What is the importance of price elasticity of demand to government decision-making?

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pohnpei397 eNotes educator| Certified Educator

Price elasticity of demand is the degree to which the quantity demanded of a product will change as the product’s price changes. It can be important for the government for at least two reasons.

First, let us imagine an area whose economy depends on people buying things. This might be an area in which tourism is very important. Price elasticity of demand would be important for the people making decisions in this area’s government. They would want to know what the elasticity was so they know how much to tax things like hotel rooms. The more elastic the demand for tourism, the less they would want to raise taxes because they would want to avoid driving down the quantity demanded by tourists.

The second reason applies to all governments. This has to do with the incidence of taxation. When a government imposes a tax on sales, it can fall more heavily on the producers or it can fall more heavily on the consumers. This depends on price elasticity of demand and price elasticity of supply. If the elasticity of demand is higher than the elasticity of supply, the incidence of the tax (its burden) will fall more on the supplier. If, on the other hand, the elasticity of demand is lower than the elasticity of supply, the burden of the tax will fall more on the consumer. The government needs to know this so it can try to target taxes to burden the group it feels is more capable of handling that burden.

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