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.
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?
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:
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.
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.
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.
Take this assessment to see how well you understood this unit.