Assignment 2 Price Elasticity Of Demand Price Elasticity of Demand is the quantitative measure of consumer behavior whereby there is indication of response of quantity demanded for a product or service to change in price of the good or service ( Mankiw,2007). The Price Elasticity of Demand is calculated using either the point method or the midpoint method. The Point Method Price Elasticity of Demand=Percentage change of Quantity Demanded Percentage change of Price The Midpoint Method Price Elasticity of Demand=(Q2 ‘ Q1) [ (Q2 + Q1)/2] (P2 ‘ P1) [ (P2 + P1)/2] Were: Q1= initial Quantity Demanded
Q2 = new Quantity Demanded P1=Initial Price P2= new Price (Source : Mankiw 2007) A good or service can either be elastic, inelastic or unit elastic. When the price elasticity of demand of a commodity is elastic this is when the quantity demanded of a good or service responds significantly to the increase or decrease in price. Therefore after calculation the answer is greater than one making it elastic which means that increase in price decreases quantity demanded which in turn causes a decrease in total revenue because the decrease in quantity demanded will be proportionally larger than the increase in price. (Mankiw, 2007).
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The good or service has either relatively elastic demand ( diagram (d) ) or perfectly elastic demand ( diagram (a) ). The difference of these two is that perfectly elastic has a Price Elasticity of Demand of infinity and this means that a small change in price would lead to an infinitively large increase in demand and this is shown in the diagram below (http://ecoteacher. asn. au/Demand/elastsli/e14. htm, n. d). While on the other hand Relative Elastic Demand is when the Price Elasticity of Demand is more than one and this shown in the diagram (d). Perfectly Elastic Demand (a)[pic]( Source : http://ecoteacher. sn. au/Demand/elastsli/e14. htm,n. d) Perfectly Inelastic Demand [pic] Source: http://ecoteacher. asn. au/Demand/elastsli/e15. htm, n. d) (b) Inelastic Demand , Elastic Demand and Unit Elastic Demand Source: ( Welker’s Wikinomics Page -http://welkerswikinomics. wetpaint. com/page/Price+Elasticity+of+Demand, n. d) [pic] (c)(d)(e) When a good or service is said to be inelastic after calculation it is less than 1. This is whereby an increase in price leads to an increase in total revenue because the price increase is proportionally larger than the decrease in quantity demanded (Hakes 2007).
There is relative inelasticity of demand ( diagram (c) ) and perfectly inelasticity of demand were a good is demanded regardless of its price and the demand curve is vertical diagram (b) . When a good is said to be Unit Elastic (diagram (e) ) after calculation the outcome 0. This whereby change in price has no impact on total revenue because the increase in price is proportionally equal to decrease in quantity demanded (Hakes, 2007). Price Elasticity of Cigarettes The demand for an addictive good like cigarettes is likely to be relatively inelastic while the demand for specific brands of cigarettes is likely to be relatively elastic.
Governments usually impose ‘Sin Tax” on goods like cigarettes and this means consumers have to pay higher prices. This in turn leads to a decrease in sales but the price elasticity remains inelastic because cigarettes contain an addictive substance therefore consumers will keep on purchasing to suit their cravings. In Taiwan the government imposed taxes on cigarettes in 2002 in order to reduce consumption and to reduce the health problems caused by cigarettes which were putting strain on the government’s health system (Lee, Hwang, Ye and Chen, 2004).
This led to reduced overall consumption and increased tax revenues but the price elasticity remained inelastic at 0. 5274 and even after estimations for 2003 were made after further increased taxation consumption was reduced but the price elasticity remained inelastic at 0. 309 (Lee, Hwang, Ye and Chen, 2004). “In the past, increases in the real value of duty (taxation) on cigarettes has had little effect on demand from smokers because demand has been inelastic. ” ( Riley, 2006) Although taxes have been imposed in countries and some smokers have quit habitual spending on cigarettes remains high although sales are falling (Riley, 2006). Higher cigarette prices result in decreased cigarette consumption, but price sensitive smokers may seek lower priced or tax-free cigarette sources, especially if they are readily available. This price avoidance behaviour costs states excise tax money and dampens the health impact of higher cigarette prices” ( Hyland, Bauer, Abrams, Higbee, Peppone and Cummings, 2006). Certain brands that are more expensive are elastic because they are easily substituted by cheaper more affordable ones which remain inelastic because at the end of the day the consumer is satisfied.
