Episode 16: Elasticity of Demand
There are many types of elasticity. In particular, I'll focus on the price elasticity of demand. Before I get into a specific discussion of elasticity, let me ask you a question. If a business wants to generate more revenue, should it raise the price of its product or lower the price of its product? I ask, because I have a friend who runs a children's bookstore, and when she found out that I was an economist, she asked me this question.
Well, actually, she asked if she should be giving an educator discount. But what this really meant was that she wanted to know if she should discount or lower her prices. So generally, what would you say? Should a business owner increase prices or decrease prices in order to generate more revenue? The answer, as usual, is, it depends.
Think about it. When your local electric company wants to raise more revenue, it will enact a rate increase. Yet, when an airline wants to quickly generate additional revenue, it will cut ticket prices. Which approach is correct? They both are.
Here's the issue. If I raise my prices, I know that quantity demanded, or the willingness to purchase on the part of my consumers, will drop. That's just the law of demand. But what the law of demand doesn't tell me is how much the quantity demanded will drop. When I raise my price, will my customers be very sensitive to the price increase, cutting back a lot on their purchases? This will be bad for me, because I'd lose a lot of revenue. But if I raise my price and my customers only by a little bit less, not reacting too much to the price increase, this is good. I'd see increased overall revenue.
So the crucial issue here is to find out how sensitive my customers will be to a price change. Elasticity is a measure of sensitivity or responsiveness to price. In equation form, the elasticity of demand or e d is equal to the percentage change in quantity demanded over the percentage change in price. Because demand exhibits an inverse or negative relationship, elasticity of demand will be a negative number.
I use percentage change to measure elasticity, rather than absolute change. Let me illustrate why. If I tell you that product price has gone up by $1-- this would be the absolute change-- is this a big change or a small change? It depends. What's the product? More to the point, what was the original price?
OK, look, say we're talking about a pack of gum. Originally, the price was $1. Now, it's $2. This represents an absolute change of $1. But is it a big change or a small change? It's actually a pretty big change-- price doubled or increased by 100%.
What if we're talking about a text book rather than a pack of gum? Originally, the price was $100. Now, it's $101. This is still an absolute change of $1, but is it a big change or small change?
In this case, it's a small change. Price has increased by 1%. Bottom line is that we need to know not only the dollar amount of the price change, but also how this compares to where we started.
Now, technically, the formula for elasticity of demand is the percentage change in the quantity demanded over the percentage change in price, which can be found by taking the ratio of the difference between the new and the old quantities over the average of the new and the old quantities, all over the ratio of the difference between the new and the old price over the average of the new and the old prices. Frankly, I've found that if I use this version of the elasticity formula, students eyes glaze over. People get so hung up on the math that they lose sight of the intuition and what elasticity means, so I'll be sticking to the slightly easier form and will frame my questions for you accordingly.
How would you actually use this formula? Take a look at this article about the Clinton administration's proposed cigarette tax policy. If you look at the last paragraph, you'll find enough information to determine the elasticity of demand for youth smoking. Remember, elasticity of demand is the percentage change in quantity demanded over the percentage change in price. The article states that for every 10% increase in price there's a 7% decrease in youth smoking. This means that elasticity of demand, according to the formula, is minus 7% over plus 10%, or negative 0.7.
OK. Now, what do I do? I know that the elasticity of demand for youth smoking is minus 0.7, but what does it mean? The critical component to look at when dealing with elasticity of demand is the magnitude-- how big is this number? The bigger the number, the more people respond to the price. The smaller the number, the less people respond to price. The fact that the number is negative only signifies that demand is a negative or inverse relationship between price and quantity demanded.
Since I care about the size of the elasticity number, rather than a sign, let's make things easier and just look at the absolute value or the size only of elasticity of demand. In this example, the absolute value of the elasticity of demand is 0.7. Again, what is this number really mean, and what does it tell us?
Ultimately, the key value where elasticity is concerned is 1. In the case of youth demand for cigarettes, the size of the elasticity figure is less than 1. Since elasticity of demand equals the percentage change in quantity demanded over the percentage change in price, this means that the absolute value of this ratio is less than 1. It follows then, in order for this ratio to be less than 1, it must be the case that the size of the price change is greater than the size of the quantity change.
What this tells me is that it takes a relatively large price change to initiate a relatively small quantity demanded reaction. In other words, if the elasticity of demand is less than 1, people don't react much to price changes. They're insensitive to price changes, or their demand is inelastic.
Question-- does this make sense, that where cigarettes are concerned people don't react much to price changes? Note that the article specifies data for youth smoking. Do you think that youth sensitivity to cigarette prices is any different from adult sensitivity? Which group would respond more to a price change, youth smokers or adult smokers?
If you thought that youth smokers would respond more to a price change than adult smokers, you're right. Adults tend to have more disposable income, so a price increase affects them less. In addition, the nicotine addiction is likely to be stronger for someone who's been smoking longer. This means that the size of elasticity for adults will be even smaller than the magnitude of the elasticity of demand for youth smokers, indicating a smaller reaction to any price change.
One last question for you regarding inelastic demand-- if the absolute value of the elasticity of demand is less than 1-- that is, people don't respond much to a price change-- would you raise your price or lower your price to generate more revenue? Well, the demand for electricity is inelastic. When the price changes, people tend to purchase about the same amount of electricity. We don't like the rate increases. But other than trying to conserve a bit here or there, we continue to consume the electricity. This means that the electric company could raise prices quite a bit and not see very much decrease in the quantity demanded. As a result, total revenue-- price per unit times the number of units sold-- will increase overall.
What if the absolute value that elasticity had been greater than 1? That would mean that the absolute value of the percent change in quantity demanded over the percent change in price is greater than 1, which could only be true if the size of the quantity change is greater than the size of the price change. So having a value of elasticity that's greater than 1 indicates a relatively large quantity demanded reaction to a relatively small price change, or demand is "elastic."
Question-- if it's a case that demand is elastic, would you raise your price or lower your price in order to generate more revenue? Answer-- demand for airline tickets is fairly elastic, meaning that customers react a lot to fairly small price changes. So by decreasing prices a little bit, the airlines will see a relatively large increase in quantity demanded or ticket sales. Overall, this would yield greater total revenue.
Is it possible for elasticity of demand to be equal to 1? Technically, it is. If so, the size of the quantity change is going to be equal to the size of the price change. The changes exactly offset one another. That is, a 10% increase in price results in a 10% decrease in quantity demanded, and there would be no change in total revenue.
Next time, characteristics that determine elasticity of demand.