🛒 Inelastic demand
Customers need the good and keep buying. Sellers can pass almost all the tax on in a higher price. Consumers bear most of the burden. Quantity falls only a little, so the government collects a lot of tax revenue.
Elasticity » Why Elasticity Matters to Business and Government
What you'll learn this session
Study time: 30 minutes
Edexcel spec: 1.1.4 (s)
- Why PED decides who pays most of an indirect tax, and how much tax the government collects
- How PED changes the effect of a subsidy
- How businesses and governments use YED to plan for changes in income
- How to write a clear Paper 1 answer on elasticity and tax
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Unlock This CourseWhy does elasticity matter?
So far you have learned how to calculate PED and YED and how to read the numbers. Now comes the big question: so what? Businesses and governments make real decisions about prices, taxes and spending. Elasticity helps them guess what will happen before they decide.
This topic is examined on Paper 1 (Microeconomics and Business Economics), as part of section 1.1.4. The spec asks you to explain the importance of PED and YED to businesses and the government in two areas: indirect taxes and subsidies, and changes in income.
Key terms:
- Tax burden: the share of a tax that is paid by a group. It is shared between consumers (who pay a higher price) and producers (who keep less of each sale).
- Tax revenue: the money the government collects from a tax. For an indirect tax charged per unit, it is the tax per unit multiplied by the quantity sold.
Indirect taxes and PED
Demand for cigarettes is price inelastic, so taxing them raises lots of revenue for the government
An indirect tax raises the cost of supplying a good. The supply curve shifts to the left, so the price rises and the quantity sold falls. But how much does the price rise, and how much does the quantity fall? That depends on PED.
🛍 Elastic demand
Customers can easily go without or switch. If sellers raise the price, many customers leave, so sellers must absorb most of the tax. Producers bear most of the burden. Quantity falls a lot, so the government collects less tax revenue.
Worked example
The government charges a tax of 50p per unit on two goods. Each sold 10,000 units a week before the tax.
| Good | PED | Price before | Price after | Units sold after |
|---|---|---|---|---|
| Rice | Inelastic | £2.00 | £2.45 | 9,500 |
| Designer sunglasses | Elastic | £20.00 | £20.10 | 5,000 |
Rice: consumers pay 45p more (£2.45 − £2.00), so they bear 45p of the 50p tax. The seller keeps £2.45 − 50p = £1.95, which is only 5p less than before. Tax revenue = 50p × 9,500 = £4,750.
Sunglasses: consumers pay only 10p more, so sellers bear 40p of the 50p tax. Tax revenue = 50p × 5,000 = £2,500.
The same tax raises almost twice as much money from the good with inelastic demand.
This is why governments often put indirect taxes on goods such as fuel, alcohol and tobacco, where demand is fairly inelastic. The tax raises a lot of money. Businesses use the idea too: a firm selling a good with elastic demand will fear a new tax, because it may have to cut its own profit margin or lose many customers.
Whether taxes are a good way to deal with harm to society is a different question, covered in Government Policies for Externalities. Here we focus only on how PED affects the burden and the revenue.
Subsidies and PED
A subsidy lowers the cost of supplying a good, so the supply curve shifts to the right. The price falls and the quantity sold rises. Again, PED decides the size of each effect.
- Inelastic demand: the price falls a lot, but the quantity rises only a little. Consumers gain mostly through cheaper prices.
- Elastic demand: the price falls by less, but the quantity rises a lot. The subsidy is very good at getting more of the good bought and made.
The government pays the subsidy on every unit sold, so the total cost = subsidy per unit × quantity sold. With elastic demand, more units are sold, so the cost to the government is higher. A government that wants to boost sales of a good, for example public transport tickets, gets the biggest rise in quantity if demand is elastic.
Changes in income and YED
Car dealers plan for changes in income: demand for new cars rises strongly when people earn more
YED tells us how demand reacts when incomes rise or fall. Incomes change during booms and recessions, so YED helps with planning.
📈 For businesses
A firm selling luxury goods (YED above 1) will see sales rise faster than incomes in a boom, so it may hire staff and increase stock. In a downturn its sales will fall faster than incomes, so it may cut costs. A firm selling inferior goods (negative YED) may sell more when incomes fall. Many businesses sell a mix of goods so that a fall in income does not hurt all their sales at once.
🏦 For the government
When incomes rise, demand for luxury goods and services grows, and the government collects more tax from spending on them. It can plan for more demand for things like roads, airports and tourism. When incomes fall, tax revenue falls and demand for inferior goods rises, so the government can plan its spending and taxes ahead.
Remember from Income Elasticity of Demand that a normal good has a positive YED and a luxury good has a YED above 1. A business with a high positive YED is more exposed to ups and downs in the economy than a business selling necessities.
Common mistakes
Common mistakes
- Saying "the producer pays the tax". The producer sends the money to the government, but the burden is shared. PED decides the share.
- Mixing up the effects: inelastic demand means consumers bear more of the tax and revenue is higher. Elastic demand means producers bear more and revenue is lower.
- Saying a luxury good always does badly. It does well when incomes rise and badly when incomes fall.
- Giving only a definition. Paper 1 answers need a chain of reasoning: tax or income change, then price or quantity, then who is affected.
Exam-style question
The government of Zalmora adds an indirect tax of 40 cents per unit to two goods. Good X is a daily bus ticket (PED is inelastic). Good Y is a theme park ticket (PED is elastic). Both sold the same number of units before the tax.
(a) Identify which good will raise more tax revenue for the government. [1 mark]
(b) Explain why consumers bear most of the burden of the tax on Good X. [3 marks]
(c) Analyse how a rise in incomes might affect the sales of a business selling luxury goods. [4 marks]
Model answer
(a) Good X, the bus ticket (1).
(b) Demand for bus tickets is inelastic, so customers keep buying even when the price rises (1). Sellers can pass most of the tax on in a higher price (1). So consumers pay most of the extra and the producer keeps almost the same amount per ticket (1).
(c) Luxury goods have a YED above 1 (1). When incomes rise, the percentage rise in quantity demanded is bigger than the percentage rise in income (1). So sales rise faster than incomes (1). The business could increase stock or hire more staff to meet the extra demand (1).
Exam tip
In an "explain" or "analyse" question, build a chain: PED or YED value, then what happens to price or quantity, then who gains or loses. One link per mark.