Plain Sense Economics

In the discussion of demand and supply we noted that demand for a product is chiefly determined by its price. For almost all products the demand curve slopes down and to the right – with a negative slope. The shape of the typical demand curve tells us that demand is inversely related to changes in price.

Price elasticity gives us a better picture of this relationship between demand and price. It describes how responsive demand is to a change in price.

Let’s take a product we all buy – gasoline. Not to date this post terribly, but let’s say that a gallon of gas costs $3.00. Now let’s say that tomorrow, when we go to fill up our tank, gas prices have increased 10 percent – to $3.30. After muttering some profanities under our breath – or out loud – we will probably fill our tank. If the price stays this high we might re-think the weekend trip to the coast, but in general we will probably drive approximately the same number of miles over the coming week as we did last week. For the sake of the example let’s assume that our gas consumption declined by only 5 percent. So – a 10 percent rise in the price of gas led to a 5 percent decrease in our demand.

We call our demand for gasoline “price inelastic.” In English this means that our demand is not very responsive to changes in price. Our demand is still inversely related to price, but our response is pretty limited.

Products and services that are price inelastic tend to be necessities, have fewer substitutes (i.e. not many alternatives), and the behavior is more common in the short run.

OK – this invites a contrasting example. Let’s look at demand for rented DVDs. At let’s say that I can rent a movie for about $3.00. This coming weekend I go to my local rental store and discover that the rental price has gone up 10 percent – to $3.30 per day. For some people this would be an annoyance but not a deal killer. For me, however, the price increase reminds me that I have lots of options and alternatives – both on the television, and in terms of other evening entertainment. As a result I find that my rental of DVDs goes down by 20 percent over the coming months. To summarize: a 1o percent increase in price led to a 20 percent drop in my demand for the rentals.

We call my demand for DVDs “price elastic.” My demand is very responsive to a change in price. Demand is inversely related to price, as with the gasoline example, but with my tastes in entertainment and the availability of substitutes I am sensitive to price changes.

If you are in the habit of thinking about demand curves on a graph, in general demand that is price inelastic will have a fairly steep demand curve. Demand that is price elastic will have a more shallow demand curve.

Elasticity comes into play in policy decisions – particularly when government decides to impose a tax on a product. Let’s look at cigarette taxes as an example. Cigarette taxes are usually in the form of an excise tax – where a specific tax is imposed per pack of cigarette’s sold.

So – quick test here – would you describe the market for cigarettes to be price elastic or price inelastic?

If you said price inelastic you would be right! (or at least you would agree with me…) If I can find the studies quickly I’ll add them here later. In general research shows that cigarette consumption is price inelastic – a increase in price (due, for example, to a new tax) will decrease the cigarette purchases, but by a smaller percentage than the increase in price.

So, what are the policy implications of this? There are several:

• If you want to raise a lot of tax revenue, apply the tax to a product like cigarettes. Demand will go down only slightly, but the government can collect significant revenue.
• If you want to impose a tax in order to discourage smoking, the strategy will not be very effective – at least within a reasonable range of prices.
• However, one silver lining is that price elasticity of cigarettes among young smokers is higher. They are more responsive to a change in price. An increase in tax will help reduce smoking among young smokers to a larger degreee than among adult smokers.

The note about revenue brings us to the last observation on price elasticity. If we run a business and have some discretion on setting prices, and we wish to increase revenue, here are the guidelines we can use:

• If demand for our product is price elastic and we want to increase revenue, we should lower our prices. We will lose some revenue due to the lower price, but that will be more than offset by the increased demand for the product.
• If demand for our product is price inelastic and we want to increase revenue, we should raise prices. We will lose some business/customers with the price increase, but not very much in comparison to the increase in price.

As a little exercise to test your understanding of these concepts, imagine that you are a telephone company, faced with relatively inelastic demand for phone calls during the day and elastic demand during the evening. How might you adjust your daytime and evening prices to increase revenue?