Microeconomics Quiz: Price Elasticity Of Demand
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Price Elasticity Of DemandQuestion 1 of 20

A coffee shop notices that when it raises the price of its specialty latte from $4.50 to $5.50, daily sales decrease from 120 lattes to 96 lattes. However, when the shop raises the price of its basic coffee from $2.00 to $2.40, daily sales decrease from 200 cups to 180 cups. What can be concluded about the relative price elasticities of demand for these two products?

The specialty latte has more elastic demand than basic coffee because luxury items are always more price-sensitive than necessities
Basic coffee has more elastic demand than the specialty latte because the percentage change in quantity demanded is greater for basic coffee
The specialty latte has more elastic demand than basic coffee because its elasticity coefficient is approximately -1.0 compared to -0.5 for basic coffee
Both products have identical price elasticity because they both experienced the same absolute decrease in sales per dollar of price increase
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Microeconomics Quiz

Microeconomics Quiz: Price Elasticity Of Demand

Practice Price Elasticity Of Demand in Microeconomics with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

What this quiz covers

This quiz focuses on Price Elasticity Of Demand, giving you a quick way to practice the rules, question types, and explanations that matter most for Microeconomics.

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Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

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Question 1

A coffee shop notices that when it raises the price of its specialty latte from $4.50 to $5.50, daily sales decrease from 120 lattes to 96 lattes. However, when the shop raises the price of its basic coffee from $2.00 to $2.40, daily sales decrease from 200 cups to 180 cups. What can be concluded about the relative price elasticities of demand for these two products?

  1. The specialty latte has more elastic demand than basic coffee because luxury items are always more price-sensitive than necessities
  2. Basic coffee has more elastic demand than the specialty latte because the percentage change in quantity demanded is greater for basic coffee
  3. The specialty latte has more elastic demand than basic coffee because its elasticity coefficient is approximately -1.0 compared to -0.5 for basic coffee (correct answer)
  4. Both products have identical price elasticity because they both experienced the same absolute decrease in sales per dollar of price increase
Explanation: For the specialty latte: % change in quantity = (96-120)/120 = -20%; % change in price = (5.50-4.50)/4.50 = 22.2%; elasticity = -20%/22.2% ≈ -0.9. For basic coffee: % change in quantity = (180-200)/200 = -10%; % change in price = (2.40-2.00)/2.00 = 20%; elasticity = -10%/20% = -0.5. The specialty latte is more elastic. Choice A makes an unsupported generalization. Choice B incorrectly compares absolute rather than percentage changes. Choice D ignores the percentage-based nature of elasticity calculations.

Question 2

A company's demand curve is given by P=50−2QP = 50 - 2Q, where P is price and Q is quantity. At what output level is the price elasticity of demand equal to -2, and what is the significance of this point for revenue management?

  1. Q = 10, P = $30; this represents the revenue-maximizing point where marginal revenue equals zero and further price cuts reduce total revenue
  2. Q = 12.5, P = $25; this is the unit elastic point where small price changes have proportional effects on quantity demanded
  3. Q = 16.67, P = $16.67; this point indicates highly elastic demand where price reductions will significantly increase total revenue
  4. Q = 8.33, P = $33.33; this point shows moderately elastic demand where the firm should consider price reductions to increase revenue (correct answer)
Explanation: From P = 50 - 2Q, we get Q = (50-P)/2, so dQ/dP = -1/2. Elasticity = (dQ/dP) × (P/Q) = (-1/2) × (P/Q) = -2. This gives us P/Q = 4, so P = 4Q. Substituting into the demand equation: 4Q = 50 - 2Q, so 6Q = 50, Q = 8.33, P = 33.33. At elasticity of -2, demand is elastic, so price reductions would increase revenue. Choice A gives the unit elastic point. Choice B incorrectly identifies this as unit elastic. Choice C has wrong calculations.

Question 3

A retailer observes that when the price of Product X increases from $20 to $24, the quantity demanded of Product Y increases from 100 units to 130 units, while the quantity demanded of Product X decreases from 150 units to 120 units. What can be concluded about these products and their market relationships?

