Elasticity (business)

Abstract

Presenting some applications and insights to undergraduate students on the topic of elasticity, this essay contains discourse that aims to facilitate their understanding of the concept. The essay addresses several variants of elasticity along with definitions, calculations, and examples. A large portion of this essay covers price, cross, and income elasticities of demand. The author devotes an ample amount of attention to those demand elasticities striving to alleviate learning difficulties. Frequently, students encounter problems associated with line graph characteristics, expenditure and revenue changes, and elasticity determinants. The article also presents price elasticity of supply and its comparative relevance to those who incur the tax burden on some items.

Keywords Demand; Economics; Elasticity; Income; Price; Revenues; Supply; Taxes

Economics > Elasticity

Overview

Elasticity is a concept of central importance to business, marketing, and economics. Studies in economics begin by expressing the importance of the ceteris paribus ("all else is held constant") assumption and by focusing on relationships between the possible prices of an item and the quantities consumers are willing and able to purchase at each price; likewise, the quantities suppliers are willing and able to produce. On the consumer or demand side, students learn very early in their coursework that an inverse relationship exists between price and quantity in accordance with the Law of Demand. Relatively speaking, smaller amounts are in demand at higher prices, and vice versa. On the producer or supply side, they learn that a positive relationship exists according to the Law of Supply. Whether one chooses to focus on demand or on supply, elasticity is a concept that helps us to understand in precise terms exactly how much quantity changes in response to a price change.

Many students who complete and evaluate introductory courses in economics for non-business majors find the elasticity topic easy to comprehend. In addition, they report that the topic makes perfect sense to them and is highly relevant to their everyday exchanges. However, they report having difficulties mastering the varied types (price, income, and cross) of elasticity. To overcome those obstacles they encourage other students to elicit examples from their professors and to practice calculating, interpreting, and applying elasticity.

Some commonly used textbooks in economics (Arnold, 2005; Guell, 2007; McConnell & Brue, 2008; Parkin, 2000) provide basic topical coverage, but unfortunately very few articles present economic elasticity in a straightforward manner, without references and narrow application to a specific context. Furthermore, those contexts usually require readers to have an advanced understanding of economics and other business disciplines. In a demonstration of how the elasticity concept is relevant to marketing, Dickinson (2002) makes the case that textbook presentations of elasticity provide a weak foundation for studying price-quantity interactions and for simulating behavioral complexities of consumers in the marketplace. From an economics education perspective, this article represents one effort to facilitate an undergraduate student's understanding of the elasticity concept.

Applications

Price Elasticity of Demand

Cigarette smokers, beer drinkers, and motor vehicle drivers are consumers who are likely to identify most readily with the elasticity concept. Examples pertaining to alcohol and tobacco will follow later, but gasoline prices serve as an excellent example for starters. Motor vehicle drivers probably retain their awareness of the daily price for gasoline and its fluctuations during any given period. Furthermore, it is likely that these consumers will purchase greater quantities when the price of gasoline falls and fewer quantities when the price rises. Calculations of the price elasticity of demand for gasoline allow us to determine precisely in percentage terms how sensitive drivers' purchases of fuel are in response to changes in its price. Though most dislike rising gasoline prices and generate some noise about it, the evidence strongly suggests that consumer demand is relatively unresponsive, or inelastic, as they tend to purchase the same amounts over time irrespective of price. To explore this observation further, students need to understand demand elasticity coefficients, calculate them, and determine whether demand for gasoline is truly inelastic.

Guell (2007, p. 41) summarizes a few studies on the price elasticity of demand for gasoline, stating that any given 10 percent increase in its price will result in a decrease of less than 3 percent in quantities purchased; coincidentally, the gasoline prices can fluctuate by 10 percent or more during any given week. The latter percentage varies depending on how long consumers have to adjust their driving and spending habits; for example, the amount of gasoline in their car's tank and the remoteness of their geographic location jointly influence whether they can afford to shop for cheaper gasoline. In 2014, the US Energy Information Administration (EIA) reported the estimated price elasticity of demand for gasoline at about 0.02 to 0.04 in the "short-run." The EIA noted that factors beyond price, such as changing employment status, urbanization, and increasing vehicle fuel efficiency, can play a role in changing the price elasticity of demand for gasoline over time.

Calculating & Presenting Demand Elasticity Coefficients

Note the simplifying omission of the negative sign from the aforementioned coefficients because of the explicit inverse relationship that exists between price and quantity demanded. Calculations of the elasticity coefficient involve division of the percentage change in quantity demanded by the percentage change in price. The coefficient is unit free and its basic formula is:

Percent change is the observed difference between two points—namely, the starting point and the endpoint—divided by the value at the starting point. Readers of textbooks will find variants in the formula that are merely designed to accommodate calculations whether one holds an interest in the observing the elasticity at the starting point, the endpoint, or somewhere near the middle of those two points and when facing different shapes of the line that represents all the price-quantity combinations.

