ELASTICITY OF DEMAND AND SUPPLY Objectives At the end of the chapter, the student is expected to: 1. Understand the concept of elasticity of demand and supply; . 2. Differentiate are and point elastici 3. Compute elasticity values of demand and supply with given changes in price and quantity; 4, Distinguish the different degrees of elas- ticity of demand and supply; 5. Apply the concept of elasticity to various economic situations; and 6. Recognize the value of elasticity in rela- tion to a seller’s revenue. ‘An analysis of demand and supply en- tails a subsequent study on their responsive? ness or elasticity with respect to changes in their determinants. The discussions in this chapter focus on their respective elasticity with reference to price and income. For every clasticity topic discussed, the measurements are first presented followed by the analysis and interpretation. Ts your demand for these goods sensitive to price? 45 Terms to Remember arc elasticity ~ the coefficient of price elas- ticity of demand between two points along the demand curve coefficient of elasticity ~ absolute value of clasticity complementary goods ~ goods that supple- ‘ment each other and are used together cross elasticity of demand — measures the percentage change in quantity demanded of one good compared with the percent- age change in the price ofa related good elasticity — the responsiveness of demand/ supply to a change in its determinant Engel curve ~a curve depicting the quantities of a good the consumer is willing to buy at all income levels, assuming all other things remain the same income elasticity of demand ~ measures the percentage change in quantity demanded compared with the percentage change in income ne inferior goods — goods which are bought when income levels are low, the demand for which tends to decrease when income increases Will you still buy rice or any staple food no matter what the price is?am 46 = normal goods ~ goods for whieh demand tends to increase when income increases change in Price elasticity ~ the percentage change 1 quantity compared with a percentag! change in price point elasticity — the coefficient of price ales ticity of demand at one point along the demand curve Prestige goods — goods bought for the status and prestige they give to the consumer and are bought when the prices are high substitute goods — goods used in place of another total revenue — the price of an item multiplied by the number of units of that item sold Introduction PRICE ELASTICITY OF DEMAND Price elasticity of demand is the degree of responsiveness of quantity demanded toa change in price.-It is measured by dividing the percentage change in quantity demanded by the percentage change in price. The follow- ing discussion illustrates the computation of the absolute value of elasticity relationship (Le., without considering any negative sign) as derived from Table 4. Introductory Mier, " 2 vo & Let us suppose that price changes from 35 to P40 and consequently, quantity demanded decreases from 100 to 80. The decrease in quantity demanded, which is 20, is a20% change based on the original quantity of 100. The price change of P5 represents a 14.3% change based on the original price determining the degree of responsiveness of demand to a change in price, the negative sign is set aside and only the absolute value of the coefficient is considered. On the other hand, the elasticity at one point along the demand curve is called point elasticity andElasticity of Demand and Supply measures as follows Epa = 4YQ AP/P Let us use the follow lowing demand schedule to show how the formula works. Point PP) Q A 8 b 2 i 10 6 20 2 5 30 ee ul 3 50 S 2 60 us 1 70 I 0 80 Computing the point elasticity for a change from points B to C, we get: AQP oP. Epa ="9- "ap 10 ,7_1 Ze, =o T= 7 Tp = 40 =10 This gives an elasticity coefficient of more than 1, which means that the percentage change in quantity demanded is greater than the percentage change in the price. The demand is thus described as elastic. Point Elasticity The measurement of point elasticity is more exact than that of arc elasticity. It measures only one point on the demand curve, such as point A on the following graph: Price per Unit of Good x ° Quantity of Good X A ‘Are elasticity becomes point elasticity when the distance between the two points originally measured becomes zero. On the graph above, to measure elastic- ity at one point, that is point A, we use the formula: Epp= a = dx/x x p/dp Whered represents insignificant changes in price