Elasticities, Taxes & Subsidies

Question 1

What is price elasticity of demand (PED) and the formula?

Answer 1

The responsiveness of demand of a product when there is a change in price.

PED = % change in demand / % change in price

Question 2

What are 4 factors affecting PED?

Answer 2

Availability/ no. of substitutes, proportion of income, necessity/ addictive, time.

Question 3

Why may PED be inelastic? [0 < PED < 1] (Steep curve)

Answer 3

No alternatives, bought infrequently, low % of income, no time.

Question 4

Why may PED be elastic? [PED > 1} (Flatter curve)

Answer 4

Not necessity or addictive, expensive/ big % of income, lots of substitutes, bought frequently

Question 5

What is price elasticity of supply (PES) and the formula?

Answer 5

The responsiveness of supply of a product when there is a change in price.

PES = % change in supply / % change in price

Question 6

What are 4 factors affecting PES?

Answer 6

Lots of time, spare capacity (available FoPs), mobility factors (adjusting production & resources), availability of stock.

Question 7

What is income elasticity of demand?

Answer 7

The responsiveness of demand of a product when there is a change in income.

YED = % change in demand / % change in income

Question 8

What is an inferior good and what are their YED?

Answer 8

As incomes rise, demand of a good falls. People have more money to buy goods they can now afford.

YED < 0, negative

Question 9

What are normal goods and what are their YED?

Answer 9

As incomes rise, demand of a good rises. People have more money to buy more goods.

YED > 0, positive

Question 10

What are luxury/ superior goods and what are their YED?

Answer 10

As incomes rise, demand of a good rises A LOT. People can now afford expensive goods.

YED > 1, positive & elastic

Question 11

What are necessities and what are their YED?

Answer 11

As incomes rise, demand of a good rises a little, generally everyday items.

0 < YED < 1, positive & inelastic

Question 12

When may a good be perfectly income inelastic (YED = 0)

Answer 12

When income has no effect on quantity demanded. Eg. water/ electricity bills.

Question 13

What is cross-price elasticity of demand (XPED) and what is the formula?

Answer 13

The responsiveness of demand of one good when another good changes in price.

XPED = % change in demand of good x / % change in price of good y

Question 14

What are substitute goods and what are their XPED?

Answer 14

Goods which are used for the same thing, you either get one or the other. (eg. wine and champagne)

XPED < 0
Close substitute - big negative
Weak substitute - small negative

Question 15

What are complementary goods and what are their XPED?

Answer 15

Goods which are commonly used together. (eg. milk and cereal)

XPED > 0
Close complement - big positive
Weak complement - small positive

Question 16

What is a direct tax?

Answer 16

Taxes imposed on income, wealth or a firm’s profits. (eg. income tax, corporation tax)

Question 17

What is an indirect tax?

Answer 17

Taxes imposed on expenditure.

Question 18

Specific and ad valorem taxes are types of indirect tax, what is the difference?

Answer 18

Specific tax - fixed amount of tax added to the market price of a G/S. (eg. excise duties on alcohol)

Ad valorem tax - amount of tax depends on the value of a good. Often depends on % of its value. (eg. VAT)

Question 19

How do you show a specific tax on a D/S diagram?

Answer 19

A parallel shift to the left of the supply curve equal to the tax per unit.

Question 20

How do you show an ad valorem tax on a D/S diagram?

Answer 20

A non parallel shift to the left of the supply curve.

As tax per unit is a % of its value, the two supply curves diverge as quantity increases.

Question 21

What is consumer incidence and where is it shown on the diagram?

Answer 21

The consumer’s contribution to the tax.

Lower section of rectangle.

Question 22

What is producer incidence and where is it shown on the diagram?

Answer 22

The producer’s contribution to the tax.

Upper section of rectangle.

Question 23

What is deadweight loss and where is it shown on the diagram?

Answer 23

The overall economic loss due to the tax, causing a fall in demand.
Triangle between old and new quantity demanded.

Question 24

How do you find total tax revenue?

Answer 24

Consumer + Producer incidence

Tax per unit x new quantity (specific only)

Question 25

How does PED affect consumer and producer incidence of an indirect tax and why?

Answer 25

If PED is elastic, PI is large
If PED is inelastic, CI is large

When PED is inelastic, firms can afford to put more costs on the consumers as their demand won’t change much if £ increases.

Question 26

How would subsidies be shown on the D/S diagram?

Answer 26

A parallel shift to the right of the supply curve equal to the subsidy per unit. (subsidies are never ad valorem)

Question 27

How would consumer and producer gain be shown on the diagram?

Answer 27

Producer gain is the upper section of the rectangle, consumer gain is the lower section. (swapped from taxes)

Question 28

How would additional trades made from subsidies be shown on the diagram.

Answer 28

Triangle between old and new quantity demanded, as it is cheaper for both consumers and producers, demand increases.

Question 29

How would PED affect consumer and producer gain on a subsidy and why?

Answer 29

Inelastic PED, producer gain is large (+ vice versa)

When PED is inelastic, producers can take more of the gain and lower prices less for consumers as their demand won’t change much.

Question 30

How would you calculate the cost of subsidies to the government from the diagram?

Answer 30

Consumer gain + producer gain

Subsidy per unit x new quantity demanded