Another justification for omitting the negative sign is to simplify interpretations of a price elasticity of demand coefficient by examining it as an absolute term. In the broadest sense, we can think about and talk about elasticity of a specific item at its extremes along a demand spectrum. The demand for an item is either elastic, inelastic, or unitary elastic when the respective coefficient as an absolute term is greater than one, less than one, or equal to one. The coefficient in the gasoline example is less than one, which informs us that the demand for gasoline is inelastic; in other words, consumers are unresponsive to changes in the price of gasoline. We generally dislike the price hike, but collectively gasoline consumers maintain their purchase levels.

Think of the larger array of items that you purchase on a regular basis. My guess is that readers of this article, like other consumers, are more responsive to changes in price for some items and not so for other items. In absolute terms, price elasticity of demand coefficients range between zero and infinity extending outwardly from unitary elasticity, which is where the coefficient is equal to one. Those extremes carry specific names. At one extreme, your purchases of an item will cease or go to zero quantity when a price increase occurs. Demand is perfectly elastic in this instance. At another extreme, your purchases of an item will remain the same regardless of price. Demand is perfectly inelastic in this instance.

Demand Line Graphs & Elasticities

The coefficient of elasticity is different than, but has some relation to, the slope of a straight line. The slope formula calls for dividing the rise by the run or, in other words, the change in the vertical direction by the associated change in the horizontal direction. In general, rearrangement of the elasticity coefficient formula will reveal that coefficient is the product from multiplying a point on the line by the inverse of the line's slope. This rearrangement allows for the calculation of elasticity at a specific point on the line using the slope of the line. In addition, it allows for applications to straight lines or curved lines.

Another important distinction between elasticity and slope is that the slope is the same along a straight line at any given point on the line, but its elasticity varies. Conversely, the slope varies along a curved line at any point on the line, but its elasticity is the same. At this point, let us put these technical considerations aside and return some additional characteristics of graphs that display demand as taking the form of a straight line.

Three regions of elasticity exist along the demand line. The upper segment of the line is where demand is elastic. The lower segment is where it is inelastic. The segment in the middle is where demand is unitary elastic. Recall that the "price elasticity of demand" is a term that describes how sensitive consumer purchases are in relation to changes in price. In a relative sense, these regions inform us that consumers are more sensitive to changes in price for items having high prices than they are for items having low prices.

At two extremes, the demand line can be horizontal or it can be vertical. These extremes carry the term "perfect" with respect to elasticity. On the one hand, demand is perfectly elastic when the line is horizontal. This means item purchases will cease for any change in price. On the other hand, demand is perfectly inelastic when the line is vertical. This means item purchases will persist regardless of any change in price.

Consumer Expenditures & Producer Revenues

Suppliers would love to sell only those items for which demand is perfectly inelastic. However, such a fantasy is often a far cry from reality with few exceptions. In actuality, their revenues increase in concert with price rises but only to a point. As market prices move higher along the demand curve and begin to enter its upper region, consumers exhibit greater sensitivity to price changes and they begin to curtail their purchases. Consequently, purchase quantities fall faster than prices rise resulting in decreases in consumer's total expenditures and supplier's total revenues.

Unabated price increases or decreases eventually move past the point at which demand is unitary elastic (for instance, where the price elasticity of demand coefficient in absolute terms is exactly equal to 1.00). The total revenue test and, conversely, the total expenditure test, as they are commonly known, direct attention to danger of constant increases in an item's price and to the appeal of constant decreases in an item's price. In summary, upward movements in price through the middle region of the demand line tend to decrease seller's total revenues and consumer's total expenditures whereas downward movements tend to increase them.

Determinants of Elasticity

Elasticity depends on a set of factors known as the determinants of elasticity. The set includes the number and relative availability of items considered to be viable alternatives or substitutes for any given item. Are there items considered as close substitutes? In addition, the set includes whether an item is something that a consumer needs and wants (a necessity like food, clothing, or shelter) or something that a consumer wants but perhaps doesn't need (a luxury like jewelry, cruises, or newest electronic gadgets). Is the item a necessity or is it something else? A third factor is the portion of the consumer's budget spent on the item. The last factor within the set of determinants is the amount time available to a consumer in making a purchase decision. Is a delay in the item's purchase a wise decision? Recall the gasoline example in which the long run or the short run depend largely according to your geographic location when the gas tank gauge indicates it is near the empty mark.