and in the quantity demanded of Good X. Point elasticity, in contrast to arc clasticity, is measured over an infinite range. ‘The above formula can be rearranged to: ax oo PP (ap) x On the demand eurve shown on the pre- ceding graph, = measures the slope of the demand curve for small price changes from point A. Geometrically, this slope is MA, MT’ thus, equating with MA or 98. MT. ap MT” dp MA Since price at point Z is MA and quantity at that point is OM, then at point A:am 48 = Commodities and Their Elasticities We already learned that the 1 sential a good is to the consumer, the inelastic will be the demand for the good. The lastic pre 08 more less of'a necessity a good is, the more el is the demand for it. Based on elasticity C0 ficients, the following goods have elasticities which are less than one Infant milk Electricity Medicine Rice Sugar On the other hand, the following goods have elasticities which are greater than one: Signature bags Chocolates Imported shoes Perfumes High-end furniture Original Price: 6 Original Original 2,000 TR:P 12,000 New Price: 4 New Qi:2,100 New TR: 8,400 On the other hand, an increase in price will benefit the producer if demand is inelas- tic because it will cause an increase in his total revenue. For example: Original Price: P6 Original Original Q:2,000 ‘TR: P12,000 New Price: ®7 New Q::1,900 NewTR:P13,;300 ‘The increase in price has resulted in a significant decrease in demand, consequently causing the total revenue to decrease. A decrease in price may ultimately benefit the seller if demand is elastic, Original Price: 6 Original Original 2,000 TR: 12,000 New Price: P5 New Qe-2,500 NewTR:P12,500 However, if demand is unitary elastic, neither an inerease nor a decrease in price will affect the seller's total revenue as can be seen in the examples in the next rows, Introductory 44 ic Example A : Original Price: P4 Original Ong Qu:5,000 ‘ain TR: Poy Now Pree:P2__ New 10.000 Nowy RP r Example B My Original Price: PA Original Op 5,000 TR may, _ 009 New Price: P2 New Qu:2, 500 New TR Pa Substitution and Price Elasticity of Dem The degree of substitution be, product and related products deters price elasticity of demand. The exte, stitution depends on the substituti ‘ond ste ine tof ON effect, One factor of substitution is the numb of competing products. More compen” products mean more market shares fy product to gain or lose when its price gy. eases or inereases, respectively. Thus = seller invites more demand when he under prices more rivals in a market where produ, are homogeneous in type and quality. Ths kind of competition is evident among adjacen retail outlets for the same product brands of more or less the same size like supermarkets department stores, bookstores, and the like In these examples, demand is said to be price elastic: Another factor of substitution is the desirability of a product relative to its substitutes due to quality. In Figure 18, the consumption of Product B decreases from Q; to Q: when its price increases partly because of substitution effeet. If Product B were better, the new indifference curve from reference point A would be the steeper on where less of Product B can be given up for an additional unit of Product A. As a restlt consumption of Product B does not decreas? all the way to Q; but only up to Q:. This inasmuch as less of Product B would be give? up to mateh the additional consumptio? and utility of Product A in the substitute? if it were better and more satisfying: "™* it would be difficult for'a product to lose" market share when its price increas’ quality were its primary selling point aElasticity of Demand and Supply Qa a Q@ Figure 18: Relative Product Importance One example is San Miguel Beer which is the undisputed leader in the beer market despite its higher price because of its exqui- site taste that is unequalled by any other brand. Normally, its demand is said to be price inelastic as price increases. On the other hand, the absence of substi- tutes makes the demand for a product highly price inelastic since it is only income effect that is behind price-demand relationship. Such is the case of a certain kind of drug that is produced under only one brand. Since a sickness cannot be postponed, consumers in need will buy the product even at a much higher price. Finally, the relative importance of con- sumers’ needs determines the degree of substitution between the commodity items in the consumption basket, e.g., essentials and nonessentials. Going back to Figure 18, the steeper indifference