Importance of elasticity demand

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Price Elasticity of Demand (PED) measures the percentage change in the price of a product, to the percentage change of demand for that same product. It is measured through varying degrees of elasticity. An inelastic good means that a change in price will have a very little effect on the demand. Due to PED=%?Q / %?P, inelastic ­goods have a PED<1, explaining the gradient of the graph in Figure 1. If a product is completely inelastic (PED=0),it implys that however much a tax increases, it does not affect demand, as consumers are still going to buy it. If the price doubles and people buy more than half of what they were originally going to buy, it's inelastic. If it's less than half, it's elastic. Because smoking is addictive, and buyers are always willing to pay, it is inelastic.

Taxation is the process in which the government influences the economy, and is the basis of the Fiscal Policy. The main motivation for this policy is revenue, as tax raises money to spend on improving society for the public, for example improving the NHS, schools and roads. It also helps redistribute wealth more equally among the public, and reduce negative externalities. There are two types of indirect taxation. Ad Valorem Tax is implemented most frequently, where the tax attached to a good is correlated to the price it is being sold at, so is a percentage of the total price, currently levied at the standard rate of 15%. However, Specific Tax is a form of indirect taxation that is not based on the value of the goods, only the quantity. For example, if two packets of cigarettes both contained 20 cigarettes, one was priced at £5.99 and the other at £2.99, because they both contain the same quantity, the tax added would be a constant value, regardless of the original selling price. There are many factors that need to be taken into consideration when looking at price elasticity of demands and taxation. The availabilty of substitutes will make demand more elastic, as customers have more alternatives to buy. However, when there are no appropriate substitutes, and the customer does not have the ability to postpone consumtion, they are seen as a necessity, and therefore the price elasticity of demand will be very inelastic.

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When considering specific tax being mandatory for buyers of cigarettes, and the changes this would bring about regarding elasticity, the addictive element of niccotine must be taken into account as to what effects this would have on demand. It is shown that "taxes on cigarettes can be raised nearly 2.5 times the current level without any fall in revenue" (Rigo, 2005). Therefore, the demand for cigarettes will be inelastic. As shown in Figure 1, the demand for an inelastic goods such as cigarettes, is very unresponsive to a change in price.

The creation of a larger specific tax for cigarettes is not only a burden on the consumer however. The producer may have to lower their original price to make sure their customers still purchase their product. This means the company has to absorb most of the tax if the PED is elastic. However, the alternative is that the business can pass the tax on to the consumer by increasing the price of a good, and this is called shifting the burden of tax. Seeing as cigarettes have a very inelastic demand, this gives the company the ability and confidence to increase prices without worrying about loss of sales. This is shown in Figure 2.

Figure 2 shows the effect that a specific tax has on consumers when demand is inelastic. It will cause demand to fall from D to Dt, which causes the quantity demanded to fall from q* to qt. The equilibrium price after the tax is Ps, which is what the producers will charge, and adding the tax on top of that price will give Pc, with the tax revenue being AC.

Similarly, when demand is elastic and a specific tax is imposed, it will cause demand to shift left from F to Ft. this will cause the quantity demanded to also fall. With a new equilibrium, suppliers will charge Ts, however consumers are paying Tc. This is shown in Figure 3.

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Therefore, due to the fact that demand for cigarettes is highly inelastic, the imposition of a specific tax on consumers for this good will have little effect on the quantity bought, as shown in Figure 2.

Another major contributing factor to the tax incidence is called the Deadweight Loss, which is shown by the shaded triangle In both Figure 2 and Figure 3. B+D is the dead weight loss that occurs due to the imposition of the tax on consumers. In the case of cigarettes, the government would hope to minimise the size of the negative externality that is caused by people smoking. It shows the loss of economic activity due to the tax.

The government gets a lot of positive results from raising revenue through increasing taxes. It is needed as their budget may be running in a deficit. The publics money could be used to reduce this. By placing a specific tax on cigarettes, it means they get direct control over how much money they receive from each packet of cigarettes bought, as it is not a percentage. Through the increase in price, this will hopefully cut out a small minority of smokers; however the vast majority of the target consumers will still be prepared to pay the increased price, due to how inelastic the demand is. It disencourages smokers, which for the government's image shows altruism as they are trying to protect the health of their country, however, they are still benefiting by receiving all the additional tax. A consequence of this is less people relying on the NHS for smoking related problems, meaning the government can put more time and money into improving other aspects of society. So the government has two motivations; the tax decreases demand whilst also raising revenue.

Cigarettes are seen as a demerit good, meaning that directly to the consumer they have a negative effect, but also to all of society indirectly. Some tangible costs are as follows. The NHS is put under strain as they have to deal with medical conditions as a consequence of tobacco consumption. This includes the effect of passive smoking to non-smokers. It also can affect production for a company, as if there is more sickness or death due to smoking, productivity will decrease. Another negative aspect of smoking is the potential for fires. Dropping cigarettes in the home, or even in public, may result in fires, which will put an additional strain on the government as they need to provide a fire service. A similar demerit is litter. Cigarette butts are littered throughout streets, and once again it's down to your council or government to clean up. By imposing a specific tax on smokers, these the number of people buying cigarettes will decrease slightly; however the biggest impact will be the increase in funds the government has to spend combating these problems more efficiently.

In societies where the government takes advantage of its power over charging society whatever it wants, black markets may appear. These sell goods that are cheaper than normal goods, as they exclude any tax implemented by governments. Therefore, if the government imposed an extreme tax on cigarettes and the target market could not afford the product, they could turn to black markets. "In England, one-half of all cigarettes are sold on the black market." (Smoking Aloud, 2006) These markets are very detrimental to the government, as it means that they start to lose a fragment of control over cigarettes, and consequently they cannot keep accurate records of the nicotine market. The addictive nature of smoking could lead to more people using black markets as demand is so inelastic.

Although the demand for cigarettes has been very inelastic, there is evidence that a 'tipping point' may be approaching, meaning the government will have to be careful about how much tax they place on the product. The evidence for this change is the recent boom in substitute goods, such as nicotine patches and chewing gum, however, this only affects cigarette sales on a small scale- "for every £1 spent on nicotine replacement, over £130 is spent on cigarettes" (Riley, 2006). As long as the PED is very inelastic, the government can control and increase the specific tax placed on cigarettes, as the consumers will always be willing to purchase.

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It is clear from the examples shown above that elasticity has a significant effect on the imposition of taxes on buyers. In the case of cigarettes there is an extremely inelastic demand for the good, due the lack of presence of no close substitutes and the addictive nature of the product.

References

  • MANKIW, N. & TAYLOR, M. (2006) Economics. Thompson Learning.
  • Rijo, J. (2005). Research Gate [online] Available at: https://www.researchgate.net/publication/5127282_Price_elasticity_estimates_for_tobacco_and_other_addictive_goods_in_India [Accessed 25 November 2009]
  • Smoking Aloud (2006). Black Market Cigarettes [online] Available at: http://www.smokingaloud.com/black-market-cigarettes.html [Accessed 25 November 2009]