Understanding price elasticity and how it relates to Global Mobility

    Jun 12, 2020 @ 07:34 AM / by Patrick Robinson

    Background conceptual image with business sketches on chalkboard

    Price elasticity  

    Price elasticity can be defined as a measurement of the change in demand when the price of a good changes. While this number can range from 0 to infinity, it is most commonly thought of as 0 to -1 and referred to in absolute value (positive values only) terms.

    A price elasticity of zero represents no change in demand for any change in price for a given good. We call this a perfectly inelastic good. Toilet paper is an example of a relatively inelastic good where demand stays fairly constant despite price fluctuations. On the other end of the spectrum, we have a perfectly elastic good where an increase in price has a one-to-one relationship with a decrease in demand. Can you think of a good that’s demand has a one-to-one relationship with its price?


    How much of the burden falls to the producer versus the consumer?

    Whether or not a price change is shouldered more by consumers or producers depends on the demand elasticity of a good. A good that is relatively inelastic will more heavily burden the consumers.

    Going back to our toilet paper example from above, a tax increase of 5% might directly increase the price of toilet paper by 5%. A good that is relatively elastic will see the producers sharing more of the burden because consumers are more sensitive to price changes. A luxury good such as jewelry might only see its price increase 1% with a 5% increase in tax. For this reason, when VAT rates change in a location, we don’t always see the exact same rate of change to cost of living.


    Example: Pre-tax

    In the graphic below, we can see the supply and demand curves of hamburgers. In this graphic, we assume there is no tax added to the cost of hamburgers. In this state, the equilibrium price of a hamburger is $10 and at that price, 20 million hamburgers are produced by all companies in the market.

    Graph 1

    Example: Post-tax

    In the graph below, the government has instituted a specific tax of $3 per hamburger sold. We can see that this has shifted the supply curve up and to the left. We now get fewer hamburgers for more money with an equilibrium price of $12, and at that price, 18 million hamburgers are produced.

    Graph 2

    Tax incidence actually paid by consumers

    You might have noticed in the above example that although the tax increased $3, the consumer only took on $2 of the price increase. This is where price elasticity comes into play: because the price elasticity of demand for hamburgers is only -.5, part of the cost increase will be absorbed by producers. In fact, for every price increase with this given demand curve, consumers will only incur 2/3 of the price increase with 1/3 being incurred by the producer.


    How does price elasticity relate to Global Mobility?

    In light of economic pressure caused by the COVID-19 pandemic, governments around the world are searching for ways to stabilize and stimulate their economies. Adjustments to direct and indirect tax have been a common mechanism. While many countries have instituted reductions to VAT (value-added tax), Saudi Arabia was the first country to buck this trend, announcing a VAT increase from 5% to 15% earlier this month, which will go into effect July 1, 2020.

    Among different kinds of indirect taxes, impacts of tax change on consumer prices vary. Taxes levied at the point of consumption (like excise taxes) are often less complex than VAT, which is levied at each stage of a supply chain, with price elasticity impacting each step from production to point-of-sale. While tax increases like the VAT increase in Saudi Arabia are expected to impact consumer prices, the tax decreases seen more widely around the world are primarily implemented to support businesses, and are less likely to be passed on in the form of lower prices for consumers.

    For expatriate consumers, who typically purchase more imported goods, impacts of VAT to consumer pricing can differ from changes seen in a local market basket. AIRINC’s methodology is an advantage here because it takes into account expatriate spending patterns.

    The COVID-19 pandemic and the collapse of global oil demand present more complex economic impacts and mechanisms that make impacts harder to predict. AIRINC will continue to monitor the VAT increase in Saudi Arabia as well as changes to tax and cost of living around the world. If you have questions about this or any other global mobility issue that you're facing right now, please reach out today: 

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    Topics: Global Mobility, Global Compensation, Insights and Experience, Price Elasticity

    Patrick Robinson

    Written by Patrick Robinson