Elasticity, Surplus, and Taxation
Table of Contents
This section covers the following topics:
- Elasticity
- Income elasticity of demand
- Cross-price elasticity of demand
- Producer and consumer surplus
- Taxation and deadweight loss
Section Summary
Elasticity describes how sensitive something is to changes in price. The elasticity of supply or demand is the percentage change in supply or demand over the percentage change in price. If supply or demand is inelastic, that ratio is between 1 and 0. The ratio is exactly 1 in the unit elastic case and is greater than 1 if supply or demand is elastic.
If demand for a good is inelastic at the current price, businesses should raise their prices (and vice-versa). The income elasticity of demand shows how demand will react when the average consumer’s income changes. The cross-price elasticity of demand relates the price of one good to the demand for another. When the price of a substitute (Ford and Toyota are substitutes) rises, demand rises, but when the price of a complement (milk and cookies are complements) rises, demand falls.
Surplus is the benefit that someone gains by producing or consuming a good minus its cost, and is divided into producer surplus and consumer surplus. If the market is not at equilibrium, total surplus is reduced and a deadweight loss is created.
Taxation also creates a deadweight loss. Whoever is more inelastic (suppliers or demanders) bears a greater portion of the burden of taxation.
People also have a tendency to engage in unproductive rent-seeking activities, such as lobbying, in which they try to transfer surplus to themselves.
