What this lesson teaches
I can explain how price elasticities of demand and supply change the effect of an intervention.
Syllabus 8843, 2.1.3(c). Government Intervention in Markets: Impact of government intervention on markets may be affected by price elasticities of demand and supply
Make a guess
The same tax is put on two goods. Demand for good A is very inelastic; demand for good B is elastic. Which tax cuts consumption more?
- The tax on good B.
- The tax on good A.
- Both cut consumption equally.
Show the answer
The tax on good B.
With elastic demand, buyers switch away when the price rises, so quantity falls a lot. Inelastic demand barely responds.
The same tax cuts consumption a lot when demand is elastic, and very little when it is inelastic.
When a tax raises the price, how much people cut back depends on price elasticity of demand (PED).
If demand is price inelastic, as with cigarettes for addicted smokers, quantity falls only a little. The tax raises a lot of revenue but does little to cut consumption.
If demand is price elastic, quantity falls a lot. The tax discourages consumption well but raises less revenue.
Supply matters too. A subsidy meant to increase output works slowly if supply is price inelastic, for example when new nurses take years to train. Elasticity is usually greater in the long run.
- Inelastic demand
- Tax raises revenue, cuts consumption a little.
- Elastic demand
- Tax cuts consumption a lot, raises less revenue.
- Long run
- Responses are usually larger.
What elasticity tells you about each tool
Tax
Inelastic demand: good for revenue, weak at cutting consumption.
Subsidy
Inelastic supply: output responds slowly, so more of the subsidy shows up as higher producer receipts.
Controls
More elastic demand and supply mean a bigger shortage or surplus.
Worked example: Two markets, the same tax
A tax raises the price from $10 to $11 in two markets. In market A, sales fall from 100 to 98. In market B, they fall from 100 to 85.
- The price rises 10% in both.
- Market A: quantity falls 2%, so PED = -2 / 10 = -0.2 (inelastic).
- Market B: quantity falls 15%, so PED = -15 / 10 = -1.5 (elastic).
- If the aim is to cut consumption, the tax works much better in market B.
Watch out for this
A tax only works if people stop buying the good.
It depends on the aim. If the aim is revenue, inelastic demand is ideal. If the aim is to cut consumption, elastic demand is needed.
Check your understanding
The government wants to cut smoking. Demand for cigarettes is very price inelastic. What is the likely effect of a higher cigarette tax?
- A large fall in smoking and a fall in tax revenue.
- A large rise in tax revenue but only a small fall in smoking.
- No change at all, because demand is inelastic.
Show the answer
A large rise in tax revenue but only a small fall in smoking.
Right. Smokers cut back only a little, so most of the tax is collected on continued sales.