Question

a. Suppose that government would like to maximize tax revenue. Explain why it may not be a good idea for the government to lower tax rates for the goods that have very low price elasticities of demand (less than one).

b. Suppose that the government wants to maximize tax revenue. Explain why it may be not a good idea for the government to raise tax rates for a good with a price elasticity of demand more than one.

c. Use a demand/supply diagram to discuss why producers for luxury goods may benefit from a technological improvement in producing the goods.

Answer 1

When goods have price elasticity of less than 1 the increase in price by one unit causes a one unit decrease in demand and thus lowering taxes will cause the overall recenues to fall due to already high prices paid causing low consumption and hence low government tax revenues.

Similarly when price elasticity of good is more than 1, the increase in prices by one unit causes the demand to rise by one unit. Hence when government raises taxes the overall net effective prices will rise causing consumptions to fall and hence the government tax revenues will decline again.

Producers from luxury goods benefit from technology improvements as their overall costs come down due to newer technologies and the excitement to purchase increases. For example, with advent of AI based processors the cost of making luxurious smartphone has halved and the consumption has doubled as it has high elasticity of demand. This makes consumers well off with dounle win situation of low cost and high demand ultimately giving higher revenues in topline and bottomline.

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