Chapter 5: Introduction
Elasticity
In this chapter, you will learn to:
- explain why measures of price responsiveness by consumers (also called price elasticity) are important to producers and consumers
- discuss price elasticity of demand and how it is calculated
- list the factors that affect the price elasticity of demand
- describe three additional elasticity calculations: (a) cross-price elasticity of demand, (b) income elasticity of demand, and (c) price elasticity of supply
- describe applications of price elasticity of demand, cross-price elasticity of demand, and income elasticity of demand
- calculate the four different elasticities: price elasticity of demand, cross-price elasticity of demand, income elasticity of demand and price elasticity of supply
Consider an economic example. Cigarette taxes are an example of a “sin tax,” a tax on something that is bad for you, like alcohol. Governments tax cigarettes at the state and national levels. State taxes range from a low of 17 cents per pack in Missouri to $4.35 per pack in New York. The average state cigarette tax is $1.69 per pack. The 2014 federal tax rate on cigarettes was $1.01 per pack, but in 2015 the Obama Administration proposed raising the federal tax nearly a dollar to $1.95 per pack. The key question is: How much would cigarette purchases decline?
Taxes on cigarettes serve two purposes: to raise tax revenue for the government and to discourage cigarette consumption. However, if a higher cigarette tax discourages consumption considerably, meaning a greatly reduced quantity of cigarette sales, then the cigarette tax on each pack will not raise much revenue for the government. Alternatively, a higher cigarette tax that does not discourage consumption by much will actually raise more tax revenue for the government. Thus, when a government agency tries to calculate the effects of altering its cigarette tax, it must analyze how much the tax affects the quantity of cigarettes consumed. This issue reaches beyond governments and taxes. Every firm faces a similar issue. When a firm considers raising the sales price, it must consider how much a price increase will reduce the quantity demanded of what it sells. Conversely, when a firm puts its products on sale, it must expect (or hope) that the lower price will lead to a significantly higher quantity demanded.