curve in broken lines would represent more preference for Product B if it were more important relative to Product A. Likewise, the consumption of Product B would only decrease from Q; to Qs ifits price increases since the more satisfying Product A Product B would be given up to match more consumption of Product A in the substitu- tion. Thus, consumers try to maintain their consumption of rice despite higher prices by paying more for it. ‘A decrease in price would increase earn- ings if demand were price elastic enough to stretch quantity demanded and revenue in order to offset the increase in cost with more quantity produced. Likewise, an increase in price due to higher production cost or cost of business would increase earnings if demand were price inelastic enough to stretch price and revenue in order to offset the said increase in cost. The price inelasticity of demand to maximize revenue and earnings is also true even without a change in cost. Increasing quantity demanded, without changing price highlights the effect of decreasing price and increasing quantity demanded with a very elastic demand on revenue and earnings. Conversely, increasing price without changing quantity demanded highlights the effect of increasing price and decreasing quantity demanded with a very inelastic demand on revenue and earnings. Price Increase Price Decrease Elastic | Decrease Increase Inelastic Increase Decreaseam 50 = rico decreases ‘Thus, revenue increases as price de when the increase in quantity demanded offsets the decrease in price with an elasti- City coefticient of more than one (clastic); The opposite is true when price increases with inelastic demand, To emphasize the point, a seller can imerease earnings with a decrease in prite if the product were substitutable enough 4 pull considerable demand from rival prod- ucts to maximize elasticity and earnings. An example is when retailers of the same rice variety underprice one another in the public market for bigger market shares. On the other hand, a seller can increase earnings with an increase in price if the product were exclusive enough to be sold even at a higher price to maximize earnings. An example is the only grocery in a subdivision, which can increase prices without suffering a decrease in sales volume in the absence of competi- tors in the area, Thus, a change in price and quantity demanded can inerease revenue and earnings depending on the substitutionality of the product. A decrease in price would increase earn- ings if demand were price elastic enough to 'nlroductory Microeconomics stretch quantity demanded and revenue in order to offset the increase in cost with more quantity produced, Likewise, an increase in price due to higher production cost or cost of business would increase earnings ifdemand were price inelastic enough to stretch price and revenue in order to offset the said increase in cost. The price inelasticity of demand to maximize revenue and earnings is also true even without a change in cost. The Tax Burden When a good is sold, a sales tax has to bbe paid to the government on the sale of that commodity. The question on who between the buyer and the seller shoulders the burden is dependent mostly on the degree of elasticity of the demand for that good. Let us take a bottle of soft drink which the government levies a 100% sales tax as an example, If the price per bottle is P5, the consumer has to pay P10 on account of the tax. However, the consumer does not always have to shoulder the entire tax burden by himself, Let us look at the following graph in Figure 19 and study the demand and supply curves of a cola drink. 12 1 10 9 a 8 5 7 Seller's g 6 share <5 4 3 2 1 , 9 400-200» «300 -—400~—=«500 Quantity of Cola Figure 19: Hypothetical Demand and Supply Curves of a Cola Drink with Equal Sharing of Tax Burdentansy of Demand and Supply mes = 12 " 10 9 8 g 8 ‘ a 6 4 3 2 ; { +} 2 100 200 © 300 © 400» 500 Quantity of Cola Figure 20: Hypothetical Demand and Supply Curves of a Cola Drink with a Bigger Tax Burden for the Seller The demand and supply curves for the cola drink are normal sloping curves. On the left side of S, is another curve S,, which rep- resents the supply plus tax curve, showing various after-tax prices that have to be paid by the consumers. Before the government imposes the tax, the market equilibrium is attained at ®7.50 at an equilibrium quantity of 250 bottles; with Ss, the new equilibrium position is at a price of P10 and a quantity of 200 bottles. We can see in Figure 19 