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Cross-price elasticity is important for producers to recognize.

Demand for goods in


industries such as autos are significantly impacted by changes in price of
complements and substitutes, most noticeably gasoline and the prices of cars produced
by a competing firm. Individual firms will carefully judge the impact of competitor
pricing and the responsiveness of consumers to those price changes. Goods with a
higher degree of substitution will have a greater positive value for their cross-price
elasticity. Likewise, goods that show a more complementary relationship have an
increasing negative value for their cross-price elasticity.
Take the example of the airline industry and consider goods that are close substitutes.
For example one good is the price of seat on American Airlines, the other good is the
demand for seat on United Airlines, each on an identical flight route - say Boston to
Washington DC. In the case of the airline industry, the cross-price elasticity of
demand for airline tickets is very high, and firms respond immediately to fare
changes. If one airline such as American initiates a fare war, competitors such as
United quickly follow in reducing prices to prevent a loss of market share. Since there
is a high cross-price elasticity, if American lowers its fare from Boston to Washington
DC, and United keeps its fares constant, consumers quickly shift consumption
towards the lower priced American tickets. The resulting decrease in the demand for
United Airlines tickets is large (3).
(3) In this example the cross-price elasticity takes on a positive value,
indicating American and United tickets are substitutes. If American lowers
its fare the coefficient is negative since the fare decreases and since United
holds its fare constant, demand for United tickets falls as well, resulting in a
negative coefficient also. Dividing a negative decrease in demand by a
negative drop in price results in the negative coefficients canceling out and a
positive coefficient for the result.

Elasticity of Demand and Taxation


Taxes are levied by governments at the time of sale for some goods. The effect of the
tax causes the consumer to pay a higher price for the good than the price the producer
receives for the same good, the difference in the price paid and the price received is
the amount of the tax. In this section, will first look at how a tax that is imposed at the
point-of-sale impacts our analysis and then relate the incidence, or burden of taxation
to the elasticity of demand for the good. Typical taxes we will examine in this section
include excise taxes such as cigarette and gasoline. As you will see, governments
prefer to tax goods with a relatively inelastic demand, since there will be little
decrease in demand by consumers when the good's price increases.

Let us begin our analysis with the general effect of an excise tax. We begin with an
initial, pre- tax equilibrium at Po and Qo. As mentioned, the effect of the tax is to drive
a wedge between what the consumer pays for the good (P c) and what the producer
receives (Pp). The graphical consequences as shown in Figure 4-6, where the supply
curve shifts inward by the amount of the tax. As the graph shows, due to the tax the
price paid by consumers exceeds the price received by producers, the difference being
the amount of the tax.

The above graph shows that a tax drives a


wedge between the consumer's price paid and
the price received by the producer. Now we
turn our attention to the effect on
consumption, which depends on the relative
elasticity of demand. In Figure 4-7 we look at
a 50 cent tax on cigarettes, imposed at the
point-of-sale.
Since the demand for cigarettes is relatively
inelastic, the associated demand curve has a steep slope. Beginning with the original
equilibrium price for cigarettes prior to the tax, we see that the tax drives the supply
curve for cigarettes upward by the amount of the tax. Since the demand curve for
cigarettes is relatively inelastic, consumers end up absorbing the majority of the tax
incidence, by paying the majority of the tax - the difference between the price paid by
consumers after the tax (Pc) and the price paid before the tax (Po). Using the same
analysis, the amount of the tax burden imposed on producers is measured by the
difference between the price received by producers (P p) and the pre-tax price received
by cigarette manufacturers (Po).
Note in Figure 4-7 the effect on the
demand for cigarettes due to the tax drop in demand is small, since
cigarettes are a relatively inelastic
Smokers are most likely to pay the tax
little reduction in their consumption of
cigarettes. To measure the area of tax
by the consumer, we take the
differences in prices paid after (Pc) and
(P0) the tax, times the new level of
consumption, Q1. The producers
allocation to the tax is measured by the

