1. Agricultural prices have fallen fairly steadily since 1910. During that time, agricultural employment and incomes have declined steadily.
2. Computer prices have fallen steadily at least since 1960. During that time, the computer industry has expanded and become more and more important.
3. The LP record industry cut prices in an experiment, and profits increased, leading to industry growth.
4. Public transportation services have to increase their prices to reduce their deficit by increasing fare revenues.
How can we sort these seeming contradictions out?
R=p*Q
The product of price and quantity sold. When the record industry and the computer industry cut their prices, they sold so many more records and computers that their sales revenue increased. But that didn't work for agriculture and public transportation -- if they cut prices, they only sell a little more, and their sales revenues and incomes fall.
We cannot say much about this in general. The answer will vary from industry to industry. The answer may be different for agriculture, for example, than for computers.
What we can do is define some general terminology and principles to understand these differences.
Elasticity of demand is a measure of how strongly the quantity demanded responds to a change in price.
Noticing that
We can see that the elasticity is related to the slope (and the derivative) but is not quite the same as the slope of the demand curve.
The figure above shows an example of high elasticity: a small decline in price (about 20%) leads to a large increase in quantity (about 120%), so that elasticity would be about 6.
This figure shows an example of inelasticity: a large decrease in price (about 75%) leads to a small increase in quantity (about 25%), so that elasticity would be about 0.33.
>1 we say that "demand is elastic."
As in "The demand for computers is elastic."
When
<1 we say that "demand is inelastic."
As in "The demand for public transportation is inelastic."
There is no brief term for an elasticity of exactly one.
Here's why:
The products of other firms in the industry are close substitutes for the product of any one particular firm. Each firm faces many, close substitutes -- making for highly elastic demand. However, for the industry as a whole, the substitute products are not so close or numerous, so the elasticity is lower.
But this is an important point in itself, as we will see later on.
Example: Demand for public transportation is inelastic -- probably about 0.3. So, when the price is raised by 1%, quantity demanded declines by only three-tenths of 1%, and revenue increases by seven-tenths of 1%.
Example: The demand for computers is elastic, so when prices are cut by 1%, quantity demanded increases by more than 1%, and sales revenue increases.
| When elasticity is | And price | Then revenue |
|---|---|---|
| >1 | increases | decreases |
| >1 | decreases | increases |
| =1 | increases | doesn't change |
| =1 | decreases | doesn't change |
| <1 | increases | increases |
| <1 | decreases | decreases |
Example:
Demand for agricultural products (industry as a whole) is inelastic. Thus, when the weather is good or technical progress makes farmers more efficient, prices of farm products decline, and farmers' sales revenue fall with them.
Why are the farmers "crazy" enough to cut their prices? Each individual farmer has a firm demand curve that is elastic -- since his products are very good substitutes for those of thousands of other farmers -- so each farmer gains revenue by cutting.
But when they all do it at once, they all lose.
If the income elasticity is greater than one (demand is income-elastic) then demand increases more than proportionately with income.
For example, the demand for beer is income-inelastic.
If the cross elasticity is positive then the two goods are substitutes. If it is negative, then they are complements.
For example, butter and margarine are substitutes, so we would expect their cross-elasticities to be positive.
