Elasticity Concepts/Applications (10/8/09) Review From 10/06/09. Exam Question. Factors Affecting the Magnitude of the Own-Price Elasticity of Demand

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1 ε Elasticity Concepts/Applications (10/8/09) the Own- Elasticity of Demand Relationship of Elasticities to the Total Elasticity Applications Review From 10/06/09 Identify demand shifters, the direction of the shift, and its impact on price and quantity Define own-price elasticity of demand Describe and show graphically, elastic vs inelastic demand Recall that we can estimate own-price elasticities of demand by: - Q P % Change In Q ε = = D. = P Q % Change In P Exam Question Review the following resource on the price elasticity of demand. /priceelasticity.htm Be able to compute a (own) price elasticity of demand from the given table. Follow example provided Elasticities If the product of interest has several good substitutes, then there is likely to be a larger or smaller??quantity response for any given price change (holding all other factors constant), and therefore the larger or smaller? the elasticity of demand (in absolute value) and thus is more. elastic or inelastic? Alternatively if there are few substitutes Elasticities for Some Foods Table 4.3 Schrimper Elasticities of Demand (Extreme Cases) Elasticity Beef -.62 Pork -.73 Chicken -.37 Turkey -.53 Eggs -.11 Cheese -.25 Milk -.04 Butter -.24 Sugar -.04 Coffee -.17 Inelastic Demand Insulin Example? Perfectly Inelastic Demand Individual Corn Example? Farmer Perfectly Elastic Demand 1

2 Elasticities The quantity response for a price change of a good that makes up a relatively small amount of one s total expenditures is likely to be very small or large? and therefore a have a relatively small or large? elasticity of demand (in absolute value). Alternatively. Elasticities Which one of the following do you think is more elastic Beer Wine Bourbon E D = -0.2 E D = -1.0 E D = -1.5 Elasticities Demand Relationships For Different Lengths of Time Time horizon (adjustment period) The longer time period consumers have to adjust to price changes the greater or smaller? the quantity response and therefore the greater or smaller? the elasticity of demand (in absolute value). Alternatively Q * 2 Gasoline Example? D 2 /Time Elasticities Time horizon (adjustment period) Degree of Necessity The greater the degree of necessity of an item the greater or smaller? the quantity response for a given price change and thus the greater or smaller? the elasticity of demand (in absolute value). Alternatively Other Estimated Own- Elasticities of Demand 2

3 ε Relationship of Elasticity of Demand to Changes in Total Own- Point Elasticity of Demand Total (TR) = (P) X (Q), Given the inverse relationship between P and Q along a given demand curve, will TR increase or decrease with a given price change? If the demand schedule is: Inelastic -- the percentage change in price is more than the percentage change in quantity resulting in revenue changing in the same direction as prices ε D = % Change In Q % Change In P Elastic --the percentage change in price is less than the percentage change in quantity resulting in revenue changing in the opposite direction as prices Total Changes for a Given Change Total Changes for a Given Change D 2 D 2 Inelastic Demand Elastic Demand Inelastic Demand Elastic Demand Relationship of Elasticity of Demand to Changes in Total Journal # 10 In-Class Exercise (10/08/09) Total Elastic Increase Decrease Decrease Increase Inelastic Increase Increase Decrease Decrease Note that for: Elastic Demand, and Move in the OPPOSITE Direction Inelastic Demand, and Move in the SAME Direction 3