that the tax of P5 was shared equally between the buyer and the seller with an equal tax share of 2.50. Let us now take a case when consumers feel that a cola drink is not a necessity, and they can easily forego its consumption if the price gets too high because of a tax burden. In the next graph, we have a demand curve that is highly elastic. In Figure 20, the original equilibrium position is at a price of P8 and a quantity of 400 bottles. With the new supply plus tax curve (S + {) in the graph, a new equilibrium position is attained at the price of ®10 and a quantity of 300. The difference between the old price of P8 and the new price of P10 represents the consumer's share in the tax, which is P2, The remaining 3 of the tax should be shouldered by the seller. ‘The reason why the seller has to shoulder a bigger tax burden in this example is that the demand for the good is highly elastic, as reflected in the highly slanting demand curve in Figure 20. Should the price prove to be too high for the buyer as a result of the tax, he can afford to decrease his consumption of the good, which he considers to be non-essential. However, itis'also possible for a buyer to shoulder a bigger portion of the tax burden. This happens when the buyer cannot do away with the consumption of a good and thus considers it essential. Therefore, in spite of a tax levy that could jack up the price of the good, he would still be willing to buy it and the producer can afford to pass on a bigger portion of the tax to the buyer. This will now be illustrated in the next graph. In Figure 21, we see a relatively inelastic demand curve for the cola drink. From the original equilibrium price of P7, the buyer now pays the price of P10 with the 3 differenceIntroductory Meroecongy, ey am 52 =P on 12 " 0p 8, 9 Buyer's 8 share £, ‘ s. selle’s g 6 share go5 if 4 3 2 1 Oo 100 200 © 300 400 500 Quantity of Cola fa Cola 2 tical Demand and Supply Curves of meat Dari e Bigger ‘Tax Burden for the Buyer representing his share in the tax. Here the _As income increases, a coefficient of: buyer shoulders a bigger share in the P55 1 means demand is elastic and the tax (with only 2 shouldered by the seller) good is superior; since he is unwilling to do away with the consumption of the good despite the tax, and is thus willing to pay a higher price for the , commodity. = Imeans demand is unitary and the - good is normal. <1 means demand is inelastic and the good is inferior; and San ncaY OF DEMANS) Ernest Engel made a study of income The coefficient of income elasticity of elasticity for food. The findings of his study demand measures a product's percentage are depicted in what is now accepted as change in demand as ratio ofthe percentage Engel’s Law. According to Engel, when change in income, which caused the shift in income increases, the, ‘percentage that is spent the demand curve. for food tends to decrease. The resulting AD aD coefficient is less than one because food is 2 D_. D__ ¥.. _ necessity. When income increases, the increase BY is given as = [yor 7" goes mostly to the purchase of luxury items, YY education, travel, and leisure. or simply = 24D. An analysis of income elasticity figures AY is shown in Table 5 on the next page. Where AD represents the change in If elasticity is equal to 1, the share of demand and AY the change in income. the product in the allocation of incremental The absolute value of the coefficient of 9 additional income is equal to its share in income elasticity is also a measure of. how™ the allocation of total income, thus maintain- responsive demand is to change in income, _ ing the product’s importance in the overall consumption basket.Dre Elasticity of Demand and Supply means predeets fe unperlead ar alec, Table 5 Analysis of Income Elasticity Income Elasticity | Degree of Demand ‘Type of Good : astic |__Normal luxury me Normal luxury jastic Inelastic Normal necessity 50 Inelastic Normal necessity sid Inelastie Inferior ze Inelastic Inferior To express in quantitative terms: aD (sc “AY AY) constant S) 2(S) won aera where: (c) CE) = the consumption ofthe produet as a ratio of total income before change aa fc . {| = the consumption of the product 2 as a ratio of total income after change 5 (AC) = incremental consumption of the Y) product for every unit increase in income However, elasticity greater than 1 means that the product gains i ince in the allocation of incremental income > fore, in the allocation of total income as the following relationship illust 8; %&SD AC) aD, (29) nen