# MIC ECON Lec 02 – Elasticity

CHAPTER 2:

ELASTICITY

LEARNING OBJECTIVE The purpose of studying elasticity is to determine how a small change in price may result in either a large or small change in quantity. The concept is first defined and explained. Its measurement is discussed. The relationship between total revenue and elasticity is outlined. Supply elasticity and its determinants are analyzed. The concepts are applied to analyze price ceilings, price supports and tax incidence.

ELASTICITY The concept of elasticity is intended to measure the degree of responsiveness of a buyer or seller to a change in a key determinant, in particular price. The degree of responsiveness of the quantity demanded to a price change is called the price elasticity of demand. If the price change is that of another good then the study deals with cross elasticities of demand.

 Suppose a store manager wants to run a sale. Should he lower the price of a given item? And, if yes, by how much? The answer will depend on whether the increase in purchases by customers will be larger than the price decrease, (both calculated on a relative basis). This change in purchases by customers is what elasticity is intended to measure.

ELASTICITY MEASUREMENT If elasticity were measured by absolute quantities, then it would be affected by the units of measure used for both price and quantity. To avoid this difficulty, elasticity is a ratio of relative changes in quantity and price:

Ed = (dQ/Q) / (dP/P)

Or Ed = % change in quantity / % change in price.

 If a grocery store can increase its sale of milk by 12 quarts (from 24 to 36) when the price is dropped by 10 cents (from \$1.00 to \$.90), the elasticity measured in absolute terms is 1.2 (that is 12/10). But, when the quantity of milk is expressed in gallons, the elasticity in absolute terms is now 0.4 (4/10). If dollars instead of cents are used, it becomes 40 (4/0.1). This difficulty disappears when the elasticity is a relative measure.

MIDPOINT ELASTICITY The calculation of elasticity using the formula of change in relative quantity over change in relative price results in different values depending on whether the starting point of the calculation is the highest or lowest price. To avoid this difficulty, both price and quantity are averaged: this is the equivalent of taking the elasticity at the midpoint of the price-quantity range.

Ed = ((Q2-Q1)/ ((Q1+Q2)/2)) / ((P2-P1)/ ((P1+P2)/2))

It should be noted that price elasticity of demand is always negative and absolute values are often quoted without indicating the negative sign.

 If price is decreased by -10 percent (from \$1.00 to \$.90) to increase sales of milk by 50% (from 24 to 36), the elasticity is -5 (that is 50% divided by -10%). Looking at the same number the other way: there is a decrease in quantity of -33.3% (from 36 to 24) when the price is increased 11.1% (from \$.90 to \$1.00): an elasticity of -3. The presence of 2 values does not make sense. The midpoint (and correct) elasticity is -3.8 (that is (12/30) / (-0.10/0.95)).

ELASTIC DEMAND If the demand is elastic, it means that a small price change results in a large quantity change. This would generally take place on the upper portion of the demand curve. If the demand is perfectly elastic (which means that the smallest possible price change results in a virtually infinite quantity change), the demand curve is then horizontal.

 A mother wants to surprise her children by bringing home some fancy pastry for desert. But, after discovering that the pastry shop has raised its prices to unreasonable levels, she decides to skip the pastry. Her reaction shows very high, virtually infinite, elasticity.

INELASTIC DEMAND If the demand is inelastic, it means that even a substantial change in price leads to hardly any change at all in quantity demanded. This generally occurs in the lower portion of the demand curve. If the demand is perfectly inelastic, quantity does not change at all. A perfectly inelastic demand is vertical.

 For most people, items that are considered as necessities are items for which the demand is inelastic. No matter how much the price may change, if we think we really need an item, we will buy it. Medicine or basic food items are probably in this category. Milk for a family with children is such a basic food: you will always find it somewhere in the refrigerator, no matter its price.

TOTAL REVENUE AND ELASTICITY If demand is elastic, then price and total revenue are inversely related; that is, if price is increased, total revenue decreases. If demand is inelastic, price and total revenue are directly related; that is, if price is increased, then total revenue increases as well.

 In the previous milk example, the demand was elastic: 3.8. The revenues increase from \$24 (when the price is \$1.00 for 24 gallons) to \$32.40 (when the price is lowered to \$.90 for 36 gallons). Thus, total revenue is indeed inversely related to price change when demand is elastic.

DEMAND ELASTICITY DETERMINANTS The determinants of demand elasticity are

– The time framework (market period, short run or long run),

– The availability of substitutes,

– The proportion the item represents in total income, – the perception of the item as necessity or luxury.

 The ability to switch to another brand, another product or another form of consumption, is the overall criterion of all the determinants of demand elasticity. It is clearly a very subjective factor, quite different from person to person.

SUPPLY ELASTICITY Supply elasticity is the degree of responsiveness of the quantity supplied to a change in price. It is calculated as

Es = % change in quantity / % change in price.

