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"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" - - - - - - - - - - - CATHERINE ROBINS 03008113 - - - - - - - - - - - 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? ...read more.


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. ...read more.


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. ...read more.

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