Elasticity

Topics: Supply and demand, Externality, Price elasticity of demand Pages: 6 (1997 words) Published: August 29, 2013
Question 1, part (a)
What is elasticity? The term elasticity is defined as a way to measure how responsive doe’s quantity demanded or quantity demanded towards its determinants (Mankiw, 2008). In this world today, every government need revenue or income in order to increase the welfare of citizens and improve the country itself. One of the ways that government use in order to increase their revenue is by taxation. To do so, government needs to impose taxes on goods and services. If tax is imposed on a certain good, what will happen to the demand and supply of the good? This is when the theory of elasticity comes to play.

Government should impose tax on cigarettes as it is price inelastic. According to Investopedia (2010) states that smoker with fewer substitutes will continue purchasing cigarettes as cigarettes are inelastic when price of cigarettes increases. An increase in price would bring a small reduction in quantity demanded.

The diagram above shows the effects of tax towards the demand and price of cigarette. Before the tax was imposed, the price of cigarette is $10 per unit at quantity of “q0.” This is when the market is at equilibrium, where consumers and producers are not yet worse off. Consumers are paying at a reasonable price while producers are receiving a good amount of money. The diagram shows that consumer surplus is at area A+B+E while producer surplus is at area C+F+G. Consumer surplus refers to the willingness of a buyer to pay for a good minus the price that the buyers expects to pay for it while producer surplus is the value that the sellers receive for a good minus the cost to provide the good (Mankiw, 2008).

As we can see, when government imposes tax, price would increase from $10 to $14. Since the elasticity of demand is in elastic, the demand will fall only a small proportion compared to the increase of price. This is because cigarette is a good that causes addiction and do not have close substitution. So, area B+C shows the tax revenue earned by government. This will make producers and consumers worse off. As we can see from the graph, consumer surplus falls to only area A while producer surplus falls to area F. B and C are now the tax revenue while area E and G is the dead-weight loss.

When the demand is more inelastic than supply curve, the tax burden will eventually falls more towards the consumers (Investopedia, 2010). This will have less effect on producers making them to keep on producing cigarettes. The increase in price will cause a shift in the supply curve to the left. So, cigarette is the best good that the government should impose tax on because it brings revenue in the long run. Tax on cigarette also brings a small portion of dead-weight loss which is relatively good. Although both consumers and producers are worst off, government is better off due to tax revnue.

Question 1, part (b)
One of the examples of a good that has an elastic demand is toothpaste. For example Colgate, which is one of the brands of toothpastes, has many substitute. This is because Colgate has many other competitors selling the same type of products. So, If government wants to implement tax on this good, consumers would just switch to other brands of toothpaste. According to Mankiw (2008) states that goods which have many substitutes have elastic demand curve as consumer would just switch towards other goods.

Alcoholic drinks are another example of a good that has an inelastic demand. Alcoholic drinks are goods that have no close substitute and cause addiction. Since goods that have substitute have is elastic, so goods that have no substitute is inelastic. The two diagram below shows two different goods with two different elasticity.

Price of Colgate ($)
Price of Colgate ($)

150
150
50
50
Market of impact of tax on Colgate
Market of impact of tax on Colgate
Quantity of Colgate (Units)
Quantity of Colgate (Units)
E
E
D
D
F
F
C
C
B
B
A
A
7
7
12
12
10
10
Ss
Ss...
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