Importance of the Elasticity of Demand - Essay Example

Examine the Importance of the Elasticity of Demand in a Government Decision to impose a Specific Tax on the Buyers of Cigarettes As the price of a commodity increases by a particular percentage, consumption of the product tends to decrease, especially for goods that are not necessities. Higher prices increase expenses for consumers and may thus discourage cigarette consumption. The question is whether the percentage decline in cigarette consumption is greater than the percentage increase in price as measured by the price elasticity of demand. Price elasticity of demand can help show whether the decline in cigarette consumption can be explained by higher taxes imposed by the government. Price Elasticity of Demand Price elasticity of demand is defined as the percentage change in demand caused by a percentage change in consumer price (Mankiw and Taylor 2006). For example, if the price elasticity of cigarette demand was -0.5 percent, a one percent increase would cause a 0.5 percent decrease in demand. Elasticity indicates stretch and flexibility. The flexibility or the price elasticity of demand will change depending on the commodity (Pindyck and Rubenfeld 2001). Price elasticity can also measure the willingness and ability of an individual consumer to pay for a good. Individuals with lower incomes are likely to have lower price elasticity, because they have less money to spend. An individual with a higher income is inclined to have higher price elasticity, since he has the financial means to spend more. In both cases, ability to pay is balanced with the essential value of the commodity being sold. For example, if the good that is being sold is a necessity, even a buyer with low price elasticity may be willing to pay for the higher price. Elasticity differs among commodities because certain goods may be more important to the consumer. A commodity or service is regarded as elastic if a slight change in price leads to a sharp change in the quantity demanded (Pindyck and Rubenfeld 2001). Oftentimes, these types of commodities are easily available in the market and an individual may not essentially need them in his or her daily life. Conversely, an inelastic commodity or service is one in which changes in price result only in little changes in the quantity demanded. Commodities that are necessities are less sensitive to price changes because consumers would need to buy these products even with increases in price (Samuelson and Nordhaus 2005). Alternatively, a price increase of a good or service that is considered less of a necessity or more of a luxury will dissuade more buyers because the cost of purchasing the commodity will become too high. To calculate the price elasticity of demand of a product, this equation is used: Elasticity = Percentage % change in quantity demanded/ Percentage % change in price (Mankiw and Taylor 2006) Disregarding the negative sign, if elasticity is greater than one, the demand is deemed to be elastic. If it is less than one, the demand is regarded as inelastic (Samuelson and Nordhaus 2005). Since, the demand curve is a negative slope, if there is a large decrease in the quantity demanded resulting from a small increase in price, the demand curve appears flatter, or more horizontal. The flatter curve indicates that the commodity or service in question is elastic. On the other hand, an inelastic demand is depicted by a much more upright curve as quantity changes less relative to the increase in price. Cigarette Taxes, Prices, and Consumption For many years, cigarette has been regarded as a commodity ideal for taxation, since it is not a necessity and is bought by many people. As early as the eighteenth century, Adam Smith proposed in his book Wealth of Nations (1776) that a tobacco tax would permit poor people to "live better…and to send their goods cheaper to market." Demand for their work would grow higher, and as a result, increasing the earnings of poor individuals and contributing to the whole economy. Centuries later, almost all governments tax tobacco, most of the time hugely, by various different methods. Their purpose has almost always been to produce revenue, although in the past few years, taxes have also mirrored a heightened concern for the necessity to lower the damaging effects of smoking (Bradford 2003). For simplicity, a specific tax will be considered in this paper. This is a tax of a certain fixed amount per unit sold. Because it is included as a fixed amount to the price of cigarettes, it allows the greatest flexibility and allows governments to increase the tax with less risk that the industry will respond with actions that keep the real amount charged low (Orzechowski and Walker 2001). Advocates of higher excise taxes on cigarettes contend that, in addition to producing revenue for the government, the tax offers to decrease the incidence of cigarette use, especially among younger people (Lewit and Coate 1982). They maintain that the higher tax adds to the price of cigarettes. Because of the higher cigarette prices many young people who already smoke will discontinue smoking and those do not smoke will be discouraged to take up the habit. On the other hand, adversaries of the higher excise taxes maintain that higher cigarette taxes cause escalating black market activity in cigarettes (Moyer 2005). They also contend that the higher taxes will unjustly strain lower income groups. The effect