Elasticity, Effects of Price Changes, Price Floors/Ceilings, Taxes & Subsidies
Price Elasticity of Demand (PED)
How do you maximize revenue by deciding how much you should price your good? It depends on which is greater: the effect of the change in price or the effect of the change in quantity.
Elasticity is a measure of the sensitivity of changes in one variable to changes in another.
Elastic Demand is when a change in price causes a relatively large change in quantity demanded. We find the elasticity of demand by comparing percent change in quantity demanded vs the percent change in price. Flatter demand curve!
Why do we make price elasticity of demand positive?
↑ Always negative so take absolute value to make it positive! ↑
Inelastic Demand is when a change in price causes a relatively small change in quantity demanded. In other words, quantity demanded is NOT sensitive to price changes. Steeper demand curve!
Elasticity is the measure of how sensitive quantity demanded is to changes in price.
What Determines the Elasticity of Demand? (Factors Influencing PED)
- Number of Substitutes: More substitutes, the easier it is to switch from one to another. Greater number of substitutes, the greater the elasticity is likely to be.
- Necessity: The less necessary a good/service is, the more elastic it is. Water is inelastic, movie tickets are elastic.
- Percent of Income Spent on Good: If a person spends a large percent of their income on a good, that person is likely to be more sensitive to a change in price. Greater percent of income spent on a good makes that good elastic for that person.
- Length of Time for Adjustment: The more time we have to adjust to a price change, the more elastic demand will be. If we get less time to adjust, it’s harder to identify substitutes or adapt to living without the good.
Will Total Revenue Rise or Fall When Prices Change?
Using the formula listed above, if the number is greater than one (percent change in quantity demanded is greater than percent change in price) then demand is elastic. If it’s less than one, demand is inelastic. If it’s equal to 1, then it’s called unitary elasticity.
What’s the significance of having a unitary elasticity? At unitary elasticity, does total revenue not change when price changes?
Elasticity of Demand > 1 → Elastic
Elasticity of Demand < 1 → Inelastic
Elasticity of Demand = 1 → Unitary Elasticity
EXAMPLE: A store sells 100 phones per week. Price per phone is $200. If price were increased by 10% and quantity demanded decreased by 5%, then demand is inelastic
You can figure out if revenues will rise/fall by approximating. A 10% price increase approximately increases revenue 10%. A 5% decrease in quantity demanded approximately decreases revenue 5%. Therefore, revenue will increase by approximately 5%.
Perfectly Elastic & Inelastic Demand
A perfectly elastic (D2) demand would mean that quantity demanded would be as much as possible at only one price point. Perfect inelasticity happens when elasticity of demand is infinity (η=∞). Price doesn’t change.
A perfectly inelastic (D1) demand would mean that quantity is not affected by price changes at all. Perfect inelasticity happens when elasticity of demand is 0 (η=0). Quantity Demand doesn’t change. For example; insulin.
Price Elasticity of Supply (PES)
If market price increases and producers can respond by easily producing more, supply is elastic.
If producers cannot respond to price increases by easily producing more, supply is inelastic.
Elastic Supply is when a change in price causes a relatively large change in quantity supplied. We find the elasticity of supplied by comparing percent change in quantity supplied vs the percent change in price. Flatter supply curve!
Inelastic Supply is when a change in price causes a relatively small change in quantity supplied. In other words, quantity supplied is NOT sensitive to price changes. Steeper supply curve!
↑ Always positive! ↑
Factors Influencing Price Elasticity of Supply (What Determines PES?)
Any factor that affects producers’ ability to increase/decrease production influences PES.
Oil supply, for example, is highly inelastic. If prices of oil increase, supply for oil might not increase proportionally due to the difficulty with finding, retrieving and refining additional oil sources.
Clothes supply, for example, is highly elastic. If prices of clothes decrease, it’s not too difficult for producers to cut down on production (by reducing workers, for example).
Another factor that influences PES is how much time producers have to respond. As more time goes by, supply will become more inelastic.
Income Elasticity of Demand (YED)
Income Elasticity of Demand is calculated by the percent change in quantity demanded divided by the percent change in income. Whereas price elasticity of demand is always negative and price elasticity of supply is always positive, income elasticity of demand can be negative or positive.
When income elasticity of demand for a good is positive, the good is a normal good. Most goods are normal goods (meaning that most goods have a positive income elasticity of demand).
When income elasticity of demand for a good is negative, the good is an inferior good. Examples: Used cars, small apartments, instant noodle soup, etc.
Luxuries are a special case of normal goods, but have an income elasticity of demand of greater than positive 1. Examples: vacations, sports cars, second homes, crystal & chine, etc.
The importance is sign and size. If | ηI | > 1, then elastic. If | ηI | < 1, then inelastic.
What happens when ηI is equal to 0?
Price Ceilings & Price Floors
- Price Ceilings are legally mandated maximum prices for goods and services.
- Price ceilings have no effect if it’s above equilibrium price.
- Price ceilings often lead to shortages, as producers have less of an incentive to produce a product if the price is being artificially lowered. This means that some consumers who are able to pay won’t get the good that they desire.
- Price ceilings often lead to black markets, as consumers who are willing to purchase a good/service for a price higher than the legal limit will look for it through other avenues. Also, producers who wish to sell their goods/services for a price higher than the price ceiling will also look for other avenues to distribute their product.
- Another perspective: Price Ceilings are government policies that ban consumers from fully paying for the product they’re receiving.
- Price Floors (also known as price support) are legally mandated minimum prices for goods and services (mostly agricultural products).
- Price Floors have no effect if it’s below equilibrium price.
- Price Floors often cause a surplus, as producers have an artificially high incentive to increase supply.
- A common price floor is the minimum wage which sets a minimum for how much a worker of any kind has to be paid per one hour of work.
- Another common price floor is the American government purchasing all the surplus agricultural goods because they set the minimum prices for dairy and other products.
Wouldn’t price floors not benefit suppliers because no one is purchasing the products, since the price exceeds demand?
Taxes & Subsidies
Taxes and subsidies are other ways, outside of price floors/ceilings, to distort market equilibrium.
A Tax on a Specific Good
When taxes are levied on a specific good, like cigarettes for example, the additional cost per pack of cigarettes increases. This additional cost is usually partly paid for by consumers, as producers begin to decrease production at the current price, which cause a shortage. When there’s a shortage, there’s a pressure on the prices to increase. When prices increases, quantity demanded decreases and quantity supplied increases.
This means that when a tax is installed, both consumers & producers pay the increased costs. Who pays how much depends on the price elasticity of demand. If demand curve is inelastic, then more of the tax can be paid by the consumer.
What about when the supply curve is inelastic?
Under a system of taxes and subsidies, there’s a distinction between market price (price equilibrium) and consumer/producer price. When the tax or subsidy is directly put upon a consumer, the consumer price is higher or lower, respectfully, then the market price.
A Subsidy on a Specific Good
The impact of a subsidy depends on elasticities. If demand is elastic, then impact of a subsidy will be much greater than if demand in elastic (subsidy will cause greater change in quantity demand).