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Elasticity

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At the start of the new millennium, the price of gasoline hovered around $1.50 per gallon. Encouraged by low gas prices, consumer appetites for large vehicles rose, leading to an increase in sales in sport utility vehicles (SUVs) and trucks. Over the next ten years, however, increased tensions in the Middle East and a large spike in oil demand from emerging markets such as China and India pushed the price of a gallon of gas to over double what it was in 2000. How did consumers respond to the 100% increase in the average price of gasoline? They reduced consumption by driving less, buying more fuel-efficient cars, and using public transportation. But by how much did the quantity of gasoline demanded fall?

When global oil prices rose significantly, not only did consumers respond by reducing the amount of gasoline demanded but producers also reacted by increasing oil drilling in previously untapped oil fields. As a result, the United States and countries in Africa and Northern Europe became major oil producers, adding to the supply of gasoline on the market. But by how much did the quantity of gasoline supplied increase?

Not only did higher prices change the quantity demanded and supplied for gasoline. It also affected the demand and supply for related goods. For example, rising gasoline prices led to an increase in demand for fuel-efficient vehicles, such as hybrid and plug-in electric cars. It also led to an increase in the use of renewable fuels, such as ethanol and biodiesel. Finally, it spurred government to increase investment in public transportation. But by how much have these other industries been affected?

We learned in a previous chapter that consumers respond to higher prices by buying less, while producers respond to higher prices by producing more. We also know that as prices rise, demand for complements falls while demand for substitutes rises. However, we have not yet measured the extent of such responses. In other words, how responsive are consumers and producers to changes in prices in terms of what and how much are purchased and produced?

We answer the important “how responsive” question in this chapter by studying how consumers and producers respond to changes in the price of goods and services.

“Elasticity”—the responsiveness of one variable to changes in another—is the term economists use to measure this change. In the preceding example, we know that the price of gasoline is one variable and the quantity of gasoline demanded or supplied is the other variable. The concept of elasticity lets us measure the relative change in the quantity demanded or quantity supplied corresponding to a change in the price of gasoline.

Yet, as our example shows, elasticity can be measured for many other related goods that are affected by the change in price. If the price of gasoline changes, how will this affect sales of SUVs? Plug-in electric cars? How would demand for train and bus tickets change? And we need not limit our analysis to prices either. For example, income elasticity measures changes in consumer demand in response to changes in income. As incomes rise with a growing economy, by how much will demand for cars increase? This is information automakers want to know.

Elasticity is a simple economic concept that nonetheless contains a tremendous amount of information about demand for specific products. If a restaurant raises its menu prices by 10%, will it end up with more revenue, or will the increase in price lead to a drop in quantity demanded that more than offsets the price increase? Knowing a product’s price elasticity allows economists to predict the amount by which quantity demanded will drop in response to a price increase, or grow in response to a price decrease. The concept of elasticity helps you to put supply and demand concepts to work.