of increasing taxes on cigarette consumption To analyze the effect of government’s decision to raise taxes, knowledge of price elasticity is necessary for evaluating the entire effect of higher cigarette taxes. For instance, if the price elasticity of the demand for cigarettes is computed to be high, the percentage increase in government revenues resulting from a tax increase would be significantly less than the percentage increase in the tax, due to the higher decrease in quantity bought. When the price of cigarette increases, individuals with lower incomes generally tend to decrease their consumption of that commodity, than individuals with higher incomes (Orzechowski and Walker 2001). Alternatively, when the price decreases; they are more inclined to raise their consumption. In the case of cigarettes, if a price rise of 10 percent causes the quantity demanded to fall by 4 percent, the elasticity of demand for cigarettes is -0.4. Thus, the more price sensitive consumers are, the larger is the elasticity of demand. An essential theory in economics asserts that as the price of a good rises, the quantity demanded of that good will decrease. In the past, researchers have argued that cigarette’s addictive disposition is an exception to this rule (United States Department of Agriculture Center for Nutrition Policy and Promotion 1995). Based on their reasoning, cigarette smokers are addicted so much to smoking that they are willing to spend any amount and continue to smoke the same number of cigarettes to appease their habit. However, an increasing amount of research presently shows that this contention is wrong and that smokers' urge for cigarettes, while inelastic, is still largely influenced by its price. For instance, tax increases in Canada between 1982 and 1992 resulted in a sharp rise in the real price of cigarettes, which caused consumption to fall significantly (United States Department of Agriculture Economic Research Service 2003). The price sensitivity of different age groups can also aid the government in its decision to impose cigarette taxes. The age group composition of many low income nations' populations is generally younger and research from the high income developed nations indicates that, in general, young people are more price sensitive than older people (United States Department of Agriculture Economic Research Service 2002). This may be in part be due to their having lower disposable incomes, in part because some of them may yet be less addicted to nicotine, in part because of their more present-directed attitude, and in part because they are more exposed to peer influences (Grossman, et al 1993). Hence, if a young consumer quits smoking because he or she can not afford to buy it anymore, friends tend to follow the behavior, more than among older age groups. To illustrate, a research done by the U.S. Centers for Disease Control and Prevention concluded that demand elasticity among young adults aged between 17 and 23 in the United States was -0.5, higher than for smokers in general (Chaloupka and Wechsler 1997). Research analysts deduce that when prices are high, not only are young smokers more inclined to discontinue smoking, but that less potential young smokers will take up the habit. Based on information gathered from the elasticity of demand of cigarettes, the government can arrive at two conclusions. First, tax increases are an efficient way to lower cigarette consumption in low income countries, where majority of smokers are located. Secondly, the effect of a cigarette tax raise will have a greater impact in these countries than in high-income countries. If the price of cigarettes rises, most smokers accept it and continue smoking. For them, in the present price range, the price elasticity of demand is practically imperceptible. On the other hand, the price elasticity of demand is much higher for young people, than for people who have been smoking for longer periods of time. Thus, raising the taxes will have a much more noticeable effect on them. Word Count: 1,500 References Smith, Adam 1776, Wealth of Nations, Version edited by Edwin Canaan, University of Chicago Press, Chicago. Bradford, R. 2003, Pregnancy and the demand for cigarettes, American Economic Review, 93(5), 1752-1763. Chaloupka,P and J. Wechsler 1997, Tobacco control policies and smoking among young adults. Journal of Health Economics, 16(3), 359-73. Grossman, Michael, Sindelar, Jody, Mullahy, John, & Anderson, Richard 1993. Policy Watch: Alcohol and Cigarette Taxes, The Journal of Economic Perspectives, 45(4), 211-222. Lewit, J.P. and R. Coate 1982, The potential for using excise taxes to reduce smoking. Journal of Health Economics, 1(2), 121-45. Mankiw, N.Gregory and Mark P. Taylor 2006, Economics, London, Thomson Learning. Moyer, David 2005, The Tobacco Book, Sunstone Press, New Mexico. Orzechowski and Walker 2001, The tax burden on tobacco, McGraw-Hill, Arlington, VA. Pindyck, Robert and Daniel Rubinfeld 2001, Microeconomics, Prentice Hall, New Jersey. Samuelson, Paul and William Nordhaus 2005, Economics, McGraw-Hill, New York. United States Department of Agriculture Center for Nutrition Policy and Promotion. 1995, The healthy eating index. Washington, DC. United States Department of Agriculture Economic Research Service. 2002, Tobacco outlook report. Washington, DC. United States Department of Agriculture Economic Research Service. 2003, Tobacco outlook report. Washington, DC. Read More