Wednesday, May 09, 2007

Oikos 101: Price elasticities

Welcome to the first in what I intend to be a regular series: Oikos 101.

Here I’ll attempt to explain useful economic, ecological or environmental policy concepts in a way that’s simple but still accurate. (If it’s not simple or is inaccurate, please let me know).

I’ll then use these concepts in future posts without the need to explain them each time.

The first concept is an important one in economics: price elasticity.

Elasticity generally is a measure of responsiveness: how much one variable changes when another variable changes. The more “elastic” something is, the more responsive it is. Two important elasticities in economics are the price elasticity of demand and the price elasticity of supply.

When the price of something goes up, the quantity that consumers demand generally goes down. If McDonalds doubled the price of its Big Macs, people would by fewer Big Macs. (Some would switch to Whoppers, some would cut back from two Big Macs for lunch to one, some would decide it’s finally time to take their own sandwiches to work, etc etc). The price elasticity of demand refers to how much the quantity demanded changes as price changes.

Different goods have different price elasticities. Some things are easy to avoid or substitute for. When the price of bananas shot up in Australia after Cyclone Larry devastated Queensland banana plantations last year, people mostly bought other fruit or just ate less fruit. We can describe demand for these sorts of items as price-elastic or just elastic. (The quantity demanded is quite responsive or sensitive to changes in price). Other things are difficult to avoid or substitute for. If the price of cigarettes increased suddenly, some people would quit or smoke less, but many would not change their habits much. Demand for cigarettes is relatively inelastic. (The quantity demanded is quite unresponsive or not sensitive to changes in price).

We can also look at the price elasticity of supply. Again, let’s look at bananas in the aftermath of Cyclone Larry. The price that producers could get for their bananas rose substantially, but it takes a while for bananas to grow. So in the short term, growers couldn’t take advantage of the high prices by supplying extra bananas. Perhaps some overseas producers could ship more bananas to Australia. But many overseas producers are prevented from selling bananas to Australia because of Australia’s strict quarantine laws. So, in the short term, supply was not very responsive even to the much higher prices: we would say it was inelastic.

It’s also important to note that the elasticity of a good depends on the price of that good. Imagine petrol is so cheap that it costs me only $10 to fill the tank of my car. If the price increases by 50% to $15 a tank, I still probably won’t cut back on my driving very much. However, if the price of petrol meant that it cost me $50 to fill the tank and it then rose by 50%, that change would have a much larger impact on my consumption. So at low prices, petrol is highly inelastic (it’s so cheap that even if you double the price I’ll still buy almost as much) but at high prices it’s elastic (I’m already near breaking point, if the price doubles I’ll buy much less – I might even sell my car).

Looking at elasticity of their products is important for businesses (will I lose many sales if I put the price up?) but elasticity is also useful for looking at a number of environmental and economic policy issues. So, for example, if we want to reduce water use and we’re thinking about water restrictions versus an increase in water charges, we might want to know how elastic the demand for water is. If it’s highly inelastic, so that consumption will not respond much to price increases, we could conclude that modest price increases aren’t going to be very effective: we’ll need to look either at substantial price increases or other measures such as water restrictions.

More info:
Other Oikos posts that use the concept of elasticity:


Teh SarSar said...

Hey, thanks so much for your explanation of price-supply and demand elasticity. I'm studying it at the moment at uni and your description was very precise, clear and easy to understand - as well as having some great examples. You even make more sense than my text book! :P I'll be sure to drop by for more advice on economics in the future ;)

Anonymous said...

Thank you so much, I am studying intro to economics at the moment, and it has all been very wordy and difficult to understand... you have just saved me! THANKS ALOT!!!