Robert J. Stonebraker, Winthrop University
The Joy of
Economics: Making Sense out of Life
Robert J. Stonebraker, Winthrop
University
Elasticity of Demand and Supply
In spite of the cost of living, it's still popular.
...author Laurence Peter
We know that when the price drops the quantity demanded will rise and the quantity supplied will fall. In many cases, the directions of these changes are all that matter. However, in other cases, the magnitude of the change matters as well. Will a change in price have a large impact or only a small impact on consumer and producer behavior?
Economists use the concept of elasticity to measure the changes. The price elasticity of demand is measured as the percentage change in quantity demanded divided by the percentage change in price, and the price elasticity of supply is measured as the percentage change in quantity supplied divided by the percentage change in price. For example, if a 10 percent increase in price causes consumers to cut their willingness to buy by 12 percent and producers to increase their quantity supplied by 6 percent, then the elasticity of demand = 12/10 = 1.2 [Purists will note that the elasticity is actually negative 1.2, but we will worry only about the absolute value] and the elasticity of supply = 6/10 = 0.6. If the elasticity numbers exceed one, we say that demand and/or supply is elastic. If the numbers are less than one, we say that demand or supply is inelastic. If elasticity equals one, we say that demand or supply is unit elastic. In this example, demand is elastic and supply is inelastic.
The essential idea is that elasticity measures how sensitive we are to changes in price. If prices matter very little, changes in price only will have small impacts on our willingness to buy or sell. Because the percentage change in quantities demanded and supplied will be small, the elasticity calculation will also be small and we will get inelastic results. On the other hand, if we are very sensitive to prices, even small changes in prices will cause large changes in our willingness to buy or sell. The large changes in quantity will give us large elasticities.
In terms of the graphs, larger elasticities translate into flatter or more horizontal supply and demand curves. Smaller elasticities translate into more vertical curves. Work through some examples to see how this works.
Determinants of elasticity
What determines elasticity? The primary factor is the availability of close substitutes. For example, suppose a Sunoco station raises the price of its gasoline by 10 percent. Most consumers treat rival brands as almost perfect substitutes and will quickly switch to other suppliers. Sunoco is likely to lose far more than 10 percent of its volume -- an elastic response. But, suppose that the Sunoco station is the only one in town; suppose that no other brands are available. In this case, consumers are stuck. Without an alternative, they will continue to patronize the Sunoco station despite the higher price. Consumers might cut back on unnecessary driving to save money, but the drop in quantity demanded is likely to be quite small -- an inelastic response.
How much of our income we spend on an item can be a second factor that impacts elasticity. For example, I never comparison shop for shoe laces. The price doe not concern me. I spend so little on laces that even a doubling of their price would have no noticeable impact on my annual budget. Shopping for a better deal would cost me more than it realistically could be worth. To me, saving five cents on a pair of laces is insignificant. But not to Nike or New Balance or Adidas. For a firm that is selling millions of pairs of shoes per year, five cents per lace starts to matter. It may not pay an individual to shop around for a better deal on laces, but it certainly will pay Nike to do so. All else equal, the more we spend on item, the more elastic our demand will be.
Time is a third factor that affects elasticity. Given more time we can make more substitutions. Suppose the price of gasoline rises. In the short run consumers will continue to feed their voracious SUV's. But, when they next shop for a new car, many will shift to more fuel-efficient options. The more time we have to shift our purchasing patterns, the more elastic our demands will be.
Elasticity and total revenue
Extend the Sunoco example above. If the Sunoco station does raise price, what will happen to its total revenue? Total revenue (TR) is simply price multiplied by quantity [TR = PQ]. In our example, price rises by 10 percent. What happens to TR will depend upon whether demand turns out to be elastic or inelastic. If demand is elastic and more than 10 percent of the station’s customers jump ship, the Sunoco station will find TR dropping. Its 10 percent increase in price will be more than offset by the larger drop in quantity. However, if demand is inelastic and the station can maintain most of its customers at the higher price, its TR will rise. The effect of the higher price will more than offset the small drop in volume.
Do you see the relationship? If demand is elastic, the percent change in quantity will exceed the percent change in price and TR will move in the same direction as quantity. But if demand is inelastic, the percent change in quantity will be smaller than the percent change in price and TR will move in the same direction as price.
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Testing Yourself
To test your understanding of the major concepts in this reading, try answering the following:
1. Define and calculate price elasticities of demand and supply.
2. Differentiate between elastic, inelastic, and unit elastic demand and supply.
3. Explain why curves with more elastic demands at a particular price are more horizontal than those with less elastic demands.
4. Identify and explain the three factors that determine whether demand is likely to be elastic or inelastic and give examples.
5. Understand and explain the relationship between elasticity of demand and total revenue; explain why elasticity determines whether TR will rise or fall as a result of a price change.