Chapter 6: Applications of Rational Choice and Demand Theories

Why is pricing public transport difficult?

Trade off betw:

1. Low fare:

• Increase use of PT → reduce traffic, pollution

• Accessible/affordable for low income citizens (w no car access)

2. High fare:

• Increase revenue (cover costs)

• Expensive to maintain

• Most consumers are well-off

Why might passenger numbers rise despite a fare increase?

Other factors may increase demand

• Shift DC right

Why is PED greater in the LR than SR? (more elastic)

More time to find subs

Why might governments subsidise public transport?

To

• Improve mobility

• Reduce inequality (more affordable for low income citizens)

• Reduce congestion

• Reduce emissions

What is the main trade-off of cheaper public transport?

Greater accessibility vs lost gov revenue

How to calculate % change in QD

PED x % change in price

What can PED help predict?

Changes in QD after a price change

• Which can be used to estimate gain / loss in revenue after a price change

Why do we need PED for different consumer groups?

PED differs betw consumer groups → avg PED = misleading + hides differences betw groups

• Eg need to know if low income residents will acc increase PT use if prices fall (ie have elastic demand)

Normative judgement abt public transport

Policymakers must decide whether the social benefits of cheaper transport justify the financial cost.

• A value-based judgement about whether a policy is desirable

Are people living in the suburbs proportionally more or less likely to be in poverty?

More

Purpose of very very low fares for public transport

Help people in poverty afford PT / increase mobility + reduced CO2 emissions

• Redistributive policy from those with high → low incomes

Pros + cons of redistributive policies (ie very low PT fares)

Benefit	Cost
Greater mobility for poorer households	Lower government revenue
Reduced inequality	Financial pressure on public transport
Reduced congestion and emissions

What does an inelastic PED imply for a fare increase?

• Proportionately smaller fall in QD

• Decrease in gov rev

Sin tax

A tax on goods considered harmful to individuals or society

• Eg sugary drinks, alc, tobacco

• Eg sugar tax

Aim of sin taxes

Increase price → consumers switch to healthier subs:

1. Discourage consumption of harmful goods

2. Improve health

What is needed to analyse the effect of a sin tax?

PED

Effect of sin tax

Sin tax = increase price

1. Elastic demand: larger reduction in consumption, less revenue (preffered)

2. Inelastic demand: smaller reduction in consumption, more tax revenue

For sin taxes, would gov prefer reduction in consumption or increase revenue?

Reduction in consumption

• Bc main aim is to change behaviour (not max gov rex)

Why is an elastic PED desirable?

• Consumers respond strongly to higher prices,

• Greater reduction of consumption of harmful goods

Cons of sin tax

Regressive

Regressive tax

Disproportionately affects lower income households

• Takes larger proportion of income from poorer than richer households

Why are sin taxes potentially regressive?

• Poorer households spend a larger proportion of their income on goods like sugary drinks.

• → price increases affect them disproportionately

When might a regressive sin tax still be justified?

If reduced consumption produces sufficient health benefits.

• Inelastic demand: poor consumers pay more but consumption is barely reduced. Tax is HARMFUL

• Elastic demand: pay more but consumption decreases significantly → improves health. Tax is BENEFICIAL

What does the argument for regressive sin taxes not neccessairily being bad assume?

1. Low income consumers have elastic demand (not js avg consumers)

2. Consumers may underestimate the LT health consequences of their consumption

For addictive goods, is the substitution effect small or large?

Small

Why might heavy drinkers have inelastic demand?

• They drink bc it is a habit (addictive)

• So small substitution effect

What are the two effects of an alcohol price increase?

• Income effect

• Substitution effect

Explain the 2 effects of a price increase on alcohol (alc tax)

1. Substitution effect

• Alc becomes relatively more expensive.

• Consumers substitute towards other goods.

• Expected to be small for heavy drinkers because of habitual consumption.

2. Income effect

• Higher alcohol prices reduce consumers' real purchasing power.

• Heavy drinkers often spend a large proportion of their income on alcohol.

• Their incomes also tend to be lower than average.

• Therefore, the income effect can be substantial, forcing them to reduce consumption.

Evidence:

• Estimated PED for heavy drinkers = −0.3.

• This suggests demand is relatively inelastic.

• Alcohol taxes reduce overall consumption, but heavy drinkers bear a disproportionate financial burden.

Why can the income effect be large for heavy drinkers?

Heavy drinkers:

1. Drink lots of alc = expensive = large budget share

2. Tend to have smaller incomes = alc takes up larger proportion of income

• So substantial alc tax can decrease consumption

Why can heavy drinkers have elastic demand in the long run (if price of alc increases)?

1. Small / no substitution effect bc addictive

2. But large income effect bc alc takes up large portion of income + lower incomes

Pros of alcohol tax

Reduce alc consumption of heavy drinkers → reduce problems asociated w alc abuse (improve health)

Cons of alcohol tax

Demand tends to be inelastic (bc addictive) (SE>IE)

• So won’t significantly reduce consumption

Would a small tax on alcohol be a good policy (ie effective)?

No

Small vs large alcohol tax

Small tax	Large tax
May affect moderate drinkers	More likely to affect heavy drinkers
Little effect on heavy drinkers	Could reduce excessive drinking
May be ineffective	Also places a larger burden on moderate drinkers

What do policy decisions involve?

1. Economic calculations

2. Trade-offss

3. Normative judgements