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Elasticity of Demand and Taxation..

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Suppose a local coffee shop knows that its elasticity of demand is 0.2. Would you recommend that the coffee shop increase its price by 20%? Why or why not?

Suppose a cigarette manufacturer knows that its elasticity of demand is 1.3. Would you recommend that they raise price by 20%? Why or why not?
Would government be better off taxing gasoline or Nike tennis shoes? Use the concept of elasticity (or inelasticity) of demand to defend your choice
Define the following:

a. Consumer surplus

b. Producer surplus

c. Total welfare

d. Deadweight loss

Refer to Slide 18 in the Attend section. Explain the effects of a tax on consumer and producer surplus. Explain what happens to total welfare when government levies a per-unit tax on a good. Use the concept of deadweight loss in your explanation

What are the two characteristics that must be met for a good to be considered a "public good?" Give an example of the "free rider" problem and explain why the good or service is subject to this problem

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Solution Summary

This answer looks at basic effects of elasticity on quantity demanded. It also looks at taxation and its effects on producer surplus, consumer surplus, and deadweight loss. The end of the answer also addresses public goods and the free rider problem with examples.

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Before addressing this question, here are a few things that help when looking at elasticities:
For price elasticity of demand/elasticity of demand--
If it is less than one, it is inelastic.
If it is greater than one, it is elastic.
If it is zero (0) [often a horizontal curve], it is perfectly inelastic.
If it is infinite (∞) [often a vertical curve], it is perfectly elastic.

Suppose a local coffee shop knows that its elasticity of demand is 0.2. Would you recommend that the coffee shop increase its price by 20%? Why or why not?
Since the demand is less than zero, this is fairly inelastic demand. This means that quantity demanded won't be affected much by changes in price. knowing this to be the case, I would suggest increasing price because while there will be some decrease in quantity demanded, it will be more than offset by the larger profits earned by the quantity demanded remaining.

Suppose a cigarette manufacturer knows that its elasticity of demand is 1.3. Would you recommend that they raise price by 20%? Why or why not?
In this situation, since the elasticity is greater than 1, I know that the demand for this product is pretty elastic. That tells me that percent changes in price will be smaller than percentage changes in quantity demanded. Another way to think of this is that changes in price will cause larger changes in quantity demanded. Here the change would be a decrease in quantity demanded due to the increase in price as price and quantity demanded generally have an inverse relationship.

Would government be better off taxing gasoline or Nike tennis shoes? Use the concept of elasticity (or inelasticity) of ...

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