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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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) on a particular product can and will have on the demand for that product. Thus, it can determine how revenues via Indirect Taxation will change. For the benefit of analysis, Indirect Taxation on Cigarettes will be discussed. It is also important to derive a reliable figure of Income Elasticity of Demand for the purposes of deciding on a Direct Taxation (Valorem Taxation) policy or deciding on a product on which to place duties. Also, Governments can utilise knowledge of Cross Elasticity of Demand to encourage/discourage consumption of a certain good or service, possibly due to negative externalities or positive benefits of its consumption. First, however, Price Elasticity of Demand shall be discussed.
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In 2000, the World Bank (formerly the International Bank for Reconstruction and Development) calculated that an increase in the price of Cigarettes of 10%, leads on average to a decrease in consumption of Cigarettes of 4%.2 This suggests a Price Elasticity of Demand figure of 0.4 (obtained by dividing the percentage change in quantity demanded by the percentage change in price). This is illustrated in diagram "a" below. Originally, the price of cigarettes is P1 and thus quantity Q1 is demanded. However, as an Indirect Tax is imposed on cigarettes, the price of cigarettes rises to P2, thus ...

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