Jim’s Guide for Unit 4: Elasticity
The tool of politics (which frequently becomes its objective) is to extract resources from the general taxpayer with minimum offense and to distribute the proceeds among innumerable claimants in such a way to maximize the support at the polls. Politics, so far as mobilizing support is concerned, represents the art of calculated cheating, or more precisely, how to cheat without being really caught.
– James R. Schlesinger
Systems Analysis and the Political Process.
Journal of Law and Economics,
(October 1968), p. 281.
Let’s suppose for a moment that you are either in charge of raising revenue for the government or that you are in charge of some monopoly business. You want to, in the words of former Secretary of Defense James Schlesinger above, extract the maximum amount of resources from taxpayers (or your customers if you are a business). Economically, what do you need to do? If you are a government what should you tax? If you are a business, should you raise the price? Should you lower the price?
At first thought, it seems to make sense to raise the price, right? Charge each customer more money. But the demand curve says that customers will then buy fewer units. So why not lower price? After all there’s the old business cliché about “cut the price and make it up on volume”. Which do you do? Will cutting the price actually bring in more total revenue? Or will charging a higher price bring more total revenue even though customers will buy less?
In this unit we will discover that economics offers a way to answer these questions. That way is a concept called elasticity. And along the way we hope to give a method for answering these questions. We should even figure out why governments levy extra taxes on cigarettes, liquor, gasoline, and telephone service, but not on milk, sweaters, or television. We will figure out why Coca-Cola and Pepsi Cola are often put on sale at the grocery and the drugstore is always running a “sale”, but the electric power utility company never does run a sale.
In this unit, we have these main objectives:
- Explain price elasticity of demand and interpret given elasticity numbers
- Explain the relationship between the price elasticity of demand for a product and the effects of a price change on total revenue.
So far we have described the demand curve in supply and demand market model as just conforming to the “Law of Demand”. Graphically, the “Law of Demand” simply states that Price and Quantity Demanded are inversely related. That is, the demand curve slopes downward and to the right. But, ‘downward and to the right’ covers a lot of possibilities. The demand curve could very, very steep — almost vertical. Or, it could be the opposite – it could have so little slope that the curve is almost flat and horizontal. Or, it could be non-linear –not a straight line at all, but curving throughout. Mathematicians describe the question of the steepness of curve as “slope”. Economists, however, use a measure called elasticity because it is much more meaningful economically.
The concept of elasticity can have very real economic meaning and can tell us something about whether people are willing to substitute other goods for this good. In the case of a demand curve, it elasticity tells us how “price sensitive” the buyers are. Elasticity is similar to the mathematician’s concept of slope, but it is measured differently. The calculation of a slope is very dependent on the units that you’re using to measure price and quantity. Economists get around this problem by comparing the percentage changes in price and quantity. We call this number elasticity.
Elasticity: Measuring Sensitivity
How sensitive are you to prices? When the price goes up on a good, how do you react? I don’t mean how much do you complain, or what kind of names do you call the seller, I’m talking about how do you change your buying habits when the price goes up?
When the price of gasoline goes up, most of us just keep buying almost the same amount of gas. We may complain. We may have to cut our spending on other things to buy the gas. But, for the most part we buy it. After all, just because the gasoline costs 10% more doesn’t mean I only have to drive 90% of the way to work!. Gasoline purchases, in the short run, are very inelastic. People aren’t really very sensitive (in terms of how much they buy) to the price.
On the other hand, some products seem to encourage very price sensitive behavior. A simple cents-off coupon (a small price cut) on some products in the grocery may cause a huge increase in the quantity people want to buy. Why? Such a product is called “elastic”. People are very price-sensitive for these products because they have alternatives that are very attractive. They have good substitutes available.
The important part of this unit is the concept and the meaning of elasticity. Don’t get too caught up in the math. The math (formulas) look formidable, but they’re not really. They all get down to comparing a price change to a quantity change. The formulas get complex because of two measurement problems. We want a measure of sensitivity (elasticity) that can be compared meaningfully between different products and situations. To do that, we must measure the changes in price (or quantity) as % changes. This adds a little complexity to the formulas.
The next problem is trying to make the % change sound the same no matter which direction you’re moving. This is why we have the “mid-point formula”. This is a way around the following problem. Suppose you’re comparing two prices: $110 and $90. Which number should you use as the denominator? After all, $110 is a 22% increase over $90, but $90 is 18% less than $110! So instead, we use the midpoint between them in calculating the percentage change. That way they both come out to 20% changes.
Don’t Miss Seeing the “Forest” for the Math!
The most common problem students encounter in studying elasticity is the math. The equations in the book can look pretty intimidating and complex, especially to any student who’s mildly math-phobic. The math and the formulas for elasticity are just tools to overcome a couple of problems in understanding elasticity.
Keep your mind on the bigger question. With elasticity, we’re trying to better understand the consumer’s (or supplier’s) attitude or feeling toward the good. To be even more precise, we’re trying to develop a way to measure how price-sensitive or responsive the consumer is. Elasticity is just a standardized way to measure sensitivity.
