Elasticity of Demand Elasticities in Government Elasticity

¶ … Elasticity of Demand

Demand elasticities in government

Elasticity of demand and effect on indirect taxation.

Demand elasticities in business

Factors that affect the price elasticity of demand

In this paper, we discuss the microeconomic concept of elasticity of demand. Elasticity of demand, a term which refers to the responsiveness of the demand of a given commodity to change is very integral for the efficient operation of businesses and the government (Hays and DeLurgio,2008).The concept of elasticity of demand which in a way may refer to the responsiveness of the amount of quantity of a product which is demanded to the change in disposable income, price of a good as well as price of related goods is noted to be a subject of discussion in virtually all the textbooks on microeconomic principles. In this paper, we perform a critical evaluation of the view that the knowledge of the various elasticities of demand is critical for governments and businesses to operate effectively.

Introduction

Elasticity of demand, a term which refers to the responsiveness of the demand of a given commodity to change is very integral for the efficient operation of businesses and the government. The concept of elasticity of demand which in a way may refer to the responsiveness of the amount of quantity of a product which is demanded to the change in disposable income, price of a good as well as price of related goods is noted to be a subject of discussion in virtually all the textbooks on microeconomic principles. In this paper, we perform a critical evaluation of the view that the knowledge of the various elasticities of demand is critical for governments and businesses to operate effectively.

The concept of elasticity of demand

The change that takes place in any of the factors that affects demand are noted to automatically lead to a shift in the demand curve (Maurice and Ferguson,1973;Diewert,1971; Bronfenbrenner,1940; Shepherd,1936).It is also worth noting that there is an instance of elasticity which corresponds to each and every factor. The elasticities by themselves also are dependent on the amount of time which is available for the adjustment. The various elasticities can be used by both the government and business managers in forecasting the various effects of either a single or multiple shifts/changes in the various factors which underlie the demand.

Nanda (n.d) indicated that elasticity of demand plays an important role in a given community's economic decision making process (Karlan and Zinman,2005).This is however dependent on whether a given economic decision is to be deemed beneficial or non-beneficial to the given decision maker. This is however, dependent on the elasticity of demand of the commodity in question. As a consequence of this, all of the economic decisions by businesses, investors, governments and consumers must take a due consideration of the elasticity of demand of a given good. In order to elaborate this, we make use of a few leading examples in the next section.

Demand elasticities in government

The concept of elasticity of demand is essential to the government in the formulation of its revenue collection as well as welfare policies (Gamble,1989).The fact that the government must have its own resources in order to finance its own activities as well as provide the essential good and services for use in the general society means that it must fund its activities via taxation as well as supplement it by borrowing. While collecting taxes and levying the citizens, the government must keep in mind the specific response of the market. For instance, the basic necessities of life have been indicated to have a particularly low level of elasticity of demand. The government when taxing them has an opportunity of collecting a very large sum of tax revenue without necessarily reducing their level of demand by the citizens (consumers).The government must remember that an imposition of taxation upon such goods may lead to a burden on the consumers. The result would be a reduction on the consumption of other goods that are untaxed or even taxed at lower rates. Such goods would most likely be the healthy ones that are also nutritious like vegetables, milk and cereals. However, if the good (s) or rather products in question are considered to be harmful and with elastic demand, then the particular government can resort to a deliberate levying of a huge tax on the items but with the objective of subsequently reducing their consumption.

Elasticity of demand and the effect on indirect taxation.

Several products are indicated to be subjected to indirect taxation that is imposed by governments. A practical example being the excise duty imposed on cigarettes. Alcohol as well as fuels. It is worth noting that cigarette taxes in the United Kingdom are some of the highest the entire Europe. Indirect taxes are noted to have effects on the producers cost. Price elasticity of demand is also noted to have an effect on the quantity as well as market price.

A tax imposition is noted to cause an increase in the cost of doing business. This leads to an inward shift in the affected supply curve. This is indicated in Figure 1 below. The vertical distance which exists between the pre- and post-tax supply curve indicates the level of tax per unit. With an imposition of an indirect tax, the supplier may effectively pass on some of the tax to the consumers by means of a higher price. This is referred to as the shifting of the burden of tax (Hanson and Sullivan,2008).The ability of businesses to practice this shifting of the burden of tax is dependent on the nature of price elasticity of demand as well as supply.

Figure 1.

The work of Harris (1987) and Keeler et. al. (1996) provided evidence via state level data to indicate that the burden of tobacco taxation is somehow over-shifted to the consumers. Their estimates on the level of overshifting are however somehow different. The work of Sumner and Wohlgenant (1985) estimated that just a small amount of tax is successfully passed on to the consumers. The work of Ashenfelter and Sullivan (1987) however suggested that the level of increase in excise tax do not necessarily lead to an increase in the level of retail prices.

The other studies that discussed the application of demand elasticities by the government are the works of Dolan (1988) who provided how excise duties are applied to apartments and gasoline. The work of McDonell (1987) presented a standard incidence analysis while Eckert and Leftwich (1988) analyzed the effects of an imposition of incidence tax and specific tax.

