Question

6a. In a market where the supply curve is inelastic, how does an excise tax affect the price paid by consumers and the quantity exchanged? Illustrate with a market diagram. 6b. In the market diagram, show the amount of the excise tax. Do consumers or suppliers pay a higher proportion of the tax? 7. Write the formula for calculating cross price elasticity of demand. Beneath the formula, on four separate lines, identify the two variable terms in the numerator and the two variable terms in the denominator 8. Compute the cross price elasticity of demand of tea for coffee if the price of coffee rises from $4.50 per pound to $5.50 per pound and as a result consumer demand for tea increases from 600 to 800 packets 9a. For what range of values does cross price elasticity indicate two goods are complements. 9b. For what range of values does price elasticity indicate two goods are substitutes.

Answer 1

6.a. We know that a tax falls more heavily on the side of the market which is more inelastic. Elasticity measures the responsiveness of buyers or sellers when market price changes. Here inelastic supply means that sellers have to bear a higher burden of the tax because inelastic supply means, sellers do not have many options to switch to other markets as tax is imposed in this market. The following diagram explains this situation.

6b. In the following figure, supply curve is relatively inelastic or steeper and without tax, the equilibrium price is P0 and the equilibrium quantity Q0. Now with the imposition of an excise tax, the supply curve shifts leftward from S1 to S2 and the price paid by buyers after tax is Pb while the price received by sellers after the imposition of excise tax is Ps. Here the tax burden on buyers is very small which is given by (Pb-P0). While sellers receive much lower price from the previous equilibrium price of P0. The tax burden on sellers is much higher which is= (P0-Ps). Also after the imposition of the excise tax, quantity exchanged declines from Q0 to Q1. Hence as supply curve is relatively inelastic, suppliers bear a large burden of the tax than the buyers.

,62 Say Encise Tan P Demand -Q CS Scanned with Qat QO CamScanner

and Y cross price elasticity of demand betwas good X can be written an. (AQx1ax) 1 Ee - TAPYIPY) or Adex Ec = Dax By - py? Chage in price goody Hue AQ X = Change in the quantity demanded of godx Py = price of goody APY = Chage in price of goody Qx= quantity of goodx. 8 Now price of coffee risus from $4,50 pupoud to $5.50 pu pand and as a result demand for tea increases from 600 to 800 packets. Scanned with CamScanner

how here Now here Pi = $4,50 /pond P2 = $5.50 / pond Q1 = 60o packets Q2 = 800 packets. w percentage chage in quantity demanded of tea : Now Pacentage cha Q2-Q1] X100 1Q2+QI 88.57.10 a 1800-600 x 100 = 1800+6001 Now Pucentage Change in Price of coffee! a B2-P) fx loo IPTP S (5.50-4.502 5.5074,50 % 100 = 20.40 2 u cross puce elasticity of demand betwen tea and coffee will be = tochage in quantity demanded of tca O % change in price of coffee 28.57% = 1:43 20% Ec = 1.43 Hice As Ee = 1.43 is positive, hence exass puse coffee and tea are putect substitute of each other or in wease in the price of coffee will in crease the demand for Scanned with CamScanner

a 1. Two goods will be com plements of each other when Ee Lo or when Goss price elasticity tween two goods is negative. Here is crease in the - one good will reduce the uontity demanded price of S - ide good. for the other Two a 9. b) bh Two goods will be substitutes of eachothes when .yo or when cross-price elasticity of doming domand between two goods is positive. Scanned with CamScanner