Question

a. Define the price elasticity of demand.

b.Suppose that government would like to maximize tax revenue. Explain why it may be a good idea for the government to lower tax rates for the goods that have very high price elasticities of demand (exceeding one).

c.Suppose that government would like to maximize tax revenue. Explain why it may not be a good idea for the government to lower tax rates for the goods that have very low price elasticities of demand (less than one)

Answer 1

(a)

Price elasticity of demand (Ed) measures the responsiveness of quantity demanded (Qd) of a good to a change in its price. It is computed as:

Ed = % Change in Qd / % Change in price

When |Ed| > 1, for N% increase (decrease) in price, Qd decreases (increases) by more than N%, so demand is elastic.

When |Ed| < 1, for N% increase (decrease) in price, Qd decreases (increases) by less than N%, so demand is inelastic.

When |Ed| = 1, for N% increase (decrease) in price, Qd decreases (increases) by exactly N%, so demand is unit elastic.

(b)

When price elasticity is high, demand is very elastic, so an increase in price caused by increase in price will decrease quantity demanded by a more than proportionate amount. So, reducing tax rate will increase quantity demanded by a more than proportionate amount, which will increase tax revenue and decrease deadweight loss.

(c)

When price elasticity is low, demand is very inelastic, so an increase in price caused by increase in price will decrease quantity demanded by a less than proportionate amount. So, reducing tax rate will increase quantity demanded by a less than proportionate amount, which will decrease tax revenue and increase deadweight loss.