Conversely, some products lose impor- tance because others do otherwise as income increases. A product of such nature is inferior as its elasticity 1 less than 1 and its share in the allocation of incremental and therefore diminishes in the allocation of total income; The Consumption Line Figure 22 presents a hierarchy of bud- get. lines and indifference curves whicl determines different levels of through the points of tangen: betwee! the two factors, The curve connecting these points of tangency represents the consump- tion of the two commodities (meat. and dried fish) at varying levels of income, otherwise Ymnown as the consumption line. The con- sumption line is upward sloping from the point of origin of the graph. The increase int meat production (Y-axis) accelerates for every unit increase in the consumption of dried fish (X-axis) implying that: For meat: aD D Got LY — ——7— = Dae wi ¥ For dried fish: wad <%sY — 4D |__ D AY Y’ Therefore, meat is superior as its elas- ticity is more than 1; whereas, dried fish is inferior with its elasticity of less than 1. Moreover, meat gains importance in the consumption basket as a substitute for dried fish as income increases. _, It should already be clear at this point that as income increases, some products gain inaportance (superior goods) while some do otherwise (inferior goods) in the consumption basket. Moreover, superior goods will eventu- ally become inferior as income continues to increase to give way to new superior goods.J Introductory Micron a 4 =v . men, Consumption Line 3 = B, B, B, B, Dried Fish . Figure 22; Hierarchy of Budget Lines and Indifference Curves ‘There are two underlying reasons for spending shifts to those commodity items with the change in the relative importance,of commodity items as income continues to Ancrease. One is the gradual satisfaction of the consumer's hietarchy of needs fram the hasir to the non-basic. Thus, a consumer shifts the ‘emphasis of consumption toward shelter ata certain level of income after satisfying, up to some degree, the need for clothing and good. This makes shelter a superior good and the others as inferior goods at the said level of income. On the other hand, a smaller budget can constrain a consumer from consuming goods of better quality due to higher prices and the consumption of which is only possible at a higher level of income. Thus, those who belong to the higher income groups can afford to buy imported shoes and clothing, making these products superior over their local counterparts in their expenditure basket. The other one is the theory of diminishing marginal uilty Uuat fhe comerstoneot fhe concept of income elasticity of demand. ‘The shift in consumption from inferior goods to superior goods as income increases im plies that the marginal utility of the latten is greater than that of the former, ‘Marginal higher marginal utilities due to their relating scarcity, thus making them superior as su stitutes for inferior goods. However, these commodity items will eventually lose thei, superiority as income continues to increase due to the theory of diminishing marginal utility and their individual elasticity wi decrease at most to zero. This is the point of maximum satisfaction and incremental spending shifts instead to the consumption of new and relatively scarce goods. CROSS ELASTICITY OF DEMAND The coefficient of cross elasticity of demand measures the percentage change in the demand of Good X which is a shift of the demand curve in response to a percentage change in the price of Good Y, thus: ~ec may also have a coefficient of greater than one, less than one, or equal to one, indi- cating demand sensitivity.Elasticity of Demand and Supply Goods X and Y may be related in two ways: first as substitutes; and second ascom plements. Ithe coefficient ee is positive, this fneans commodities X and Y are substitutes. ‘An increase in Py will cause consumers to purchase more of Good X, the substitute ood, thus causing Qx to increase. On the other hand, ifee is negative, Goods X and Y are complements and are thus used together. Ifthe price of Y increases, the demand for Y decreases, and hence the demand for X also decreases. Thus, the coefficient of the cross clasticity of demand practically measures the Qa, dy, is relatively inelastic. A change in degree of substitution or complementation price leads toa very slight change in quantity between products, demanded. Table 6 Numeral Example on How to Solve for Elasticity Demand Income Elasticity Original Price _ Quantity