  1. Products X and Y are substitutes with a cross-price elasticity of +1.5, and Product X has elastic demand with own-price elasticity of -0.6
  2. Products X and Y are substitutes with a cross-price elasticity of +1.5, and Product X has unit elastic demand with own-price elasticity of -1.0 (correct answer)
  3. Products X and Y are substitutes with a cross-price elasticity of +6.0, and Product X has inelastic demand with own-price elasticity of -1.0
  4. Products X and Y are complements because both quantities change when Product X's price changes, indicating joint consumption patterns
Explanation: When you encounter a question involving price changes and quantity responses for multiple products, you're dealing with elasticity concepts - specifically cross-price elasticity (how one product's demand responds to another's price change) and own-price elasticity (how a product's demand responds to its own price change). Let's calculate both elasticities using the midpoint method. For cross-price elasticity of X and Y: the percentage change in Y's quantity is (130−100)(130+100)/2=30115=26.1%\frac{(130-100)}{(130+100)/2} = \frac{30}{115} = 26.1\%. The percentage change in X's price is (24−20)(24+20)/2=422=18.2%\frac{(24-20)}{(24+20)/2} = \frac{4}{22} = 18.2\%. Cross-price elasticity = 26.1%18.2%=+1.4\frac{26.1\%}{18.2\%} = +1.4 (approximately +1.5). For X's own-price elasticity: percentage change in X's quantity is (120−150)(120+150)/2=−30135=−22.2%\frac{(120-150)}{(120+150)/2} = \frac{-30}{135} = -22.2\%. Own-price elasticity = −22.2%18.2%=−1.2\frac{-22.2\%}{18.2\%} = -1.2 (approximately -1.0). The positive cross-price elasticity confirms X and Y are substitutes - when X becomes more expensive, consumers buy more Y instead. Answer A has the wrong own-price elasticity (-0.6 instead of -1.0) and incorrectly classifies X's demand as elastic when it's actually unit elastic. Answer C drastically overstates the cross-price elasticity as +6.0. Answer D misidentifies the relationship entirely - these products are substitutes, not complements, since their cross-price elasticity is positive. Remember: positive cross-price elasticity = substitutes, negative = complements. Own-price elasticity of -1.0 indicates unit elastic demand.

Question 4

An economist estimates that the price elasticity of demand for gasoline is -0.3 in the short run and -1.2 in the long run. If gasoline prices increase by 25%, what is the expected difference between short-run and long-run percentage changes in quantity demanded?

  1. The long-run decrease will be 22.5 percentage points greater than the short-run decrease in quantity demanded (correct answer)
  2. The long-run decrease will be 0.9 percentage points greater than the short-run decrease in quantity demanded
  3. The short-run decrease will be 7.5 percentage points less than the long-run decrease in quantity demanded
  4. The difference will be 4 times greater in the long run, representing a 1.5 percentage point increase in responsiveness
Explanation: Short-run: % change in quantity = elasticity × % change in price = -0.3 × 25% = -7.5%. Long-run: % change in quantity = -1.2 × 25% = -30%. The difference is 30% - 7.5% = 22.5 percentage points. Choice B confuses the elasticity coefficients with the actual percentage changes. Choice C states the correct values but reverses the comparison. Choice D incorrectly calculates the relationship between the elasticities.

Question 5

A luxury car dealership notices that during economic recessions, a 20% decrease in consumer income leads to a 60% decrease in luxury car sales, while a 15% increase in the price of gasoline leads to a 45% decrease in luxury car sales. What do these elasticities suggest about the dealership's optimal pricing strategy during economic downturns?

  1. Decrease prices aggressively because the high income elasticity (+3.0) suggests luxury cars are normal goods that benefit from lower prices during recessions
  2. Maintain current prices because the gasoline cross-price elasticity (-3.0) indicates that fuel costs are the primary demand driver, not car prices
  3. Focus on cost reduction rather than price changes because both income elasticity (+3.0) and gasoline cross-price elasticity (-3.0) indicate demand is driven by external factors (correct answer)
  4. Increase prices to maintain revenue because luxury car buyers are less price-sensitive during recessions when income effects dominate purchasing decisions
Explanation: Income elasticity = (-60%)/(-20%) = +3.0 (luxury good). Gasoline cross-price elasticity = (-45%)/(+15%) = -3.0 (complementary relationship). Both elasticities are high in absolute value, indicating that external factors (income and gas prices) have much larger effects on demand than the dealership's own pricing decisions would. Therefore, focusing on operational efficiency and cost control makes more sense than price manipulation. Choice A misunderstands how income elasticity works during recessions. Choice B ignores that both effects matter. Choice D contradicts economic logic about luxury goods during recessions.

Question 6

An agricultural economist studies corn demand and finds that a 10% increase in corn prices leads to a 15% increase in quantity demanded for wheat, while corn consumption decreases by 4%. If wheat prices simultaneously increase by 5%, what is the net effect on wheat demand, assuming wheat's own-price elasticity is -0.8?

