What are the principle determinants of the price elasticity of demand and what are the implications for

governments taxation?
Price elasticity of demand is defined as 1 A units free measure of the responsiveness of the quantity demanded of a good to a change in price, ceteris paribus. We can calculate the price elasticity using this equation: Price elasticity of demand = % change in quantity demanded % change in price If price elasticity of demand is equal to zero then there is a perfectly inelastic demand curve, if price elasticity of demand equals infinity then it is a perfectly elastic demand curve; when price elasticity of demand equals 1 then there is a unit elastic demand ( meaning, there is the same proportional change of quantity demanded in relation to price- so total revenue will remain unchanged). When the percentage change in quantity demanded is larger than the percentage change in price (PED>1) then the demand for a particular good or service will be price elastic. Demand is price inelastic if the percentage change in the quantity demanded is smaller than the percentage change in price (0<PED<1). However, along a sloped demand curve, the price elasticity of demand changes as you move down the demand curve, from elastic through unit elastic to inelastic. Price elasticity of demand determines how many consumers in a particular market, will leave the market at a given price change in a given period of time, ceteris paribus. Therefore, before looking at determinants it is necessary to know what demand is. Demand is defined as "The quantity of a product that consumers are willing and able to purchase per time period at a specific price, ceteris paribus." The larger the magnitude of price elasticity of demand, the more responsive the quantity demanded for a good is, to a given change in price. The determinants of elasticity of demand include; how close substitutes are for a particular good; the breadth of definition of the good; the percentage of income spent on the good; the necessity of the good; the Brand loyalty; the duration of the price change. The more and closer the substitutes available are, the more elastic demand will be. This will mean a price increase for one good would lead to a large decrease in the quantity demanded for the good, ceteris paribus. This is because consumers will have left the market to enter the market for the cheaper substitute. For example, Pepsi and coke are considered substitutes for each other. When the price of coke rises, the demand for coke will decrease and the demand for Pepsi will increase (assuming the price for Pepsi is unchanged), ceteris paribus. So, the more substitutes a good has the more easily consumers can switch to alternatives. Further more, it is also the breadth of definition of the good which ties into the substitute effect on price elasticity of demand. Using the example of Pepsi again: Pepsi versus soft drinks is a broadly defined comparison, and therefore the demand for Pepsi in this case would be fairly inelastic, however, if Pepsi versus coke comes up again, this is a narrowly defined case, and therefore the demand for Pepsi in this situation would be fairly elastic. The higher the proportion of income spent on a good, the more consumers are pressurised to lower consumption as price increases, meaning the bigger will be the income effect, and the more elastic demand will be. On the other hand, if a small proportion of the income is spent on a good, the income effect is insignificant, and a change in price won't affect the spending behavior, demand is therefore price inelastic. Obviously the more insignificant the income effect, the more inelastic the demand curve is. The more necessary a good is in a consumers life, the more inelastic the demand curve becomes. Necessities in places such as in America, where insulin is paid for, the demand curve is inelastic, as no matter the price, consumers for these goods will always purchase them. In extension to the idea of necessity, goods which are addictive become a necessity to a proportion of the market,. For example cigarettes. Here there will be a fairly inelastic demand curve, as a price increase in a given period of time, will lead to a proportionally smaller loss in demand, ceteris paribus. This is because the good has become a necessity for addicts. This has implications on the decision 1 Parkin, Michael, Kent Matthews, and Melanie Powell. Glossary Economics. Harlow [u.a.: Pearson/AddisonWesley, 2005. Print 2. ."Government Taxation." Tutor2u | Economics | Business Studies | Politics | Sociology | History | Law | Marketing | Accounting | Business Strategy. Web. 04 Sept. 2011. <http://tutor2u.net/business/gcse/external_environment_economic_govt_taxation.html>.

