Indicate how an understanding of demand and of elasticity of demand is useful in analysing the following statement.
“If total consumer expenditure remains the same after a new tax is imposed on cigarettes then spending on cigarettes will decrease and spending on other goods will increase.”
To analyze the given statement, an understanding of demand and elasticity of demand is crucial.
Demand refers to the quantity of a product or service that consumers are willing and able to purchase at a specific price and time. It depends on various factors such as price, income, preferences, and availability.
Elasticity of demand measures the responsiveness of quantity demanded to a change in price. It helps to determine how sensitive consumers are to price changes. If demand is elastic, a small change in price will lead to a large change in quantity demanded. If demand is inelastic, a change in price will result in a proportionately smaller change in quantity demanded.
Now, let's break down the given statement and see how demand and elasticity play a role:
"If total consumer expenditure remains the same after a new tax is imposed on cigarettes..."
In this part, understanding demand is useful to analyze the impact of the tax on cigarette consumption. If demand for cigarettes is inelastic, meaning that consumers are less responsive to price changes, the tax may cause only a small decrease in cigarette consumption and therefore maintain total consumer expenditure. If demand for cigarettes is elastic, the tax could result in a significant decrease in consumption and a decrease in total consumer expenditure.
"...then spending on cigarettes will decrease and spending on other goods will increase."
Here, understanding elasticity of demand is key. If demand for cigarettes is inelastic, a decrease in consumption due to the tax will result in a smaller decrease in expenditure on cigarettes compared to the decrease in quantity demanded. As a result, consumers may have more disposable income, leading to an increase in their spending on other goods. Conversely, if demand for cigarettes is elastic, a decrease in consumption will result in a larger decrease in expenditure on cigarettes, potentially leaving consumers with less disposable income and a smaller increase in spending on other goods.
In summary, an understanding of demand helps us evaluate whether the tax will impact consumer expenditure, while elasticity of demand helps us assess the magnitude of the impact on both cigarette expenditure and expenditure on other goods.