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Definition (Key Terms)

• Price Elasticity of Demand (PED): A measure of the responsiveness of quantity demanded when there is a price change.

Explanation/Economic Theory

• PED Calculation
  • The PED for a good or service is calculated by the ratio of the percentage change in quantity demanded over the percentage change in price:
  • \text{PED} = \frac{%\Delta Q_d}{%\Delta P}
  • When a percentage change in price leads to a lower percentage change in quantity, the PED is lower than one and is termed inelastic.
  • The demand curves for goods and services with price inelastic demand tend to be steep. This is due to the fact that a a percentage change in price leads to a lower percentage change in quantity.

Diagram

• A demand curve on a price-quantity graph drawn with a relatively steep slope.

• Labels:

  • Vertical Axis: Price (P).
  • Horizontal Axis: Quantity (Q).
  • Demand Curve: D, illustrating that even if price increases significantly from P₁ to P₂, the quantity demanded moves only slightly from Q₁ to Q₂. Axes that showcase this are also valid.

• Essential Nature of Basic Raw Materials

  • Basic raw materials serve as vital inputs in the production process of many goods.
  • Producers using raw materials, such as wood, in their production often cannot easily switch to alternatives, so the demand remains relatively high, even if prices increase.
  • Therefore, since large percentage changes in price lead to lower percentage changes in quantity, the demand for basic raw materials is lower than one and hence inelastic.
  • This is due to the following reasons.

• Lack of Close Substitutes

  • The fewer substitutes available for a raw material, the harder it is for producers to switch to other inputs.
  • This lack of alternatives causes the quantity demanded to remain relatively stable when prices change.

• Proportion of Total Cost and Necessity

  • In many industries, certain raw materials represent a small proportion of total production costs (for example, a crucial chemical in a manufacturing process), leading producers to continue purchasing roughly the same quantity despite price changes.
  • Where the raw material is indispensable (such as oil in transportation), producers have little choice but to absorb higher costs to maintain output.

• Time Period

  • In the short run, firms may not have the time or resources to adjust production processes or find new suppliers if raw material prices rise.
  • The immediate rigidity in replacing essential inputs contributes to a more inelastic demand over shorter time horizons.

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Definitions

• Price Elasticity of Demand (PED): Measures the responsiveness of the quantity demanded of a good to a change in its price. Calculated as the percentage change in quantity demanded divided by the percentage change in price.
• Indirect Tax: A tax levied on the expenditure of goods or services, typically imposed on producers (who pass some or all of the tax burden onto consumers through higher prices).

Economic Theory

• As seen in the diagrams above, when a government imposes an indirect tax, the supply curve effectively shifts upwards by the amount of the tax per unit ($S \rightarrow S_{+tax}$).
• The new higher price reduces the quantity demanded ($Q_m \rightarrow Q_tax$) depending on the PED of the product:
• If demand is price inelastic (PED < 1), consumers are relatively unresponsive to price changes.
• The tax burden falls mostly on consumers, as producers can pass on a larger portion of the tax without losing significant sales volume.
• This is reflected by the fact that the increase in consumer price consumer pay ($P_c$) from the original market price ($P_m$) is greater than the decrease in producer post-tax price ($P_p$).
• Government revenue is usually higher because quantity demanded does not fall drastically.
• If demand is price elastic (PED > 1), consumers are relatively responsive to price changes.
• A significant portion of the tax burden falls on producers, since passing on a large price increase would result in a proportionally larger drop in quantity demanded.
• This is reflected by the fact that the increase in consumer price consumer pay ($P_c$) from the original market price ($P_m$) is lower than the decrease in producer post-tax price ($P_p$).
• Government tax revenue may be lower because the fall in quantity demanded is large.
• Welfare loss:
  • As seen by the diagram (the loss in total social surplus) arises if the tax significantly reduces the quantity traded in the market.
  • If the product has relatively inelastic demand, the overall loss to society is typically smaller in quantity terms, but consumers bear more cost.
  • If the product has elastic demand, quantity falls more, potentially increasing the deadweight loss but decreasing the price burden on consumers.

Evaluation

• Short-Run vs. Long-Run Effects:

  • In the short run, demand might be inelastic because consumers cannot easily change consumption patterns (e.g., addiction to cigarettes). Government may earn substantial revenue, and consumer demand may not fall significantly.
  • In the long run, consumers may find substitutes or change preferences, making demand more elastic. The fall in quantity demanded becomes more pronounced, reducing government revenue and shifting the tax burden more onto producers.

• Positive and Negative Impacts on Stakeholders:

  • Government: Gains revenue, which can be used for public goods. However, if demand becomes more elastic over time, total revenue might diminish.
  • Consumers: Face higher prices, especially if demand is inelastic (e.g., necessity goods like fuel). This can disproportionately affect low-income groups.
  • Producers: Bear a higher burden if demand is elastic, leading to reduced producer surplus and possible job losses.
  • Society as a whole: Potential reduction in consumption of harmful products (e.g., sugary drinks). However, if the product is a necessity, the tax can create regressive effects.
  • Government budget: If the goal of the tax is to collect revenue, considering the PED of the good in which the tax is levied is crucial. As seen by the diagrams above, the PED will have a considerable impact on the government revenue collection.

• Real-World Examples

  • Cigarette Taxes in Australia: Demand is relatively inelastic, allowing the government to raise substantial tax revenue (exceeding AUD 12.0 billion annually in recent years). Consumption decreases only marginally due to strong addictive factors, and the consumer burden is high.
  • Fuel Taxes in France: Attempts to raise fuel taxes led to significant public backlash (e.g., “Gilets Jaunes” protests), reflecting more elastic demand in the long run as consumers can switch to public transport or fuel-efficient vehicles. The government’s revenue goals conflicted with social acceptance, illustrating how elasticity can vary with time and economic circumstances.

• Conclusion

  • PED is crucial for a government’s strategy when imposing indirect taxes because it affects tax incidence, revenue, and overall consumption.
  • Governments often tax goods with relatively inelastic demand (e.g., tobacco, alcohol) for stable revenue and to discourage negative externalities.
  • However, shifts in consumer behavior over time, protests, and potential equity issues all underscore the importance of considering both short-run and long-run elasticities when setting indirect tax policies.