Price Quantity Demand for Good X 50 30 Good Y 10 100 15 60 al Let us use the following examples to solve fe for the elasticity of the demand for Good X with respect to the price of Good Y. Solving for ec, we get: eo = 20, 10 a) 5 ec = .80 The negative sign of the coefficient means a Goods X and ¥ complement each other. More- over, the demand for Good X is inelastic to the change in the price of Good Y because the value of the coefficient is less than 1. Demand Curves and Elasticity As a result of the different degrees of clasticity, there are different ways of present- ing the demand curve. d, is relatively elastic. A change in price leads to a significant change in quantity demanded. dy is perfectly elastic. At a given price, quantity demanded can change infinitely. PpSe meno on dys perfectly inelastic. At any price, os Sr is relatively inelastic tity 8 price results in a s\ quantity demanded will remain the same. Qe Price results in asi is equal to zero, ight change hae Be in gy * iy qu Anti, Pp P 8, ch Q PRICE ELASTICITY OF SUPPLY Ifdemand varies in response to a change in its determinants, so does the supply. The coefficient of price elasticity of supply meas- ures the percentage change in the quantity supplied of a commodity compared with a percentage change in the price of such a | commodity The difficulty or ease of increasing or > s, decreasing the supply of goods determines its elasticity. Goods which are relatively easy to manufacture tend to have elastic sup- plies; whereas, goods which are difficult to produce have inelastic supplies. Just as in the | demand curve, the supply curve is elastic if __$, is perfectly elastic. At a given priv, Es> 1; inelastic if Es <1; and unitary elastic quantity supplied remains constant (or @, if Es = 1. Normally, the coefficient of Es is is equal to zero). positive, because of the direct relationship . between price and quantity supplied. a Asa result of the varying degrees of elas- ticity of supply, the following supply curves are also possible. Ssi ly inelastic. At quantity supplied may change Pp @ given pri ic, infinitely Q S, is relatively elastic. A change in price results in a significant change in quantity supplied. P Ss, a PROJECTING THE FUTURE Important decisions about what and how many goods to produce depend very much | on the entrepreneur's estimate of future | demand. Ifthe entrepreneur produces nu" a more than what is demanded, he would hav’ | | 4tostiity of Demand and Supply an inventory in his hand. If this inventory jemuch more than what is necessary, it be- comes an additional cost in the form of money {ied up with too much inventory, in addition to storage and spoilage costs. However, if the entrepreneur produces much less than vhat is demanded, he would be missing out jn what could have been additional profits earned. Thus, it is very important that the entrepreneur knows forecasting techniques. ‘There are different methods of making a forecast. Let us use two methods. The simplest way is the use of the average arith- metical growth rate method. Another way ig a more sophisticated statistical method called regression analysis or the least squares regression method. 1. Average Arithmetical Growth Rate Method ‘The computation of this method is car- ried out by getting the percentage change between two values which is simply the ratio of the change between two years expressed inpercentage form. The average growth rate js then computed by getting the sum of the percentage changes divided by the number of period covered. Let us try this method by looking at historical sales figures shown in the following table: a 57 Td ‘Average Growth Rate = 58 21.96% Projected Values 2005: P52.7 x 21.96% = 11.57 +52.70 P64.27M 2006: P64.27 x 21.96% = 14.11 + 64.27 P78.38M 2, Trend Line Using the Least Squares Regression Method ‘This method uses statistical tools and monly used method of com- trend of a time series. The Teast squares regression method, as the name implies, fits a trend line to the date in a man- her such that the sum of squared deviations sractual data from estimated or trend data at ‘minimum. On these grounds, the resulting trend line can be characterized as a “line of pest fit” since the sum of the square devia- tions is at a minimum. The trend values thus best approximate the actual values. is the most com puting long-term ‘The equation for the straight line trend is Y, = a + by where X is the independent variable. Since their values must be deter- Table 7 r i : : Historical Sales Figure of Company