Question in Paper Instructions

ELASTICITY OF SUPPLY AND DEMAND
Name:
Course:
December 1, 2016
Introduction
Tax is a mandatory contribution to the revenue of the state. The government levies taxes on income of its workers and profits of businesses as well as on the costs of certain goods and services. When a tax is imposed in a good, naturally the price goes up. When the price goes up, for a non-basic good with substitutes, the quantity demanded will naturally fall as people look for cheaper alternatives. However, certain goods are too essential that even an increase in price does not have any significant impact on the quantity that the consumers demand. A subsidy, on the other hand, is an advantage that the government offers groups or individuals in the form of tax cuts or cash payments. Governments typically give subsidies to relieve the public of some financial stress. When a subsidy is given on a product, the price goes down and the quantity of the commodity purchased naturally goes up. This paper will analyze the effect that tax or subsidies have on the quantities, prices, and economic welfare based on the elasticity of supply and demand model.
The Theory of Elasticity of Supply and Demand
Elasticity is used to refer to the level at which the supply and demand curves respond to price changes. It is expressed in equation form as “elasticity equals percentage change in quantity/ percentage change in price.” This fact means that goods and services with high elasticities will result in significant changes in the supply or demand following very tiny price changes.

A number of elements can affect elasticity. The first factor is the existence of substitutes; where there are more substitutes, there is a high elasticity and vice versa. Time and the amount of available income are also significant determinants of the elasticity of demand and supply. The idea of elasticity is somehow intuitive; that is people are willing and ready to part with any amount for life-saving medication but might switch from one brand of soda to another due to a slight change in price. However, the idea is one that can be applied to critical areas of the economy. The concept plays a significant role in pointing out the impacts of price changes on the revenues of businesses, the advantages of trade, the evaluation of tax burdens, and the results of advertising.
Tax Concept
Tax on a particular commodity is known as an excise tax. This tax can raise the cost of the product to a consumer and lower the net amount that the producer receives. It will generally do a combination of the two and reduce the amount purchased and marketed. The effects of this kind of tax will rely on the mechanisms that regulate the market price of goods as well as the structure of the market in which a business operates. A market demand function is a relationship between the quantity of a commodity demanded and its price. Similarly, the function of supply is the relationship between the amount of a good supplied and their prices. The supply and demand functions can be illustrated using graphs such as the ones shown below.

Source: Victor, David G. “The Politics of fossil-fuel subsidies.” Available at SSRN 1520984 (2009).

Source: Victor, David G. “The Politics of fossil-fuel subsidies.” Available at SSRN 1520984 (2009).