Cross & Price Elasticities of Demand

Other types of elasticity need some discourse as we move toward closure in this essay. Attention up to this point was on the price elasticity of demand. Before we move to a discussion of a supply-side related elasticity, this article describes two additional types of demand-side related elasticities: cross elasticity and income elasticity. All these remaining elasticities serve a purpose in economics and use percent changes to portray how quantities change in relation to a change in income or price. A brief description of each comprises the sections that follow.

Some instructors spend a considerable amount of time with their students comparing apples to oranges. Those comparisons are highly appropriate when examining the cross elasticity of demand concept. One might begin by asking the question: What happens to the purchases of oranges when there is an increase in the price of apples? In more precise terms, the economics instructor may inquire by adding the word "percentage" with respect to the changes in price and quantity.

Calculating cross elasticity of demand and its examination will reveal whether consumers switch between apples and oranges and/or whether they eat them in some combination. They are likely to be substitutes, but it is possible that they group goods in combinations of complements; an example of the latter would be hot dogs and hot dog buns. If the coefficient for the cross elasticity of demand is a positive number, we can conclude with some certainty that apples and oranges are indeed substitutes; for instance, the percentage increases in price and in quantity move the same direction. On the other hand, if the coefficient is a negative number, we can be certain that they are complements; for instance, the percentage increases move in opposite directions.

Leaving cross elasticity behind and moving to another type of elasticity, we can determine whether an apple, an orange, or some other item is a normal good or an inferior good. Accordingly, we look at the percentage change in the item purchase quantities in relation to the percentage change in consumer income and then we seek to determine whether the income elasticity of demand coefficient is positive or negative. If the coefficient is positive, then we can conclude that the item is a normal good; for example, an increase in income may generate an increase in apple consumption. In other words, the normal case is that higher incomes generate additional purchases and larger quantities. If it is negative, then we can conclude that the apple is an inferior good. Next, we introduce the price elasticity of supply concept, which is the last concept, and its relevance to economic decision making.

Price Elasticity of Supply

Tax Burdens & Price Elasticities Comparison

Calculation of coefficients for the price elasticity of supply is slightly different than those for demand. The differences being the use of percentage change in quantities of an item supplied or sold as opposed to quantities demanded or consumed and the positive or direct relationship between price and quantity supplied. A major benefit of knowing the price elasticity of supply accrues by analyzing the potential impact that a tax will exert on an item's exchange. We can think of the imposition of a tax as being quite similar to a price increase, except that is has implications for demand and/or supply quantities.

Taxes on tobacco and alcohol are government agency revenue generators. The evidence suggests the demand for these items is inelastic, probably a result of their habit forming or addictive natures. The World Health Organization reported the price elasticity of demand among adults for cigarettes in 2012 was −0.40 in high-income countries and −0.2 to −0.8 in low- to middle-income countries. A 2013 meta-analysis by economist Jon P. Nelson of studies on alcohol price and income elasticity from a number of countries found that for beer, the price elasticity is −0.3, while for all alcohol, it is −0.6. Thus, price increases would produce a negligible change in consumption patterns.

The supply of these items could be inelastic as well, or it could be elastic. Comparisons between the price elasticity of supply and the price elasticity of demand will reveal whether the consumer or the producer will pay any tax imposed on an item. If the evidence indicates that suppliers are more sensitive than consumers to price changes, then the latter will likely bear the tax burden. Empirical data on price elasticity of supply are available elsewhere including the articles of the suggested reading list, but it stands to reason that sellers would be more sensitive than consumers to tax-induced price increases and therefore ready to pass the tax burden along to their customers. In closing, this essay seeks to provide information in a clear and concise manner in order to promote elasticity concept mastery among undergraduate students.

Terms & Concepts

Ceteris Paribus: Latin meaning "all else is held constant."

Complements: A combination of goods consumed or used at same time

Cross Elasticity of Demand: The percentage change in demand quantity of one good divided by the percentage change in a related good's price.

Determinants of Elasticity: The amount of time available for an adjustment to a price change and the portion of a budget required to obtain an item.

Elastic: When percentage change in supply or demand quantity is greater than percentage change in price or income.

Elasticity Coefficients: Numeric result from dividing percentage change in demand or supply quantity by percentage change in price or income.

Income Elasticity of Demand: The percentage change in demand for an item divided by the percentage change in consumer's income.

Inelastic: When percentage change in supply or demand quantity is less than percentage change in price or income.

Inferior Good: The demand for the good decreases as income increases.

