ore concerne$ %ith econo!ic
inci$ence than legal inci$ence 'hat !ay be s"rprising, ho%ever, is that the legal
inci$ence of a ta: has no effect on the econo!ic inci$ence %hether a ta: is legally
applie$ to cons"!ers or pro$"cers !akes no $ifference in %ho bears the econo!ic
b"r$en of paying it
To see these i$eas in action, consi$er the follo%ing e:a!ple 5et o"r c"rves be given by
+: * , 100 >7 an$ (: * , 7, an$ apply a E<0 e:cise ta: to cons"!ers This sit"ation is
pict"re$ belo%:
'itho"t a ta:, the !arket has an e)"ilibri"! price of E<0 an$ an e)"ilibri"! )"antity of
<0 'ith the ta: in place, the )"antity tra$e$ falls to 7T , 1M an$ the price sellers receive
falls to *(T , E1M, %hile the price pai$ by cons"!ers rises to *9T , E3M Cro! o"r
previo"s %ork %ith e:cise ta:es, %e kno% that this ta: generates E.3M 1M/ : 1M , E3<0
of reven"e Fo%ever, the rectangle that %e e:pect to represent the ta: reven"e has been
$ivi$e$ into t%o s!aller rectangles, labele$ 9ons"!er Ta: 4nci$ence .9T4/ an$ *ro$"cer
Ta: 4nci$ence .*T4/ These bo:es represent ho% !"ch of the econo!ic b"r$en of the ta:
falls on cons"!ers an$ pro$"cers, respectively Dote that if there %ere no ta: on this
!arket, then the entire yello% bo: %o"l$ be part of cons"!er s"rpl"s, %hile the orange
bo: %o"l$ be part of pro$"cer s"rpl"s 4nstea$, the yello% an$ orange bo:es are
govern!ent ta: reven"e s"rpl"s lost $"e to the i!position of the ta: The for!"las for
calc"lating 9T4 an$ *T4 are belo%:
9T4 , E.*9T *Q/ : 7T , E.3M <0/ : 1M , E<;M
*T4 , E.*Q *(T/ : 7T , E.<0 1M/ : 1M , EM>
4f %e instea$ %ante$ to e:press this as a percentage, %e can $ivi$e each n"!ber by the
total ta: reven"e, so
9T4 , <;M / 3<0 , J02 an$ *T4 , M> / 3<0 , <02
'hat $oes all of this have to $o %ith elasticity3 'ell, an alternative %ay of calc"lating
the percentages above "ses 0 an$ 0( $irectly, as sho%n belo%:
S
S
CTI

+
=
an$
S
PTI

+
=
%here the elasticities 0 an$ 0( are calc"late$ at the point
.7Q, *Q/, the e)"ilibri"! %itho"t ta:es
5et&s try o"t this for!"la "sing the e)"ations fro! o"r above e:a!ple:
> / 1
<0
<0
>
1
Q
Q 1
=

=
Q
P
slope

, an$
1
<0
<0
1
1 1
=

=
A
A
S
Q
P
slope

, so
( ) ( )
2 J0
;
>
> ;
1
> 1 1
1
= = =
+
=
+
=
S
S
CTI

an$
( )
( )
2 <0
;
1
1 > 1
> 1
= =
+
=
+
=
S
PTI

This elasticity for!"la allo%s "s to !ake an i!portant realization: %hichever si$e of the
!arket is !ore inelastic %ill bear !ore of the ta: b"r$en 4n o"r above e:a!ple, the
$e!an$ c"rve is less elastic than the s"pply c"rve, an$ cons"!ers bear the !aBority of
the ta: b"r$en
(o, this has been a lot of !aterial 5et&s $o one final e:a!ple %hich ties together !any
of the above i$eas to test yo"r "n$erstan$ing 4n 1990, the +e!ocratically=controlle$
9ongress passe$ a Nl":"ry ta:O The i$ea %as to ta: things %hich the very %ealthy
p"rchase so that only the very %ealthy %o"l$ pay the ta: E:pensive cars, Be%elry, large
boats, an$ other si!ilar ite!s %ere ta:e$, an$ 9ongress tho"ght they ha$ co!e "p %ith
an effective %ay to ta: the rich 5et&s see if they %ere right by "sing o"r ne% concepts to
analyze the l":"ry ta: 4n partic"lar, %e&ll consi$er the !arket for yachts
'hat $oes the $e!an$ c"rve for yachts look like3 'ell, they&re certainly l":"ries, an$
there are lots of s"bstit"tes for potential yacht b"yers to spen$ their inco!e on s!aller
boats, international vacations, etc (o it see!s reasonable to believe that the $e!an$ for
yachts is highly elastic 'hat abo"t the s"pply c"rve for yachts3 The labor "se$ to !ake
yachts has so!e alternative "sesR they co"l$ !ake s!aller boats, or fin$ Bobs %el$ing in
other in$"stries 8"t the other inp"ts .say, yacht h"lls/ are not nearly as fle:ible, an$
co!bining this %ith the fact that getting s"ch inp"ts .specialize$ parts, skille$ labor/ !ay
be $iffic"lt !ight lea$ "s to believe that the s"pply c"rve is inelastic
5egally, the inci$ence of this ta: fell on cons"!ers, so the $e!an$ c"rve shifts $o%n as
pict"re$ above 8"t look at %hat has happene$ %ith the econo!ic inci$ence: yacht
pro$"cers, not cons"!ers, pay the !aBority of the l":"ry ta: 'hen %e say Nyacht
pro$"cersO, %e really !ean everyone involve$ on the pro$"ction si$e so %hile the
o%ners of yacht factories !ay be rich, the %orkers are probably not %ealthy Th"s, o"r
theory pre$icts that the l":"ry ta: %o"l$ be pai$ !ostly by the %orking class in this
!arket, not the rich as originally inten$e$ 'hile the yacht !arket is only one !arket
i!pacte$ by this ta:, %e co"l$ !ake si!ilar arg"!ents abo"t the relative elasticities of
s"pply an$ $e!an$ in other s"ch !arkets 5ear Bets, personal helicopters, f"r coats, or
9a$illacs, for e:a!ple 4n reality, the l":"ry ta: fell heavily on pro$"cers in the vast
!aBority of affecte$ !arkets, an$ 9ongress respon$e$ by repealing !ost of the l":"ry ta:
in 1993 The political fallo"t fro! the fail"re of this ta: %as consi$erable: the $a!age
$one to 6!erican fir!s, partic"larly in e:port !arkets, %as "se$ as a ca!paign iss"e by
Sep"blicans in 199> as they took control of both ho"ses of 9ongress for the first ti!e in
>0 years The l":"ry ta:, therefore, stan$s as an e:a!ple of B"st ho% i!portant
econo!ic inci$ence can be an$ ho% a fa"lty "n$erstan$ing of this concept can have
serio"s political reperc"ssions