Demand and Economic Evolution

Here are four developments in economic history that raise

questions about demand:
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?

Revenue and Demand

A first step is to distinguish between sales revenue and price.
Revenue is
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.

Demand in General
To make sense of this -- and, indeed, for any practical
applications of the economics of demand -- we need to know
something about the numerical characteristics of the
demand relationship. For example: we know that if the price
is cut, quantity sold will increase. But how much will it
increase.
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
A key concept for this purpose is the price elasticity of
demand. Elasticity of demand is

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.

Elasticity and Slope

While elasticity and slope are not the same thing, we can
roughly correlate elastic demand with a shallow slope of the
demand curve, and conversely.

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.
The Other Side

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.

Example: Elasticity of Demand

For example, in fiscal year 1990, SEPTA raised their fares in
two steps from $1.15 to $1.50, the number of riders
decreased by 6%. Since the increase in fares was 30%, this
would give an approximate elasticity of 6/30=0.2. This is only
approximate, since some other things were changing at the
same time. In particular, SEPTA claimed that the ridership
would have decreased by 3.5% just because of population
decrease. That would leave 2.5% decrease because of the
fare increase, and that would give an elasticity of
2.5%/30%=0.083. In any case, it is clear that the demand for
SEPTA services in the city is very inelastic. (Figures mostly
from the Philadelphia Inquirer, Oct. 28, 1990, pp. 1B, 4B).
More Terminology
When

>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.

Some Determinants of Elasticity

Elasticity will be greater --
• When substitutes are closer and more numerous
• When the proportion of the budget spent is larger

Application
The demand for an individual firm's product will be
different than that for the whole industry, and the elasticity
of demand will be greater than the elasticity of demand for
the entire industry.
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.

Elasticity and Revenue 1

Elasticity is a key to understanding the relationship between
price and sales revenue.
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.
Elasticity and Revenue 2
Here is how price changes, elasticity and revenue changes
are interrelated:
Elasticity and Revenue

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

Elasticity and Revenue 3

This relationship can explain some of the puzzles of
economic events.
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.

Income Elasticity
Economists use formulae like "elasticity" to measure the
responsiveness of quantity demanded (and other things) to
various influences. For example, we have the income
elasticity of demand,
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.

Cross Elasticity
Sometimes the price of one good will influence the demand
for another good. We measure this by the cross-elasticity of
demand:

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.

Income Elasticity
Economists use formulae like "elasticity" to measure the responsiveness of quantity
demanded (and other things) to various influences.

Remember, the demand curve itself can shift, predictably. For example, an increase in
consumer income can shift the demand for any good the consumer buys. In most
cases, but not all, the increase in income increases demand -- shifts it to the right. To
measure this response, we have the income elasticity of demand,

For example, suppose income in the country as a whole increases by 10% over a
decade. We might observe that the demand for beer increases by 2.5% over the same
time, even with no change in the price of beer. Then we would conclude that the
income elasticity of demand for beer is 2.5/10 = 0.25. (According to the statistics I
have, that's about right).

If the income elasticity is greater than one, we say that demand is income-elastic. It
means that demand increases more than proportionately with income. If the income-
elasticity is less than one, we say that demand is income-inelastic. Then demand
increases less than proportionately to income. We might even observe that the income
elasticity of demand is less than one, for some goods. That would mean that the good
is an "inferior good." Recall, an "inferior good" is a good for which demand decreases
as income goes up -- hamburgers, for example. Then the change in income and the
change in quantity will have opposite signs. The quotient (and so the elasticity) is
negative.

Looking back at the beer example above, we see that the demand for beer is income-
inelastic, but beer is not an inferior good. For some consumers, beer may be an
inferior good, but there are enough beer-drinkers who increase their consumption
when their income is higher, so that on the average, beer consumption rises with
income. But not by much -- 0.25 is a quite small elasticity of demand.

Since we now have two kinds of elasticity, from here on we will say "price elasticity"
when we mean the elasticity with respect to price, and there might be any ambiguity.
We will always say "income elasticity," when that is what we mean. Just "elasticity,"
by itself, always means the price elasticity.