Question

a-Define the demand function of a good and its price elasticity of demand.

b- Suppose that the government wants to maximize tax revenue. Explain why it may be not a good idea for the government to raise tax rates for a good with a price elasticity of demand more than one.

Answer 1

(a)

Demandfunction shows the relationship between quantity demanded of a good and it's determinants. For example price , price of related goods, income etc.

The price elasticity of demand measures the responsiveness quantity demand of a good due to change in the price.

If Ed<1 inelastic demand, if Ed>1 elastic demand and if Ed=1 unit elastic demand.

(b)

If elasticity of demand is inelastic, it raises more tax revenue because with the increase in price of a inelastic good, the responsiveness of quantity demanded doesn't change much. If the elasticity of demand is greater than one, then with the change in price due to tax, the quantity demand of a good is affected by more amount.

Sothe tax revenue decrease if tax is imposed on the elastic demanded good. Therefore if government wants to maximize tax revenue, then it should not impose tax on elastic demanded good (Ed>1)