Case study analysis: The elasticity of demand for luxuries | Microeconomics | Trường Đại học Quốc tế, Đại học Quốc gia Thành phố Hồ Chí Minh

Group 6 – EBBA 16.2
Group assignment presentation 4: Case STUDY ANALYSIS
The Surprising Elasticity of Demand for Luxuries
1. How can you use the theory of "Supply, Demand- and elasticity " to
explain the case (by using graphs)? -
When the Congress imposed the 10% tax on luxury goods, the producers
reacted to the cost increase created by the tax by trying to increase prices to cover this new cost
-> The Supply curve shifted up to the left 1.1.
Case 01 - Assumption: The demand for luxury products is inelastic
 The government assumed that the demand for big-ticket items was
relatively inelastic, which meant that:
- the supply curve shifted up with a larger rise in equilibrium price and a
relatively small fall in equilibrium quantity
 In this case, the demand curve showed that the wealthy were willing
to pay for the extra cost in the price of luxury goods and bore a higher
percentage of tax. The tax raised the price of goods, leading to an
increase in total revenue. That resulted in a reduction in the US Budget deficit.  Tax incidence:
- The rich people who do not respond dramatically when there is a change in
price would pay most of the tax
-> The consumer's tax incidence is greater than the producer's (P1 - PE > PE - P2)
- The wedge between a and b in the demand curve/ the vertical distance at
the y-axis between these two Supply curves is the 10% tax
 Total consumer surplus at price P1: the max price that consumers
are willing to pay minus the price paid (P1)
 Total producer surplus at price P2: The left revenue producers
obtain after paying the tax to the authority (P2)
 Deadweight Loss: The total loss of producer and consumer surplus from underproduction 1.2.
Reality: The demand for luxury products is elastic
 In fact, the demand for such big-ticket items was reasonable elastic,
- In this case, the graph illustrated that the upward shift in the supply
curve would lead to a much smaller rise in equilibrium price and a
lager fall in equilibrium quantity.
- Main reason (for this demand elasticity): The increased cost from the
tax caused an increase in the price of the products, making customers
to shift away from their original purchase (the wealthy were unwilling
to pay for the extra cost) -> then they moved to buy substitute
products in order to avoid paying the high tax.
 As a consequence, The quantity demanded dropped
dramatically, leading to the drop in total revenue. For example,
sale of pleasure boats also fell by nearly 90% in South Florida,
as prospective buyers bought the substitution - boats in the
Bahamas to not to pay the extra cost.
 Therefore, that resulted in the fact that the luxury tax raised far
less money than had been expected. The Congressional Budget
Office had forecast that the tax would raise about $1.5 billion
over five years (300m/ year). But in the first year, it raised only
about $ 20 million. Once the costs of setting up and enforcing
the new tax were considered, it probably lost money for the Government in its first year.  Tax incidence:
- The producer had to suffer from a higher rate of luxury tax than the rich.
 The producer's tax incidence is greater than the consumer’s (PE – P2 > P1 - PE )
 In result, rather than falling on the wealthy as had been hoped,
the burden of the new luxury tax actually ended up falling on
the workers and retailers who manufacture and sell these luxury items (middle class)
- The wedge between a and b in the demand curve/ the vertical distance at
the y-axis between these two Supply curves is the 10% tax
 Total consumer surplus at price P1: the max price that consumers
are willing to pay minus the price paid (P1)
 Total producer surplus at price P2: The left revenue producers
obtain after paying the tax to the authority (P2)
 Deadweight Loss: The total loss of producer and consumer surplus from underproduction
2. What is implication for the Government in the tax policy ?
“If the demand for these luxury goods was reasonably elastic, however, then the
upward shift in the supply curve would lead to a much smaller rise in equilibrium
price and a larger fall in equilibrium quantity. As it happened, sale of pleasure
boats fell by nearly 90% in South Florida, as prospective buyers bought boats in
the Bahamas to avoid paying the tax. Sales of high-price cars like Mercedes and
Lexus also fell substantially when their customers moved to buy substitution products.”
*To avoid paying tax, buyers had done:
- buying goods in other places where the price weren’t affected by the luxury tax
- buying substitution products => the fall in the sales of luxury goods
For those reasons, there were some negative consequences including: 
When the taxes are high, businesses will find ways to deal with them,
one of which is to reduce worker’s wages and increase export prices
for retailers. Thus, the people who subject to this tax are workers and
retailers instead of the wealth => this is the wrong direction 
high taxes will lead to a decrease in supply so the government loses.
This is because too high taxes lead to some cases of tax evasion so
the government have to spend money to make up for the loses
*To fix this, the policy tax should be change as: 
Lower tax collection or before taxation must be tested in some places to see as if it is positive 
Anti tax evasion and anti dumping 
raising the import duty to prevent consumers from buying the
substitution products with lower or no taxes 
setting import quota on certain luxury goods to benefit local producers and workers
=> All these alternatives are supposed to prevent the wealth from
buying things without paying taxes; pressing the workers and retailers who
are mostly in the middle class and losing money on the government’s budget.