Demand elasticities in business

A review of literature indicates that the knowledge of elasticities of demand is critical for businesses to operate effectively. The reasoning arrived at by the consideration of the excesses of its revenue receipts over the total cost of running the business. The profits is determined by a consideration of the product (X) and the unit price of the item (Px) as well as the quantity of the product's demand (Dx).

Whenever a business alters Px, it experiences a change in its total revenue on the account of the recorded change in the unit price of the item (Px) as well as the resultant change in the quantity of the product's demand (Dx).Subsequently, a firm finds that in the process of determining it's the price of its products, it must consider the level of elasticity of demand. This may however be elaborated further by taking into account the fact that elasticity of demand differs from one market to the next.

Organizations also realize that they can price their products more with a limited reduction in the level of demand within a short period of time. When faced with a persistent increase in prices, consumers are forced to shift their level of demand to substitutes that are fairly prices. Examples of studies that examined the elasticities of price for business scenarios are Tellis (1988) when he examined the level of price elasticities of demand for various branded products as well as Hamilton, East and Kilafatis (1997).

Discussion

Consumers in a given market economy are noted to be influenced by several factors in their decisions to arrive at their purchases. Price is noted to be one of these factors. The law of demand and supply acts as a determinant of the relationship between demand and supply. The concept of price elasticity of demand is however indicated to extend the relationship between the demand as well as supply by examining the extent of changes in demand as well as its effects on the price. The level of expansion or contraction of demand in response to the changes in price is noted to be important to various businesses as well as governments alike. The price elasticity of demand is employed in measuring the responsiveness or rather the sensitivity of the demanded quantity of a good to the changes in price (King and Charterjee,2003).The standard economic theory states that customers would naturally react to the changes in the prices by appropriately adjusting their demands for the concerned goods. As the prices rise, the consumers tend to reduce the quantity of good that they demand. A drop in the prices leads the consumers to increase the amount of goods that they demand. There are several measurements for elasticity. One of the measurements is the consumer's change in the level of consumption in a similar period when a price change is noted. The other measurement of elasticity is the consumer's shift in consumption levels across various time periods.

A price elasticity of demand indicates the percentage of change in the amount of goods demanded that arises from a one percent (1%) increase in the prices. Demand can therefore be said to be elastic in a relative sense, relatively inelastic or even unitary elastic.

If the demand is perfectly elastic, consumer are noted to demand an unlimited (infinite) quantity at a given price. They will however demand nothing at all at certain prices that are either above or even below that level. These conditions are note to be very difficult to satisfy in any given market. Such a situation is therefore largely hypothetical.

It is however worth noting that an individual seller may experience a perfectly elastic demand in some circumstances. If a given seller were in a market which is experiencing perfect competition, then no seller would be in apposition to charge higher prices because they would lose all of their customers to sellers who are offering identical products.

In a perfectly inelastic demand situation, the consumers are noted to be willing to part with any amount in order to obtain a particular quantity of good or service. In this circumstance, it would be very difficult to fully satisfy the conditions for a given market in entirety. The situation could however effectively apply to certain products over a certain range of prices. An example being individuals with life-threatening illnesses that can just be treated with a certain drug. This would make them to be willing to pay any amount of money in order to lay their hands on the given drug. These markets should therefore be regulated by the government (Duggard and Morton,2005).This is in a bid to prevent monopolistic tendencies in the market which would otherwise result in the exploitation of the vulnerable customers.

Factors that affect the price elasticity of demand

The price elasticity of demand may be affected by several factors (Lyon and Simon,1968).The price elasticity of demand is indicated to be dependent on whether a given product or service is a necessity or a luxury brand. Goods as well as services are deemed necessities if they are necessary for daily life. These include items such as milk and bread all of which have a relatively inelastic demand. This is because should there be an increase in the price of these items, the quantity which is demanded is noted to experience no notable contraction. Conversely, the price elasticity of demand is expected to be greater for items that are regarded as pure luxuries. They include things like going for safari, dinning out in expensive restaurants as well as going for a private massage at an exclusive parlor.

Good and services that are known to have close substitutes like breakfast cereal's brands are indicated to have a demand which is highly elastic. This is because an increase in the price of a given brand of cereal is likely to cause a contraction which is proportionate. This is as a result of the fact that individuals are likely to switch to other brands which they perceive to be as good as the brand in question. Goods as well as services having few or even no close substitutes like the local water supply are noted to have a rather inelastic demand. This is because a price increase is less likely to force people to switch to other products and the demand will not fall sharply.

Goods as well as services whose costs make up a tiny sum of an individual's income like affordable pens, lighters as well as chewing gum are noted to have a lower level of elasticity of demand. Goods and services such as alcoholic beverages and cigarettes which are potentially habit forming are noted to have a relatively inelastic demand. This is because individuals who drink alcohol regularly as well as smoke are note to continue with the habit even after there is a price increase.