(6) Elasticity

Total Video Time: 67 minutes

Introduction

In the last few modules, we’ve looked at the model of supply and demand to see how market determine prices and allocate goods, and what happens when the government intervenes. But a lot of the interesting stuff happens when we’re talking about how markets change, either in response to a shift in the demand or supply curve or in response to some government program. And any time that happens, the size of the effects in the market depend on what the demand and supply curves actually look like.

The law of demand says that the demand curve slopes down, but it doesn’t say whether the demand curve will be relatively steep or relatively flat; the law of supply says that the supply curve slopes up but also says nothing about how steep or flat the supply curve will be. The relative steepness or flatness of a curve is what we call “elasticity” — just another word for “sensitivity” or “responsiveness.” We know that consumers respond to prices, but just how much do they respond to prices of specific goods?

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Before I get into the videos, I do want to provide a few useful tips for you and explain why economists use this measure called elasticity.

Why elasticity?

If we are trying to describe what the demand curve for gasoline looks like, the obvious way to do it would be to try to determine the slope of the line. For example, we could determine that for every $1 increase in gas prices, the quantity of gasoline demanded decreases by 30 million gallons per day (a rough approximation based on current gas use). That would be useful to us.

The problem with looking at the slope of the line is that the information is limited to the US gasoline market. If we wanted to compare the demand for gasoline in the US to the demand for gasoline in Canada, it would get a little complicated. We have to convert dollars to Canadian dollars using some exchange rate. Canadians measure gasoline in liters, not gallons, so we have to convert for that too — and they probably spell it litres instead of liters, so that’s even more annoying. And our analysis only holds for the gasoline market. We cannot apply anything we are learning to other markets.

The beneficial part of using elasticity is that it is unit-free. There are no dollars or gallons or liters or anything else. You just get a number — -0.4 in this case, based on your textbook’s estimate of the price elasticity of demand for gasoline. This allows us to easily compare US demand with Canadian demand — just compare the two numbers. We can also compare different products easily.

We use elasticity instead of slope because it’s so much more versatile. Regarding slope and elasticity at the principles level of economics, you need to understand two things:

1. On a linear demand curve, the elasticity actually changes as we move down along the curve. Elasticity = %dQ/%dP (where d = change). We can rewrite this as (dQ/Q)/(dP/P), which can be further rewritten as (dQ/dP)*(P/Q).  Note that (dQ/dP) is how much Q changes when P changes, which is related to the slope of the demand curve — on a linear demand curve, that is fixed. But as we move down along the demand curve, we get lower P’s and higher Q’s, so our number gets smaller and smaller in size (closer to zero, since it’s a negative number). Thus, demand becomes more inelastic as we move down along the demand curve.

2. Having said that, for most intents and purposes you can think of “inelastic demand” as having a relatively steep slope, and “elastic demand” as having a relatively flat slope. True, the elasticities change along a linear demand curve, but when you consider that a perfectly vertical demand curve has an elasticity of 0 (perfectly inelastic) and a perfectly flat demand curve has an elasticity of negative infinity (perfectly elastic), you can see that as you go from steeper to flatter, your demand curve becomes more elastic.

Also, don’t worry about the constant elasticity of demand curve — the curved demand curve in your textbook. We’re not going to deal with that at all. You do need to know the perfectly inelastic and elastic demand curves, but not the curved one.

You also need know that there are some goods that have easily determined elasticities. Gasoline and cigarettes have inelastic demand — you have estimates of this in the table in your text, and you know from experience that prices don’t seem to affect people’s consumption of these two goods that much. So from now on, whenever you’re drawing the market for gasoline or cigarettes, you should be drawing your demand curve relatively steep. Land has inelastic supply — there’s a fixed amount of it. So pay attention to the examples that your book uses so that instead of just memorizing numbers for elasticity, you get a feel for the kinds of goods that are inelastic/elastic in demand and/or supply.

Another tip: there are several elasticities of demand (price, income and cross-price). Any time I just talk about the “elasticity of demand” without specifying which one, I’m talking about the price elasticity of demand; that’s the most important one for us.

Now at this point if you have not already watched the videos in the Asarta/Butters Library on this topic, you should. None of these videos will make much sense until you have done that. Once you’ve watched those videos and have a better understanding of what elasticity is and how it’s calculated, come back and watch these videos.

Video 6.1: Elasticity and Price Fluctuations (14 min)

This video explains how the price elasticities of supply and demand help determine how much prices in a market will change when there is a shift in one of the curves, and why the prices of some goods fluctuation more than others.

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Video 6.2: The War on Drugs (13 min)

This video explains how the inelasticity of the demand for drugs has played a predictable role in preventing our war on drugs (efforts to decrease supply) from being very effective. It then examines two alternative proposals to see how they would affect the quantity of drugs sold and the total revenue earned in the drug trade.

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Video 6.3: College Subsidies (7 min)

This video explains how programs that provide funding for people to go to college have had little impact on the quantity of students attending college and have led to increases in tuition rates; both of these results are quite predictable, of course, if you understand the elasticity of supply for college.

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Video 6.4: Rent Control (7 min)

This video explains how the effects on renters (and efficiency overall) from rent control change as supply becomes more elastic as time passes.

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Video 6.5: Minimum Wages (7 min)

This video explains how the effects of a minimum wage depend on the elasticity of demand for labor. If demand is elastic enough (because firms have other options, like outsourcing), minimum wages can make workers overall worse off, not better.

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Video 6.6: Taxes and Elasticity (19 min)

This video explains how the effects of a tax on the market depend on the elasticities of supply and demand. This has implications for how much tax revenue a tax will generate, and how that amount will likely decrease over time as consumers and producers find alternatives.

One key implication of this analysis is that taxes can either be a good source of revenue or a good way of getting people to stop using a good — but the government cannot determine this. This is based on the price elasticity of demand. If the good has inelastic demand, it’s a good way of raising tax revenues but it is not really going to affect people’s behavior much. If the good has elastic demand, you can get people to stop using the good by taxing it, but you’re not going to collect much in revenues.

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