The Concept of Elasticity of Demand - Essay Example

ELASTI OF DEMAND IN A GOVERNMENT DECISION TO IMPOSE A SPECIFIC TAX ON CIGARETTES. Introduction It is a common misconception among executives andbusinessmen faced with rising costs or the need to improve profit margins that increasing the price of ones product is an effective way to increase revenue. Also, when the government imposes an excise tax the common tendency is to charge the full amount of the tax to the consumer with the conviction that profit objectives will not be affected. Decision makers who do not understand the concept of demand elasticity in economics are bound to be disappointed when their preconceived notions are proven wrong. This paper will discuss the concept of elasticity and how a government tax on a product -- in this instance, cigarettes -- can affect the business firm in terms of how much a specific tax on cigarette can be shifted to the buyer and how much has to be absorbed. B. The concept of elasticity: A brief review Price elasticity (Ep) of demand is the ratio of the percentage change in quantity to the percentage change in the price of a product or service, all other things remaining unchanged. Algebraically, this is expressed as follows: Ep = %∆Q / %∆P where P and Q are the price and quantity, respectively. This formula assumes point elasticity instead of an arc price elasticity for simplicity sake, as our objective of understanding the concept of elasticity can be sufficiently served by this simple assumption. Price elasticity measures how responsive the sales would be in relation to changes in price. Products and services inherently have different price elasticities, so that managerial decisions on expansion or reduction of output would depend to an important degree on how accurate are the determination of such elasticities. At the outset, we may consider the benchmark elasticity = 1 as indicating that a percentage change in price is just equaled by the same percentage change in quantity demanded. Where demand is somewhat less responsive to changes in price, we can say that demand is relatively inelastic -- that is to say, a percentage increase in price triggers a lower percentage change in quantity demanded. Demand is relatively elastic when a change in price causes a larger percentage change in quantity demanded. A vertical demand curve denotes perfectly inelastic demand with an Ep of 0, whereas a perfectly elastic demand would be a horizontal demand curve with an Ep of infinity ( ∞). An important elasticity criterion is whether a good is a necessity or a luxury. A necessity has an inelastic or relatively inelastic demand curve. A good that is inessential (or a luxury) has a relatively elastic demand curve; a certain percentage rise or fall in its price causes the quantity demanded to change more substantially. This holds true for products that have available substitutes in the market, when the product in question is an insignificant proportion of the individuals total income, and when the consumer can do without it or postpone his purchase without much discomfort. Occasionally products whose demand is inelastic in the short term can change into one whose demand is elastic in the long run, as illustrated by the case of fuel oil prices in the early 1970s: Consumer adjustments in terms of alternative fuel increased its elasticity in the succeeding years. We may illustrate the concept of demand elasticity graphically (Note that the supply curve is included in order to point out that the concept is not complete without identifying the equilibrium point, the point of intersection, of demand and supply): 1. Unitary elasticity (Ep = 1) of demand 2. Relatively inelastic demand (0.5): 3. Perfectly elastic demand (∞) 4. Perfectly inelastic demand Tax Incidence Below is a basic chart where the elasticity is unitary. We will demonstrate how the tax burden on a product is shared between the seller and the buyer. a. Basic chart When a $30 specific tax is imposed on a product where the elasticity is unitary, the price rises from $100 to $130 in this example as shown by the line PR on the new supply curve S. However, because the new equilibrium point is at H the seller is compelled to charge only the amount H which is about $115, and after giving $30 to the government, he is left with a net proceeds of $85 at G. The buyer bears the other half of the tax ($15). b. Where demand is inelastic (< 1). The tax incidence will be borne fully by the buyer, as shown below: Because of the perfectly inelastic demand, all the tax burden (RP) will be borne by the consumer. The seller