What you need to know

Price elasticity of demand (PED) measures how responsive the quantity demanded is to a change in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. Because quantity and price move in opposite directions the result is negative, but the sign is usually ignored and the absolute value is reported. Elasticity matters because it tells a business what will happen to its total revenue (price × quantity) if it changes price, and tells a government how much a tax will reduce consumption and how much revenue it will raise.

• Availability of substitutes: the more close substitutes, the more elastic (one brand of bottled water is elastic; water in general is inelastic).
• Necessity or luxury: necessities such as medicine are inelastic; luxuries are elastic.
• Proportion of income spent: goods that take a large share of income (cars) are more elastic than cheap items (salt).
• Time: demand becomes more elastic over time as consumers find alternatives.
• Habit or addiction: habit-forming goods such as tobacco are inelastic, which is one reason governments tax them.
• Definition of the market: 'food' is inelastic; 'apples' is much more elastic.

Price elasticity of supply (PES) is the percentage change in quantity supplied divided by the percentage change in price. If a 10% price rise lifts the quantity supplied by 5%, PES = 5 ÷ 10 = 0.5, so supply is inelastic. Supply is more elastic when producers hold spare capacity or stocks, when production can be increased quickly and when the time period is longer; agricultural supply is inelastic in the short run because crops take a season to grow. Two further measures are also used. Income elasticity of demand (%ΔQd ÷ %Δincome) is positive for normal goods and negative for inferior goods: if income rises 5% and demand for restaurant meals rises 10%, income elasticity is 10 ÷ 5 = 2, a luxury. Cross elasticity of demand (%ΔQd of good A ÷ %Δprice of good B) is positive for substitutes and negative for complements: if a 10% rise in the price of tea lifts demand for coffee by 4%, cross elasticity is 4 ÷ 10 = +0.4, confirming they are substitutes.

Market failure occurs when the free market, left to itself, allocates resources inefficiently: too much of some goods is produced, too little of others, or some are not produced at all. Market failure is the main economic justification for government intervention in a mixed economy. The most important sources are summarised below, together with the responses typically used in Australia.

Check yourself

1. Price rises from $8 to $10 and quantity demanded falls from 400 to 300. Calculate PED and classify it.
2. If demand for a product is inelastic, what happens to total revenue when the price falls?
3. Give two reasons why demand for petrol is inelastic in the short run.
4. A 20% rise in price increases quantity supplied by 30%. Calculate PES.
5. Why does the free rider problem prevent private firms from supplying public goods?
6. Which Australian body enforces competition law to deal with market power?

Answers: 1. %ΔP = 2 ÷ 8 × 100 = 25%; %ΔQ = −100 ÷ 400 × 100 = −25%; PED = 25 ÷ 25 = 1, unit elastic. 2. Total revenue falls (the small rise in quantity does not make up for the lower price). 3. Few close substitutes; it is a necessity for most car users; it takes time to change vehicles or travel habits (any two). 4. PES = 30 ÷ 20 = 1.5 (elastic). 5. Because people cannot be excluded from using the good once it exists, they have no incentive to pay for it, so a firm could not cover its costs. 6. The Australian Competition and Consumer Commission (ACCC).