Overview: Elasticity

Why would McDonald's lower the price of a Big Mac to raise revenues? Why would some politicians argue for lower tax rates as a way to increase tax revenue? Why would Massachusetts' attempt to raise tax revenues by raising sin taxes on booze and butts? Why would Brazil, one of the world's largest producers of coffee, burn some of their coffee harvest? Why would the OPEC countries lower production if their goal was greater income? Why does farm income fall in years of a good harvest? Why have farm prices lagged behind industrial prices?  Why do we see the automobile industry hurt far more in recessions than the textile industry?  And how about you. If you were in charge of setting trolley and subway fares for the MBTA (Boston), would you raise or lower the fare if your goal was to raise revenue?

What is the common denominator of these questions?  In each one the answer depends in large part upon the responsiveness of demand to changes in factors that influence demand, upon what economists would call the elasticity of demand.  On the short-list of important concepts, elasticity would be there and in this unit we are going to examine the concept in some detail.  To understand the situation, let's look at the OPEC decision in 1973 to reduce the supply of oil to the world.  From our work with supply and demand we know a reduction in supply means the supply curve will shift leftward.  When this happens, at the existing price (P*) there will now be excess demand for oil which we may see as longer lines at the gas stations. As the owner of the gas station, you would react to the lengthening lines by raising your price until the lines disappeared - until supply and demand were brought into balance at a price of P.

But how much would you need to raise the price?  If demand were very unresponsive to price, if people would buy gas regardless of the price, then a large increase in price would probably be necessary to bring supply and demand into balance.  You can see from this simple example why it is important to have some idea of the responsiveness of demand to price changes, what economists call the own-price elasticity of demand [usually shortened to be price elasticity].  When demand is responsive to price changes, demand is said to be elastic, while demand that is unresponsive to price changes is said to be inelastic.

Our analysis of price elasticity of demand will begin with some definitions. We will also discuss the link between elasticity and the slope of supply and demand curves. Although price elasticity and slope are not exactly the same concepts, there is a close relationship, and in general you can say something about elasticity from observing the slope of the demand curve.  We will then discuss the determinants of elasticity, a section about the factors likely to have an impact on elasticity.  It is here where we will try to develop some rules of thumb regarding price elasticity of demand.  

But what happens to the revenues at the gas station as you raise the price?  Since revenue (R) is equal to price (P) times quantity (Q), an increase in price that substantially lowers demand can be expected to decrease total revenue (R = P*Q).   Similarly, if the price increase has little negative effect on demand, then you can expect the price increase to raise revenue as the upward pressure from the price increase dominates the downward pressure from the quantity decrease.  This unit will conclude with a formal analysis of the link between elasticity and revenue.

Armed with the information on elasticity in this unit, you can avoid the mistakes made by the people at McDonalds and the tax officials in Massachusetts, you can understand why the decisions by officials in Brazil and OPEC worked, and you will be able to explain why a fare decrease is unlikely to lead to greater revenue for the MBTA. You will also understand why firms spend so much in advertising to differentiate their product - convincing people there are not any close substitutes for their product. 

Elasticity as a concept is not restricted to the relationship between price and demand.  In fact elasticity is a generic concept and there are a number of additional elasticities you will hear mentioned.  The cross-price elasticity refers to the responsiveness of demand to changes in the price of other goods or services - how much will demand for Reebok sneakers change when the price of Nike sneakers change?  There is also the income elasticity of demand that measures the responsiveness of demand to income changes.  This is where you will look to find the explanations for the differential growth and cyclical behavior of certain industries - why agricultural products have declined relative to manufacturing goods and why the automobile industry gets "hammered" in recessions.

And finally, we can talk about elasticity of supply that captures the sensitivity of supply to price. Now it is time to begin our analysis of elasticity.