Category Archives: Demand Elasticity

QUESTIONS FOR CLASSROOM DISCUSSION ON DEMAND ELASTICITY

 After reading about the intended and unintended consequences of these luxury taxes, consider the following:

  • Are consumers the only segment of the economy affected by taxes on consumption goods?
  • Are consumers always negatively affected by taxes on consumption goods?
  • Are taxes that raise revenue “without harming the poor and middle class” justifiable?

Looking forward to a lively discussion in class on Tuesday!

Posted by Prof. C-S

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 elasticity of demand, or price elasticity of demand is specifically spoken of in this article.  This price elasticity is defined as the ratio between the percentage changes in quantity demanded with the percentage change in price of a product.  Demand elasticity (as well as supply elasticity) is often broken up into its two major components, inelasticity and elasticity.

Jeffrey Perloff in the article “Tax Revenues from Federal Luxury Taxes” points out a major flaw that sometimes occurs when taxes are being appropriated to specific social levels.  The article explains that an “ad valorem” tax was imposed on many luxury goods in 1990, intending to tax those rich enough to buy luxury goods more than was being taxed to those with less wealth.  It is important to note that policy makers made the judgment that those buying luxury items were more inelastic, or less sensitive to price changes.

These so-called inelastic consumers actually stopped buying yachts and planes, scared because of the extra money needed to spend.  This showed these products were in fact very elastic, and individuals who can afford luxury goods can actually be price sensitive for certain products.

In attempting to avoid harming the poor and middle classes, the “luxury tax” actually proved that the upper class does not have as inelastic of a demand as the government had hoped.  When prices of luxury goods such as yachts, planes, and expensive furs and jewelry began to increase because of the added price of their respective taxes, the consumer market for these items showed elastic demand in their willingness to seek out cheaper substitutes rather than pay more for the same luxury items that they previously would have considered buying.  Strategies for these consumers included buying luxury items at just under the tax level or simply not buying the item at all.

The responses of the consumers of luxury goods proved that even though the income level of the people who would be buying these goods is much higher than the average consumer, their demand can still be elastic if the price does not fit their demand.  The negative effect that the tax had on luxury goods showed that even price hikes among already expensive goods will deter consumers from buying the taxed products.

A real world example of demand elasticity is the gasoline market in the US. Despite rising oil prices, people still buy oil – they need it for daily activities. Casey’s, a convenience store that sells gasoline in the Midwest, remarked that during 2010, when gas prices were changing constantly, they saw no real change in quantity demand for gasoline. As gas prices have risen astronomically in the last 15 years, consumption of gasoline has only grown in the US. Therefore, gasoline is an inelastic good.

Another inelastic good is alcohol. Alcohol is subject to a very stiff excise tax yet consumption of alcohol has not changed heavily in past years. This stands in contrast to tobacco – for years considered an inelastic good – which is now seeing a drop in demand as taxes rise and healthier substitutes (such as nicotine patches) become more readily available. The demand for tobacco has become elastic as the more price increases, the less quantity demanded is for the product.

Posted by John, John and Jason (Section 4)

Resources:

 http://www.caseys.com/media/Caseys_AR_2010.pdf

 http://ecocentric.blogs.time.com/2011/08/16/why-dropping-the-gas-tax-would-be-a-disaster/

 http://www.taxfoundation.org/news/show/245.html

 http://tutor2u.net/economics/revision-notes/as-markets-price-elasticity-of-demand.html

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

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 concept of demand elasticity is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. Demand elasticity is of extreme importance to the firm, as it helps the firm model potential changes in quantity demanded due to changes in price, therefore optimizing competitive behavior. In Jeffrey Perloff’s article, “Tax Revenues from Federal Luxury Taxes,” the government thought it would be beneficial to tax luxury items in order to raise tax revenues by imposing a tax on the wealthy without affecting the poor. The goal was to minimize harm on the poor, while increasing revenue through taxes on the wealthy. However, a failure to incorporate demand elasticity caused unexpected results.

A 10% tax imposed on luxury items such as yachts, planes, cars, furs, and jewelry costing over a certain amount of money caused differing changes in revenues. The article highlights the differing elasticity between cars and yachts; cars are inelastic, while the yacht market is very elastic. This tax failed to address all possible side effects that are present in markets, specifically demand elasticity.

Due to the miscalculation of the effects of demand elasticity, the yachting industry demonstrates the harm of this tax to domestic producers. Congressional analyst didn’t take into consideration the tax avoiding behavior of consumers, the tendency to not purchase a product if the price increases. This had the unforeseen consequences of costing around 45,000 people their jobs in only one year in the yachting industry alone.

As Perloff clearly states, the information about elasticities of demand and supply are integral when making Congressional decisions that affect tax laws in order to address these unintended effects.