of governments to impose a tax on such products, as a lot of the consumers won't leave the market, but an opportunity cost comes about for both producers of goods and services and consumers. A higher tax on cigarettes would lead to some consumers still purchasing the cigarettes but leaving the market for other products which are not demerit goods. For example, a meal from Waitrose, could be foregone for a packet of cigarettes. Another determinant is Brand loyalty. When consumers are attached to a particular brand, this can override the sensitivity to a change in price, therefore giving the particular good or service a more inelastic demand curve. Lastly, the longer the time period after a price change the more price elastic demand is for the good: Consumers take some time to find alternatives and adjust the consumption pattern. The uses of price elasticity of demand include; It allows a comparison of quantity changes with monetary changes. It permits a firm to employ price discrimination, meaning with an inelastic demand curve, a higher price will be charged. It helps firms conclude how much of the indirect tax should be passed on to consumers. It helps governments decide how much tax is needed to reduce consumption of a demerit good. Governments can also use price elasticity of demand to predict the effect of currency devaluation on the trade balance (The difference between export and import value of goods and services, in a given period of time), of the country. An economy is always searching for the most efficient way to allocate resources. Free markets often do a good job at this however, sometimes, too much, or too little of a good or service is being produced, and/or consumed. Governments can tax to rectify the problem. Other reasons for government taxation include raising tax in order to finance government spending. This is to manage aggregate demand, to help meet government economic objectives. Another reason for tax, is to change the distribution of income and wealth; and referring back to the first point, taxes can help in the situations of market failure, e.g. pollution. There are two main forms of taxation, direct tax, and indirect tax. Direct tax is that which is levied on income, wealth and profit. Indirect tax is mainly levied on spending of consumers through purchasing goods and services. e.g. Ad valorem (VAT). In this case whether the burden of the tax is mainly on consumer or producer depends on the elasticity. Tax incidence is the division of the burden of a tax between the buyer and seller. When an item is taxed, if the price rises by the full amount of the tax, then the buyer pays the tax, if the price rises by a smaller amount on the product than the tax, then both the buyer and producer share the tax. If the price of the good or service doesnt rise at all with the implementation of tax, then the seller will bare the burden of tax. The burden of tax on demand, and the effect of the elasticitys can be illustrated by the diagrams below. a) b)
S +TAX

s
Price (pounds per bottle) Price (pence per cookies)

S +TAX

2.0 1.50 D
50 Quantity (thousands of bottles per day)

s D

90 70 1 4

Quantity (hundreds of cookies per day)

In diagram 'a' the demand for insulin is perfectly inelastic. Where demand is at a quantity of 5o thousand bottles per day of insulin and sold at an original price of 1.5 pounds per bottle. Insulin is now taxed at 50p per bottle, so now the price per bottle is at 2.00 pounds. The demand is perfectly inelastic, so consumers would rather purchase the insulin and reduce spending elsewhere. The supply curve now shifts to the left along the demand curve, the new supply curve is now at s + TAX. This new curve is the tax added to the minimum price for the bottles of insulin. The result of a change in price has no effect on the quantity demanded and therefore the buyers have the burden of the whole tax to pay. This is represented by the pink shaded area. On the other hand, in diagram b, the demand curve is perfectly elastic for cookies. So the responsiveness of quantity demanded when there is a change in price is very high. The quantity demanded before tax was at 400 per day at a price of 90 pence per cookie. Now tax on the good is added at 20 pence per cookie. This is added to the minimum price charged per cookie. Price still remains at 90 pence per cookie but quantity falls to 100 cookies per day, ceteris paribus. This is because the whole of the tax is

placed upon the producers, lowering the revenue made by producers. The tax paid by the producers is represented by the pink shaded area, as the new supply curve occurs at s + TAX. The more inelastic the demand curve is, the more the burden of the tax is placed upon consumers. In the case of supply, the more elastic the supply curve the more burden of the tax the consumers have. Usually demand is not perfectly elastic or inelastic and the tax is usually split between sellers and buyers, however, depending on the elasticity of demand (and supply) determines who pays the bigger proportion of the tax imposed. The implications with government taxation are different for different types of tax. In the case of income and national insurance taxes, levied on income. This would affect the disposable income of households, leading to a lower spending from consumers on goods and service (how much lower depend on the elasticity of demand for the good). Higher income taxes would also lower the incentives for people to work, going against the government aims for economic growth. In the case where tax is levied on firm profits, would reduce profits available to retain and reinvest in the business further, forcing some firms to leave the markets. When vat is levied on household spending, this affects the selling prices directly on goods and services. The increase of VAT can increase inflation (fiscal policies) and can decrease purchasing power of consumers. Leading to specifically more elastic goods and services losing demand, some firms having to leave the market because of a decrease in revenue. Lastly, the possible implications of tax put on profits and shares would reduce the benefits received from financial shares. In conclusion, Government taxation affects more elastic goods and services differently from those of more inelastic supply and demand curves. The burden of the tax on either consumer or producer is reliant on what the elasticity of the curve is, at that particular period of time, ceteris paribus.