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.
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.
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).
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…