The concept of price elasticity of demand and price elasticity of supply, the factors that affect each, and the relevance of elasticity to the operation of markets and to the effect of government intervention

What this dot point is asking

VCAA wants you to define price elasticity of demand and price elasticity of supply, explain the factors that determine each, and apply elasticity to how markets work and how government intervention (especially indirect taxes and subsidies) plays out. Expect short-response calculation and explanation questions plus extended responses linking elasticity to tax incidence.

The answer

Price elasticity of demand defined

Price elasticity of demand (PED) measures the responsiveness of quantity demanded to a change in the price of the good.

PED is normally negative (price and quantity move in opposite directions), so VCE convention uses the absolute value.

• Elastic (PED greater than 1): quantity is very responsive. A small price rise causes a large fall in quantity.
• Inelastic (PED less than 1): quantity is not very responsive. A price rise causes only a small fall in quantity.
• Unit elastic (PED equal to 1): the percentage changes are equal.

Determinants of price elasticity of demand

1. Availability and closeness of substitutes. The single most important factor. More close substitutes makes demand more elastic, because buyers switch away when the price rises. One brand of petrol station is elastic; petrol as a whole is inelastic.
2. Degree of necessity. Necessities (basic food, electricity, prescription medicine) have inelastic demand. Luxuries (restaurant meals, overseas travel) are elastic.
3. Proportion of income spent. Goods that absorb a large share of income (a new car, a house) tend to be elastic; low-cost items (salt, matches) are inelastic.
4. Time period. Demand is more elastic over a longer time horizon, because consumers can change habits, find substitutes, and replace equipment. Petrol demand is very inelastic this week but more elastic over several years as people buy more fuel-efficient cars.
5. Addictiveness or habit. Addictive and habit-forming goods (tobacco, alcohol, caffeine) have inelastic demand.

Price elasticity of supply defined

Price elasticity of supply (PES) measures the responsiveness of quantity supplied to a change in price.

Determinants of price elasticity of supply

1. Spare capacity. If firms have idle plant and labour, they can expand output quickly when price rises, so supply is elastic.
2. Availability of inputs and stock. Easy access to extra inputs, and the ability to hold inventories, makes supply more elastic.
3. Time period. The decisive factor. In the very short run, supply is often near-vertical (inelastic); over the long run, firms can build capacity and new firms can enter, so supply becomes more elastic.
4. Ease of factor mobility. If resources can be shifted into the industry easily, supply is more elastic.
5. Production lags. Agricultural and resource supply is inelastic in the short run because crops take a season to grow and mines take years to develop.

Elasticity and total revenue

For a price change, the effect on a firm's total revenue (price multiplied by quantity) depends on PED:

• Elastic demand: a price cut raises total revenue (the quantity gain outweighs the lower price).
• Inelastic demand: a price rise raises total revenue (the small quantity loss is outweighed by the higher price).

This is why firms with market power over goods with inelastic demand can raise revenue by raising prices, and why a bumper harvest (large supply rise) can lower farmers' total revenue when demand for food is inelastic.

Elasticity and government intervention

Tax incidence. When the government applies an indirect tax, the share borne by consumers versus producers depends on relative elasticities.

• Inelastic demand (relative to supply): consumers bear most of the tax. They keep buying despite the higher price, so producers pass the tax through. Revenue collected is high and the fall in quantity is small.
• Elastic demand: producers bear most of the tax. A higher price would cut quantity sharply, so firms absorb much of the tax. Revenue collected is lower and quantity falls more.

This is why "sin taxes" target inelastic goods: tobacco excise raises large revenue and the burden falls mainly on smokers, while still discouraging consumption at the margin.

Subsidies work in reverse: a subsidy on a good with inelastic demand mostly lowers the price paid by consumers; on an elastic good, more of the benefit shows up as higher quantity.

Price controls. The effect of a minimum or maximum price depends on elasticity. A minimum wage causes more unemployment where labour demand is elastic; a price ceiling on rent causes larger shortages where supply is inelastic.

Examples in context

Example 1. Tobacco excise

Demand for cigarettes is highly inelastic (addiction, few substitutes), with PED estimates around 0.4 in absolute value. When the government raises tobacco excise, the retail price rises, quantity falls only modestly, and consumers bear most of the tax. This produces large excise revenue and a modest public-health reduction in smoking. The inelasticity is exactly why this good is targeted.

Example 2. Petrol in the short and long run

A spike in global oil prices raises pump prices, but motorists cannot quickly change their commute, so short-run demand is very inelastic and quantity barely falls. Over several years, households buy more fuel-efficient or electric vehicles and shift commuting patterns, so long-run demand is more elastic. The same good has different elasticities over different horizons.

Example 3. Australian housing supply

The dwelling stock is essentially fixed in the short run, so supply is highly inelastic. When net overseas migration surged through 2023-24, the demand shift right pushed rents and prices up sharply rather than expanding quantity. Only over a multi-year horizon, as construction responds, does supply become more elastic. Check current ABS and CoreLogic releases for the latest rent and dwelling figures.

Try this

Q1. Define price elasticity of demand and state the formula. [2 marks]

• Cue. Responsiveness of quantity demanded to a change in price; PED = (% change in quantity demanded) / (% change in price).

Q2. A 10 percent rise in the price of a good causes quantity demanded to fall by 4 percent. Calculate the PED and state whether demand is elastic or inelastic. [2 marks]

• Cue. PED = 4% / 10% = 0.4. Less than 1 in absolute value, so demand is inelastic.

Q3. Explain, using the concept of elasticity, why an indirect tax on tobacco raises large government revenue while a similar tax on a good with many substitutes would not. [4 marks]

• Cue. Tobacco demand is inelastic, so quantity falls little when price rises and consumers bear most of the tax, giving high revenue. A good with many substitutes has elastic demand, so a tax causes a large fall in quantity, producers absorb more of the tax, and revenue is lower.