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Demand and Supply Applications and Elasticity
(Part G)
by
Charles Lamson
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The Determinants of Demand Elasticity
Elasticity of demand is a way of measuring the responsiveness of consumers' demand to changes in price. As a measure of behavior, it can be applied to individual households or to market demand as a whole. Some people love peaches and would hate to give them up. Their demand for peaches is therefore inelastic. However, not everyone is crazy about peaches, and, in fact, the market demand for peaches is relatively elastic. This may not be the best example, but the point is that because no two people have exactly the same preferences, reactions to price changes will be different for different people, and this makes generalizations hazardous. Nonetheless, a few principles do seem to hold. Availability of Substitutes Perhaps the most obvious factor affecting demand elasticity is the availability of substitutes. Consider a number of farm stands lined up along a country road. If every stand sells fresh corn of roughly the same quality, Mom's a Green Thumb will find it very difficult to charge a price much higher than the competition charges, because a nearly perfect substitute is available just down the road. The demand for Mom's corn is thus likely to be very elastic: an increase in price will lead to a rapid decline in the quantity demanded of Mom's corn In Table 1 from Part 22 of this analysis and reintroduced below, we considered two products that have no readily available substitutes, local telephone service and insulin for diabetics. There are many others. Demand for these products is likely to be quite inelastic.  The Importance of Being Unimportant When an item represents a relatively small part of our total budget, we tend to pay little attention to its price. For example, if I pick up a pack of mints once in awhile, I might not notice an increase in price from $0.25 to $0.35. Yet this is a 40 percent increase in price (33.3 percent using the midpoint formula introduced in last post and reintroduced below). In cases such as these, we are not likely to respond very much to changes in price, and demand is likely to be inelastic. Midpoint Formula   The Time Dimension When the OPEC nations cut output and succeeded in pushing up the price of crude oil in the early 1970s, few substitutes were immediately available. Demand was relatively inelastic, and prices rose substantially. During the last thirty years, however, there has been some adjustment to higher oil prices. Automobiles manufactured today get on average more miles per gallon, and some drivers have cut down on their driving. Millions have insulated their homes, most have turned down their thermostats, and some have explored alternative energy sources. All of this illustrates a very important point: The elasticity of demand in the short run may be very different from the elasticity of demand in the long run. In the longer run, demand is likely to become more elastic, or responsive, simply because households make adjustments over time and producers develop substitute goods. Other Important Elasticities So far we have been discussing price elasticity of demand, which measures the responsiveness of quantity demanded to changes in price. However, as we noted earlier, elasticity is a perfectly General concept. If B causes a change in a and we can measure the change in both, we can calculate the elasticity play with respect to the. Let us look briefly at 3 other important types of elasticity. Income Elasticity of Demand Income elasticity of demand, which measures the responsiveness of demand to changes in income, is defined as:   Measuring income elasticity is important for many reasons. Government policymakers spend a great deal of time and money weighing the relative merits of different policies. During the 1970s, for example, the Department of Housing and Urban Development (HUD) conducted a huge experiment in four cities to estimate the income elasticity of housing demand. In this "housing allowance demand experiment," low-income families received housing vouchers over an extended period of time, and researchers watched their housing consumption for several years. Most estimates, including the ones from the HUD study, put the income elasticity of housing demand between .5 and .8. That is, a 10 percent increase in income can be expected to raise the quantity of housing demanded by a household by 5 percent to 8 percent. Cross-Price Elasticity of Demand Cross-price elasticity of demand, which measures the response of quantity of one good demanded to a change in the price of another good, is defined as:  Like income elasticity, cross-price elasticity can be either positive or negative. A positive cross-price elasticity indicates that an increase in the price of X causes the demand for Y to rise. This implies that the goods are substitutes. If cross-price elasticity turns out to be negative, an increase in the price of X causes a decrease in the demand for Y. This implies that the goods are complements (goods whose appeal increases with the popularity of their complement). Elasticity of Supply Elasticity of supply, which measures the response of quantity of a good supplied to a change in price of that good, is defined as:  In output markets, the elasticity of supply is likely to be a positive number---that is, a higher price leads to an increase in the quantity supplied, ceteris paribus.  In input markets, however, some interesting problems arise. Perhaps the most studied elasticity of all is the elasticity of labor supply, which measures the response of labor supply to a change in the price of labor. Economists have examined household labor supply responses to such government programs as welfare, Social Security, income tax system, need-based student aid, and unemployment insurance, among others. In simple terms, the elasticity of Labor Supply is defined as:  It seems reasonable at first glance to assume that an increase in wages increases the quantity of labor supplied. That would imply an upward-sloping supply curve and a positive labor supply elasticity, but this is not necessarily so. An increase in wages makes workers better off: They can work the same amount and have higher incomes. One of the things that they might like to "buy" with that higher income is more leisure time. "Buying" leisure simply means working fewer hours, and the "price" of leisure is the lost wages. Thus it is quite possible that an increase in wages to some groups and above some level will lead to a reduction in the quantity of labor supplied.  *MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 94-96* end |
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