APPLICATIONS OF DEMAND &

SUPPLY ELASTICITY

SEM I
Managerial Economics
 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

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
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
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

 DEMAND ELASTICITY & TAX BURDEN

Perfectly Inelastic Demand Perfectly Elastic Demand

 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
 ELASTICITY OF SUPPLY & TAX INCIDENCE

Perfectly Elastic Supply Perfectly Inelastic Supply

• Price rises by the full amount of the tax • No increase in price
• Full incidence on buyer • Full incidence on seller
 CALCULATING TAX INCIDENCE ON BUYER &
SELLER

Tax incidence on Buyer Tax incidence on Seller

The fraction of tax borne by the The fraction of tax borne by the
buyer = seller =

is elasticity of supply
is elasticity of supply
We consider here absolute value for

If price elasticity of demand is -0.4 and price elasticity of supply is 0.5, the incidence on the buyer is
= 0.56 = 56%
The incidence on the seller is 44%
 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?
PARADOX OF POVERTY AMIDST PLENTY
 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

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
 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%
DEMAND ELASTICITY, SUPPLY ELASTICITY, TIME
HORIZON & OIL PRICE
 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