Economics International Baccalaureate (IB) Practice Question: 1. Explain why price elasticity of demand varies along the length of a linear demand curve. 2. Using real-world example...

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Definitions

1. Price Elasticity of Demand (PED): A measure of the responsiveness of quantity demanded when there is a price change.
2. Elastic Demand: When the percentage change in quantity demanded is greater than the percentage change in price (PED > 1).

Diagram

• Diagram Required: A linear demand curve.
• 
• Indications on Diagram:
  • Label the axes: Price (P) on the vertical axis and Quantity (Q) on the horizontal axis.
  • Draw a straight-line demand curve from the top left to the bottom right.
  • Indicate different points along the curve to show varying elasticity (e.g., elastic, unitary, inelastic).

Explanation

• Understanding the Demand Curve:

  • A linear demand curve has a constant slope but varying elasticity along its length.
  • At higher prices and lower quantities, the demand is more elastic because consumers are more responsive to price changes.

• Elasticity at Different Points:

  • Upper Portion (Elastic):
    • At higher prices, a small decrease in price leads to a relatively large increase in quantity demanded.
    • Consumers are more sensitive to price changes due to the higher proportion of income spent on the good.
    • Diagram Reference: Show a large horizontal movement for a small vertical movement at the upper part of the curve.
  • Midpoint (Unitary Elastic):
    • At the midpoint of the demand curve, the percentage change in quantity demanded equals the percentage change in price (PED = 1).
    • Diagram Reference: Indicate the midpoint where the curve transitions from elastic to inelastic.
  • Lower Portion (Inelastic):
    • At lower prices, a large decrease in price leads to a relatively small increase in quantity demanded.
    • Consumers are less sensitive to price changes as the good takes up a smaller proportion of their income.
    • Diagram Reference: Show a small horizontal movement for a large vertical movement at the lower part of the curve.

• Additional Explanation:

  • Total Revenue Implications:
    • In the elastic range, a decrease in price increases total revenue, while in the inelastic range, a decrease in price decreases total revenue.
    • This is because the percentage change in quantity demanded is greater than the percentage change in price in the elastic range, and vice versa in the inelastic range.

• Complex Point (Optional):

  • Mathematical Derivation:
    • The elasticity can be derived from the formula: $PED = \frac{\Delta Q/Q}{\Delta P/P}$.
    • As you move down the demand curve, $\Delta Q/Q$ decreases while $\Delta P/P$ remains constant, leading to a decrease in elasticity.

Answers may include:

Definitions

1. Price Elasticity of Demand (PED): A measure of the responsiveness of quantity demanded when there is a price change.
2. Indirect Tax: Taxes levied on spending on goods and services. They are called indirect because while consumers contribute to part or all of the tax, it is the suppliers (firms) who collect and transfer these taxes to the government authorities (consumers pay the taxes indirectly).

Economic Theory

• Price Elasticity of Demand (PED):

  • Goods with high PED are highly responsive to price changes. A small increase in price leads to a large decrease in quantity demanded.
  • When a tax is imposed on such goods, the price increases significantly, leading to a substantial drop in quantity demanded.

• Impact on Government Revenue:

  • For goods with high PED, the decrease in quantity demanded may offset the increase in price, potentially leading to lower overall tax revenue.
  • The effectiveness of tax revenue generation depends on the balance between the price increase and the reduction in quantity demanded.

• Consumer and Producer Burden:

  • In the case of high PED, consumers are more sensitive to price changes, so the tax burden is more likely to fall on producers.
  • Producers may face reduced sales and profits, potentially leading to negative economic impacts such as layoffs or reduced investment.

Diagram

• Supply and Demand Diagram:
  • Illustrate a demand curve that is relatively flat, indicating high elasticity.
  • Show the initial equilibrium price and quantity.
  • Indicate the new equilibrium after the imposition of the tax, with a higher price and lower quantity.
  • Highlight the tax revenue area and the deadweight loss.

Evaluation

• Stakeholders:

  • Consumers may benefit from reduced consumption of potentially harmful goods (e.g., sugary drinks), but they face higher prices.
  • Producers may suffer from reduced sales and profits, leading to potential job losses.
  • Government may not achieve the desired increase in revenue due to the high elasticity of demand.

• Long-run vs. Short-run:

  • In the short run, consumers may reduce consumption significantly, leading to lower revenue.
  • In the long run, consumers may find substitutes or adjust their consumption habits, potentially stabilizing revenue.

• Advantages vs. Disadvantages:

  • Advantages: Potential health benefits from reduced consumption of harmful goods; alignment with public health goals.
  • Disadvantages: Potentially lower revenue than expected; negative impact on producers and employment.

• Prioritize:

  • Governments should consider the primary objective of the tax. If the goal is to reduce consumption of harmful goods, taxing high PED goods may be effective.
  • If the primary goal is revenue generation, targeting goods with lower PED may be more effective.

• Real-world Example:

  • The UK sugar tax on soft drinks, introduced in 2018, aimed to reduce sugar consumption and improve public health.
  • Initial results showed a reduction in sugar content in drinks and a decrease in consumption, but the revenue generated was lower than expected due to the high elasticity of demand.

Conclusion

1. Taxing goods with high PED may not effectively increase government revenue due to significant reductions in quantity demanded.
2. The policy may achieve other objectives, such as reducing consumption of harmful goods, aligning with public health goals.
3. Governments should carefully consider their primary objectives and the characteristics of the goods being taxed to design effective tax policies.