Elasticity measures how responsive demand is to price changes. It's foundational for understanding tax incidence, revenue, and all government intervention evaluation.
Quick definition
Price elasticity of demand (PED) = percentage change in quantity demanded ÷ percentage change in price
Elasticity tells you: if price goes up 10%, how much will quantity fall?
The visual rule: flat curve = elastic
Don't memorize numbers. Look at the shape:
- Flat demand curve = elastic (responds a lot to price changes)
- Steep demand curve = inelastic (doesn't respond much to price)
Why? A flat curve means a small price change causes a big quantity change. A steep curve means a big price change causes a small quantity change.
Elastic demand — real-world examples
Demanded strongly declines when price rises:
- Luxury goods (designer clothes, holidays) — people can do without them
- Non-essentials (cinema tickets, restaurant meals)
- Goods with substitutes (Pepsi vs Coke, one airline vs another)
- Small budget share (ballpoint pens — a 50% price rise still costs only a few pence)
Inelastic demand — real-world examples
Quantity demanded hardly changes when price rises:
- Necessities (food, fuel, water) — people need them to survive
- Addictive goods (cigarettes, caffeine) — demand persists despite price
- Few/no substitutes (insulin for diabetics, petrol in rural areas)
- Large budget share, but essential (electricity) — people can't cut usage easily
Why elasticity matters in exam questions
1. Tax revenue
When you tax an inelastic good, quantity falls only a little → tax revenue is high.
When you tax an elastic good, quantity falls a lot → tax revenue is lower (and DWL is bigger).
This is why governments tax cigarettes (inelastic, high revenue) but not luxury items (elastic, less revenue).
2. Tax burden (incidence)
Inelastic demand = consumers bear most of the tax. Elastic demand = producers bear most (or people avoid the tax).
3. Deadweight loss
Inelastic demand = smaller DWL triangle, fewer lost trades.
Elastic demand = larger DWL triangle, more lost trades.
4. Policy effectiveness
A tax on elastic goods reduces consumption a lot (good for correcting negative externalities like smoking).
A tax on inelastic goods has little effect on quantity (bad if your goal is to reduce consumption; good if your goal is revenue).
The four determinants you MUST know
| Determinant | Elastic if... | Inelastic if... |
|---|---|---|
| Number of substitutes | Many substitutes exist | Few/no substitutes |
| Necessity vs luxury | Luxury/non-essential | Basic necessity |
| % budget spent | Large share of budget | Small share of budget |
| Time horizon | Long term (time to adjust) | Short term (can't adjust quickly) |
Exam tip: Apply elasticity to evaluation
In a 15-mark question about taxing sugary drinks, don't just say "it reduces consumption." Say:
"If demand is elastic (many substitutes: water, juice, diet drinks), a tax will significantly reduce consumption. If demand is inelastic (habit, brand loyalty), quantity falls less but tax revenue is higher. Effectiveness depends on elasticity."
This shows examiner you understand the concept and can apply it to real policy.
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