5.3 Elasticity and Pricing

Elasticity measures how responsive buyers and sellers are to changes in price, income, or other factors. It's central to understanding why some price changes cause big shifts in quantity demanded or supplied, while others barely register. This topic connects elasticity directly to firm pricing decisions, tax burden distribution, and how markets behave differently in the short run versus the long run.

Elasticity and Its Impact on Markets

Price elasticity and firm revenue

Price elasticity of demand measures how sensitive quantity demanded is to a change in price. The relationship between elasticity and total revenue is one of the most tested concepts in this unit, so it's worth understanding thoroughly.

Total revenue equals price multiplied by quantity:

$TR = P \times Q$

When price changes, it pushes $P$ and $Q$ in opposite directions (law of demand). Elasticity tells you which effect wins:

• Elastic demand ($|E_d| > 1$): Quantity demanded changes by a larger percentage than price.
  • A price increase decreases total revenue because you lose too many buyers.
  • A price decrease increases total revenue because you gain enough new buyers to more than offset the lower price.
• Inelastic demand ($|E_d| < 1$): Quantity demanded changes by a smaller percentage than price.
  • A price increase increases total revenue because you don't lose many buyers.
  • A price decrease decreases total revenue because you don't gain enough new buyers to make up for the lower price.
• Unit elastic demand ($|E_d| = 1$): Quantity demanded changes by the same percentage as price.
  • Total revenue stays the same regardless of the direction of the price change.

The elasticity formula itself:

$E_d = \frac{\%\ \text{change in quantity demanded}}{\%\ \text{change in price}}$

Elasticity's impact on market curves

Several factors determine whether demand or supply is elastic or inelastic. These factors don't shift the demand or supply curves themselves; rather, they shape how steep or flat the curves are, which reflects how responsive buyers or sellers are to price changes.

Factors that make demand more elastic (flatter curve):

• Availability of close substitutes: If Pepsi raises its price, you can easily switch to Coke.
• Higher proportion of income spent on the good: A 10% increase in rent hits your budget harder than a 10% increase in the price of toothpaste.
• Longer time horizon: Over months or years, consumers can research alternatives and change habits.

Factors that make demand less elastic (steeper curve):

• Few or no substitutes: A diabetic patient has very limited alternatives to insulin.
• Small share of income: You probably won't change your gum-buying habits over a small price increase.
• Shorter time horizon: In the moment, you have fewer options to adjust.

Factors that make supply more elastic (flatter curve):

• Ease of scaling production: A software company can distribute more copies at almost zero marginal cost.
• Longer time horizon: Firms can build new factories, hire workers, and enter new markets over time.

Factors that make supply less elastic (steeper curve):

• Difficulty increasing production: You can't quickly produce more beachfront land or rare minerals.
• Shorter time horizon: A factory running at full capacity can't instantly ramp up output.

Short-Run and Long-Run Elasticity Effects

Short-run vs long-run elasticity effects

Time is one of the biggest determinants of elasticity. Both demand and supply tend to be more inelastic in the short run and more elastic in the long run.

Short run:

• Consumers have limited ability to adjust. If gas prices spike tomorrow, you still need to drive to work. You can't buy an electric car overnight.
• Producers face similar constraints. When demand for face masks surged in early 2020, manufacturers couldn't instantly build new production lines.
• Because neither side is very responsive, short-run price changes tend to be large while quantity changes tend to be small.

Long run:

• Consumers can find substitutes, change habits, or switch products entirely. Over several years, higher gas prices push people toward fuel-efficient or electric vehicles.
• Producers can expand capacity, enter or exit markets, and adopt new technology. Factories get built, supply chains adjust.
• Because both sides are more responsive, long-run quantity changes tend to be larger while price changes tend to be smaller.

This distinction matters for predicting market outcomes. A supply shock will cause a sharp price spike in the short run, but the price effect fades as the market adjusts over time.

Tax Incidence and Elasticity

Elasticity and tax burden distribution

Tax incidence refers to who actually bears the economic burden of a tax, which is not necessarily who writes the check to the government. The key principle: the less elastic side of the market bears a larger share of the tax burden, because they're less able to adjust their behavior to avoid the tax.

Here's how to think through the extreme cases:

• Perfectly inelastic demand ($E_d = 0$): Buyers can't reduce their purchases at all. They absorb the entire tax. Think of a heavy tax on a life-saving medication with no substitutes.
• Perfectly elastic demand ($E_d = \infty$): Buyers will leave the market entirely at any price increase. Sellers absorb the entire tax.
• Perfectly inelastic supply ($E_s = 0$): Sellers can't reduce their output at all. They absorb the entire tax. Think of a tax on land, which is fixed in supply.
• Perfectly elastic supply ($E_s = \infty$): Sellers will exit the market rather than accept a lower price. Buyers absorb the entire tax.

Most real-world cases fall between these extremes. The tax burden gets split, with the less elastic side paying more.

Taxes also create deadweight loss, which is the reduction in total economic surplus caused by the tax driving a wedge between the price buyers pay and the price sellers receive. Some transactions that would have benefited both sides no longer happen. The size of deadweight loss depends on elasticity: the more elastic demand and supply are, the greater the deadweight loss, because more transactions are lost.

Other Types of Elasticity

Cross-price and income elasticity

Cross-price elasticity of demand measures how the quantity demanded of one good responds to a price change in a different good.

$E_{cross} = \frac{\%\ \text{change in quantity demanded of Good A}}{\%\ \text{change in price of Good B}}$

• A positive cross-price elasticity means the goods are substitutes. When the price of Pepsi rises, quantity demanded of Coke increases.
• A negative cross-price elasticity means the goods are complements. When the price of printers rises, quantity demanded of ink cartridges falls.

Income elasticity of demand measures how quantity demanded responds to a change in consumer income.

$E_{income} = \frac{\%\ \text{change in quantity demanded}}{\%\ \text{change in income}}$

• Positive income elasticity means the good is a normal good: people buy more of it as their income rises (restaurant meals, vacations).
• Negative income elasticity means the good is an inferior good: people buy less of it as their income rises (instant noodles, bus tickets).

Determinants of elasticity

These factors come up repeatedly across all types of elasticity:

• Availability of substitutes: The single most important determinant. More substitutes means more elastic demand.
• Time horizon: Longer time periods allow more adjustment, making both demand and supply more elastic.
• Proportion of income: Goods that take up a larger share of your budget tend to have more elastic demand.
• Necessity vs. luxury: Necessities (food, medicine) tend to be inelastic; luxuries (vacations, designer clothes) tend to be elastic.
• Addictive nature: Addictive goods like cigarettes tend to have inelastic demand because consumers are less willing or able to cut back.