Will this new tax increase change the quantity demanded for cigarettes by a lot, a little or not at all.

Transcription

1 Price Elasticity

2 California Proposition 56 increased the tobacco tax by $2.00, bringing the total tax up to $2.87 per pack of cigarettes. The average cost of a pack in 2016 was about $5.50. Prop 56 would raise prices by 36%. The federal government also levies a tobacco tax at $1.01 per pack of cigarettes (since 2009) that is included in the average price. Will this new tax increase change the quantity demanded for cigarettes by a lot, a little or not at all.

3 The Congressional Budget Office (CBO) summarizes the existing research and concludes that a 10 percent increase in cigarette prices will lead people under age 18 to reduce their smoking by 5-15 percent. Among adults over 18, CBO concludes, the decline would be 3-7 percent (see Figure 1). Taking the mid-point of the estimate for youth suggests that each 1 percent price increase leads to roughly a 1 percent decrease in youth tobacco consumption. (Approximately half of the decline in smoking is due to fewer smokers (people either quitting or not starting to smoke), while the other half is due to fewer cigarettes consumed by people who smoke.)

4 o-your-health/wp/2015/08/27/why-a-bagof-heroin-costs-less-than-a-pack-ofcigarettes-2/?utm_term=.3fa8b23cb9e8 tics/fact_sheets/adult_data/cig_smoking/

5 2015 Competition + Free Trade =

6 Price Elasticity of Demand The law of demand tells us that as the price of a good increases the quantity that will be bought decreases but it does not tell us by how much. Price elasticity of demand measures how much QD will change by when the price changes. Uses Used by firms to help determine prices and total revenue Used by the government to decide how to tax

7 Price Elasticity of Demand measures how much QD will change by when the price changes. e p c ha n ge in qu a ntity d em a nd ed % % ch an g e in price % QD = Q2-Q1/ Q1 % P = P2 -P1/ P1 Use absolute value ( drop negatives) Inelastic buyers are not very responsive to changes in price Elastic buyers are very responsive to changes in price Unit Elastic the QD changes according to the same percentage as the change in price.

8 Price Elasticity of Demand measures how much QD will change by when the price changes. Price QD $3 4 $6 3 Inelastic - buyers are not very responsive to changes in price. % Q < % P ep < 1 The price increase from $3 to $6 3-4/4 = 0.25 ep = = /3 = 1 Effect on Total Revenue? TR = P x Q For every 1% change in price, QD will change by 0.25% At $3, TR = 3 x 4 = 12 At $6, TR = 6 x 3 = 18 P and TR move in the same direction. P and TR or P and TR

9 Price Elasticity of Demand measures how much QD will change by when the price changes. Elastic -buyers are very responsive to changes in price % Q > % P ep > 1 The price increase from $4 to $5 2-4/4 = 0.5 ep = = 2 5-4/4 = 0.25 For every 1% change in price, QD will change by 2% At $4, TR = 4 x 4 = $16 At $5, TR = 5 x 2 = $10 P and TR move in the opposite direction P and TR or P and TR

10 Price Elasticity of Demand measures how much QD will change by when the price changes. Unit Elastic - the quantity demanded changes according to the same percentage as the change in price. % Q = % P ep = 1 The price increase from $4 to $6 4-6/6 = 0.33 ep = = 1 4-6/6 = 0.33 At $4, TR = 4 x 6 =$24 At $6, TR = 6 x 4 = $24 TR is unchanged For every 1% change in price, QD will change by 1%

11 Calculating Price Elasticity of Demand Use absolute value so drop negatives Ex. When price of a car wash increases from $10 to $11, the number of customers drop from 60 to 48. Step 1: compute the % changes for quantity demanded & price % change = x100 = $10-$11 x100 = $10 Step 2: plug in those % in the formula for elasticity elasticity = 20 =

12 Practice Problem: A dentist with 80 patients cuts his fees for a cleaning from $60 to $54. He attracts 2 new clients. Calculate the elasticity x100 = 2.5 & $60-$54 x100 = $60 Elasticity = 2.5 =.25 10

13 Is the range between A and B, elastic, inelastic, or unit elastic? 10 x 100 =$1000 Total Revenue 5 x 225 =$1125 Total Revenue 50% A B Price decreased and TR increased, so Demand is ELASTIC 125%

14 Perfectly Inelastic and Elastic Perfectly Inelastic -QD does not respond to a price change. Perfectly Elastic any price increase will cause the quantity demanded to drop to zero. In the case where a good has many different sellers and the product (e.g. dollars) is identical., if a firm decides to raise the price above the market price, it will lose all its customers to other firms selling the same product.

15 %QD = 5/25 = 0.2 %P = 1/10 = 0.1 E = 0.2/0.1 = 2

16 Determinants of Price Elasticity Availability of substitutes the greater availability of substitutes, the higher the elasticity Type of good - the broader the definition of a good, the lower the elasticity (apple vs. fruit) since there are fewer substitutes. Degree of necessity -The greater the necessity for a good, the lower the elasticity Proportion of the purchaser's budget consumed by the item the more expensive the good is in proportion to income, the higher the elasticity since consumers will be less able at higher prices. Duration of price change -elasticity increases over time as consumers are more able to adjust their consumption and find substitutes Brand loyalty -an attachment to a certain brand can override sensitivity to price changes, resulting in more inelastic demand. Slide 16

17 Perfectly inelastic demand ep = 0 Perfectly elastic demand ep = Assume that the prices of following goods have increased by 20% Cigarettes Toothpicks Salt Chevrolet car Movies at the theater Coffee Automobiles Gasoline (to be used Medical services this weekend) Matches Gasoline (continual 20% Lunch at Fiore Cafe increase for the next 5 years)

18

19 Perfectly inelastic demand Perfectly elastic demand Salt Matches Toothpicks 0.1 Coffee 0.25 Physician Services 0.6 movies 0.9 Autos Chevrolet 4 Gas SR 0.2 Tobacco SR 0.45 Gas LR 0.7 Restaurant meals 2.3