VCE Economics (Year 12) · Markets, Efficiency and Scarcity · 11m read

Price Elasticity of Demand and Supply

Ever wonder why a petrol price rise hits your pocket hard, but a coffee shop can raise prices without losing customers? That's elasticity in action—it measures how much buyers and sellers actually change what they do when prices shift. You'll learn to calculate elasticity and predict who really pays when taxes are introduced or prices change, which is crucial for understanding real-world business decisions and VCE economics questions about market behaviour.

Learning objective: Calculate and interpret price elasticity of demand and supply.

By the end of this lesson you can:

• I calculate PED and PES using the formula.
• I classify elastic/inelastic/unitary.
• I explain determinants of elasticity.

Elasticity is how squishy a market is. Inelastic markets barely squish when price changes; elastic ones squish a lot.

Elasticity measures and drivers

PRICE ELASTICITY OF DEMAND (PED)
PED = % change in Quantity Demanded ÷ % change in Price (absolute value).

Interpretation:
• PED > 1 — ELASTIC (quantity responds more than proportionally).
• PED = 1 — UNITARY ELASTIC.
• PED < 1 — INELASTIC (quantity responds less than proportionally).
• PED = 0 — perfectly inelastic (vertical curve — e.g. life-saving drugs).
• PED = ∞ — perfectly elastic (horizontal curve — perfect competition).

DETERMINANTS OF PED:
• SUBSTITUTES — more substitutes → more elastic.
• NECESSITY vs LUXURY — necessities less elastic.
• SHARE OF INCOME — bigger share → more elastic.
• TIME — long run more elastic (adjustment time).
• ADDICTION/HABIT — less elastic.

PRICE ELASTICITY OF SUPPLY (PES)
PES = %ΔQS ÷ %ΔP.
Determinants:
• SPARE CAPACITY — more spare → more elastic.
• INVENTORY — high inventory → more elastic.
• MOBILITY of factors of production.
• TIME — long run more elastic.

IMPLICATIONS:
• TAX INCIDENCE — who pays more of a tax depends on relative elasticities. The more INELASTIC side pays more.
• REVENUE — if PED<1, price rise INCREASES revenue.
• EXCHANGE RATES — inelastic export demand = higher export earnings when $ appreciates.

POLICY USES:
• Government taxes inelastic goods (tobacco, alcohol) — predictable revenue, lower consumer response.
• Subsidies on elastic goods (e.g. education, solar) generate big Q changes.

Elasticity underpins why markets behave so differently — it's the sensitivity dial for every policy.

Elasticity cheat sheet

• Formula: %ΔQ ÷ %ΔP.
• >1 elastic: < 1 inelastic; = 1 unitary.
• Substitutes + luxuries: More elastic.
• Time: Longer run → more elastic.
• Tax: Inelastic side pays more.

Quick reference

| PED | Meaning | Total revenue if price ↑ |
|---|---|---|
| > 1 | Elastic | Falls |
| < 1 | Inelastic | Rises |
| = 1 | Unit elastic | Unchanged |
| Determinants | Substitutes, necessity, % of income, time | |

Worked example (Medium)

Coffee price rises 10%, quantity demanded falls 4%. Calculate PED and interpret.

1. Formula. PED = 4% ÷ 10% = 0.4.
2. Classify. 0.4 < 1 → INELASTIC.
3. Interpret. Quantity responds less than price change; consumers relatively loyal. A tax on coffee would mainly raise prices (consumer pays most).
4. Revenue impact. Price ↑10%, Q ↓4%. Revenue rises (inelastic demand).

Answer: PED = 0.4 (inelastic). Consumers bear most of tax incidence; sellers can raise prices to increase revenue.

Worked example (Hard)

A government imposes a $2 per unit tax on cigarettes. PED = 0.3 and PES = 1.5. Determine who bears most of the tax burden and calculate the approximate consumer and producer shares.

1. Identify elasticities. PED = 0.3 (very inelastic — consumers are addicted/habitual). PES = 1.5 (relatively elastic — producers can adjust output).
2. Apply the tax incidence rule. The MORE INELASTIC side bears the GREATER share of the tax. Since PED (0.3) < PES (1.5), consumers bear the larger share.
3. Calculate approximate shares. Consumer share ≈ PES/(PES+PED) = 1.5/(1.5+0.3) = 1.5/1.8 ≈ 83%. Producer share ≈ PED/(PES+PED) = 0.3/1.8 ≈ 17%.
4. Interpret. Of the $2 tax: consumers pay ~$1.66 extra per unit (price rises by this amount), producers absorb ~$0.34. This is why governments tax cigarettes — revenue is predictable because quantity barely falls, and consumers bear most of the cost.

Answer: Consumers bear ~83% ($1.66) and producers ~17% ($0.34) of the $2 tax. The inelastic side always pays more. This explains why excise taxes target addictive goods.

Common mistakes

• Forgetting to take the absolute value of PED PED is technically negative (price up → quantity down), but we use absolute values for comparison. Students sometimes write PED = -0.4 and get confused comparing it to PES = 1.2. Fix: ALWAYS convert PED to its absolute value before classifying or comparing. |PED| = 0.4 means inelastic.
• Claiming inelastic demand means quantity does not change at all Inelastic means quantity changes LESS than proportionally to price — not that it does not change. PED = 0.4 means a 10% price rise causes a 4% quantity fall. Fix: Inelastic = quantity DOES change, just by a smaller percentage than price. Only perfectly inelastic (PED = 0) means zero quantity change.
• Mixing up the effect on total revenue for elastic vs inelastic goods Students often state that raising price always increases revenue, ignoring the quantity effect. Fix: If PED < 1 (inelastic): price ↑ → TR ↑ (quantity falls less than price rises). If PED > 1 (elastic): price ↑ → TR ↓ (quantity falls MORE than price rises). Draw a quick revenue rectangle to verify.

Elasticity, Tax Policy and the Australian Tobacco Excise

Australia's tobacco excise is one of the highest in the world — over $1.20 per cigarette stick (2024). This policy relies directly on elasticity concepts studied in VCE Economics.

Why tobacco? Cigarettes have very inelastic demand (PED ≈ 0.3–0.5 in Australia). Because smokers are addicted, quantity demanded falls only modestly when prices rise. This makes tobacco excise an efficient revenue tool — the government collects substantial revenue with relatively little market disruption.

Tax incidence in practice: With PED ≈ 0.4 and PES relatively elastic, consumers bear approximately 70-80% of each excise increase. A 12.5% annual excise increase translates to roughly 10% higher retail prices — with only a 4-5% fall in consumption.

But does the tax "work" for health? Yes — research shows Australia's tobacco consumption has fallen from 30% of adults (1980) to under 11% (2024). The price signal, combined with plain packaging and advertising bans, has been effective over the long run — consistent with the principle that PED is higher in the long run than the short run.

Equity concern: The tax is regressive — lower-income smokers spend a higher proportion of their income on cigarettes. This creates a tension between health policy objectives and equity in income distribution — a classic VCE evaluation point.

Practice questions

1. A good with PED = 1.8 is:

   1. Perfectly inelastic
   2. Unitary
   3. Elastic
   4. A Giffen good

   (1 marks)

2. Why does the government tax cigarettes heavily?

   1. They are a luxury
   2. Demand is highly elastic
   3. Demand is inelastic — predictable tax revenue
   4. To boost exports

   (1 marks)

3. Explain how the elasticity of supply for housing affects prices during a demand surge.

   (3 marks)

Summary

• Calculate PED and PES using the formula.
• Classify elastic/inelastic/unitary.
• Explain determinants of elasticity.