Question 1, part (a) What is elasticity? The term elasticity is defined as a way to measure how responsive doe’s quantity demeaned or quantity demeaned towards its determinants (Manama, 2008). In this world today, every government need revenue or income in order to increase the welfare of citizens and improve the country itself. One of the ways that government use in order to increase their revenue is by taxation. To do so, government needs to impose taxes on goods and services. If tax is imposed on a certain good, what will happen to the demand and supply of the good?
This is when the theory of elasticity comes to play. Government should impose tax on cigarettes as it is price inelastic. According to Investigated (2010) states that smoker with fewer substitutes will continue purchasing cigarettes as cigarettes are inelastic when price of cigarettes increases. An increase in price would bring a small reduction in quantity demeaned. The diagram above shows the effects of tax towards the demand and price of cigarette. Before the tax was imposed, the price of cigarette is $10 per unit at quantity of “quo. This is when the market is at equilibrium, where consumers and producers are not yet worse off. Consumers are paying at a reasonable price while reducers are receiving a good amount of money. The diagram shows that consumer surplus is at area A+B+E while producer surplus is at area C+F+G. Consumer surplus refers to the willingness of a buyer to pay for a good minus the price that the buyers expects to pay for it while producer surplus is the value that the sellers receive for a good minus the cost to provide the good (Manama, 2008).
As we can see, when government imposes tax, price would increase from $10 to $14. Since the elasticity of demand is in elastic, the demand will fall only a small proportion compared to the increase of price. This is because cigarette is a good that causes addiction and do not have close substitution. So, area B+C shows the tax revenue earned by government. This will make producers and consumers worse off. As we can see from the graph, consumer surplus falls to only area A while producer surplus falls to area F. B and C are now the tax revenue while area E and G is the dead-weight loss.
When the demand is more inelastic than supply curve, the tax burden will eventually falls more towards the consumers (Investigated, 2010). This will have less effect on producers making them to keep on producing cigarettes. The increase in price will cause a shift in the supply curve to the left. So, cigarette is the best good that the government should impose tax on because it brings revenue in the long run. Tax on cigarette also brings a small portion of dead-weight loss which is relatively good. Although both consumers and producers are worst off, government is better off due to tax revenue.
Question 1, part (b) One of the examples of a good that has an elastic demand is toothpaste. For example Colgate, which is one of the brands of toothpastes, has many substitute. Products. So, If government wants to implement tax on this good, consumers would just switch to other brands of toothpaste. According to Manama (2008) states that goods which have many substitutes have elastic demand curve as consumer would just switch towards other goods. Alcoholic drinks are another example of a good that has an inelastic demand.
Alcoholic drinks are goods that have no close substitute and cause addiction. Since goods that have substitute have is elastic, so goods that have no substitute is inelastic. The two diagram below shows two different goods with two different elasticity. Price of Colgate ($) 150 50 Market of impact of tax on Colgate Quantity of Colgate (Units) c 7 12 10 as Market of impact of tax on Beer The two graph above shows the increase in price after tax is implemented. Before tax was implemented, consumer surplus in diagram for Colgate is at area A+B+D which is the same for the market of Beer.
The producer surpluses for both the goods are also the same which is at area C+E+F. This shows that the market is at equilibrium where demand and supply curve intersects. When tax is implemented, area B+C would be the tax revenue to the government for both goods. As we can see, the area of consumer surplus in the first diagram is smaller than the producer surplus. This shows that the burden of tax is more towards the producer compared o consumer. This is due to the elastic demand curve for Colgate where a change in price would bring a fall in demand.
In fact, consumers are actually benefiting in this situation as the tax burden is on the producers. For the beers, the area of consumer surplus, A, is larger than the area of producer surplus, F. This is because of the inelastic demand for beer. Since an increase in price does not really affect the quantity demeaned, producers would pass on the tax burden on the consumer. So, producers is at advantage since consumers are willing to pay for beers despite of the increase in price. Besides, the tax revenue from the taxation is higher for beers compared to Colgate.
Goods with inelastic demand would bring higher tax revenue compared to elastic demand. Tax revenue can be calculated by finding the area of B For Colgate, the tax revenue would be $1 ,250, while for beer; tax revenue would be $4,500. Finally, goods with elastic demand would decrease social welfare as consumers would switch to substitute causing a fall in demand which leads to a fall in tax revenue while for the beer, tax revenue will keep increasing because consumers will keep consume beers. This will increase the tax revenue which will be seed to increase the social welfare of society.
Question 2 Externally is defined as “uncompensated impact of one person’s actions on the well-being of a bystander” (Manama, 2008). Eternally arises when one person’s activity influences the well-being of a bystander where the compensation for the effect is not paid or receive. Externalities can be split into two types. One is a positive externally and another one is a negative externally. Positive externalities refer to the action done by a consumer that is impacted on the bystander which is beneficial to the bystander (Manama, 2008). Immunization and burglar alarms are example of positive externalities.
Negative externally is the opposite of positive externalities where it brings negative effects towards the third party. Cigarettes and pollution from factories are example of negative externalities. Market for burglar alarms Based on the diagram, when burglar alarms brings benefits to bystanders, social value which includes the private value plus the external benefit is higher than the demand curve which is the private value. The difference between these two curves shows the external benefits. The spot where the social-value curve and the supply rev intersect shows the optimal quantity of burglar alarms.
This shows that the market is producing a smaller quantity of alarms than it’s socially desirable. This will eventually result in low production of alarms. Burglar alarms or anti-burglar alarm systems brings positive externalities to the third party. According to Yakima, Renter and CompuServe (1995) states that resident with non-alarm system experience a little bit of benefits from those who earns an alarm system. This shows that burglar alarms are positive consumption which brings a positive externally because it brings benefits to the bystanders or the third party.
If a nonuser installed a burglar alarm in his/her house in a big residential area and a burglar break into the consumer’s house causing the alarm to be activated. This will eventually inform other residents around the residential area that there’s a burglar breaking into a house. It would be a benefit as other residents will be more careful and cautious next time. How do burglar alarms give benefits to those who do not install it? It is when criminals are unable to identify which house have install an alarm system and this leads to providing extra benefits to potential victims (Ares, house, the burglar would have targeted one specific house.
But since one of the houses or maybe more are equipped with a anti-burglar alarm system, the burglar would have difficulties in choosing the correct house to break into. So, crime rate will eventually fall. This will provide comfort towards the community in that particular residential area. In conclusion, since the burglar alarms brings positive externally when a consumer installed it which is a positive consumption, the value of consumption of these alarms will increase causing the value determined by the market is lower. This causes the producer to produce less. Reference list Areas, Ian; Levity, Steven.