X vee in en of tp ation analy zed, a and Tor 1996-2004" are referred to as unknowns. They are also nd called constants because once their values %Growth | are determined, they do not change. Year Sales Rate Let us illustrate this method by using 1996 23.2M = the same data in Table 7. Our straight line 1997 2d 39 trend equation is: 1998 40.3 67.22 Y,=a+bx 1999 30.2 (25.06) where: 2000 35.8 18.54 bY XY 2001 15.6 (66.42) N’ =x? 2002 24,9 59.62 Going back to the aforementioned equa- 2003 25.8 3.61 tion, we can now substitute our values based 004 52.7 704.26 on the table, thus: 175.67% Y, a4 bxIntroductory Micog, Oh a 58 =" Our trend equation is: ‘Table 8 cee Historical Sales Figure of company X Y, = 30.29 + 1.30X for 1996-2004 We can now compute our fore a 2005 and 2006. Since the last year in Table 8 is given an X value of 4.0%; 9 values for 2005 and 2006 should be 5 ‘the x 9 | respectively. Our for endl 4 | would then be completed, thus 2 1 0 Yogs = 30.29 + 1.3005) 1 = 30.29 + 6.60 : = 36.79 9 16 Yong = 30.29 + 1.30(6) = 30.29 + 7.80 e = 38.9 After all these computations, we cay graph our actual sales, the trend line, ang the projections in the following figure: fi Crt SE-EFHH4 =a se HHH} Figure 23: Sales Figure of Company X in Graphical Form Oerostoty of Domand and Supply case STUDY 1 P155B Projected from “Sin Taxes” “The national government h expects to ear 9154.73 billion in additional revenues from 3013 to 2016 if Congre ‘gin tax’ system this Finance (DOF) said Data from the finance department showed that once Congress approved a new excise tax mon *sin products” this year, the govern- ment could easily earn 31.35 in additional revenue next year, from approved a new the Department of Of the amount, the DOF expects 26.87 Billion revenwe from cigarettes, another P3.03 Billion from fermented liquor, and the re- maining 1.45 billion from distilled spirits. By 2014, state revenues from sin prod- ucts would increase to 39.02 billion. Of the amount, 34.72 billion will be contributed by tobacco companies, 2.52 billion from fermented liquor, and P1.78 billion from distilled spirits. Government income from excise tax is expected to further rise come 2015 as it is expected to generate an additional P42.68 billion revenues. The DOF estimated that smokers will ‘pay °36.27 billion in excise tax, while revenue from fermented liquor will grow to 3.79 billion and 2.62 billion would come from distilled spirits. ‘Meanwhile, the DOF projected that state revenues from sin product to decline in 2016 to P41.51 billion. Of the amount, the government sees 35,38 billion in taxes from cigarettes, P3.03 Billion from distilled spirits, and 3.1 billion from fermented liquor. With the new excise tax system, the gov- emment expects its efficiency in collecting taxes would likewise improve, putting the country in better position to its goal of attain- ing investment grade. Tax effort, used to gauge efficiency of tax collection, is computed as a percent of the country’s gross domestic product. mae 59 = To manifest efficiency in tax collection, a government should be able to increase the ‘amount of taxes it collects every time income Tevels grow Data from the finance department showed that the country’s tax effort has been in a declining trend from 14.1 percent in 1998, ‘adding on worries of the three international credit rating firms and investors. Inaneffort to further improve the govern- ment tax efficiency, the finance department is pushing forthe restructured excise tax regime tnd rationalization of fiscal incentives. London-based Fitch Ratings earlier said that the Philippines’ low revenue base is the country’s key weakness in the sovereign credit profile, suggesting the need for a structural reform rather than just administrative meas- ures. Fitch cited the proposed reforms to the so-called “sin taxes” on alcohol and tobacco products as a measure that would enhance the government's revenue sources. Source: Chino S. Leyeo Rights reserved, courtesy of Manila Bulletin Publishing Corporation, August 21, 2012 Questions: 1. Is the proposed sin tax progressive or regressive? Who will be burdened most? Why? 2. Will there be substitution between brands? Why? CASE STUDY 2 Luxury Vehicle Sales Decline 30% MANILA, Philippines — Sales of luxury uehicles in the first quarter dropped by a steep 30 percent as buyers, mostly upwardly mobile middle class, have become extra careful not to attract the overzealous eyes of the Bureau of Internal Revenue (BIR). An official from one of the luxury car ‘companies