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

Transcription

1 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 Elasticity 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. Elasticity is a measure of how responsive a dependent variable is to a change in an independent variable(s) 3 Types: Price, Income, and Cross-Price 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 %QD = 5/25 = 0.2 %P = 1/10 = 0.1 E = 0.2/0.1 = 2

12 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%

13 Price Elasticity of Demand measures how much QD will change by when the price changes. The price increase from $3 to $6 3-4/4 = 0.25 ep = = /3 = 1 What if the price decreases from $6 to $3? 4-3/3 = 0.33 ep = = /6 = 0.5

14 Price Elasticity Midpoint (Arc) Formula The midpoint formula gives us the average between the initial and ending values, thus eliminating any differences resulting from a price increase or decrease. ep = (3-4) /(3+4)/2) = 1 / 3.5 = 0.28 ep = = 0.42 (6-3) /(6+3)/2 = 3 / 4.5 = 0.66 B A A to B: 0.25 B to A: 0.66 Midpoint: 0.42

15

16 Practice Problem: A dentist with 80 patients cuts his fees for a cleaning from $60 to $54. He attracts 2 new clients. USE MID-POINT FORUMULA. Calculate the elasticity. % QD = (82-80) (82+80/2) % P = (54-60) (54+60/2) ep = (2/81) = = (6/57) =

17 MID-POINT FORMULA PRICE QUANTITY DEMANDED $6 80 $5 100 $4 120 $3 140 $2 160 $ What is the price elasticity o demand when the price changes from $1-$2? Over this price range, the price elasticity of demand is What is the price elasticity o demand when the price changes from $5-$6? Over this price range, the price elasticity of demand is %QD = 20 / 170= % P = 1/1.5= E = 0.118/0.66 = 0.177

18 Perfectly Inelastic and Elastic Perfectly Inelastic -QD does not respond to a price change. Ep = 0 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.

19 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 19

20 Perfectly inelastic demand ep = 0 Inelastic or Elastic? 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)

21

22 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

23 Price Elasticity Rap Video

24 Income Elasticity Income elasticity shows how sensitive a product is to a change in income It shows if goods are normal or inferior

25 Income Elasticity Income elasticity shows how sensitive a product is to a change in income It shows if goods are normal or inferior Use -/+ to show an decrease/increase in price Positive = normal good Negative = inferior good The QD of cronuts increases by 15% when income rises by 10% +15/+10 = 1.5 Since the QD increases as income increase, cronuts are a normal good. The QD of Big Macs decrease by 30% when incomes rises by 10% -30/+10 = -3 Since the QD decreases as income increases, Big Macs are a inferior good If 0, an increase inincomeis not associated with a change in the demand of a good

26 Cross Price Elasticity Cross-Price elasticity shows how sensitive a product is to a change in price of another good It shows if two goods are substitutes or complements Use -/+ to show an decrease/increase in price P increases 20% QD decreases 15% E = -15/+20 = Bikes and helmets are complementary products QD increase 30% E = +30/+20 = 1.5 Bikes and skateboards are substitutes Positive = substitutes Negative = complement If the coefficient is = 0, the two goods are not related. The higher the value, the stronger the relationship is.

27 When the price of Good W increases by 4 percent, the amount demanded of Good A increases by 3%, the amount demanded of Good B falls by 2% and the amount demanded of Good C is unchanged. The C-P elasticity of Good A and W is = 3/4 = 0.75 The C-P elasticity of Good B and W is = -2/4 = -0.5 The C-P elasticity of Good C and W is = 0/4 = 0 Which goods are substitutes? Complementary? Unrelated?