 The government is interested to know how much more electricity electric companies would be willing to supply if they were allowed an increase in the rates they charge. What measures this responsiveness of the electric companies is the supply elasticity. Naturally, building a power plant takes a long time. Thus, the supply price elasticity of electricity can be expected to be higher in the long run than in the short run.

SUPPLY ELASTICITY DETERMINANTS The major determinants of supply elasticity are

– The time framework (market period, short run or long run), – the ability to shift resources.

INCREASING COST INDUSTRY When a resource is scarce and the cost of that resource increases over time, the long run equilibrium price of products made from it increases and the industry is referred to as an increasing cost industry. Most industries have increasing costs over time. Some industries do not have scarce resources; they are constant cost industries. New emerging industries may experience decreasing costs for a while.

 Production of electricity is very likely to be of increasing cost industry type. The various energy sources (gas, coal, fuel, and hydropower) are all extensively used. Alternative sources (nuclear, sun, wind) have their own additional danger or costs. That is why our electric bill usually goes up, and is likely to do the same in the future.

PRICE CEILING A price ceiling creates a shortage in the short run. Since both demand and supply curves are more elastic as the time framework lengthens, this causes the shortage to increase over time. This can be verified by observing that a price below equilibrium is an incentive for buyers to buy more and a disincentive for suppliers to supply more.

 In most major cities, rent control laws have been enacted to provide affordable housing to low and middle income families. But, landlords have been discouraged to keep increasing the number of apartments available at those moderate rents, and have often preferred to convert ownership to cooperative or condominium form. This has taken apartments off the rental market and increased shortages of affordable housing in many cities.

PRICE SUPPORT In the short run a price support creates a surplus. In the long run, both demand and supply become more elastic. This causes the surplus to increase over time. The price support, being higher than equilibrium, acts as incentive for producers to produce more and as a disincentive for buyer to buy.

 Milk production has been subject to price support for many years in many countries. Consequently, governments have been forced to buy up excess milk produced by farmers. These government stock piles are regularly converted into cheese distributed free to poor people. The surplus of milk continues because farmers have a price incentive to produce more. Now, the government is trying to cut the number of cows farmers are allowed to have.

TAX INCIDENCE AND ELASTICITY Technically, a sales tax is paid by the consumer; the seller only collects the tax on behalf of the taxing authority. A further analysis of the incidence of a sales tax (i.e. the analysis of who really bears the burden of the tax) reveals that the burden of the tax is shared. The price increase resulting from the sales tax reduces the quantity traded and forces the seller to lower the selling price.

TAX INCIDENCE AND ELASTIC DEMAND If the demand is highly elastic (that is, customers are able to switch), the supplier will be forced to lower selling prices considerably to continue on selling some of his/her products. Thus, if demand is elastic while supply is inelastic the burden of the tax is shifted almost in its entirety to the supplier.

 Suppose a county increases its sales tax while its adjoining county does not. The residents will prefer to buy their products in the county which does not have a sales tax. To retain their customers, merchants of the county which has enacted the sales tax will have to lower their prices. Thus the incidence of the tax has been shifted onto sellers.

TAX INCIDENCE AND INELASTIC DEMAND If the demand is inelastic, the quantity demanded will not change much after the sales tax is imposed, the supplier will not have to lower the price and the burden of the tax is borne almost in its entirety by the buyer.

 In the example of the adjoining counties, the shift in the incidence takes place because the residents are assumed to be able to shop equally in one or the other county. (That is, they have a highly elastic demand). But, if some barrier existed, such as a toll bridge between the two counties or customs duties, the incidence of the tax would then remain entirely on the consumers.

TAX REVENUE AND ELASTICITY If the purpose of a sales tax is to raise revenue for the government, such tax will be effective only if demand and supply are inelastic. Indeed, if both or either are elastic – which they usually are in the long run – the decrease in quantity purchased will cause the additional revenue from the tax to be minimal or even negative.

 Many countries have import duties on luxury items. When those import duties are very high (30% or more), smugglers are willing to take the chance on breaking the law. Then, revenues from those duties decline.

SUMPTUARY TAX AND ELASTICITY The purpose of a sumptuary tax is to change the pattern of consumption in a society. Such a sales tax will be effective only if the demand and supply are elastic. Indeed, if both or either are highly inelastic, no matter how large the tax is, the quantity will not change.

 Sumptuary taxes exist in virtually every country, including the United States. They are most often assessed on items such as cigarettes, wines and liquor.

TAX INCIDENCE AND SUPPLY ELASTICITY When supply is elastic, an increase in sales taxes will result in a large increment in the price paid by consumers and the tax burden being largely paid by consumers. When supply is inelastic, an increase in sales taxes will result in a price reduction by sellers, and the tax burden is largely paid by sellers.