The Uses of Price Elasticity When Making Prices Decisions For Producers Since Price Elasticity shows how a good or service reacts after change in price this is a tool for producers and they utilize this when making pricing decisions. It is crucial that producers know how to maximize their revenue and the price they choose determines this. There is an effect of a change in price on total revenue and expenditure of a product. When a product is elastic the rise in price leads to the decrease in revenue due to the decrease in quantity demanded being proportionally larger than the increase in price.
Therefore producers can make a decision when changing the price on an elastic good and increasing the price is not favourable while decreasing the price has a reverse effect. While increasing the price of an inelastic good leads to the increase in revenue because the proportional increase in price is larger than the decrease in quantity demanded and decrease in price leads to decrease in revenue. Therefore Price Elasticity of a product is used as a prediction tool by producers when price changes are being made.
Predictions for ‘The likely price volatility in a market following unexpected changes in supply ‘ this is important for commodity producers who may suffer big price movements from time to time’ (Riley, 2006) can be made using the Price Elasticity. Other predictions about effects of tax on the product and whether it is possible to pass the tax onto the consumer and when trying to make price discriminations when charging different prices for the same product in different regions (Riley, 2006). Effects Of Tax Imposed on Cigarettes a) Pre-Tax Diagram [pic] Source : Economics Help (http://www. conomicshelp. org/microessays/equilibrium/consumer-producer-surplus. html) The imposition of tax on the price of cigarettes is common and these are referred to as sin taxes. These taxes help to reduce the amount of people who smoke and also provides extra tax revenue for governments. Producer surplus is defined as the difference between the amount the producer receives and the amount it is willing to sell a good for and this is the difference between the supply curve and the market price (Economics Help). Consumer surplus is defined as the difference between the demand curve and the market price.
Imposition of tax has an implication on producer and consumer surplus. Before tax is implicated the producer and consumer surpluses are as shown in the diagram(a) on the pre tax diagram and therefore after tax both surpluses are reduced as shwn in the diagram (b) post tax diagram. Weight dead loss refers to the costs to society that are due to inefficiency in the market. When demand is inelastic this means the deadweight loss is small even though the deadweight loss causes the reduction for both consumers and producers surpluses and is indicated on the post-tax diagram.
The tax burden however describes who pays for the tax the buyer or the seller. In the case of cigarettes, because they are inelastic even if tax is added or increased the demand remains fairly constant and inelastic which means that the tax burden falls more on the consumers. This means that the buyer will continue to buy and the tax burden mainly is paid by the buyer and the buyer carries the heavier burden. The government receives tax revenue from imposing such taxes which will help to develop the country.
Nowadays most developed countries such as Taiwan are against smoking and take advantage of this by imposing high taxes. The government receives both tax revenue and reduces the number of smokers at the same time. The taxes on cigarettes improve the general welfare of the public as they promote better health due to others quiting smoking while it has a negative impact whereby there is substitution using street drugs such as marijuana that are not legal and are also harmful to ones health.
The use of illegal drugs causes more problems as these drugs alter people’s thinking and are highly addictive and are highly linked to crime. The deadweight loss reduces the consumer and producer surpluses which in-turn affects the general welfare of the society due to this loss. [pic] b) Post-Tax Diagram Reference List • Jie-Min Lee, Tsorng-Chyi Hwang, Chun-Yuan Ye, and Sheng-Hong Chen. 2004. The effect of cigarette price increase on the cigarette consumption in Taiwan: evidence from the National Health Interview Surveys on cigarette consumption http://www. pubmedcentral. nih. ov/articlerender. fcgi? artid=539350 • Geoff Riley. 2006. Price Elasticity of Demand: Habitual spending on cigarettes remains high but sales are falling http://tutor2u. net/economics/revision-notes/as-markets-price-elasticity-of-demand. html A Hyland, J E Bauer, Q Li, S M Abrams, C Higbee, L Peppone and K M Cummings. 2006. Higher cigarette prices influence cigarette purchase patterns http://journal. shouxi. net/html/qikan/yyglyyfyxwsx/yckzzz/20054142/20080831184348861_207469. html • Economics Help http://www. economicshelp. org/microessays/equilibrium/consumer-producer-surplus. html