Unit 3: Elasticity and its Applications
In this unit, we delve into the concept of elasticity and its practical applications for how firms make pricing decisions and how governments analyze and make policy decisions. Put simply, elasticity measures responsiveness. It helps us understand why Netflix increases their prices for their Standard and Premium tiers more frequently, compared to their entry-level Basic plan. Government analysts also rely on elasticity to determine the extent of tax increases.
We can apply elasticity to demand and supply analysis. Elasticity measures how quantity responds to changes in the price of the product, the price of related goods, income, advertising, and more. Once you grasp the concept and its basic calculations, applications of elasticity in economic analysis are nearly limitless.
Completing this unit should take you approximately 4 hours.
Upon successful completion of this unit, you will be able to:
- explain the concept of elasticity as it applies to microeconomics;
- discuss price elasticity of demand and understand how to measure it;
- give examples of income elasticity of demand and cross price elasticity of demand and understand their results;
- explain price elasticity of supply and its applications;
- predict how elasticity affects revenue and pricing decisions; and
- discuss how tax incidence relates to the model of demand and supply and to elasticity.
3.1: The Concept of Elasticity
According to the Cambridge Dictionary, The word elastic means "an elastic material is able to stretch and be returned to its original shape or size." Think of a rubber band. In the context of economics, elasticity measures how much a variable will "stretch" in response to a change in a related variable.
In this section, we introduce the concept of elasticity as it is studied in microeconomics. While this concept can be challenging due to its various types and the necessity to make calculations and interpret the results, you will discover it is not only highly useful but also quite intuitive and easy to grasp.
Read this introduction to the concept of elasticity. It offers examples that make it easier to understand why we need an economic tool to measure the degree of responsiveness of one variable to changes in another variable.
In early 2019, Netflix announced its biggest price hike ever in the united States. Consequently, the company experienced a drop in subscribers for the first time since 2011. In April 2018, Amazon announced a 20 percent increase in the price of its Prime subscription, and... 53 percent of respondents to an eMarketer survey said the increase had no impact whatsoever on their subscription to the service.
We can attribute the different reactions from Netflix and Amazon clients to various factors. Nevertheless, both companies benefit from understanding how their consumers react to changes in the price of their products. Do you think we should introduce "ceteris paribus" into this discussion?
3.2: Elasticities of Demand
Now that you are familiar with the concept of elasticity as a measure of responsiveness, you are ready to apply it to the concepts you learned in Unit 2. We begin by analyzing how demand (quantity demanded) responds to changes in specific variables that affect it.
As you know, the quantity demanded of a good or service reacts to changes in its price, and the price elasticity of demand tells us by how much. Additionally, the demand for a good or service also responds to changes in consumers' income, measured by the income elasticity of demand, and the prices of related items, indicated by the cross-price elasticity of demand.Watch this video on calculating the price elasticity of demand over the demand curve graph and with the elasticity formula.
Revisit the previous explanation by watching this video and further your understanding by interpreting the results of price elasticity of demand. Pay close attention to whether we are using the absolute value to calculate elasticity. Avoid memorizing the interpretation of the results; they are so intuitive that it is not worth occupying your brain's storage capacity with these details. Be sure to grasp the concept that elasticity is a unit-free measure.
Let's now delve into the analysis of income elasticity of demand. Watch this video to explore this concept, paying close attention to the interpretation of results. Income elasticity of demand results provide valuable information for both firms and the government. They help us understand how much consumers' quantity demanded reacts to a change in income at a specific price and determine whether, at that given price and within a particular income bracket, the analyzed good or service is normal or inferior.
The next elasticity of demand we will discuss is the cross-price elasticity of demand. There is no need to be intimidated by the complex sound of its long name!
The cross-price elasticity of demand simply measures the percentage change in the quantity demanded of one good or service due to the percentage change in the price of a related good or service. We are sure Elon Musk would like to know how much the quantity demanded of the Tesla Cybertruck would change in percentage terms in response to a given percentage change in electricity prices.
You have already observed that elasticity calculations can yield diverse results. Economists classify results of zero, infinite, or one as extreme or polar cases. Read the explanation, and make sure you understand that while these outcomes are not common, they serve as valuable analytical benchmarks.
In conclusion, understanding the elasticity of demand is essential for businesses and policymakers alike. It provides valuable insights into how changes in prices and income can affect consumer behavior and market dynamics.