4 Application of Demand Elasticities: U.S. Tobacco Leaf/Industry Soft Drinks Snack Foods For copies of illustrative slides go to class website for slides on 10/08/09 Application of Demand Elasticities to U.S. Tobacco Market Farm-Level Leaf Demand Prior to the 1970s, U.S. tobacco producers had limited overseas competition. How do you think this affected the overall demand elasticity for U.S. leaf? During the past two decades, the price differential between U.S. tobacco and foreign tobacco s widened, while an increasing quantity of foreign quality tobacco s entered the market. What effects do you think this had on the demand elasticity for U.S. tobaccos? Tobacco Product Demand The U.S. Tobacco Program P The U.S. Tobacco Program P Support Quota Note Effects In Response to Inelastic Demand Support S2 S1 Note Effects In Response to Demand Becoming More Elastic Free Market Supply TR = P*Q Free Market TR = P*Q Demand Q D1 D1 D2 Q Application of Demand Elasticities to U.S. Tobacco Market Farm-Level Leaf Demand Tobacco Product Demand Do you think the overall price elasticity of demand for tobacco products is elastic or inelastic? Why? What effects on total revenue do you think tobacco product price increases have on tobacco company revenues or consumer expenditures on tobacco products? What effects on total revenue do you think increases in tobacco taxes have on tax revenues for state and federal governments? Application of Demand Elasticities to U.S. Tobacco Market Farm-Level Leaf Demand Tobacco Product Demand Cigarette sales have been declining for years Should tobacco companies lower prices to increase sales and revenues or should they increase price which leads to higher revenues? Same type of an analysis for governments taxing tobacco products which are taxed for two primary reasons. 1) REDUCE CONSUMPTION 2) INCREASE TAX REVENUE 4

5 ε Kentucky Cigarette Net Tobacco Tax s Kentucky Cigarette Taxes Per Pack llars Millions of Dol $25 $20 $15 $10 $5 $0 In 2004: Avg -- $2.50 Tax -- 3 cents/pack Packs sold 700 mil Tax $17 mil Cents Per Pack Kentucky Cigarette Sales Kentucky Cigarette Net Tobacco Tax s Millions of Packs Fiscal Year Millions of Dollars $250 $225 $200 $175 $150 $125 $100 $75 $50 $25 $ Fiscal Year What does this imply about the Own- Elasticity of Demand for Cigarettes: Elastic or Inelastic? Most studies indicate the Own- Elasticity Of Demand for Cigarettes in the range of to -0.5 Extremely Inelastic Elasticity Applications A policymaker wants to reduce cigarette consumption by 10%, Research has indicated that every 1% increase in the price of cigarettes via a tax increase will reduce cigarette consumption by 0.33%. (This statement implies the price elasticity of demand is or -1/3). What percentage increase in price must occur for the policymaker to achieve the desire effects, assuming all other factors remain constant ε D = -10% % Change In Q % Change In P X 5

6 , Consumption, and Effects of a Increase or a Per Unit Tax Increase (t), assuming an Inelastic Demand Consumer Expenditures on Cigarettes, Tobacco Farm Value, and the Marketing Bill PRICE P 0 + tax p 0 Additional Tax tax S + tax S industry revenue due to reduced consumption Dollars Billion Taxes Marketing Bill Farm Value Consumer Expenditures D Source: USDA O Q 0 QUANTITY, Consumption, and Effects of a Increase or a Per Unit Tax Increase (t), assuming an Inelastic Demand Application of Demand Elasticities to Taxing Foods/Beverages PRICE P 0 + tax p 0 Additional Tax tax D S + tax S industry revenue due to reduced consumption WSJ soda tax NEJM I -- You Tube Video: from-youtube-to-new-england-journal-to-congress/ NEJM: Baltimore Sun Editorial: Mercatus: O Q 0 QUANTITY A tax of 1 cent per ounce of beverage would increase the cost of a 20-oz soft drink by 15 to 20%. The effect on consumption can be estimated through research on price elasticity (i.e., consumption shifts produced by price). The price elasticity for all soft drinks is in the range of 0.8 to 1.0. (Elasticity of 0.8 suggests that for every 10% increase in price, there would be a decrease in consumption of 8%, whereas elasticity of 1.0 suggests that for every 10% increase in price, there would be a decrease in consumption of 10%.) With the use of a conservative estimate t that t consumers would substitute t calories in other forms for 25% of the reduced calorie consumption, an excise tax of 1 cent per ounce would lead to a minimum reduction of 10% in calorie consumption from sweetened beverages, or 20 kcal per person per day, a reduction that is sufficient for weight loss and reduction in risk (unpublished data). Another Application Taxing Salty Foods Taxing Snack Foods: What to Expect for Diet and Tax s. USDA/ERS, August /aib74708.pdf Source: The Public Health and Economic Benefits of Taxing Sugar-Sweetened Beverages, New England Journal of Medicine, 9/16/09. 6

I. Introduction to Taxation

University of Pacific-Economics 53 Lecture Notes #17 I. Introduction to Taxation Government plays an important role in most modern economies. In the United States, the role of the government extends from