2019 (PED, Indirect Tax)
Paper 1 HL
2. (b) Examine the significance of price elasticity of demand for the decision making of firms and governments.
Definitions
PED – a measure of the responsiveness of the quantity demanded to a change in the price along a given demand curve.
Indirect Tax = is a tax placed on the producer (produced goods and services) which is then (partly) passed on to the consumer in the form of a higher price.
Total Revenue and elasticity of a good = If the demand for a good is elastic and the firm (gov) increases the price the Qd for the good will decrease by a larger percentage than the price change causing the total revenue for the firm (gov) will decrease. If the demand for the good is inelastic and the firm (gov) increases the price the Qd for the good will decrease by a smaller percentage than the price change causing the total revenue for the firm (gov) will increase.
An indirect tax will raise the price of a good causing the supply curve to shift left and the Qd to decrease, there is a loss of Consumer Surplus and Producer Surplus and DWL. Usually if there is an indirect tax consumers and producers will share the tax meaning that some of the tax will be paid for by consumers while some will also be paid for by the producers.
Of course the producers would like to make the consumer pay all of the tax but if the demand for the good is elastic and the producer forces the whole indirect tax onto the consumer the price will rise by the amount of the tax and then a larger percentage (compared to the price increase) of consumers will stop buying the product causing the firm's total revenue to decrease.
Understand that the more inelastic the demand, the people buying the good will still purchase much of it even when the price increases. This implies that if the government is trying to gain revenue by the imposition of the indirect tax it would do well to tax goods that have an inelastic price elasticity of demand. If the government is trying to stop people from consuming a product such as taxes, and the cigarettes demand is very inelastic the indirect tax must be higher than if the good has a very elastic demand to get people to forego consumption.
Answers may include:
definition of price elasticity of demand (PED), diagrams to show the relationship between PED, price changes and the total revenue offirms; the relationships between PED, the size of an indirect tax, tax incidence, quantityproduced/consumed and government tax revenue, explanations of the relationship between: PED, price changes and total revenue of firms; how PED affects government tax revenue, production/consumption and tax incidence, examples of PED proving significant for firms and governments in practice, synthesis and evaluation (examine).
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Examination may include: the differing incidence of indirect tax on consumers and firms due to differing price elasticities, the impact of PED on the uses of tax/subsidy to address market failure, the impact of time on PED (and total revenue) when price changes, the difficulty of estimating PED values for firms, other factors affecting demand that cause a change in total revenue/tax revenue.
Classic Example of government taxes destroying the yacht industry back in 1990: the government decided to make the rich pay more and decided on a 10% luxury tax all yachts produced would be effective. I think we can understand that a luxury goods elasticity of demand is fairly elastic. When the taxes were imposed the rich simply bought other goods or bought in other countries or just decided not to buy a yacht. It destroyed the boat building industry. Read below.
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