How useful is elasticity for firms and government?

Overview

Claim that because elasticity says nothing about costs.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Assess whether a firm's estimate of the price elasticity of demand for its product is reliable enough to base a pricing decision on.

   Model answer

   In favour: the estimate is drawn from the firm's own sales records, so it reflects real behaviour by real customers, and it converts a vague hunch about responsiveness into a number that can be compared and acted on. Against: it is measured from the past, and tastes, incomes, rivals' prices and the range of substitutes all move on; it assumes other things stayed constant when in practice they did not; and it is only valid near the prices actually observed. Conclusion: it is reliable enough for a modest price change in a stable market, but a firm contemplating a large change or operating in a fast-moving market should treat the figure as one input among several rather than as a decision rule.

2. 2

   Evaluate the usefulness of price elasticity of demand to a government deciding which goods to place an indirect tax on.

   Model answer

   In favour: taxing goods with inelastic demand raises predictable revenue, because consumers keep buying and the tax base does not shrink; and knowing the elasticity tells the government how much of the tax will be passed on to consumers rather than absorbed by producers. Against: an inelastic good is often a necessity, so the tax falls hardest on low-income households and is regressive; and if the aim is to cut consumption rather than raise money, inelastic demand is precisely what makes the tax ineffective. Conclusion: price elasticity of demand is genuinely useful, but only once the government has decided which objective it is pursuing - revenue and behaviour change point towards taxing different goods.

3. 3

   How far is it true that a government can always raise more revenue by increasing the duty on a habit-forming product?

   Model answer

   The case for: demand for habit-forming products is price inelastic, so quantity falls proportionately less than price rises, and total spending - and therefore duty receipts - increases. The case against: the elasticity is inelastic only within the observed price range, and repeated large increases eventually push consumers past the point where they cut back, quit or turn to untaxed and illegal supplies, which removes them from the tax base entirely. Demand also becomes more elastic in the long run. Conclusion: it holds for moderate increases over a short horizon, but it breaks down for large or repeated rises, so the claim is true only within limits that the elasticity value itself cannot identify.

4. 4

   Assess the usefulness of income elasticity of demand to a supermarket chain planning its product range for the years ahead.

   Model answer

   In favour: it sorts the range into lines that will grow faster than incomes, lines that will grow more slowly, and inferior lines that will shrink in a boom but expand in a downturn. That guides shelf space, promotion and which new products to develop, and holding goods across the range stabilises sales over the cycle. Against: the values are estimated from past data and shift as tastes change; the same good can be normal for one income group and inferior for another, so a single chain-wide figure conceals regional differences; and income elasticity says nothing about how rivals will react. Conclusion: it is a strong planning tool at the level of broad ranges, but it is too blunt for decisions about individual products in individual stores.

5. 5

   Evaluate how useful cross price elasticity of demand is to a firm judging whether a rival's price cut is a serious threat.

   Model answer

   In favour: it puts a number on the closeness of the two products. A large positive value warns that a rival's cut will pull away a substantial share of the firm's customers and demands a response, while a value near zero shows the products barely compete and the cut can safely be ignored. It also identifies complements, where a rival's cut could actually raise the firm's own sales. Against: the estimate comes from past episodes and may not hold if the rival has changed its product; it ignores non-price competition such as advertising and quality; and it says nothing about whether matching the cut would be profitable. Conclusion: it is useful for gauging the size of the threat, but not for choosing the response.

6. 6

   Assess whether estimates of the price elasticity of supply are useful to a government concerned about housing.

   Model answer

   In favour: they quantify what the government suspects - that the number of dwellings responds very little to price - and so demonstrate that policies which raise demand, such as buyer subsidies, will end up mainly in higher prices rather than more homes. They also help predict how long a shortage will persist. Against: a single number hides the causes, whether planning delay, land availability or construction labour, and it is the cause that determines which policy would work; and the estimate is drawn from a period whose planning rules and interest rates no longer apply. Conclusion: it is useful for diagnosing that supply is the problem, but a government still needs separate evidence on why before it can choose a remedy.

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