Chapter 4: Elacticity, Goverment Policies and Market Efficiency

Introduction

The price-sensitivity or responsiveness of consumers is measured via the price elasticity of demand. The income elasticity of demand, on the other hand, measures the response of the quantity demanded to a change in consumer income. As the third type of elasticity, The cross-price elasticity of demand measures the response of demand for one good to changes in the price of another good.

If demand is elastic, an increase in price causes total revenue to decrease. The concept of elasticity is important because buyers and sellers can use the concepts to understand and decide what kind of strategies they are going to follow.

Elasticity and its Applications

While the theory of demand and supply allows us to predict the direction of the change in a market, it does not allow us to know how much change occurs in the quantity of demand when there is a change in price. Therefore, another measure, called elasticity, has been developed in economics.

In broad terms, elasticity is a measure that shows how much buyers and sellers respond to changes in market conditions, which is represented by the changes in variables that determine demand and supply.

Elasticity shows both the direction of the relationship between two variables and the quantitative response of one variable to another.

Economists compute elasticity as the percentage change in a variable (e.g. variable A), divided by the percentage change in another variable (e.g. variable B).

Elasticity of Demand

Elasticity is used in order to measure how much consumers respond to changes in the determinants of demand such as changes in price of the good, their income, or price of the related goods in the market place. There are different sorts of elasticity of demand.

First, the price elasticity of demand measures the responsiveness of demand to changes in price. It is calculated as the percentage change in the quantity demanded of the good divided by the percentage of change in the price of that good.

The law of demand states that an increase in the price of a good causes the quantity demanded of the good to fall. Due to this law, the sign of the price elasticity of demand is always negative.

Mid-point approach is different than the standard way to compute price elasticity of demand. This method calculates the percentage change by dividing the change by the average of the initial and final levels of price and quantities.

The results of the computations by using the mid-point approach give the same values, and the problems involved in the standard method are avoided.

The price elasticity of demand can take values between zero (0) to minus infinite (–?). If the percentage change in quantity demanded is smaller than the percentage change in the price of a good, the demand for a good is said to be inelastic. Inelastic demand always takes a value between zero and -1. However, if the percentage change of quantity demanded is greater than the percentage change in the price of a good, the demand for a good is said to be elastic. Elastic demand has an absolute value greater than 1.

The price elasticity of demand for a good or service depends on many factors such as whether close substitutes are available, the good is necessity or luxury for the consumer, weight of the good’s cost in consumers’ budget, and the time period.

The slope of a demand curve is different from its price elasticity of demand. The slope of a demand curve, whether it is flat or steep, is based on absolute changes in price and quantity. On the other hand, the price elasticity of demand is concerned with relative changes in price and quantity.

However, the price elasticity of demand can be understood by looking at the slope of the demand curve in the following cases:

1. When price and quantity are identical, by looking at the slopes of the two intersecting demand curves it can be said which one is more elastic than the other.
2. If the demand curve is vertical, its slope and its price elasticity is zero, and
3. If the demand curve is horizontal, its slope and the price elasticity would be infinite.

It is also possible to say that the flatter the demand curve is, the bigger the price elasticity of demand, the steeper the demand curve is, the smaller the price elasticity.

A perfectly elastic demand curve indicates “extreme price sensitivity” which means that the tiniest price increase causes the demand to fall to zero for the analyzed good. In economic theory, a good example of a perfectly elastic demand curve is the demand curve that firms face in competitive markets.

The reason why competitive firms face a perfectly elastic demand curve is that elasticity is greater when there are lots of close substitutes available.

In any market, for any firm with the aim of maximizing its profit, the amount of revenue that it earns is important. Total revenue is computed as the price of a good times the quantity sold.

If the demand is elastic, an increase in the price causes the total revenue to decrease. In contrast, a decrease in price causes total revenue to increase.

However, the total revenue increases following the increase in price when the demand is inelastic because the increase in price leads to a decrease in quantity demanded that is proportionally smaller.

Non-linear demand curves mostly have different price elasticity along the entire curve whereas the linear demand curves have a constant slope.

For the linear demand curves, price elasticity of demand falls as you move downward along the demand curve.

While on the inelastic portion of the demand curve, an increase in price causes the total revenue to increase, on the elastic portion of the demand curve, a reduction in the price causes the total revenue to increase.

Such relationships between elasticity and total revenue indicate that while firms that face elastic demand can increase their revenues by cutting their prices, the firms that produce goods with inelastic demand should follow the price increase strategy to increase their sales revenues.