the
good.
with
paid
before

differences in prices received after (Pp) and before (P0) the tax, times the new level of
consumption, Q1. The amount of tax received by the government equal the consumers
plus the producers shares of the price wedge caused by the tax times the new level of
consumption, Q1.
To complete our story, there is also what is known as a deadweight loss due to
taxation, illustrated by the decrease in output from Q o to Q1. The deadweight loss is the
reduction in economic activity, or output, due to the tax. Specifically, the deadweight
loss is the shaded triangular area bounded by the original point of price and output
equilibrium before the tax (Po, Qo) and the new prices paid by the consumer (P c) and
received (Pp) by the producer.
In contrast to a good with an inelastic price elasticity of demand, we compare tax
incidence for a good which has a relatively price elastic demand such as satellite
dishes used for receiving television stations. In areas with a developed coaxial cable
infrastructure, the majority of the United States for example, demand for satellite
dishes is fairly elastic, since the consumer has the alternative of relatively low priced
cable hookup. We would expect any increase in the price of the dish to reduce demand
significantly. Similarly, a reduction in the price of a dish, especially the smaller dish
(Direct TV, etc.), leads to gains in demand.
For a similar story, consider the VCR (video cassette recorder). Introduced in the early
1980s, the original VCR's were very expensive, costing close to a $1,000 for a
machine that would be considered ancient in comparison to today's cheapest models.
As a consequence of the high price, demand was low. As prices fell continuously
during the 1980s, demand soared, making the VCR as common as the television in
people's homes. Over the next few years, as the price of small satellite dishes fall, we
can expect the cable companies that only recently monopolized the cable market, to
experience intense competition, as dish sales experience tremendous growth.
Figure 4-8 illustrates a relatively elastic demand curve and the impact of a tax
imposed on satellite dishes at the time of sale (holding the price elasticity of supply
constant from the previous graph). As you already understand, the tax causes the
supply curve for satellite dishes to shift leftward, creating a gap between the price
paid by consumers for the dish and the price received by producers for the same item.
To measure the area of tax paid by the consumer, we take the differences in prices
paid after (Pc) and before (Po) the tax, times the new level of consumption, Q 1. The
producers allocation to the tax is measured by the differences in prices received after
(Pp) and before (Po) the tax, times the new level of consumption, Q 1. The amount of tax
received by the government equal the consumers plus the producers shares of the
price wedge caused by the tax times the new level of consumption, Q 1. The
deadweight loss is the shaded triangular area bounded by the original point of price

and output equilibrium before the tax (Po, Qo) and the new prices paid by the consumer
and received by the producer. Since demand for satellite dishes is relatively elastic,
you will notice that the majority of the tax is absorbed by the producer and a smaller
portion by the consumer.
For our analysis we can make several
conclusions about the incidence of taxation
and the elasticity of demand for the good
being taxed:
For goods with a relatively
inelastic demand, the reduction
in demand caused by a tax is
minor, and the greater burden of
the tax will fall on the consumer.
Because the response in demand
is small, governments favor
taxing goods with an inelastic demand, in order to maximize tax
revenues.
For goods with a relatively elastic demand, the reduction in demand
caused by a tax is significant, and the greater burden of the tax will fall
on the producer. While governments will imposeluxury taxes, since the
associated demand is relatively elastic, these types of taxes are often less
effective in raising substantial revenues, but they help to confer a sense
of fairness to the taxpayer.
The last point made above is an important one. Point-of-sale taxes such as excise
taxes on cigarettes, gasoline and alcohol are considered regressive. A regressive tax
places a greater burden on consumers as their income declines, since a greater
percentage of their disposable income is spent on these goods. This is not to say that
as our incomes fall, we smoke, drink and drive more, but that a greater portion of our
income is absorbed on the consumption of these goods in comparison to a wealthy
individual who may consume equal quantities of these goods. As a consumer's income
increases their tax burden for these goods falls as they spend a smaller share of their
disposable income for the consumption of these goods. In conclusion, while taxes on
luxury items such as yachts, jewelry, and extravagant automobiles do not raise
substantial sums of money, the tax system takes on a greater aura of fairness. (4).
(4) We will not explicitly cover the incidence of taxation for different price
elasticity's of supply, holding the elasticity of the demand curve constant. If

you are interested, use a similar graphical analysis to find the following
conclusion: As the relative price elasticity of the supply curve falls (becomes
more inelastic), the producer's tax burden increases relative to the
consumer's.