Explain why it is Crucial that Policy Makers have Accurate Estimates of the Relevant Demand Elasticities when deciding on a Policy Scheme.

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 reducing Demand to Q2. There is a contraction along the demand curve. However, the gradient of the curve being 0.4 (Price Elasticity of Demand), the demand curve is inelastic. Thus, the proportionate decrease in demand is less than the proportionate decrease in Price.

"a"

However, how is this demand curve derived? The answer lies in the analysis of the Income and Substitution effect. The Substitution effect suggests that as price of cigarettes increase, consumers may wish to divert consumption away from cigarettes, which are now more expensive relative to another desirable product. The income effect, on the other hand, suggests that as the price of cigarettes increase due to the indirect tax (assuming incomes remain the same) 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. Job-Seeker's Allowance). Also, a Government can aim policies of Government Expenditure to create a desirable situation (such as injecting cash flows into the National Health Service etc). However, in terms of the example given (namely an increase in the indirect taxation on cigarettes), the effect would be a decrease in Real Incomes as price increases are greater than the increase in Incomes. One can assume that the YED for cigarettes is relatively inelastic (as Incomes increase, there is little or no change in the demand for Cigarettes). Thus cigarettes are not a luxury good, and in fact, for many, they are a necessity. It is also safe to assume that as Incomes increase, consumers will not demand less of the product, thus the product is a normal good. Governments can use this information to determine what effect the decrease in Real Incomes will have on consumption of cigarettes.

Cross Elasticity of Demand (XED) refers to the responsiveness of the Demand for one good, to a change in price of another. Once again, there are different types of good when examining XED. If XED>0, then the goods are known as substitute goods (i.e. when price increases, demand for another alternative good, such as tobacco pouches in this case, or even nicotine patches, increases). However, if XED<0, then the goods are known as complimentary goods (i.e. when price increases, demand for another good used in conjunction with the first good, for example lighters or matches, decreases). Therefore, Governments can use this information once more to decide whether an indirect tax increase on cigarettes would be a wise choice. Here, the substitution effect can be examined. As the price of cigarettes (due to the increase in indirect taxation) increases, what happens to the demand of other goods? History suggests that the demand for substitutes of cigarettes will increase less proportionally to the increase in price of cigarettes. 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.

Bibliography:

Michael L. Katz and Harvey S. Rosen, Microeconomics, Third edition, published in 1998 by the McGraw-Hill Companies Inc.

Christopher Pass and Bryan Lowes, Unwin Hyman Dictionary of Economics, Second edition, published in 1999 by Unwin Hyman in Great Britain.

John Sloman, Economics, fifth edition, published in 2003 by Prentice Hall.

Hugh Stretton, Economics: A new Introduction, published in 199 by Pluto Press

G F Stanlake and S J Grant, Introductory Economics, 6th edition, published in 1995 by Longman ltd.

Christopher Pass and Brian Lowes, Unwin Hyman Dictionary of Economics, 2nd edition, 1998, p161.

2 Action on Smoking and Health, Tax and Smuggling, http://www.ashscotland.org.uk/issues/tax_intro.html

Jonathan Attwood Tuesday, 04 November 2003

Tutorial: Monday 10:00-11:00