in the country said three luxury car brands -BMW, Mercedes Benz, and Lexusi 60 =» ry rch ~only sold 264 units in the January ae Period this 30 percent lower than same od last year “Because of the heightened campais Of the BIR, bre grail especially that most of our buyers arv middle-class business men, who can now afford to upgrade their lifestyle,” the source said. Even the corporate clients and legitimate businessmen have shelved their plans to buy luxury vehicles on apprehension they could Face undue scrutiny from this tax agency. Of the three luxury models, the biggest decrease was registered by Mercedes Benz with 40 percent negative growth. German vehicle brand, BMW, posted the highest sales but declined by 37 percent, while Lexus posted a modest 2 percent decrease. Lexus sold a total of 75 units and is eyeing to sell a total of at least 300 units this year from 264 units last year. Lexus Manila is set to introduce major model changes this year including its best selling RX, which is selling for P1.3 million. Meantime, the hybrid models of Lexus have not really picked up as hybrids still account for a very small portion of total industry sales. Lexus hybrid models have sold only 50 units so far. Its hybrid cars are GT 200, GS450H, RX450H, LS600H with GT model. accounting for 40 percent of sales, being the most afford- able at P2.3 million to P2.8 million. There have been a good number of hybrid vehicle brands in the country but only Toyota has full hybrid models, the others are “mild” hybrid brands. “We need to educate the market because hybrid is still a little percentage of vehicle sales,” an official said. Aside from the lack of awareness, the price of hybrid vehicles has remained very Introductory Micro omy prohibitive because of the huge tay buy imposed on these imported cars, ‘dey The robust sales of hybrid vehier, the US, Malaysia, and Singapore hays largely attributed to the duty-tax treqypt and other perks given to these vehiajaa™® 8 in For instance, a Lexus car in the Us», sell for $200,000 with all the taxes buy gil up only at $100,000 a unit because ,. l, OF the removal of taxes. th “In the Philippines, hybrid vehicles gy, slapped with import duty, excise ta, va, gt sales tax and 4 percent municipal ta, Without these taxes, a P2.3-million hy, brid could sell at considerably lower Price P16 million. jernie Cahiles-Magkilat, Rights reserved, courtesy of Manila Bulletin Publishing Corporation, May 2, 2012, 2:16 a.m. Source: Questions: 1. Is the demand for luxury cars elastic or inelastic? Explain and illustrate. What factors influence this elasticity? Is specific tax a better alternative to raise tax revenue? Explain. SUMMARY Price elasticity of demand is the degree of responsiveness of quantity demanded toa change in price. It is measured by dividing the percentage change in. quantity demanded by the percentage change in price. ‘Two Measures of Price Elasticity 1, Arcelasticity is the coefficient of the price elasticity of demand between two points along the demand curve. 2. Point elasticity is the elasticity at one point along the demand curve.pom nastiity of Demand and Supply Comparison between Elastic, Inelastic, and Unitary Elasticity Elastic Inelastic Unitary Percentage change in quantity is higher than the percentage change in price. Percentage change in quantity is lesser than change in price. * Quantity is proportionate with change in price. Elastic coefficient is more than 1 than 1 Elastic coefficient is less Elastic coefficient is, equal to 1. Substitution has 3 factors: 1, The number of competing products; 2. Desirability of a product relative to its substitutes due to quality; and 3. Relative importance of consumer's needs. Consumption line is the curve connect- ing the points of tangency that represent the consumption of any two given commodities at varying levels of income. Income elasticity of demand measures a product’s percentage change in demand as a ratio of the percentage change in income, which causes the shift in the demand curve. Engels Law states that when income increases, the percentage that is spent for food tends to decrease. Underlying reasons for the change in the relative importance of the commodity items as income continues to increase: 1. Gradual satisfaction of the consumer's hierarchy of needs from the basic to the non-basie; and 2. Theory of diminishing marginal utility. ‘Two Methods in Making a Forecast 1. Average arithmetical growth rate me- thod; and 2, Trend line using the least squares reg- ression method.