Question

3. a) What does an income elasticity of demand of +1.33 mean? b) Explain why the government potentially can raise more tax revenue if it applies a tax to a good with inelastic demand than if it applies the tax to a good with elastic demand? c) The Vice Chancellor of a university is concerned about increasing costs, and decides to raise tuition fees in an attempt to increase university revenue. Briefly explain (i.e. 2 or 3 sentences) whether you think this move will accomplish the Vice Chancellor’s objective.

Answer 1

(a) An income elasticity of +1.33 means the good is normal good since income elasticity is positive. In addition, the good is likely to be a luxury good since income elasticity is higher than 1.

(b) A tax increases the effective price paid by buyers. When demand is inelastic, a given increase in price (caused by tax) will decrease its quantity demanded less-than proportionately, so total revenue will increase. Therefore government imposes higher tax on more inelastic goods and lower tax on more elastic goods.

(c) Whether the objective will be fulfilled depends on elasticity of demand for the university's courses. If demand is elastic, increasing fees will lower quantity demanded more than proportionately and will decrease revenue rather than raise it. But if demand is inelastic, increasing fees will lower quantity demanded less than proportionately and will increase revenue, fulfilling the target.