charges the full amount of price plus tax to the buyer ($130) and keeps the proceeds of $100 as before the tax was imposed. c. Where the demand curve is perfectly elastic. Where demand is perfectly elastic, the seller will bear the full amount of the tax RP. At the same time he will have to reduce the quantity sold by the volume NL in order to avoid build up of excess inventory. Demand elasticity: The case of cigarettes It is widely believed that the demand for cigarettes among consumers inelastic or at least relatively inelastic -- i.e., the price elasticity is less than 1. Because consumer behavior among the smoker population is difficult to measure in the aggregate, this presumption is made on the basis of the observation that consumers of cigarettes smoke owing to their addiction to nicotine and would therefore not be very sensitive to any changes in the price of cigarettes. If the demand for cigarettes was perfectly inelastic, the full amount of the tax will be paid by the consumers. However, Arnold (144) states that the demand for cigarettes in one study (not specified by source) was 0.35 for the general population of smokers, which means that it would take a three-fold increase in the price of cigarettes for the quantity demanded to fall by 1 unit. Another study (also not specified as to source) was said to have found that for every unit of price increase, the quantity demanded -- among teenage population - slipped by 1.2 units, indicating that for this group of smokers the price elasticity of demand for cigarettes was relatively elastic. Nicholson (282) says that a survey has shown that virtually all of the tax is shifted to the consumers, or close to 100 percent. Where less than the full tax is absorbed by consumers, the reasons given were that they decided to shop across state borders, or they switched to higher quality brands. Policy objectives in government taxation of cigarettes If the the policy objective is to raise the maximum amount of revenue, the government should tax a product whose demand is price inelastic. This is because the quantity bought will not drop as much, percentage-wise, as the increase in price attributable to the specific tax. However, if the policy objective is to reduce the number of smokers or discourage new smokers, as would be the case for teenagers in one survey (Arnold 144) , it is best to tax that population segment whose demand elasticity is greater than 1. Let us illustrate these by the following examples. First, let the price of 1 cartons of cigarettes be $50, and the quantity 1000 cartons, and the specific tax of $40. We will use two distinct assumptions about the elasticity of demand. Case 1 - Demand is relatively price inelastic ($40 tax causes quantity demanded to fall 10%) Price after $40 specific tax ($50 x 1.4) $70 x 1000 70,000 Quantity decrease (-10%) $70 x 900 63,000 Tax proceeds on reduced quantity $40 x 900 $ 36,000 About 75 percent of the tax is shifted to the buyer, while the seller bears the balance of 25 percent. Case 2 - Price is relatively elastic (1.2) Price after $40 specific tax ($50 x 1.4) 70 x 1000 70,000 Quantity decrease (1.4 x 1.2) = -68% 70 x 320 22,400 Tax proceeds on reduced quantity 40 x 320 12,800 The quantity demanded dropped drastically compared to the previous example. Because of the reduced quantity, tax proceeds were also much lower. However, if the government goal was to reduce the number of smokers (as evidenced by the lower number of cigarette cartons bought), then the strategy to use is to tax where the elasticity of demand is high. Conclusion The imposition of a new tax by the national government or by a state is usually undertaken in order to raise new revenues. When they are imposed on certain products that are harmful to health, in order to discourage new buyers or decrease consumption, as in the case of cigarettes, the tax has a dual purpose. It is the task of policy makers which of these objectives should have primacy and thus target those populations whose demand elasticity characteristics for the product are appropriate for a certain policy. WORKS CITED Arnold, Roger A. Microeconomics. 6th ed. Mason, OH: South-Western, 2004 Nicholson, Walter. Intermediate Economics. 7th ed. Orlando, FL: The Dryden Press, 1997 Schenck, R. Supply and Demand. Cybereconomics. Retrieved December 4, 2009, from http://ingrimayne.com/econ/DemandSupply/OverviewSD.html Simple Economics on the Web. Retrieved December 4, 2009, from http://plaza.mit.edu/econ/index.html Spencer, Milton H. & Orley M. Amos, Jr. Contemporary Economics. 8th ed. New York: Worth Publishers, 1993 Read More