EXPLAIN WHY IT IS CRUCIAL THAT POLICY MAKERS HAVE ACCURATE ESTIMATES OF THE RELEVANT DEMAND ELASTICITIES WHEN DECIDING ON A POLICY SCHEME, FOR EXAMPLE FUEL TAXATION
"EXPLAIN WHY IT IS CRUCIAL THAT POLICY MAKERS HAVE ACCURATE ESTIMATES OF THE RELEVANT DEMAND ELASTICITIES WHEN DECIDING ON A POLICY SCHEME, FOR EXAMPLE FUEL TAXATION"
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CATHERINE ROBINS
03008113
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ALEXANDROS ZANGELIDIS
THURSDAY, 12 - 1pm
INTRODUCTION
Businesses and governments alike use the concept of elasticity of demand. By looking at demand elasticities, it is possible to predict how consumers will react to a change in the price of a good. It is therefore vital for sellers in helping to assess what may happen to profits and/or market share as a result. For governments, elasticity of demand is imperative when making taxation decisions. For example, would a rise in indirect tax on cigarettes lead to a rise in total tax receipts? Will a rise in road tax cause any significant reduction in car usage, and a fall in negative externalities such as congestion? The answers to such questions can have a huge impact on governments' budgets. An increase in taxation on some goods will result in increased tax revenue, whereas on others tax revenue will decrease. The key is to establish which goods will result in an increase in revenue and implement suitable actions accordingly.
To begin with, we need to define price elasticity of demand. Price elasticity of demand (PED) measures the responsiveness of a change in demand for a good to a change in its price. When price falls we expect to see an expansion in demand, and when price rises we expect to see a contraction in demand. There is therefore an inverse relationship between price and demand, which gives a negative value for PED. To avoid confusion, we ignore the negative sign and focus simply on the coefficient of elasticity. PED is calculated by the following formula:
This calculation gives a value which indicates a commodity's price elasticity. For instance, if PED is zero, we say demand is perfectly inelastic - quantity demanded does not change at all as price changes; if PED is between zero and 1, demand is inelastic - quantity demanded changes by a smaller percentage than price; if PED is equal to 1, demand is unit-elastic - quantity demanded and price change by the same percentage; if PED is greater than 1, demand is elastic - quantity demanded changes by a larger percentage than the change in price; and if PED ...
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This calculation gives a value which indicates a commodity's price elasticity. For instance, if PED is zero, we say demand is perfectly inelastic - quantity demanded does not change at all as price changes; if PED is between zero and 1, demand is inelastic - quantity demanded changes by a smaller percentage than price; if PED is equal to 1, demand is unit-elastic - quantity demanded and price change by the same percentage; if PED is greater than 1, demand is elastic - quantity demanded changes by a larger percentage than the change in price; and if PED is infinity, we say it is perfectly elastic - consumers are so sensitive to price changes that at any other price nothing will be demanded.
There are four main factors which determine demand elasticities. Firstly, the presence of close substitutes. If a good has close substitutes, such as Coke and Pepsi, an increase in price means consumers can easily switch to another product which will still satisfy the consumer's needs, so demand is elastic. A good with no close substitutes however would be more inelastic - there are no other goods to satisfy their needs so consumers would be willing to pay more. The commodities' share in consumers' budgets affects elasticity; the bigger the share of the budget, the more significant effect a price change would have, and so the more elastic demand is. The degree of necessity has an effect too; if the good is a necessity then the demand is unlikely to change much even if price changes. This implies that necessities have inelastic demand. Lastly, the time frame of the analysis can have an effect. In the short run, it is likely that there will not be a huge change in demand as consumers don't have time to react to the price change, so demand is inelastic. However, as time goes on consumers are able to find alternatives or make relevant adjustments to their spending, so demand becomes more elastic.
One example of a good with inelastic demand is cigarettes. They have no real substitutes, especially in the short run. Cigarettes are habit-forming, so they become a necessity for smokers. Therefore, consumers cannot easily respond to a change in price.
The duty on cigarettes is an indirect per-unit tax. The burden of such tax is very important, and will vary according to the demand elasticity for the product it is imposed on. In the case of goods with inelastic demand, such as cigarettes, the burden of the tax will fall on the consumer. Consumers are not very sensitive to price changes so the bulk of the tax can be passed on by the firm1. For the government, the fact that demand for cigarettes is inelastic means that an increase in taxation on cigarettes will result in an even larger increase in tax revenue, as shown in the graph below.
By comparing the size of the boxes, we can see that the increase in price (P1 --> P2) leads to a decrease in quantity demanded (Q1 --> Q2), but the decrease in demand is smaller than the increase in price. So the overall effect is an increase in total revenue for the government.
Conversely, if the demand for a good is elastic, as represented in the graph below, then the increase in price (P1 --> P2) is far outweighed by the decrease in quantity demanded (Q1 --> Q2). Because of this the government will receive relatively little revenue from the tax.
In 2000 alone, the UK government earned £7,760 million in tobacco duty2. With approximately 13 million adult smokers in the UK3 (around 27% of the total population), it is imperative for the government to take advantage of cigarettes' inelastic demand. Otherwise a great deal of tax revenue, which could be collected and injected back into the economy, may be lost.
CONCLUSION
Price elasticity of demand measures how responsive the quantity demanded of a good is to a change in its price. The value indicates whether the good is relatively elastic (PED greater than 1) or relatively inelastic (PED less than 1). This information is important to show how a change in taxation will affect the total tax revenue of the government. If a good is price inelastic, the government can afford to increase its tax rates and expect to tax revenues to rise. If a good is price elastic, however, an increase in taxation would mean demand for that good would fall by more, and so could have a detrimental effect on the government's spending budget.
It is therefore crucial that policy makers have accurate estimates of the relevant demand elasticities when deciding on any policy scheme, as it means they can predict, before taking any action, what the eventual effect on their revenue might be.
BIBLIOGRAPHY
WEB RESOURCES:
* www.tutor2u.com
* www.bized.ac.uk
* www.adic.org.ua/adic/reports/econ/
* www.ash.org.uk/html/factsheets/html/basic03.html
* www.nosmokingday.org.uk/facts_figures.htm
TEXTBOOKS:
* M. L. Katz and H. S. Rosen: Microeconomics (third edition, McGraw-Hill)
* H. R. Varian: Intermediate Microeconomics (sixth edition, Norton)
* D. Rutherford: Routledge Dictionary of Economics (Routledge)
* D. Laidler and S. Estrin: Introduction to Microeconomics (third edition)
Incidentally, if demand was perfectly inelastic then the full amount of the tax would be borne by consumers
2 http://www.ash.org.uk/html/factsheets/html/basic03.html - 'Smoking and Economics' Basic Facts No. 3 (February 2002)
3 www.nosmokingday.org.uk/facts_figures.htm - 'Smoking Statistics' (March 2003)