The meaningful part of any elasticity is formula is contained in the name. The “price elasticity of demand” measures the % change in quantity demanded vs. % change in price of a good. The “income elasticity of demand” measures % change in demand vs. % change in income.
What’s most important is understanding:
- the concept of elasticity as measuring responsiveness or sensitivity
- what the values of price elasticity = 0, less than 1, =1, or greater than 1 mean
- what the terms elastic, inelastic, and unitary elastic mean
Formulas can always be looked up and calculated. The challenge is what does it mean if someone tells you that a particular good has a very inelastic price elasticity of demand. How would you expect that person to react to a large price increase? What would that reaction do to their demand for other goods?
Price Elasticity of Demand and Other Elasticity Measures
We spend the most time in this unit studying price elasticity of demand, but there are other useful concepts that can be measured with some form of elasticity measure. The most important other measures we will study are:
- Income elasticity of demand – How sensitive to changes in your income is your demand for the product? By looking at this measure and it’s negative/positive sign economists can classify a product as being a inferior good (see previous unit), a normal good, a necessity, or a luxury item. This allows economists to classify products based on actual buyer choices/behavior, not on what we personally think of the product.
- Price elasticity of supply – How price sensitive are the producers or suppliers of the product?
- Cross-Price Elasticity of Demand – How does your demand for this product change when the price of a different product changes. If the price of the other product goes up and your demand for this product increases, then this elasticity measure is positive and the two products are viewed by you as substitutes. If this measure is negative, then you view the two products as complements. If this measure is close to zero, then you must view these products as totally unrelated to each other.
Price Elasticity of Demand and Total Revenue
The concepts of elasticity are among the most directly useful for businesspeople (and governments). For one, elasticity tells us whether a price increase will result in more total revenue or less total revenue. For another, it provides a world of insight into consumers behavior.
The total revenue a business collects from selling a product is equal to the Price times Quantity sold. If the price elasticity of demand of a product is inelastic, then price can be increased and total revenue will also increase. The effect of the price increase will be greater than the effect of the resulting decrease in quantity. But, if the price elasticity of demand is elastic, then the effect of the price increase will be much less than the resulting large loss of quantity sold. A business with elastic demand will collect less total revenue when they increase price. A business with elastic demand, therefore, actually wants to lower price, which encourages buyers to buy a much larger quantity and that results in higher revenue.
So we can return to the examples in the introduction above and understand them better. Coke and Pepsi have elastic demand. A drugstore experiences elastic demand for most of its products (not the Rx’s though). As a result, drugstores and groceries run sales! They lower the price of these elastic items and thereby increase the total revenue they collect. On the other hand, the electric power utility experiences extremely inelastic demand, so the last thing the utility company wants to do is run a sale. It would only give away revenue back to customers. [think about it: if the power company ran a ‘half-price sale on kilowatt hours this month” sale, would then buy 50% more electricity? I doubt it.]
Elasticity also explains which products the government choose to tax. Excise taxes raise the price of the product. For example, gasoline taxes often add over a dollar to the price of gasoline. Yet, since the short-run demand for gasoline is inelastic, people continue to buy nearly as much gasoline. The government successfully collects the revenue. Same thing happens with cigarettes, liquor, and telephone service. All these products have inelastic demand and the government taxes them. The government doesn’t tax sweaters or television or soft drinks because these have an elastic demand. A tax on them would raise prices and people would not buy anywhere near as many units. The government wouldn’t then actually collect the tax.
If you’re interested in marketing or marketing research, elasticity provides a wealth of information. For example, consider the data available to grocery stores from scanning all those products at the checkout. By adding a consumer’s ID by scanning those “discount bonus cards”, groceries and manufacturers can actually measure the price elasticity of different goods. That helps them plan better sales & pricing. It even helps them plan where to put merchandise on the shelves. For example, it used to be that fresh bananas were only available in the fresh produce section. Now fresh bananas are often stocked in the breakfast cereal aisle also. Why? Scanner data shows that the cross-price elasticity of demand of bananas and breakfast cereal is very negative, indicating they are strong complements. So, groceries put the bananas next to the cereal to “remind” people to buy the bananas with the cereal.
This unit completes Part I of the course. In Part I we studied the basic models and principles of economics, focusing particular attention on how a market works. In Part II of the course we will take a closer look at theories or models that underlie the demand curve and the supply curve. In other words, we will focus on how people make the best of their limited situations. In the next unit, we look specifically at models of how consumers make choices so that they can make the most of their limited funds. Sound familiar?
If all economists were laid end to end,
they would not reach a conclusion.
–George Bernard Shaw (1856 – 1950)
To finish this unit, be sure to:
- Read the textbook (see the Reading Guide for what chapters and pages to read in the textbook or other source)
- Take a look at any tutorials, videos, or articles in Closer Look
- Try the practice quiz
- Complete the worksheet assignment
- Complete the Graded assignments in your school’s Learning Management System