Introduction to Unit 4: Elasticity

In the previous unit, we looked at the demand and supply curves and the determination of equilibrium in the market. The demand curve represents the demand for a good or service by consumers. Variations in the price of the good resulted in a change in the quantity demanded for a good, holding other factors constant. Or, if the price of the good in question is held constant, alterations in other variables such as incomes, prices of substitute or complementary goods would shift the demand curve. The supply curve reflected similar properties, but from the perspective of firms producing the good or service.

In this section we will develop the material relating to a change in the quantity demand and quantity supplied. Remember that each deals with a new price of the good being measured resulting in a movement along the curve.

If there is an increase in the price of a good, the quantity demanded will fall. We use the concept of elasticity to determine how much the quantity demanded of a good responds to a change in the price of that good. The price elasticity of demand measures the change in the quantity demanded for a good in response to a change in price. Changes are measured in percentage terms and the price elasticity of demand equals the percentage change in quantity demand divided by the percentage change in price.

If the change in demand is proportionately greater than the change in price then the good is considered to be price elastic. For example, if the price of the good increases by 1%, and the quantity demanded decreases by 1.5%, then the good has an elastic demand. Goods with an elastic demand have many substitutes in consumption or may be luxury items.

If the change in demand is proportionately less than the change in price then the good is considered to be price inelastic. For example, if the price of the good increases by 1%, and the quantity demanded decreases by 0.5%, then the good has an inelastic demand. Goods with an inelastic demand have few or no substitutes in consumption and are often necessities.

Two extreme cases are goods that are perfectly elastic and those that are perfectly inelastic. Perfectly elastic goods have a horizontal demand curve reflecting the presence of identical substitutes. For example, assume that you are shopping for flour at the local grocer. You find two bins of wheat flour located side by side. One is full of flour labeled "wheat flour from wheat grown in Zeppo County, Kansas" and costs $0.75 a pound. The other bin is also full and labeled "wheat flour from wheat grown in Harpo County, Kansas" and costs $0.40 a pound, otherwise the attributes of the flour are identical. Which would you purchase?

In this example we would assume that the elasticity of demand for wheat flour is perfectly elastic. The Zeppo country flour has a perfect substitute, flour grown in Harpo Country, or any other location for that matter. Farmers in Zeppo County face a perfectly elastic demand for their good. If they try to raise their prices above the market price, demand falls to zero. Even if they are trying to raise prices for a good cause - to buy a new engine for the local fire truck.

Perhaps you are thinking that Zeppo Country flour is organically grown. Organic foods represent a different market than non-organically grown foods. In the organic market, each firm would also have a perfectly elastic demand curve for the good in question and could charge no more than the market price for that organic good.

Make sure you understand the concept of a perfectly elastic good since it will be important later in the course. Perfectly elastic goods have substitutes that are identical in characteristics and so consumers will buy the lowest priced item. As a result, all producers can only charge the market price for that good.

The other extreme is a good with a vertical demand curve and is perfectly inelastic. Perfectly inelastic goods have no substitutes and are necessities. An example of this type of good is insulin or other pharmaceuticals that are required for someone to live. If the demand curve is vertical, the firm can raise prices by 1% or and the quantity demanded will not change. Consumers find a way to continue buying the good.

The price elasticity of supply looks at how the quantity supplied produced by a firm changes with output. The official formula is to take the percentage change in the quantity supplied of a good over the percentage change in the price of that good. Like the demand curve, the price elasticity of supply varies along the supply curve. Many firms have supply curves that begin as very elastic and relatively flat, but then abruptly become very inelastic or steeply sloped at some threshold of output.

The flat or elastic part of the supply curve represents excess capacity. A firm with excess capacity had unused capital available that can quickly be added to the production process. As a result the firm can quickly increase output with little change in production costs or the need to raise the price they change. Eventually, the firm will reach full capacity utilization where all of its machinery and other capital is fully in use. To increase output is difficult and expensive. The firm can add extra shifts and pay workers overtime, while it waits for new shipments of capital and possibly to build another factory in order to add to its productive capacity. The added labor expense raises production costs and yields only incremental changes in output as the existing plant and machinery is strained to full production. The firm will need to raise the price it charges in order to cover added costs as it continues to increase output.

Finally, we will look at the relationship of elasticity to tax policy. The type of tax examined here is an excise tax that is levied on items such as gasoline, cigarettes and liquor. An excise tax is a fixed amount per unit sold, 30 cents per gallon of gas for example.

When thinking about government tax policy in this regard, use common sense. What type of goods will the government prefer to tax? Goods with an inelastic demand of course. Since the goal of a tax is to collect revenues and the effect of the tax is to raise the price of the good, there will be smaller changes in the quantity demanded of the item, the less elastic its demand curve.

An example of a poorly conceived tax was as recent as 1990, when President Bush and Congress adopted a 10% luxury tax on such big ticket items such as pleasure boats, private airplanes, high-priced cars (e.g. Mercedes, Lexus), jewelry and furs. The goal was to raise federal tax revenues to help reduce the budget deficit. Since middle class income taxes were being raised as well, it was hoped the luxury tax would deflect some of the criticism.

But luxury items tend to be price elastic, since many of the consumers of these goods can easily afford to avoid the tax. Pleasure boat (yacht) sales in Florida fell 90% as purchasers went to the Bahamas where they could make the acquisition and avoid the tax, enjoying the cruise back to the U.S. to boot. Another popular trip for the monetarily endowed was to Europe, where a European luxury car was purchased, the continent toured and the car was brought back to America, avoiding the luxury tax if the car was purchased in the United States.

The luxury tax was forecast to raise about $300 million a year, but only raised about $30 million in 1991, an amount that didn't even cover the cost of administration, leading to the rapid repeal of the tax altogether.

The economic effect of an excise tax is to shift the market supply curve of the good being taxed to the left. Both the consumer and producer absorb part of the tax burden. The consumer pays a higher price, the producer sees a drop in sales and revenues. The more inelastic the demand curve, the smaller the resulting change in the quantity demanded of the good when the tax is raised or initially levied. In addition, as elasticity decreases, a greater proportion of the tax burden is passed on to the consumer and less is incurred by the producer.

Outline Unit 4: Elasticity