  1. Net increase of 19% in wheat quantity demanded because cross-price and own-price effects are additive in the same direction
  2. Net increase of 11% in wheat quantity demanded due to the stronger substitution effect overwhelming the own-price effect (correct answer)
  3. Net increase of 4% in wheat quantity demanded after accounting for both cross-price substitution and own-price effects
  4. Net decrease of 11% in wheat quantity demanded because the own-price effect dominates the substitution effect from corn
Explanation: When analyzing demand changes with multiple price shifts, you need to calculate each elasticity effect separately and then combine them. This question tests your understanding of cross-price elasticity (how one good's price affects another's demand) and own-price elasticity (how a good's price affects its own demand). First, calculate the cross-price effect: When corn prices rise 10%, wheat demand increases 15%. This gives us a cross-price elasticity of +1.5, confirming wheat and corn are substitutes. Next, calculate the own-price effect: Wheat prices increase 5% with an own-price elasticity of -0.8. Using the elasticity formula: \text{% change in quantity} = \text{elasticity} \times \text{% change in price}, we get: −0.8×5%=−4%-0.8 \times 5\% = -4\% The net effect combines both: +15% (from corn price increase) + (-4%) (from wheat price increase) = +11% increase in wheat quantity demanded. Choice A incorrectly claims a 19% increase, apparently adding 15% + 4% without recognizing that the own-price effect reduces demand. Choice C shows only a 4% increase, which appears to subtract the full 15% cross-price effect from some other calculation. Choice D incorrectly concludes the own-price effect dominates, leading to decreased demand, when the substitution effect (+15%) clearly outweighs the own-price effect (-4%). Remember: When multiple price changes affect demand simultaneously, calculate each elasticity effect separately using the appropriate elasticity coefficient, then add the percentage changes algebraically to find the net effect.

Question 7

For which of the following pairs of goods is the first good likely to have a significantly more price elastic demand than the second good, ceteris paribus?

  1. Gasoline in the short run vs. gasoline in the long run.
  2. All breakfast cereals vs. a specific brand of corn flakes.
  3. A round-trip airline ticket from New York to London vs. tap water from a local utility. (correct answer)
  4. Table salt vs. a new luxury sedan.
Explanation: Price elasticity of demand is determined by factors such as the availability of substitutes, whether the good is a necessity or luxury, the definition of the market, and the time horizon. An airline ticket is a non-essential service with substitutes (other airlines, other destinations, not traveling) and represents a significant budget item, making its demand relatively elastic. Tap water is a necessity with no substitutes and a small budget share, making its demand highly inelastic. Therefore, the airline ticket (first good) is more price elastic than tap water (second good). The other pairs have the relationship reversed.

Question 8

A firm faces a linear demand curve for its product. At the current price of $20, it sells 100 units per week. The firm's marketing department provides a reliable estimate that the price elasticity of demand at this point is -2.5. To maximize its weekly total revenue, the firm should:

  1. raise the price, because demand is inelastic.
  2. keep the price at $20, because any change would decrease revenue.
  3. lower the price, because demand is elastic. (correct answer)
  4. shut down production, because elasticity is negative.
Explanation: The price elasticity of demand is -2.5. The absolute value, 2.5, is greater than 1, which indicates that demand is price elastic at the current price. Total revenue is maximized when price elasticity of demand is unit elastic (equal to -1). When demand is elastic, a decrease in price leads to a proportionally larger increase in quantity demanded, thus increasing total revenue. Therefore, the firm should lower its price from $20 to move down the demand curve towards the unit-elastic point and increase its total revenue.

Question 9

Suppose a 10% increase in the price of a good leads to a 15% decrease in the total revenue earned by sellers. From this information, it can be concluded that the demand for the good in this price range is:

  1. price inelastic.
  2. price elastic. (correct answer)
  3. unit price elastic.
  4. perfectly price inelastic.
Explanation: The total revenue test provides a direct way to determine elasticity. If price and total revenue move in opposite directions, demand is price elastic. In this case, price increased by 10%, and total revenue decreased by 15%. Because they moved in opposite directions, demand must be price elastic. A student might be tempted to perform a complex calculation, but it is not necessary. For elastic demand, the percentage change in quantity demanded is greater than the percentage change in price, which causes the revenue change to follow the quantity change, not the price change.

