1. Discuss how habit-forming demerit goods and goods with lots of substitutes are each likely react to price changes, and consider the extent to which knowledge of their likely response will would be useful to government policymakers.
A demerit good refers to a type of good whose negative consumption externalities are generally under-accounted for by consumers, thus they place a value on the good that is above the real value of the good. Thus, the market price will be above the price that would be representative of the total societal cost of the consumption, and as such, the incentive to suppliers to produce such goods will be higher than desirable, in turn leading to an overproduction and overconsumption of such goods. Examples include tobacco, alcohol and chocolate. This generally occurs as a result of imperfect information to consumers which stops them from properly taking all externalities into account. A substitute is a product whose cross elasticity of demand (XED) with another product is positive, meaning that as the price of one good increases, so does the demand for the other. The reaction of a certain good in relation to a change in the product’s price is its price elasticity of demand (PED). The PED is a direct measure of the responsiveness of the quantity demanded of a product in response to changes in its price. It is calculated by dividing the percentage change in the quantity demanded by the percentage change in the price of the product, thus, as demand will always fall in response to an increase in price, the value of the PED will always be negative.