CB2400 Chap.5 Income, Cross-price and Tax Incidence
Income, Cross-price and Tax Incidence
Signs classify demand relationships
Income elasticity measures the percentage quantity response to a percentage income change. A positive sign identifies a normal good and a negative sign identifies an inferior good over the observed range. Cross-price elasticity measures how demand for one good responds to the price of another.
A positive sign indicates substitutes; a negative sign indicates complements.
A tax creates two relevant prices
With a per-unit tax, buyers pay more than sellers receive. Demand depends on the buyer price and supply on the seller receipt. The difference equals the tax.
Collecting the money from buyers or sellers changes which effective curve is shifted, but a consistent model gives the same traded quantity, buyer price, seller receipt and tax revenue.
Responsiveness locates burden
The less elastic side of the market bears more of the wedge because its quantity adjusts less readily.
Inelastic demand places more burden on buyers through a higher price paid; inelastic supply places more on sellers through a lower net receipt. Tax revenue equals the per-unit tax multiplied by the post-tax quantity. The traded quantity usually falls after the tax.
What this chapter covers
- 01
income elasticity sign
- 02
normal and inferior goods
- 03
cross-price elasticity sign
- 04
substitutes and complements
- 05
buyer and seller prices
- 06
elasticity and tax burden
Worked example · free
Solve two prices around a tax wedge
- 3Substitute the tax wedge into demand.
- 4Equate demand and supply to solve the seller price and quantity.
- 3Recover the buyer price and tax revenue.
Key terms
- Income Elasticity
- The percentage quantity response to a one per cent income increase.
- Cross-price Elasticity
- The percentage demand response for one good to another good's price change.
- Tax Wedge
- The difference between the price buyers pay and sellers receive after tax.
- Tax Incidence
- The economic division of the tax burden between buyers and sellers.
- Tax Revenue
- The per-unit tax multiplied by the quantity traded after tax.
Income, Cross-price and Tax Incidence FAQ
What does a negative income elasticity mean?
It means quantity demanded falls when income rises over the observed range, so the good is classified as inferior in that setting. The classification does not imply low quality and need not hold for every consumer or income level. It is a measured demand relationship.
Who bears a per-unit tax?
The less elastic side of the market bears more of the economic burden because it changes quantity less readily. The legal instruction about who transfers the tax to government does not determine incidence. Solve the buyer price and seller receipt, then compare each with the original equilibrium price.
How do I calculate tax revenue?
Multiply the tax per traded unit by the post-tax equilibrium quantity. Do not use the original quantity, because the wedge normally reduces trade. A useful audit is that buyer price minus seller receipt equals the tax exactly before revenue is calculated.
Exam move
Memorise a sign table with four cells: positive income elasticity means normal, negative means inferior, positive cross-price means substitutes and negative means complements. For taxes, write Pb - Ps = t before touching the demand and supply equations. Finish each problem by checking the wedge, post-tax quantity and revenue rectangle. Attach the variable names to every elasticity formula.
Income belongs in the denominator of income elasticity; the other good's price belongs in the denominator of cross-price elasticity. State classifications as relationships over the observed range, avoiding value judgements about inferior goods or physical claims about substitutes. For a tax, solve the untaxed equilibrium first so there is a reference price for incidence.
Then substitute the wedge into one market function, equate quantities and recover both prices. Four checks should agree: Pb minus Ps equals the tax, demand and supply yield the same post-tax quantity, the buyer and seller burdens add to the tax, and revenue equals the tax multiplied by the new quantity. Sketch relatively steep and flat curves to rehearse the elasticity rule.
The less responsive side absorbs more of the price change, regardless of which party sends the payment to government. Finish by distinguishing statutory remittance from economic burden in one precise sentence. Re-solve one wedge with the legal remittance assigned to the other side and verify that the economic prices, quantity and revenue remain unchanged.
Working through Income, Cross-price and Tax Incidence in CB2400? Sia is AskSia’s AI Economics tutor — ask any CB2400 Income, Cross-price and Tax Incidence question and get a clear, step-by-step explanation grounded in how CB2400 is taught and assessed. Read this chapter free, then take your hardest questions to Sia.