Economics – Classification of goods and services | e-Consult
Classification of goods and services (1 questions)
Diagram:
A standard supply and demand diagram can be used. The demand curve for a demerit good will be relatively elastic (sensitive to price changes) due to the availability of substitutes and the potential for consumers to reduce consumption. The supply curve is typically relatively inelastic. The market equilibrium will result in a quantity traded that is greater than the socially optimal quantity. The difference between the socially optimal quantity and the market equilibrium quantity represents the deadweight loss.
Price Mechanism (Tax):
A tax on the demerit good shifts the supply curve to the left. This increases the price paid by consumers and decreases the quantity consumed. The tax revenue generated can be used to compensate for the deadweight loss and improve social welfare.
Diagram of Tax Impact:
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| Diagram Description: |
| The diagram shows a standard supply and demand curve for cigarettes. The initial equilibrium point is E1, with price P1 and quantity Q1. A tax is imposed on cigarettes, shifting the supply curve to the left to S1. The new equilibrium point is E2, with a higher price P2 and a lower quantity Q2. The area between E1 and E2 represents the tax revenue. The deadweight loss is the triangle formed by the difference between Q1 and Q2 and the price difference P1-P2. |
Improvement in Social Welfare:
- Reduced Consumption: The higher price discourages consumption, leading to a reduction in the negative externalities.
- Increased Tax Revenue: The tax revenue can be used to fund public health initiatives or other programs to mitigate the negative effects of the demerit good.
- Internalizing Externalities: The tax effectively internalizes the external costs of the demerit good, making consumers bear a greater share of the total cost.