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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.

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Introduction

Economics Essay Explain why it is Crucial that Policy Makers have Accurate Estimates of the Relevant Demand Elasticities when deciding on a Policy Scheme. Elasticity is concerned with the extent that one variable responds to another. Thus elasticity of demand is a measure of the responsiveness of quantity demanded of a particular product to a given change in one of the independent variables, which affect demand for that product.1 Therefore a valid estimate of a given elasticity of demand can determine the actions of an institution with designs on changing one of those independent variables (e.g. firms and Governments). There are three types of elasticity of demand: Price Elasticity of Demand, Income Elasticity of Demand and Cross Elasticity of Demand. As the names suggest, Price and Income Elasticities of Demand concern the responsiveness of Demand to a change in price and/or Income. Cross Elasticity of Demand refers to the responsiveness of Demand of one product, to a change in price of another. Knowledge of Price Elasticity of Demand can be important for a Government as it can provide reasonably reliable foreknowledge of the effect that a change in indirect taxation (Ad Valorem Tax) ...read more.

Middle

real incomes will decrease, as the price of cigarettes is rising as a proportion of a consumer's budget, and thus a consumer can afford less than he/she had consumed before. Diagram "b" below illustrates this also. "b" Governments can also use figures of Income Elasticity of Demand (YED) when deciding on a policy. YED measures the responsiveness of demand to a change in income. There are different types of good with respect to YED. If YED>0, the good is known as a normal good. This means that as Incomes increase, consumption of the good will also increase at a proportionate level. However, if YED<0, then the good is known as an Inferior Good. This means that as Incomes increase, consumption of the good will decrease proportionately. Also, if YED>1, then the good can be called a luxury good, meaning that as a percentage increase in incomes is perceived, there will be a greater percentage increase in the consumption of the good. Governments can use these figures to decide on policies aimed at demand-sided economics, such as a change in direct taxation (e.g. Income Tax) or when deciding on benefits to be granted to the unemployed (e.g. ...read more.

Conclusion

Also, demand for complimentary goods will change only a little, if the price of cigarettes were to be increased. Therefore, a Government can be relatively assured that as it imposes an indirect tax on cigarettes, there will be little danger of a diversion of consumption away from the product. In conclusion, using the example of cigarettes, one can see that as a Government imposes an indirect tax on cigarettes, the overall level of demand will decrease only a fraction of the increase in price. Therefore, the Total Revenue to the government will most probably increase. This can have two effects. First off, it provides Governments with more income to fund public works programmes and/or fund Government Expenditure on services and benefits. Secondly, the increased price on cigarettes could lead to a decrease in the disposable income of consumers to be spent on other, alternative goods. This can lead to a decrease in the standard of living of consumers, but also to an increase when the injections of Government Expenditure are considered. However, in order for a Government to really understand the impacts of such a policy initiative, this must be analysed and considered, and conclusions must be drawn referring to externalities of the new tax as well as the overall effect on standards of living and quality of life. ...read more.

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