SingaporeEconomicsSyllabus dot point

Why do firms and governments need to know how elastic demand and supply are?

Apply elasticity to pricing decisions, taxation, and the size of price changes in real markets

A clear O-Level answer on applying elasticity. How firms use PED to set prices, how governments use it to choose what to tax, and how elasticity decides whether a shift changes mostly price or mostly quantity.

Generated by Claude Opus 4.88 min answerUpdated 2026-06-06

Reviewed by: AI editorial process; not yet individually human-reviewed

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What this dot point is asking
The answer
Examples in context
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What this dot point is asking

The syllabus wants you to apply the elasticity concepts to real decisions: how firms set prices, how governments choose what to tax, and how the elasticity of demand and supply decides whether a shift changes mostly price or mostly quantity. The big idea is that elasticity is not just a number to calculate; it is the tool that turns demand-and-supply analysis into practical advice.

The answer

Firms use PED to set prices

A firm deciding whether to change its price needs to know the effect on total revenue, and that depends on PED:

If demand for its product is inelastic, raising the price increases total revenue, because the quantity sold falls only a little.
If demand is elastic, raising the price reduces total revenue, because the quantity sold falls a lot. To raise revenue, the firm should instead cut the price.

This is why firms try to make their product's demand less elastic, for example through branding and advertising, so that they can raise prices without losing many customers.

Governments use PED to choose what to tax

A government wanting to raise revenue from an indirect tax should target goods with inelastic demand. When demand is inelastic, a tax raises the price but the quantity bought barely falls, so the government collects tax on many units. Goods such as petrol, tobacco and alcohol fit this well, which is why they are heavily taxed.

If the aim is instead to discourage consumption of a harmful good, the picture is different: a tax works best when demand is more elastic, because then the higher price causes a larger fall in the quantity bought.

Elasticity decides price versus quantity effects of a shift

When demand or supply shifts, how much of the change shows up as a price change and how much as a quantity change depends on elasticity:

If supply is inelastic, a rise in demand pushes mostly the price up, with little change in quantity (think hotel rooms during a big event).
If supply is elastic, a rise in demand pushes mostly the quantity up, with little change in price.
The same logic applies to the elasticity of demand when supply shifts.

Why farmers face unstable incomes

Farm products have both inelastic demand and inelastic supply. A good harvest raises supply, but because demand is inelastic, the price falls sharply and farmers may earn less overall. A poor harvest cuts supply, but the price rises so much that revenue can rise. This is why farm incomes swing so much, and why governments sometimes intervene.

Worked example

A government wants to both reduce smoking and raise revenue by taxing cigarettes. Cigarettes have inelastic demand. Show how to analyse whether the tax achieves each aim.

Step 1: Set up the elasticity

Cigarettes have inelastic demand because they have few close substitutes and many smokers are addicted, so the quantity demanded changes by a smaller percentage than price.

Step 2: Analyse the revenue aim

The tax raises the price, but because demand is inelastic, the quantity bought falls only a little. The government collects tax on a still-large number of packets, so revenue rises strongly. The revenue aim is met well.

Step 3: Analyse the consumption aim

Because demand is inelastic, the same price rise causes only a small fall in the quantity smoked. So the tax reduces smoking only a little in the short run. The consumption aim is met only weakly.

Step 4: Conclude

The tax is very effective at raising revenue but only weakly effective at cutting smoking, precisely because demand is inelastic. To cut consumption more, the government might add other measures, such as advertising bans or health campaigns, that make demand more elastic over time.

Examples in context

Example 1. Tobacco taxes in Singapore. Singapore taxes tobacco heavily. Because demand is inelastic, the tax raises substantial revenue and the quantity smoked falls only modestly in the short run. To strengthen the health aim, the tax is combined with advertising bans and education, which make demand more elastic over time.

Example 2. Concert ticket prices. The supply of seats at a concert venue is fixed, so supply is perfectly inelastic. When a popular act creates a surge in demand, almost all of the change shows up as a higher price rather than more seats, which is why tickets for sought-after shows become so expensive.

Try this

Cue. Explain why a firm should cut the price of a good with elastic demand to raise revenue. With elastic demand, a price cut causes a large rise in quantity sold, which more than makes up for the lower price per unit, so total revenue rises.
Cue. State the type of demand a government should target to raise the most tax revenue, and give an example. Inelastic demand, such as petrol or tobacco, because the quantity bought falls little when the good is taxed.
Cue. Explain why a good harvest can lower farmers' total revenue. Farm products have inelastic demand, so the larger quantity from a good harvest pushes the price down sharply, and the price fall can outweigh the extra quantity, lowering total revenue.

Exam-style practice questions

Practice questions written in the style of SEAB exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

Original6 marksExplain why a government wanting to raise tax revenue would place an indirect tax on a good with inelastic demand rather than one with elastic demand.

Show worked answer →

A 6 mark question rewards the link between elasticity, the change in quantity, and tax revenue.

Inelastic demand: When demand is inelastic, a tax that raises the price causes only a small fall in the quantity bought. Because people keep buying nearly the same amount, the government collects tax on a large number of units, so revenue is high.
Elastic demand: When demand is elastic, the same tax causes a large fall in the quantity bought, as consumers cut back or switch to substitutes. The government collects tax on far fewer units, so revenue is low.
Conclusion: To raise revenue, the government targets goods with inelastic demand, such as petrol, tobacco and alcohol, because the quantity falls little when taxed.

Markers reward the point that inelastic demand keeps the taxed quantity high, and the contrast with elastic demand where quantity and revenue fall sharply.

Original6 marksA bus company is considering raising its fares. Explain how knowing the price elasticity of demand for bus travel would help it decide.