From Watts, Michael, et al. "Focus: High School Economics." National Council on Economic Education, 1996. p.61
The law of demand states that as the price of a product increases, the quantity demanded decreases. Conversely, as price decreases, the quantity demanded increases. But that still leaves an important question: Will consumers purchase a great deal more or less when the price decreases or increases, respectively, or only a little more or a little less? Price elasticity of demand is a measure of consumers' responsiveness to price changes. Understanding price elasticity of demand helps us see more fully how businesses make pricing decisions and what governments must consider as they make decisions about taxing a particular product.
Economists describe the demand schedules for various goods and services as inelastic if the quantity responses to a change in price are relatively small compared to the change in price. If the quantity responses are relatively large, demand is described as elastic.
Demand for products that have few close substitutes and that make up a small part of the consumer's budget tends to be inelastic. Demand for products with many close substitutes and those that represent a large part of consumers' total budgets tends to be elastic.
Demand is typically more elastic in the long run than in the short run.
We can use a simple test to determine whether demand for a good is elastic or inelastic at a particular price. The total revenue test works as follows:
1. Calculate the total revenue for a good at a price:
b. If total revenue moves in the same direction as quantity or inversely to price, demand is price elastic.
c. If total revenue remains the same as price increases, the demand is unit elastic.
Suppose that when the price of bread is a dollar per loaf, the Iwasa family buys six loaves of bread in a week. Determine if the demand for bread is elastic or inelastic when the price per loaf changes in the following interactivity.
Given supply, the more inelastic the demand for the product, the larger the portion of the tax shifted forward to consumers.
Revenue-seeking legislatures place heavy excise taxes on liquor, cigarettes, automobile tires, and other products whose demand is inelastic.
Given demand, the more inelastic the supply, the larger the portion of the tax borne by producers. Gold is an example of a product for which supply is inelastic and therefore for which the burden of an excise tax would fall mainly on producers. On the other hand, because the supply of baseballs is elastic, much of an excise tax on this product would get passed forward to consumers.
Take a look at the
products and their elasticity coefficients. Which of the following is likely
to pass the cost of a tax to consumers? to producers? (Hint: Price elasticity
of demand <1 = inelastic; price elasticity of demand >1 = elastic.)