Question 10

A life-saving drug with no substitutes is required in a fixed daily dose by patients. The pharmaceutical company that is the sole producer of this drug increases its price by 300%. Which of the following outcomes is most likely?

  1. The quantity demanded will fall by 75%, keeping the company's total revenue approximately constant.
  2. The company's total revenue will fall, as the significant price increase will deter most patients.
  3. The quantity demanded will fall to zero as the drug becomes unaffordable.
  4. The company's total revenue will increase by approximately 300%. (correct answer)
Explanation: The description of the drug (life-saving, no substitutes, fixed dose) implies that the demand for it is perfectly inelastic, or very close to it. For perfectly inelastic demand, the quantity demanded does not change regardless of the price. Total revenue is calculated as Price × Quantity (P×Q). If the price (P) increases by 300% (i.e., becomes 4 times the original price) and the quantity (Q) remains constant, the total revenue (P×Q) will also increase by approximately 300%.

Question 11

A concert promoter lowers the ticket price for a show from $60 to $50 and observes that the quantity of tickets sold increases from 2,000 to 2,500. Based solely on this information, which action should the promoter take to continue increasing total revenue?

  1. Raise the ticket price back to $60, because demand is price inelastic in this range.
  2. Keep the price at $50, as this has been shown to be the revenue-maximizing price.
  3. Lower the ticket price further, because demand is price elastic in this range. (correct answer)
  4. Raise the ticket price above $60, as the increase in quantity sold was proportionally larger than the price cut.
Explanation: To determine the correct strategy, we use the total revenue test. Initial total revenue was $60 × 2,000 = $120,000. The new total revenue is $50 × 2,500 = $125,000. Since a decrease in price led to an increase in total revenue, the demand for tickets in this price range is price elastic. When demand is price elastic, a firm should continue to lower its price to increase total revenue, moving towards the unit-elastic point on the demand curve.

Question 12

A major city invests heavily in a new, extensive public transportation system, creating a convenient alternative to driving. At the same time, the price of gasoline rises significantly. How will the combination of these two events likely affect the price elasticity of demand for gasoline in this city?

  1. The new transit system will make demand more elastic, while the higher price will make it more inelastic.
  2. Both events will make the demand for gasoline more price elastic. (correct answer)
  3. Both events will make the demand for gasoline more price inelastic.
  4. The new transit system will make demand more inelastic, while the higher price will make it more elastic.
Explanation: Two determinants of price elasticity are at play. First, the new public transportation system is a substitute for driving, and therefore for gasoline. An increase in the availability of substitutes makes the demand for a good more elastic. Second, a significant price increase means consumers are operating on a higher portion of their demand curve. For a typical linear demand curve, demand is more elastic at higher prices than at lower prices. Therefore, both events work in the same direction to make the demand for gasoline more price elastic.

Question 13

A market for a specific type of software has only two consumers. Consumer 1's demand is given by Q1=30−PQ_1 = 30 - P, and Consumer 2's demand is Q2=50−PQ_2 = 50 - P. What is the absolute value of the price elasticity of market demand if the market price is $20?

  1. 0.67
  2. 1.00 (correct answer)
  3. 1.50
  4. 2.00
Explanation: First, derive the market demand by horizontally summing the individual demands: Qmarket=Q1+Q2=(30−P)+(50−P)=80−2PQ_{market} = Q_1 + Q_2 = (30 - P) + (50 - P) = 80 - 2P. This is valid since at P=20,bothconsumersdemandapositivequantity.Second,findthetotalquantitydemandedatP=20, both consumers demand a positive quantity. Second, find the total quantity demanded at P=20: Qmarket=80−2(20)=40Q_{market} = 80 - 2(20) = 40. Third, use the point elasticity formula, PED=(dQ/dP)×(P/Q)PED = (dQ/dP) \times (P/Q). The slope term, dQ/dP, for the market demand curve is -2. Plugging in the values: PED=−2×(20/40)=−2×0.5=−1.0PED = -2 \times (20/40) = -2 \times 0.5 = -1.0. The absolute value is 1.00.

Question 14

A student's demand for coffee from a campus cafe is known to be price inelastic. If the cafe lowers the price of coffee, what will be the effect on the student's total expenditure on coffee and the quantity of coffee they purchase?

