In a previous article Supply, demand and market equilibrium we discussed the relationship between supply, demand and price. We also saw how governments and companies often try to manipulate the price in Rationing and allocating resources.
But how much can a price be manipulated before consumers stops buying the product. How much will demand change in response to changes in price. We can calculate the magnitude of change with the elasticity formula.
Elasticity is a concept used to quantify he response in one variable to changes in another variable. Here is the general formula to calculate elasticity.
The elasticity formula has lots of application possibilities.
Price Elasticity of demand
If suppliers push up price, revenue goes up unless substitutes exists. If substitutes exists, revenue will go down because customers will turn to substitutes. For example, if the price of insulin goes up, demand will hardly be affected because people’s lives depend on it and there are no substitutes. On the other hand, if the price of bananas are pushed up, demand will drop because many substitutes are available. People will just buy more apples (for argument sake)
We can calculate the magnitude of change in quantity demanded to change in price using the elasticity formula
Demand for some products are far more sensitive to price changes than others
What determine Demand elasticity?
Elasticity of demand measures the responsiveness of consumer demand to changes in price. Consumer behavior is not always predictable, but a few determinants does stand out
- Availability of substitutes – If the prices of a product is too high, consumers will turn to cheaper alternatives.
- The importance of being unimportant – If a product represents a relatively small part of the consumer’s budget, price changes are easily overlooked.
- The time dimension – If a company keeps prices high for a product where demand is inelastic, substitutes will be developed over time.
The effect on Total Revenue
So will total revenue go up or down if a company increase the price of their product?
Remember that quantity demanded goes down when prices goes up. So, Total revenue will increase only if the percentage drop in quantity is less than the percentage increase in price. In other words, pushing up prices will only increase a companies total revenue if price elasticity of demand is inelastic.
The price of oil is inelastic. So oil companies can increase Total Revenue by reducing supply. By reducing supply, the price will be pushed up but quantity demanded will hardly change. Depressing, isn’t it?
In South Africa we have the Competition commission. The competition commission investigate claims of excessive pricing and they can fine a company if found guilty of noncompetitive behavior. In 2007 some of the bread suppliers were fined for price fixing. Currently some of the large pharmaceutical companies are being investigated for excessive pricing of cancer medication. The high prices of cancer medication makes treatment unaffordable for many.
Eskom holds monopoly over South Africa’s power supply. Fortunately we have The National Energy Regulator of South Africa (Nersa) who has to approve tariff changes requested by Eskom. The interesting thing here is that elasticity for a product can change over time. The demand for a product may be inelastic now because of a lack of alternatives. But if prices remain high and supply is unreliable, substitutes will be developed over time and a company will loose their power over consumers.
Income Elasticity of Demand
Income elasticity of demand measures how changes in income affects the demand for a specific product
Cross-Price Elasticity of demand
Cross-price Elasticity of demand measures how changes in the price of one product affects demand for another product. If the products are substitutes, an increase of the price of one product will cause an increase of demand for the other product. If the products are compliments, an increase in the price of one of the products will cause a decrease in demand for both.
Elasticity of supply
Elasticity of supply measures how changes in the price of a product affects the quantity supplied. A higher price for a product tend to increase profitability, which leads to investment (companies increase quantity supplied).
This can be used to calculate the elasticity of labor supply
Elasticity of labor supply is an interesting one. We would think that labor supply would have an upward slope like the other supply curves mentioned (If the price of labor goes up, the quantity labor supplied should also go up). This is not necessarily the case. Sometimes workers choose to buy leisure time with their higher incomes. With the higher wage rate, they can afford to work less hours.
Karl E. Case, Ray C.Fair, Principles of economics. Seventh Edition, Pearson Prentice Hall, 2004, Chapter 4