Impact of Exercise Tax
Assuming Peq is the price at the point of intersection of the supply and demand curve and Qeq the quantity at the same point. If a tax t is charged on a good and collected from the manufacturers, the first thing that one would expect would be an increase in the market price by a similar proportion to the tax charged; mathematically, this would be represented as (Peq+t). In this scenario, the manufacturers would still be receiving Peq and therefore would still supply the same quantity Qeq. However, the amount demanded at (Peq+t) would be lower than Qeq and therefore, the equilibrium would be upset. This disparity would see a fall in prices of the commodity. The equilibrium would then shift to a region between (Peq + t) and Peq.
Subsidies Overview
In standard demand and supply curve drawings, a subsidy would result in either the supply curve shifting down or the demand curve shifting up. A subsidy that results in increased production will lead to a lower price whereas a subsidy that results in an increased demand would often result in price increases. Each of these cases, just like explained in the preceding section, lead to a shift in equilibrium. As a result, it is important to factor in elasticity while approximating the total amount that a subsidy would cost. Elasticity is equivalent to the difference between the subsidised price and the market price or the new equilibrium quantity multiplied by the total subsidy divided by the number of units. However, public goods suffer a different fate from this effect. Once built, the subsidies remain the same no matter how many consumers are available. However, depending on the nature of the subsidy, the number of “producers demanding their share of benefits may still rise and drive up the costs.”
The beneficiary if a subsidy might have to be differentiated from the recipient. This evaluation will rely on the demand and supply elasticity coupled with other factors. For instance, a milk consumption subsidy for the consumers might appear to benefit the consumers or a subgroup of consumers. However, if suppliers constrain the supply of the commodity, the demand and the supply are likely to go up. In such a situation, the producer is likely to benefit where the consumer is unlikely to draw any net benefits since the increased prices of milk will offset the subsidy. The net resultant impact and the identification of the losers and winners is rarely is never easy when it comes to subsidies. However, they often “lead to a transfer of wealth from” one category of people to the other. A government may also use subsidies to transfer some of their actions that restrict competition or increase the possible prices at which the producers could retail their commodities. Tariff protections are a good example of such measures. Despite the fact that many economists hold the belief that subsidies may result in market distortions and create inefficiencies, there are unique instances where subsidies provide the most efficient solution. Even though subsidies may at times not be as effective as initially hoped, they are often much more effective than other governmental policies intended to benefit specific target groups. Direct subsidies are also, most of the time, transparent, enabling the interested parties to get rid of the wastes associated with hidden subsidies. The issues about hidden subsidies being favoured due to their lack of transparency despite evidence that they are inefficient are key to “the political economy of subsidies.” Subsidies are often given on sectors like gasoline, utilities, welfare, and student loans in some countries.
There are many types of subsidies; however, all these subsidies result in the reduction of the prices of commodities. Examples of tax subsidies may include the “depreciation for certain industries or equipment, or exemption from consumption tax.” Any tax cuts have obvious benefits to the people who produce or buy the goods. However, different products react to tax subsidies differently. The elasticity of demand and supply is one if the criteria through which economists use to group products before analysing the impact that subsidies have on them. One element of the e-supply-demand framework is the price elasticity of demand (PED); a measure of the degree to which a change in the price of a commodity affects the quantity of the product demanded. The primary factor that determines the PED of a product is the ability of a consumer to stop the consumption of a good due to price increases, so as to find cheaper substitutes.
Products like gasoline which have very few, if any, alternatives are said to have a low PED relative to that of supply. Therefore, even if the prices go up by 100 units or fall by the same margin, the change in the quantities of the product demanded would not change in a similar proportion. People who drive have to fuel their cars regardless of the price of fuel, walking is only an option within some distance. Therefore a fall in the price of fuel due to subsidies will not cause a larger increase of demand of the commodity. However, the fall is likely to cause a significant decline in the supply by suppliers waiting for the prices to go up before they release the commodity. Subsidies on products like gasoline encourage the buyers to purchase more and the suppliers to supply less. However, this kind of support promotes the dependence of people on fossil fuels. And supporting the production of any fossil fuel increases the risks of a “carbon lock-in.” This phenomenon makes it more difficult for the seriously needed shift to green energy difficult. In essence, subsidies on gasoline and other fossil fuels shift the lowered cost of producing the fuel to the poor via health and climatic impacts. The worst part is that the gas producing firms actually get rewards for the privilege. Succinctly, subsidies on products with low prices of elasticity like gasoline are not a very wise idea. Whether the prices of these goods drop or increase significantly, the change in demand is never that high but that of supply fluctuates very rapidly due to unscrupulous because of unscrupulous business persons trying to take advantage of the situation. The production and use of gasoline, in specific, helps deplete the ozone layer. As a result, tax subsidies on such a product do not improve the net welfare of the society in the long-term.
Commodities with a high PED relative to that of supply, on the other hand, tend to experience significant changes in demand whenever there is a small change in price and little change in supply following any price changes. From previous studies, a substantial increase in the price of a commodity like alcohol results in an almost equally significant change in the demand for the product. Statistics from the “Behavioral Risk Factor Surveillance System survey” of 2008 assessed the effect that a 25 percent tax increase on every drink would have on the drinkers. The investigation revealed that the 25 percent tax increase per drink would lead to “an 11.4% reduction in” the consumption of alcohol by heavy drinkers. From the study referenced above, tax subsidies on products with a high PED like alcohol would add significant financial benefits to both the consumers and producers of the commodities. The producers would experience large increases in sales while the consumers would either drink more for the same amount of money they are sued to, or drink the same quantity at a reduced price. However, just like for fossil fuels, tax subsidies on alcohol should be discouraged because they encourage too much taking of alcohol which in turn reduces the productivity hence the general welfare of the consumers. The graphs below illustrate the two situations described above.

Source: Victor, David G. “The Politics of fossil-fuel subsidies.” Available at SSRN 1520984 (2009).
In conclusion, subsidies are measures taken by governments to encourage the citizens to consume certain goods or to encourage particular companies to produce more of the goods they produce. Subsidies on products like gasoline which have a low have little impact on the demand of good but tend to have a negative impact on the supply. Suppliers tend to hoard such goods so that consumers can feel the pinch of not having the commodity as they wait for the government to remove the subsidy so that they can sell the good at a good price. This does not improve the overall welfare of neither the citizens nor the consumers. Therefore, while giving a subsidy or imposing a tax on any product, the government needs to put policies in place to ensure that the intended benefits get to the intended people without adversely affecting the economic welfare of the group that does not benefit from the subsidy or the tax.
Bibliography
Daley, James I., Mandy A. Stahre, Frank J. Chaloupka, and Timothy S. Naimi. “The impact of a
25-cent-per-drink alcohol tax increase.” American journal of preventive medicine 42, no. 4 (2012): 382-389.
Pindyck, Robert S., Daniel L. Rubinfeld, Jeffrey M. Perloff, and Ian Jacques.Microeconomics.
Boston, MA.: Pearson Custom., 2007.
Victor, David G. “The Politics of fossil-fuel subsidies.” Available at SSRN 1520984 (2009).