22 Introduction to Elasticity

Anyone who has studied economics knows the law of demand: a higher price will lead to a lower quantity demanded. What you may not know is how much lower the quantity demanded will be. Similarly, the law of supply shows that a higher price will lead to a higher quantity supplied. The question is: How much higher? This chapter will explain how to answer these questions and why they are critically important in the real world.
To find answers to these questions, we need to understand the concept of elasticity. Elasticity is an economics concept that measures responsiveness of one variable to changes in another variable. Suppose you drop two items from a second-floor balcony. The first item is a tennis ball. The second item is a brick. Which will bounce higher? Obviously, the tennis ball. We would say that the tennis ball has greater elasticity.

Consider an economic example. Cigarette taxes are an example of a “sin tax,” a tax on something that is bad for you, like alcohol. Cigarettes are taxed at the state and national levels. State taxes range from a low of 17 cents per pack in Missouri to $4.35 per pack in New York. The average state cigarette tax is $1.51 per pack. The 2014 federal tax rate on cigarettes was $1.01 per pack, but in 2015 the Obama Administration proposed raising the  federal tax nearly a dollar to $1.95 per pack. The key question is: How much would cigarette purchases decline? Taxes on cigarettes serve two purposes: to raise tax revenue for government and to discourage consumption of
cigarettes. However, if a higher cigarette tax discourages consumption by quite a lot, meaning a greatly reduced quantity of cigarettes is sold, then the cigarette tax on each pack will not raise much revenue for the government. Alternatively, a higher cigarette tax that does not discourage consumption by much will actually raise more tax revenue for the government. Thus, when a government agency tries to calculate the effects of altering its cigarette tax, it must analyze how much the tax affects the quantity of cigarettes consumed. This issue reaches beyond governments and taxes; every firm faces a similar issue. Every time a firm considers raising the price that it charges, it must consider how much a price increase will reduce the quantity demanded of what it sells. Conversely, when a firm puts its products on sale, it must expect (or hope) that the lower price will lead to a significantly higher quantity demanded.

In the previous chapter, you’ve learned the law of demand: a higher price will lead to a lower quantity demanded. But how much lower? Similarly, the law of supply states that a higher price causes quantity supplied to increase. By how much? To answer these questions, we need to understand and be able to apply the concept of elasticity, which economists use to measure the degree of responsiveness, or sensitivity, of one variable to a change in another. Consider the following situations:

• You are a pricing manager at Apple Inc. Your boss asks you to predict what will happen to Apple’s receipts from iTunes downloads if it raises the price. What should you tell your boss?
•  As the vice president for business and finance at a private college, you are trying to figure out if raising the tuition will increase the college’s revenue. Will it?
• You are a soybean farmer. Unfavorable weather decreases soybean production eve-rywhere. Should you prepare to tighten your belt?
• You are running an oil refinery, which uses crude oil to produce gasoline and other petroleum products, so the price of crude oil is a crucial factor influencing your production decisions. Suddenly, a crisis in the Middle East disrupts oil production in the region. How will that influence the price your refinery pays for crude oil?
• You are the manager of a Walmart store. Due to an increase in the federal mini-mum wage, the average income of your customers rises by 5%. How should you adjust your purchases of goods from suppliers?
• You are an economist at Dell. Hewlett Packard lowers the price of their laptops by 10%. Your boss wants to know how this will affect the sales of Dell laptops with similar characteristics. How can you figure it out?

We can continue this list of questions to include many other situations in which knowing and being able to apply the concept of elasticity helps make better business decisions. In this chapter we explain how.