You should now be able to discuss complex questions such as:- Why is food demand more income-elastic in low-income communities than in wealthier communities?
- How does the price elasticity of demand change in the long run?
- Why do you think airline seats in business class have an estimated elasticity of demand of 0.42, while seats in economy class have an estimated price elasticity of 0.60?
- What is the relationship between price elasticity and position on the demand curve? For example, what happens to the measured elasticity as you move up the demand curve to higher prices and lower quantities?
3.3: Elasticity of Supply and Its Applications
Now that you have fully grasped the concept of elasticity, let's apply it to supply. Recall from Unit 2 that supply illustrates the quantity a firm is willing to provide at each market price. Before you proceed, take a moment to assess whether you can define and calculate the price elasticity of supply.Well done! Price elasticity of supply measures the percentage change in quantity a firm supplies in response to a percentage change in price. Watch this video to review the concept of price elasticity of supply, master its calculation, and understand the interpretation of the possible results.
Here is some food for thought before we delve into the next section: Do you believe the housing supply in your city is price elastic or price inelastic? Does your perspective shift when you consider a longer time frame? Watch this video on the determinants of the price elasticity of supply.
At this stage, your mind is brimming with new concepts, challenges, and ideas. You have examined numerous diagrams, and it is quite common to mistake elasticity at a specific point for the slope. This reading will help you clarify the distinction.
3.4: Elasticity, Revenues, and Pricing Decisions
Throughout this unit, we have emphasized that elasticities of supply and demand are essential tools for the decision-making process of both firms and policymakers. In this section, we further explore the relationship between revenues and elasticity.
Before we begin, take a moment to review the concept of revenue to make sure everything is clear with income. Our course resources define income as "a flow of money received, often measured on a monthly or an annual basis," and revenue as "income from selling a firm's product, defined as price times quantity sold."
Read this section that discusses the relationship between price elasticities of supply and demand, pricing strategies, and revenues. Consider inserting your own relevant examples when you study Table 5.3. Pay particular attention to the analysis of whether firms can pass higher costs on to consumers, depending on the price elasticity of demand.
Watch this video If you need additional explanations on the relation between total revenue and the price elasticity of demand for a product.
3.5: Elasticity and Its Applications
Elasticity is a concept that often prompts the thought, "Why did I not consider this earlier?" It serves as a fundamental analytical tool. For example, organizations like the FAO (Food and Agriculture Organization of the united Nations) use income and price elasticities of demand, among other variables, to assess food security (see https://www.fao.org/3/Y2876E/y2876e08.htm). Researchers apply these elasticities to study the distribution of essential pharmaceutical products in developing countries (see https://www.fao.org/3/Y2876E/y2876e08.htm). Policymakers, as we have mentioned, heavily depend on these measures when implementing new taxes or modifying existing ones.
We usually associate revenues with companies or firms. However, governments also generate revenues, primarily through taxes. As we explore later in the course, governments aim to maximize their tax revenue to fund the provision of public goods and services.
Before you studied this unit, you may have assumed, "All the government has to do is increase taxes to boost revenue for financing their expenditure." It is not that simple!
Consider this scenario: if the government imposes a high tax on red meat, consumers may simply switch to alternative products (substitutes) and significantly reduce their demand for red meat. As you may have already noticed, this logic closely resembles that of pricing and revenues for a firm. Both firms and governments must carefully assess elasticities.
Watch these two videos on the relationship between taxes and two polar cases of demand elasticity: perfectly elastic and perfectly inelastic demand. You may need to go back to the end of section 3.2 and review the polar cases before you watch the videos.
Read this text to enhance your understanding of elasticity as it applies to labor markets. Wage elasticity allows firms to assess the extent to which workers respond by offering more work hours when wages increase. Use this analysis to revisit the labor market introduced in section 5 of Unit 2.
Watch this comprehensive video that summarizes most of what we have explored in this unit. Given its length, you may want to revisit it after completing the unit to ensure you have a thorough understanding of elasticity and its applications.
Unit 3 Assessment
- Receive a grade
Take this assessment to see how well you understood this unit.
- This assessment does not count towards your grade. It is just for practice!
- You will see the correct answers when you submit your answers. Use this to help you study for the final exam!
- You can take this assessment as many times as you want, whenever you want.