Question

Suppose we learn that the price elasticity of demand for luxury custom homes is -2.13, but for ordinary track homes it is -0.67. Interpret these elasticities, providing descriptions that an average person can understand. In addition, explain why a taxing authority might want to understand the elasticity concept when deciding whether or not to place a higher tax on luxury homes than on ordinary homes.

Answer 1

Price elasticity of demand for luxury homes decreases quickly if the price increases. This is called elastic demand. An incease in price would bring the demand down fast. On teh other hand, ordinary homes ae necessity. So their demand would not decrease that easily if their price were to increase. This is called inelastic demand.

We can judge whether the demand is elastic or inelastic by the value of their elasticity. If the delasticity of demand is more than 1, demand is said to be elastic. In the given example, the elasticity of deamnd for luxury homes is -2.13 (more than 1). So we know that the demand for luxury homes is elastic. It fluctuates easily with a change in price. Similarly, elasticity of demand for ordinary homes is -0.67 (less than 1). The demand does not fluctuate as easily for ordinary homes.

We may also notice the negative sign before the value of the elasticity. It means that the demand is inverse to price. That is, when the price increases, demand decreases, and when the price decreases, the demand increases. Price and demand move in opposite directions.

Taxing a home results in increased price. So, tax authorities would tax an ordinary home rather than a luxury home. This is because, as we have seen, the demand for ordinary homes would not decrease compared to the case if tax were imposed on luxury homes. This despite most of the tax being borne by buyers of the ordinary house (happens in case of inelastic demand). Therefore, taxing authorities would not tax luxury homes, but they would tax ordinary homes.