Determinants of Elasticity
In particular, the elasticity of demand will be different for different goods and services. What determines the demand for a particular good or service?
The most important thing in determining whether the demand will be elastic or inelastic is the availability of substitutes. For example, we have reason to believe that the demand for public transportation is more elastic in New York City than it is in some other cities. The reason could be that there are fewer good substitutes for public transportation in New York City than in some smaller cities. The private car is the most important substitute for public transportation for most local traffic, and it is more expensive to keep a car in New York than it is most other places. Insurance is more costly and parking places are harder to get. For these and other reasons, there are a larger proportion of the population in New York than in most cities who do not have cars. In all cities, in increase in the price of a ride on public transportation will cause some riders to switch to cars. In New York the proportion who make this substitution — car instead of subway — is smaller than in most American cities, for the reasons we have seen. Thus, a 1% increase in the fare in New York causes a smaller (percent) cut in the number of riders; in other words, elasticity is smaller.
In general, the more substitutes there are for the good, and the better substitutes, the more elastic demand will be. The more substitutes, the more people switch, and so, the more elastic demand is.
Another important thing that affects the elasticity of demand is the proportion of income spent on the good. An increase in the price of a good or service reduces the purchasing power of income, and with less income (in purchasing power terms) people will cut back on purchases of all goods. If people spend a large part of their income on a particular good or service, then an increase in the price of that good or service reduces the purchasing power be a relatively great deal, causing a greater cutback than might otherwise occur. This means a bigger cutback when the price goes up — more elastic demand.
It will also make a difference how much time people have to adjust to the change in price, but this can work out in several different ways. For cigarettes, for example — a good for which habit formation is important — the elasticity will probably be greater in the long run, since it will take a long time for people to break their habits and not be replaced by new smokers. For cars it would work the other way. In a short period of time, if car prices go up, people can just keep driving their old clunkers. That is, the cars already on the road are substitutes for new cars. But in a longer period of time the old cars wear out and the elasticity of demand is less.
Even after all these things are considered, there is still a lot of variation in the elasticity of demand from good or service to good or service. The only way to answer the question is to look at the numbers, do the statistics, and let the evidence tell us what the elasticity of demand is for a particular good.
Elasticity and Revenue
We have seen that a change in the price pushes the sales revenue in two ways — increasing revenue per unit but decreasing the number of units sold. Elasticity is a key to understanding this relationship.
Example: Demand for public transportation is inelastic — probably about 0.3. So, when the price is raised by 1%, quantity demanded declines by only three-tenths of 1%, and revenue increases by seven-tenths of 1%.
Example: The demand for computers is elastic. Suppose (this is a guess) that the demand for computers is 2. Then a 1% cut in the price of computers would increase the number of computers.
sold by 2%. Revenue would increase approximately by the difference – 2%-1% = 1% increase in the sales revenue every time the price of computers drops by 1%.
We see that the difference from an elasticity of 0.3 to an elasticity of 2.0 makes all the difference. When elasticity is 0.3, the price and the revenue change in the same direction, whereas if elasticity is 2, they change in opposite directions. In the second case — elasticity of 2.0 — the increase in sales more than offsets the decrease in price, but in the first case, elasticity of 0.3, the increase in sales is too small to offset the decrease in the price.
We began this chapter by puzzling over some events in economic history. This relationship can explain some of the puzzles of economic events.
The puzzle about agricultural products, for example, was that the increasing technical efficiency of farming has led to lower prices and a declining share of farming in the national production and employment. The key point here is inelastic demand.
Demand for agricultural products (industry as a whole) is inelastic. We have plenty of evidence for this. Over the years, technical progress has made the farmers more efficient, and because farming is highly competitive, prices have dropped with the costs. Each drop in farm prices brought only a small increase in the quantity of food sold — not enough to offset the price cuts, so farm sales revenues overall have declined.
Why are the farmers “crazy” enough to cut their prices? Each individual farmer has a firm demand curve that is elastic — since his products are very good substitutes for those of thousands of other farmers — so each farmer gains revenue by cutting. But when they all do it at once, they all lose.
Over a hundred years, this had an enormous impact: whereas a century ago farmers were about half the population, farmers now are about 3% of the population. The other side of the coin is that, 100 years ago, non-farmers had to spend about 1/2 of their income to buy food. Today we spend only about 3% of our income to buy food (not counting processing!)
Something like this also happens in shorter periods. When the weather is good, prices of farm products decline, and farmers’ sales revenue fall with them.But when the weather is terrible, and prices for farm products rise, the farmers are better off on the average.
Economists use formulae like “elasticity” to measure the responsiveness of quantity demanded (and other things) to various influences.
Remember, the demand curve itself can shift, predictably. For example, an increase in consumer income can shift the demand for any good the consumer buys. In most cases, but not all, the increase in income increases demand — shifts it to the right. To measure this response, we have the income elasticity of demand.
For example, suppose income in the country as a whole increases by 10% over a decade. We might observe that the demand for beer increases by 2.5% over the same time, even with no change in the price of beer. Then we would conclude that the income elasticity of demand for beer is 2.5/10 = 0.25. (According to the statistics I have, that’s about right).
If the income elasticity is greater than one, we say that demand is income-elastic. It means that demand increases more than proportionately with income. If the income-elasticity is less than one, we say that demand is income-inelastic. Then demand increases less than proportionately to income. We might even observe that the income elasticity of demand is less than one, for some goods. That would mean that the good is an “inferior good.” Recall, an “inferior good” is a good for which demand decreases as income goes up — hamburgers, for example. Then the change in income and the change in quantity will have opposite signs. The quotient (and so the elasticity) is negative.
Looking back at the beer example above, we see that the demand for beer is income-inelastic, but beer is not an inferior good. For some consumers, beer may be an inferior good, but there are enough beer-drinkers who increase their consumption when their income is higher, so that on the average, beer consumption rises with income. But not by much — 0.25 is a quite small elasticity of demand.
Since we now have two kinds of elasticity, from here on we will say “price elasticity” when we mean the elasticity with respect to price, and there might be any ambiguity. We will always say “income elasticity,” when that is what we mean. Just “elasticity,” by itself, always means the price elasticity.
Sometimes the price of one good will shift the demand for another good. For example, an increase in the price of chicken will increase the demand for pork. We measure this response by the cross-elasticity of demand.
For example, suppose the price of chicken goes up by 10%, and as a result the quantity demanded of pork increases by 2%, with no change in the price of pork or anything else that would influence the demand for pork. Then the cross-elasticity of demand for pork, with respect to the price of chicken, is 2%/10% = 0.2.
If the cross elasticity is positive, it means that an increase in the price of one good will increase the demand for the other good. When we observe a positive cross-elasticity, we say that the two goods are substitutes, as with chicken and pork. Conversely, butter and margarine are substitutes, so we would expect their cross-elasticities to be positive.
If the cross-elasticity of demand is negative, that means that an increase in the price of one good cuts the demand for the other. For example, if the price of bicycles went up, we would expect to see a decline in the demand for bike helmets. In this sort of case, we say the goods are complements.
For many practical applications, we need to know about the numerical characteristics of demand and supply for various goods and services. The most important of these is the price elasticity of demand.
Other key elasticity measures are
- the income elasticity of demand
- the cross price elasticity of demand
- the elasticity of supply
All are computed in a similar way — as the quotient of percent changes in the variables, ceteris paribus — and thus are independent of the units of measurement. All have important roles in explaining economic events.