Why elasticities matter for firms, consumers and government

Firms

• PED and pricing: a firm facing inelastic demand can raise price to raise revenue; with elastic demand it may cut price. Firms try to make demand more inelastic through branding and advertising.
• PED and passing on costs or taxes: if demand is inelastic, a firm can pass on higher costs to consumers with little loss of sales.
• YED and planning: firms selling luxuries (high YED) expect strong growth in a boom but big falls in a recession. Firms selling inferior goods may do well in a recession. Firms can plan output, staffing and stock, or diversify their product range.
• XED and competition: a high positive XED with a rival's product warns that a rival's price cut will steal sales. A negative XED shows complementary pricing opportunities: sell a printer cheaply and price the ink high.

Consumers

Consumers with inelastic demand (no substitutes, addictive goods) are vulnerable to price rises and bear most of any tax. Low-income households spend a larger share of income on necessities with low YED, so price rises on food and energy hit them hardest. Knowing about substitutes (high XED) helps consumers switch when prices rise.

Government

• Taxation: taxing goods with inelastic demand (fuel, tobacco, alcohol) raises reliable revenue because sales fall little. But if the aim is to cut consumption of a harmful good, inelastic demand means the tax has a small effect.
• Incidence: the more inelastic demand is, the more of an indirect tax consumers pay (lesson on taxes).
• YED: governments can forecast tax revenue and demand for services as incomes grow; demand for some public services rises with income.
• XED: a tax on one good affects its substitutes and complements, for example taxing sugary drinks may raise sales of low-sugar alternatives.

Evaluate: elasticity estimates are based on past data and assume ceteris paribus, so they may be inaccurate; elasticities change over time and differ between consumer groups.

Worked example

A government wants to raise tax revenue and to reduce smoking. Explain why a cigarette tax may achieve one aim more than the other.

1. Demand for cigarettes is price inelastic because they are addictive.
2. So quantity demanded falls by a smaller percentage than the price rises.
3. Tax revenue (tax per unit x quantity) stays high, achieving the revenue aim.
4. But consumption falls only a little, so the health aim is achieved less.

Answer: Inelastic demand makes the tax good for revenue but weak at reducing smoking, at least in the short run.

Check yourself

1. A firm sells products with a high positive YED. In a recession it should expect
   • a rise in demand
   • no change in demand
   • demand to become perfectly inelastic
   • a large fall in demand
   Show answer

   a large fall in demand. Falling incomes cut demand for income elastic goods sharply.

2. To raise the most tax revenue with the least fall in sales, a government should tax goods with
   • price elastic demand
   • price inelastic demand
   • negative income elasticity
   • positive cross elasticity with many goods
   Show answer

   price inelastic demand. Quantity hardly falls, so the tax base stays large.

3. A firm finds the XED between its product and a rival's is +2.5. This means
   • the products are complements
   • its demand is perfectly inelastic
   • the rival's price has no effect on it
   • a rival's price cut would significantly reduce its sales
   Show answer

   a rival's price cut would significantly reduce its sales. High positive XED: close substitutes, so customers switch easily.

4. A firm sells printers at a low price and ink cartridges at a high price. This strategy relies on the products being
   • complements with a negative XED
   • substitutes with a positive XED
   • inferior goods
   • unrelated goods
   Show answer

   complements with a negative XED. Cheap printers raise demand for the firm's ink.

5. A $2 tax per unit is placed on a good. After the tax, 4,500 units are sold. Calculate the tax revenue.
   Show answer

   $9000. Revenue = tax per unit x quantity = 2 x 4,500 = $9,000.

6. Give one reason why a firm should be careful when using an estimate of PED to set its price.
   Show answer

   The estimate is based on past data and assumes ceteris paribus, but conditions such as rivals' prices, incomes and tastes change, so the true PED may now be different and the predicted change in revenue may be wrong.. Question the reliability of the data.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (2018)

Last updated 8 November 2026. Spotted a mistake? Tell us.