The demand for luxury goods is elastic, increases in price causes steep decreases in quantity demanded. In these cases, producers are forced to bear the burden of a tax, which explains the effects on employment. In Perloff’s article, the decision to tax luxury goods is not consistent with the objective of the tax. The tax was originated to tax the wealthy not the poor, but because the demand for luxury goods is elastic, the producers absorbed the burden. The article specifically mentions the yacht industry. In the first year of the yacht tax, sales of yachts costing over $100,000 dropped by 71%. As a repercussion of this, a drop in sales caused thousands of people to lose their jobs. As a result of this job loss, the government actually lost money from the loss of payroll taxes. Therefore, this tax does not affect the wealthy as much as it impacts the poor. Poor and middle class citizens generally would hold production jobs at the yacht factories, and the tax was the main proponent of them losing their main source of livelihood.

The economic idea of demand elasticity can be seen in the real world in many different examples.  The textbook market is just one accurate example of the influence of demand elasticity on a market. In today’s world, students will always need to purchase textbooks for their classes. New versions are always coming out of specific textbooks, and classes generally require the purchase of a textbook. This creates an inelastic market. If a tax were to be imposed on new textbooks, the students will absorb the effects of the tax. Since there will always be a need for required books and updated versions this will raise tax revenues at the expense of the consumers. Overall, demand elasticity can be applied to almost every economic situation regarding prices. It is important for analysts and anyone using these measures to take demand elasticity into effect before making any major decisions that could have unforeseen consequences.

Posted by Molly, Ben and Sydney (Section 2)

Price Elasticity of Demand Blog

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 United States government’s impositions of new taxes always tend to be controversial issues both in the debates over their merits before passage and the examination of their efficacy down the road.  In 1990 the government enacted luxury taxes at values that it anticipated would increase tax revenues on yachts, planes, furs, jewelry, and cars.  However, due to the relatively low breakpoints for the onset of the 10% tax on these goods, it negatively affected demand to a significant enough degree to decrease net tax revenues for all of the goods except cars.  Since these industries produce goods that are almost exclusively at the high end of the overall price range, their sales are extremely price sensitive.  This exemplifies the classroom concept of price elasticity of demand; consumer demand for goods will shift more rapidly in highly elastic goods when their prices change.  These items tend not to be necessities, and many people in the market quickly become priced out of the desire to buy them, which is fitting with the items in Perloff’s article.

Considering the majority of yachts and aircraft cost more than their $100,000 and $250,000 respective onset amounts for the tax, the tax hit essentially every sale in these industries.  The yachting industry saw sales of yachts priced over $100,000 drop 71% in the first year of the tax, as people buying expensive yachts easily found a way to avoid the tax by acquiring boats outside the United States.  Employment in the industry dropped approximately 28% the first year, and the net tax loss from the pursuant decline in payroll taxes versus the minor increase in revenue from the luxury tax was $141 million.  Due to the negative impact of the luxury taxes in these highly price elastic industries, the tax was revoked in mid 1993 in order to avoid continued economic harm and the related losses in tax revenue.

 In the article, Perloff states that the purpose of the ad valorem tax was to raise tax revenue without hurting the lower and middle classes.  To this end, the tax was only placed on luxury goods.  However, the most effective way to raise revenue by taxing goods in general would be placing the tax on items for which demand is inelastic.  In this case consumers would continue to purchase the items, with much less of a regard for increases in price.  Such a tax would not completely erode domestic demand and would raise significant tax revenues.  This underlying concept for raising tax revenue is inconsistent with the United States’ decision to tax luxury items, since a price increase significantly reduced quantity demanded, and therefore tax revenue.  This also shows why the tax on automobiles was actually effective: automobiles are more of a necessity than planes, yachts, furs, or jewelry, so cars have a much more inelastic demand because they are the most typical and necessary mode of transportation.  The tax raised almost four times as much as expected on automobiles in the first year alone, at $98.4 million.  The relative inelasticity and inclination for consumers to rather commonly buy vehicles over $30,000 made the automobile tax a revenue winner.

 Furthermore, a current real world application of price elasticity of demand is how the extreme inelasticity in oil demand negates the more typical demand structures previously discussed.  Even with highly volatile oil prices driving changes in costs that get passed down to consumers at the bottom line, there are not drastic changes in demand for many products derived from oil.  The most obvious example is demand for gasoline, which has its price constantly fluctuating and can see swings over just weeks that constitute 20% changes in price at the pump.  The most prominent modes of transportation in the United States are completely dependent on gasoline or fuel, which is why price changes have relatively little effect on quantity demanded.  Both automobiles and airplanes warrant endless consumption that simply lacks any viable substitutes.  Much of the necessary travel is work related, but beyond that people also continuously use vehicles for the convenience factor that is still very difficult to price out.  Hence, consumers are forced to operate relatively unencumbered by price in the transportation sector because the costs passed down to them in gasoline and airline prices are effectively unavoidable.  In most industries, a 50% increase in price over a year or two would lead to drastic declines in sales.  However, when gas prices have shown such sustained jumps in the past, the declines have been much less pronounced due to consumers’ reliance on gasoline.  This perfectly exemplifies inelastic goods, which see demand schedules in stark contrast to the luxury goods that were being taxed in the early 1990s that Perloff discusses in his article.

 Posted by Mikelle, Michael and Joe (Section 1)