Elasticity

Question 1, part (a) What is elasticity? The term elasticity is defined as a way to measure how responsive doe’s quantity demanded or quantity demanded towards its determinants (Mankiw, 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 Investopedia (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 demanded. 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 “q0.” 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 producers 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 (Mankiw, 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