Demand Elasticity

Discussion on the excerpt from Microeconomics by Jeffrey Perloff, based on “Senate Panel Kills Tax on Luxury Items” (Los Angeles Times, 1992), “The Bottom Line” (New York, 1992), and “Taxes: Tempestin a Yacht Basin” (Time, 1991).

The article “Tax Revenues from Federal Luxury Goods” written by Jeffery Perloff points out the importance of recognizing Demand Elasticity in the economy. Elasticity of Demand measures the responsiveness of change in the quantity demanded of a good or service to a change in its price. If a good is inelastic, a change in price will not affect quantity demanded. However, if a good is elastic, a change in prices will affect the consumer’s willingness to buy. A good that is unit elastic will cause consumers to change their quantity demanded by the exact same percentage as the change in price.

In an attempt to avoid harming the poor and middle class while raising funds for the US, the government imposed an ad valorem tax of 10% on the amount paid over a specified price for luxury goods including cars, planes, yachts, furs, and jewels. For example, the amount paid over $100,000 on yachts would be taxed 10% and the amount over $30,000 on cars would be taxed 10%. Unfortunately, the tax did not have the desired effect the government was looking for because of their lack of consideration towards Demand Elasticity.

Due to the inelasticity of automobiles, willingness to continue buying cars even as prices increased, this tax brought in greater revenue than expected. Most of the vehicles that taxes were being imposed on were built abroad. When this realization was made, consumers began purchasing less expensive, American made, cars. While initially bringing in more money than expected, foreign output dropped affecting American sales representatives.

Despite the success of the tax on automobiles, the government received little revenue from the taxes on other luxury goods. For example, sales on yachts costing greater than $100,000 fell 71% the first year the tax was instated. People were buying in the Bahamas or purchasing yachts just under $100,000 to avoid the luxury tax. As a result, the yacht tax raised very little money and the yacht industry lost 145,000 employees within the first year the tax was put in place. The loss from worker payroll taxes was more devastating than any gain from the luxury tax. These luxury items were far more elastic than the government expected. The government did not consider potential substitutes or the opportunity to buy the same goods elsewhere.

Due to the government’s miscalculations, the taxes on elastic luxury goods were revoked by 1993, and in 1996, the luxury tax on cars began to phase out over the next six years.

As indicated previously, the demand for luxury goods proved to be elastic. Thus people are not willing to pay higher prices for that good. Therefore, the government’s tax on luxury goods was ineffective. In fact, many industries were harmed. One significant effect was a decline in employment for the poor and middle class. The decreased purchases of luxury goods resulted in the loss of many jobs. This tax contradicted the government’s original intentions of not affecting the poor and middle class.

A different real world example involving elasticity of demand is gas prices. Over the last few years, the price of gas has shot up dramatically. However, consumers are still willing to pay this increased price. This is an example of an inelastic good. In 2000, a gallon of gas was under $2.00. Today, the average cost of a gallon of gas is nearly $4.00. While there has been a small decrease in gas consumption, gas remains to be a sought after product.

Posted by Katie, Katie and Daidreana (Section 3)

Resources:

http://mbaecon.wikispaces.com/Marginal+revenue+and+the+relationship+with+elasticity+of+demand

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