Here are the two effects of price increase on revenue:

1. Higher Price means more revenue on each unit the firm sells.
2. But higher price means that the firm sells fewer units (lower Q), due to the Law of Demand.

Income elasticity of demand measures the responsiveness of demand to income changes.

The cross-price elasticity of demand is a measure of how much the quantity demanded of one good responds to a change in the price of another good. For Substitute goods, the cross-price elasticity of demand is positive since the price increase of good X causes the quantity demanded of good Y to increase.

Elasticity of Supply

The price elasticity of supply is a measure of the response of quantity supplied of a good to a change in price. Because of the law of supply, the price elasticity of supply has always a positive sign.

The supply of a good is said to be elastic if the quantity supplied changes more than the price changes. However, supply is said to be inelastic if the quantity supplied responds only slightly to price changes.

The flexibility of producers, which determines the price elasticity of supply, depends on two important factors: (i) availability of inputs to producers and (ii) the time horizon.

The elasticity of supply gets higher as the availability of inputs for production increases. Additionally, supply is more elastic in the long-run than in the short-run.

The price elasticity of supply mostly can be understood from the shape of supply curves.

As a rule of thumb, the flatter the supply curve, the larger the price elasticity and the steeper the supply curve, the smaller the price elasticity of supply.

The perfectly inelastic supply curve has a vertical shape and the slope and the price elasticity of vertical supply curve is equal to zero, which indicates that any increase in price does not cause any increase in the quantity supplied of the good or service.

Government Policies and Their Effect on Market Outcomes

The rent controls and the minimum wage laws dictated by the governments can be given as example of price control. Price controls are generally applied when decision makers believe that market prices, either rental prices or wages, are unfair to users of rental.

Price ceiling is a legal maximum on the price at which a good can be sold. Imposing a price ceiling above the equilibrium price is not binding and it has no effect on the market outcome.

Price floor is a legal minimum on the price at which a good or service can be sold. The minimum wage laws are imposed to create a fair minimum wage floor to protect workers in the job market.

Minimum wage laws generally do not affect highly skilled workers since the free labor market equilibrium is mostly above the imposed price floor. However, the law negatively affects especially the unskilled labor groups by creating unemployment.

The government can choose and make buyers or sellers to pay tax. The tax can be a percentage of the good’s price, or a specific amount for each unit sold or bought in the market.

Tax incidence is the study of who bears the burden of taxation. A tax creates a wedge between the price that buyers pay and the price that sellers receive. The wedge is equal to the tax. Moreover, regardless of whether the tax is levied on buyers or sellers, the effects of taxation are the same: the price that the buyers pay rises from P ₀ to P _B and the price that the sellers receive falls from P ₀ to P _S . In addition, the tax also reduces the market size by reducing the equilibrium quantity from Q ₀ to Q _T .

Elasticity, specifically, the price elasticity of demand and supply determines the taxation incidence. A tax burden goes more heavily on the side of the market that is less price elastic.

When supply is more price-elastic than the demand, sellers are relatively more responsive to price changes, and the supply curve is flatter than the demand curve.

The workers bear the bulk of the burden of a payroll tax if the labor supply is relatively inelastic than the labor demand, and the firms bear the bulk of the burden of a payroll tax if the labor supply is relatively elastic than the labor demand.

Benefits to Participants and Market Efficiency

Besides allocating the scarce resources to the most efficient uses, the works of market system and price mechanism also benefit the participants of the market, namely the buyers and the sellers.

Consumer surplus (CS) is the difference between the maximum amount a person is willing to pay for a good and the market price. The consumer surplus that each buyer gets is different.

The total consumer surplus that the buyers gain from the participation in the market changes with price changes. Any development that reduces the equilibrium market price causes the total consumer surplus to increase and any price increase causes the total surplus to decrease.

The benefit the producers get from participating in the market activity is called producer surplus (PS). The total producer surplus increases with the market price increase and vice-versa.

For the firms, the production of goods and services requires bearing costs. In economics, the cost is defined as the value of everything a seller must give up to produce a good which is also called as opportunity cost.

Buyers and sellers of the market make gains from trade. The sum of the gains that the buyers and sellers make is called total surplus.

Efficiency in market refers to the property of a resource allocation of maximizing the total surplus received by the society. The equilibrium in free markets is efficient because:

1. The equilibrium quantity output maximizes total surplus received by the all members of the society.
2. The goods are produced with the lowest cost.
3. The goods are consumed by the buyers who value them most highly.