33 income elasticity of demand income elasticity of

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3.3 Income Elasticity of Demand Income elasticity of demand measures the degree of responsiveness of demand to changes in income level of the consumer. It examines the relationship that exists between income level and quantity demanded. Income elasticity is used in classifying goods into normal, ostentious or luxury, and inferior goods. A positive income elasticity of demand is related to normal and superior goods, while negative income elasticity is related to inferior goods. Mathematically, it is written as Q Y Y Q Y Y Q Q e Y / / Where Q = Q 2 Q 1 and Y = Y 2 Y 1 . That is: D P O Qty Qty P S
Principles of Microeconomics ECN 210 36 1 1 1 2 1 2 1 1 2 1 1 2 ) ( ) ( / ) ( / ) ( Q Y Y Y Q Q Y Y Y Q Q Q e Y In term of luxury-necessity categorization, if ℮ y > 1 it is likely to be a luxury good; if ℮ y < 1 but positive, it is likely to be a necessity. These benchmarks help in determining whether commodities in question or involved are normal, inferior, luxury or necessity. Income elasticity of demand can be negative or positive. Less than 1.0 is income inelastic and greater than 1.0 is income elastic. 3.4 Cross Elasticity Of Demand This measures the degree of responsiveness of demand for a product or goods to changes in the price of another good. Given a two-commodity world X and Y, cross elasticity of demand is defined as percentage change quantity demanded of x as a result of a given percentage change in the price level of y. It is given as: X Y Y X Y Y X X XY Q P P Q P P Q Q e / / That is: xy = percentage change in the quantity demanded of commodity X divided by the percentage change in the price of commodity Y. The concept of cross elasticity yields a useful criteria for categorizing goods in terms of substitutes and complements. When ℮ xy > 0, it implies that commodity x and y are substitutes If ℮ xy < 0, it implies that commodity x and y are complements If ℮ xy = 0 it shows that commodity x and y are independent of one another, i.e. they have no relationship, or their uses as substitutes or complements offset each other, e.g. tomatoes and onions. 3.5 Application of Elasticity Concept 3.5.1 Tax Incidence & Elasticity of Demand
Principles of Microeconomics ECN 210 37 Incidence of Taxation : Incidence of taxation refers to the burden of tax, with reference to the point at which the tax burden finally rests. The incidence or burden tax lies more on the person who finally pays the tax. There are 2 types of tax incidence; formal and effective incidence. Formal Incidence of Tax : This is the initial effect of tax on the tax objects; it shows where the initial burden lies. The initial burden of a direct tax is usually borne by the direct tax payer. Effective Incidence of Tax : This refers to who bears the final or ultimate burden of taxation. For a direct tax, the tax payer bears the full burden of taxation i.e. the formal and effective incidence. The final burden of an indirect tax may be borne by the producer or the consumer, or it may be shared between them. The extent to which either or both the producer or consumer bears the burden of indirect tax

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