This paper will discuss the concept of elasticity and how a government tax on a product -- in this instance, cigarettes -- can affect the business firm in terms of how much a specific tax on cigarette can be shifted to the buyer and how much has to be absorbed.
Price elasticity (Ep) of demand is the ratio of the percentage change in quantity to the percentage change in the price of a product or service, all other things remaining unchanged. Algebraically, this is expressed as follows:
where P and Q are the price and quantity, respectively. This formula assumes point elasticity instead of an arc price elasticity for simplicity sake, as our objective of understanding the concept of elasticity can be sufficiently served by this simple assumption.
Price elasticity measures how responsive the sales would be in relation to changes in price. Products and services inherently have different price elasticities, so that managerial decisions on expansion or reduction of output would depend to an important degree on how accurate are the determination of such elasticities. At the outset, we may consider the benchmark elasticity = 1 as indicating that a percentage change in price is just equaled by the same percentage change in quantity demanded. Where demand is somewhat less responsive to changes in price, we can say that demand is relatively inelastic -- that is to say, a percentage increase in price triggers a lower percentage change in quantity demanded. Demand is relatively elastic when a change in price causes a larger percentage change in quantity demanded. A vertical demand curve denotes perfectly inelastic demand with an Ep of 0, whereas a perfectly elastic demand would be a horizontal demand curve with an Ep of infinity ( ∞).
An important elasticity criterion is whether a good is a necessity or a luxury. A necessity has an inelastic or relatively inelastic demand curve. A good that is inessential (or a luxury) has a relatively elastic demand curve;