  1. Total expenditure will increase, and quantity purchased will increase.
  2. Total expenditure will decrease, and quantity purchased will decrease.
  3. Total expenditure will decrease, and quantity purchased will increase. (correct answer)
  4. Total expenditure will remain the same, and quantity purchased will increase.
Explanation: According to the law of demand, a lower price will always lead to an increase in the quantity purchased. The effect on total expenditure depends on price elasticity. Total expenditure (from the buyer's side) is equivalent to total revenue (from the seller's side). When demand is price inelastic, price and total expenditure move in the same direction. Since the price falls, the student's total expenditure on coffee will also decrease. Therefore, quantity purchased increases, and total expenditure decreases.

Question 15

When the price of Product X increases by 10%, the quantity demanded of Product X falls by 5%. In response to the price change of Product X, the quantity demanded of Product Y increases by 8%. Based on this information, the price elasticity of demand for Product X is:

  1. -2.0
  2. -0.5 (correct answer)
  3. 0.8
  4. -1.6
Explanation: The question specifically asks for the price elasticity of demand for Product X. This is calculated as the percentage change in the quantity demanded of X divided by the percentage change in the price of X. The information about Product Y is extraneous and relates to cross-price elasticity. PEDX=(%ΔQX)/(%ΔPX)=(−5%)/(+10%)=−0.5PED_X = (\%\Delta Q_X) / (\%\Delta P_X) = (-5\%) / (+10\%) = -0.5.

Question 16

The demand for a specialized software product is given by the equation Q=100P−2Q = 100 P^{-2}, where Q is the quantity demanded and P is the price. Which of the following statements about the price elasticity of demand for this product is true?

  1. It is -2 at all prices. (correct answer)
  2. It varies along the demand curve, becoming more elastic as price increases.
  3. It is -0.5 at all prices.
  4. It is unit elastic when the price is $10.
Explanation: When you encounter a demand function in the form Q=aPbQ = aP^b, you're looking at a constant elasticity demand curve. The price elasticity of demand equals the exponent on price, which remains constant at every point along the curve. Given Q=100P−2Q = 100P^{-2}, the price elasticity of demand is simply the exponent: -2. This means demand is elastic (since |-2| > 1) and the elasticity remains -2 at all price levels. You can verify this using the elasticity formula: Ed=dQdP×PQE_d = \frac{dQ}{dP} \times \frac{P}{Q}. Taking the derivative: dQdP=−200P−3\frac{dQ}{dP} = -200P^{-3}. Substituting into the elasticity formula and simplifying yields -2. Looking at the wrong answers: Answer B incorrectly assumes this behaves like a linear demand curve, where elasticity varies along the curve. That's not true for constant elasticity functions. Answer C gives -0.5, which would be the elasticity if the exponent were -0.5, not -2. Answer D suggests unit elasticity (elasticity = -1) at a specific price, but this function has constant elasticity of -2 everywhere, never -1. The correct answer is A: the price elasticity is -2 at all prices. Remember this pattern: for any demand function Q=aPbQ = aP^b, the price elasticity of demand always equals the exponent b. This is a huge time-saver on exams—you don't need to calculate derivatives or plug in specific values. Just identify the exponent and you have your elasticity.

Question 17

A university aims to increase total revenue from campus parking by raising the price of parking permits. This strategy will succeed only if demand is inelastic. Which of the following independent events would make it more likely that this strategy will succeed?

  1. The university eliminates most online course options, requiring more students to attend classes in person. (correct answer)
  2. The university moves several of its largest departments to a new satellite campus five miles away.
  3. The city introduces a new, highly efficient public bus system with a stop at the center of campus.
  4. A large, private parking garage opens for business on a property adjacent to the university.
Explanation: When analyzing pricing strategies and revenue, you need to understand the relationship between price elasticity of demand and total revenue. If demand is inelastic (price elasticity less than 1), consumers are relatively unresponsive to price changes, so raising prices will increase total revenue. The key is identifying what makes demand more inelastic. Option A is correct because eliminating online courses forces more students to come to campus physically. This removes a substitute for in-person attendance, making campus parking more of a necessity rather than a choice. When consumers have fewer alternatives and the good becomes more essential, demand becomes more inelastic. Option B is wrong because moving departments to a satellite campus reduces the need for parking at the main campus, decreasing demand overall and potentially making remaining users more price-sensitive. Option C is incorrect because introducing efficient public transportation provides students with a substitute for driving and parking on campus. More substitutes make demand more elastic, not less. Option D is wrong because a new private parking garage gives students an alternative to university parking, creating more substitutes and making demand more elastic. Remember this pattern: demand becomes more inelastic when consumers have fewer substitutes and the good becomes more necessary. Look for factors that eliminate alternatives or increase the essential nature of the product. Conversely, anything that provides more choices or substitutes will make demand more elastic, making price increases counterproductive for revenue goals.

