Pizza Hut Double Deep Pizza

I love the cheese, the crust, and most of the other, assorted things that can go on a pizza. Sadly, many of those things are not good for me. This article, put out by Reuters, reports on a study measuring the impact of a tax on pizza on the number of pizza and soda calories consumed.

Over a 20-year period, a 10 percent increase in cost was linked with a 7 percent decrease in the amount of calories consumed from soda and a 12 percent decrease in calories consumed from pizza.

The team estimates that an 18 percent tax on these foods could cut daily intake by 56 calories per person, resulting in a weight loss of 5 pounds (2 kg) per person per year.

OK, budding economists. What does the first sentence sound like? If you said price elasticity, you would be right. They measured the change in demand of a product (with calories as the proxy for quantity of pizza) as a result of a change in price. Is calorie demand (at least for pizzas) price elastic or price inelastic?

Then, to add a policy bent to it, consider the idea of Pigovian taxes. If obesity is a negative externality (and it is – since obesity leads to higher health care costs and to higher insurance premiums, even among less heavy people) then one could estimate the impact of a pizza tax on consumption of those oh-so-good, but oh-so-bad for you consumer food items.

For my new micro economics students, this is an example of cross price elasticity. This concept looks at how the market for one good (in this case pressure cookers) is impacted by a change in the price of another good (in this case electricity). Though I don’t know the numbers in this scenario, let’s assume that electrical rates went up 10 percent. If we then saw a 15 percent increase in sales of pressure cookers, we’d say that this relationship is elastic – that pressure cooker sales are very responsive to a change in price of electricity.

The report mentions an estimate that a 10% rise in cigarette prices results in a 7% drop in smoking among youth and a 4% drop in smoking among adults.

There are a variety of studies on the price elasticity of demand for cigarettes, with varying estimates. The Surgeon General’s office issued a report summarizing the findings from a number of published studies. While the estimates differ some, the difference of elasticity between adults and youth smokers remains significant.

So, let’s review what price elasticity measures. The value of E is the ratio of the percent change in quantity demanded over the percent change in price. For a normal good, E should be negative – i.e. an increase in price yields a drop in quantity demanded, and a decrease in price yields an increase in quantity demanded. In either case one part of the ratio is negative, so the value of E is negative.

The figures reported by NBC (and many of the studies summarized by the Surgeon General’s office) show price elasticity for adults and children to be less than one. More accurately, the absolute value of E is less than 1.0. That means that quantity will change, percentage-wise, less than the change in price. OK – that makes sense. Smoking is understood to be addictive, and so we would expect that smokers might cut down on smoking as prices rise, but not by much.

What, then, is the explanation for youth smokers being “less inelastic”? Perhaps they are less addicted, since their experience with smoking is shorter. They also probably have less disposable income, and so even a modest price rise cuts into their budget more deeply. Are there other explanations?

By the way, the cigarette tax is an excise tax. Given the inelastic demand, we will expect only modest declines in smoking, but the government can expect to generate significant tax revenue.

Another application of elasticity is cross elasticity – or more properly the cross price elasticity of demand. In this case we look at a change in price for one product and measure the change in demand for another product. Let’s consider the markets for coffee and tea. Perhaps there is a significant crop failure in coffee, which significantly raises the retail price of coffee. We might wonder, then, if the demand for tea might change, as people switch to an alternative drink.

What would you expect? A significant increase in tea consumption when coffee prices rise? Or are coffee drinkers a stubborn lot and less prone to switch? A high value for cross elasticity means the coffee drinkers are switching to tea in significant numbers.

The current round of high gas prices is triggering changes in demand for smaller, cheaper cars, for public transportation, and for Amtrak and bus service. Greg Mankiw is keeping count. Here is his latest entry.

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?