Law of Demand: Specifies the inverse or negative relationship that exists between an item's demand quantity and its price; quantity and price move in opposite directions.

Law of Supply: Specifies the direct or positive relationship that exists between an item's demand quantity and its price; quantity and price move in same direction.

Normal Good: The demand for the good increases as income increases.

Perfectly Elastic: An extreme case in which demand or supply quantity amounts to zero in response to a price change.

Perfectly Inelastic: An extreme case in which demand or supply quantity remains constant in response to a price change.

Price Elasticity of Demand: The percentage change in an item's demand quantity divided by the percentage change in item's price.

Price Elasticity of Supply: The percentage change in an item's supply quantity divided by the percentage change in item's price.

Slope: The rise or vertical change between two points on a line divided by the run or horizontal change between those points.

Substitutes: Goods that are related and consumers switch from one to another.

Tax Burden: When responsibility for payment of tax accrues to party least sensitive to the increase in price brought about by imposition of the tax.

Total Expenditure Test: Situation in which dollar sum of purchases by consumers are expected to decrease as prices rise along the demand curve or vice versa.

Total Revenue Test: Situation in which dollar sum of revenues earned by suppliers are expected to decrease as prices rise along the demand curve or vice versa.

Unitary Elastic: Occurs where the percentage change in demand or supply quantity is equal to the percentage change in price; point at which price or supply elasticity of demand coefficient is exactly 1.00.

Bibliography

Arnold, Roger A. (2005). Economics (7th ed). Mason, OH: Thomson South-Western.

Cuddington, J. T., & Dagher, L. (2015). Estimating short and long-run demand elasticities: A primer with energy-sector applications. Energy Journal, 36(1), 185–209. Retrieved December 9, 2015, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=100170011&site=bsi-live

Dickinson, J. (2002). A need to revamp textbook presentations of price elasticity. Journal of Marketing Education, 24, 143–149. Retrieved September 8, 2007, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=7017434&site=ehost-live

Guell, R. C. (2007). Issues in economics today (3rd ed.). Boston, MA: McGraw-Hill Irwin.

Gordon, B.R., Goldfarb, A., & Yang, L. (2013). Does price elasticity vary with economic growth? A cross-category analysis. Journal of Marketing Research (JMR) 50, 4–23. Retrieved November 15, 2013, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85367837&site=ehost-live

Hamilton, R., Thompson, D., Arens, Z., Blanchard, S., Häubl, G., Kannan, P., & ... Thomas, M. (2014). Consumer substitution decisions: An integrative framework. Marketing Letters, 25(3), 305–317. Retrieved December 9, 2015, from EBSCO online database Business Source Premier.http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=97370301&site=bsi-live

McConnell, C. R. & Brue, S. L. (2008). Economics (17th ed.). Boston, MA: McGraw-Hill Irwin.

Oner, E. (2013). Simultaneous effects of supply and demand elasticity with market types on tax incidence (graphical analysis of perfect competition, monopoly and oligopoly markets). International Journal of Economics & Finance, 5, 46–55. Retrieved November 15, 2013, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85772039&site=ehost-live

Parkin, M. (2000). Economics (5th ed.). Reading, MA: Addison Wesley Longman.

Sethuraman, R., Tellis, G., & Briesch, R. (2011). How well does advertising work? generalizations from meta-analysis of brand advertising elasticities. Journal of Marketing Research (JMR), 48, 457–471. Retrieved November 15, 2013, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=60571981&site=ehost-live

Suggested Reading

Baltagi, B., & Goel, R. (2004). State tax changes and quasi-experimental price elasticities of US cigarette demand: An update. Journal of Economics & Finance, 28, 422–429. Retrieved September 8, 2007, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=15248723&site=ehostlive

Friedel, E. (2014). Price elasticity: Research on magnitude and determinants. Frankfurt am Main: Peter Lang AG. Retrieved December 9, 2015, from EBSCO online database eBook Business Collection (EBSCOhost). http://search.ebscohost.com/login.aspx?direct=true&db=e020mna&AN=904587&site=ehost-live

Goel, R., & Nelson, M. (2006). The effectiveness of anti-smoking legislation: A review. Journal of Economic Surveys, 20, 325–355. Retrieved September 8, 2007, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=21170455&site=ehost-live

Grossman, M., Sindelar, J., Mullahy, J., & Anderson, R. (1993). Policy watch: Alcohol and cigarette taxes. Journal of Economic Perspectives, 7, 211-222. Retrieved September 8, 2007, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=9403111250&site=ehost-live

Pearce, D. W. (Ed.). (1992). The MIT dictionary of modern economics. Cambridge, MA: MIT Press.