Question 18

A city government imposed a 5% tax on restaurant meals to raise revenue. A year later, it was found that total consumer spending on restaurant meals, including the tax, had decreased significantly, and tax revenues were far below projections. Which statement provides the best explanation for this outcome?

  1. The demand for restaurant meals was more price elastic than the government had estimated. (correct answer)
  2. The supply of restaurant meals was perfectly inelastic, forcing restaurants to absorb the entire tax.
  3. The demand for restaurant meals was more price inelastic than the government had estimated.
  4. The income elasticity of demand for restaurant meals was negative.
Explanation: When you encounter tax policy questions, focus on how price elasticity of demand determines consumer responses to price changes. Price elasticity measures how sensitive quantity demanded is to price changes - elastic demand means consumers are very responsive to price increases. The evidence points clearly to elastic demand: when the 5% tax raised meal prices, consumer spending fell significantly and tax revenues came in far below projections. This tells you that consumers dramatically reduced their restaurant visits in response to higher prices, indicating they viewed restaurant meals as easily substitutable with alternatives like home cooking or takeout. Let's examine why the other options don't fit. Option B suggests perfectly inelastic supply, meaning restaurants absorbed the entire tax without raising prices. But this contradicts the scenario - if prices hadn't increased, consumer spending wouldn't have dropped. Option C claims demand was more inelastic than estimated, but inelastic demand means consumers continue purchasing despite price increases, which would have generated the projected tax revenue. Option D refers to income elasticity (how demand responds to income changes), but this scenario involves a tax-induced price change, not an income change. The government clearly underestimated how price-sensitive restaurant customers are. When dining became more expensive, consumers found substitutes rather than paying the higher prices. Study tip: Remember that when tax revenues fall short of projections after a tax increase, it usually signals that demand was more elastic than policymakers anticipated. Consumers found alternatives rather than paying the higher price.

Question 19

A local cinema raises the price of a movie ticket from $10 to $15. As a result, the number of tickets sold per screening drops from 200 to 100. According to the midpoint method, the absolute value of the price elasticity of demand for these movie tickets is approximately:

  1. 1.00
  2. 1.67 (correct answer)
  3. 2.00
  4. 3.00
Explanation: The midpoint method for price elasticity of demand is calculated as ∣(Q2−Q1(Q1+Q2)/2)/(P2−P1(P1+P2)/2)∣| (\frac{Q_2 - Q_1}{(Q_1+Q_2)/2}) / (\frac{P_2 - P_1}{(P_1+P_2)/2}) |. \nPercentage change in quantity = 100−200(100+200)/2=−100150≈−0.667\frac{100 - 200}{(100+200)/2} = \frac{-100}{150} \approx -0.667. \nPercentage change in price = 15−10(15+10)/2=512.5=0.4\frac{15 - 10}{(15+10)/2} = \frac{5}{12.5} = 0.4. \nPrice elasticity of demand = ∣−0.6670.4∣≈1.67| \frac{-0.667}{0.4} | \approx 1.67. \nDistractor A (1.00) results from using the simple percentage change from the initial point. Distractor D (3.00) results from using the simple percentage change from the final point. Distractor C (2.00) results from incorrectly averaging the simple initial point elasticity (1.0) and final point elasticity (3.0).

Question 20

A government wishes to impose an excise tax on a product to raise revenue while minimizing the tax's deadweight loss. It is considering two goods: Good A has a price elasticity of demand of -0.4, and Good B has a price elasticity of demand of -1.8. Assuming supply elasticities are similar, which good should be taxed and why?

  1. Good A, because the tax burden will fall more heavily on producers, who have a greater ability to pay.
  2. Good B, because its elastic demand means the tax will cause a large change in consumer behavior.
  3. Good B, because a tax on a good with elastic demand will generate more revenue.
  4. Good A, because its inelastic demand will result in a smaller reduction in the quantity traded. (correct answer)
Explanation: Deadweight loss from a tax is greater when demand (or supply) is more elastic, because the tax causes a larger distortion in the market outcome (i.e., a larger reduction in quantity traded). Good A has inelastic demand (|-0.4| < 1), while Good B has elastic demand (|-1.8| > 1). To minimize deadweight loss, the government should tax the good with the more inelastic demand, which is Good A. The quantity sold of Good A will decrease by less than that of Good B, leading to a smaller deadweight loss. Also, tax revenue is typically higher when taxing goods with inelastic demand.