Elasticity in Labor and Financial Capital Markets The concept of elasticity applies to any market, not just markets for goods and services. In the labor market, for example, the wage elasticity of labor supply—that is, the percentage change in hours worked divided by the percentage change in wages—will determine the shape of the labor supply curve. Specifically:

Elasticity of labor supply = % change in quantity of labor supplied% change in wage

The wage elasticity of labor supply for teenage workers is generally thought to be fairly elastic: that is, a certain percentage change in wages will lead to a larger percentage change in the quantity of hours worked. Conversely, the wage elasticity of labor supply for adult workers in their thirties and forties is thought to be fairly inelastic. When wages move up or down by a certain percentage amount, the quantity of hours that adults in their prime earning years are willing to supply changes but by a lesser percentage amount.

In markets for financial capital, the elasticity of savings—that is, the percentage change in the quantity of savings divided by the percentage change in interest rates—will describe the shape of the supply curve for financial capital. That is:

Elasticity of savings = % change in quantity of financial s vings% change in interest rate

Sometimes laws are proposed that seek to increase the quantity of savings by offering tax breaks so that the return on savings is higher. Such a policy will increase the quantity if the supply curve for financial capital is elastic, because then a given percentage increase in the return to savings will cause a higher percentage increase in the quantity of savings. However, if the supply curve for financial capital is highly inelastic, then a percentage increase in the return to savings will cause only a small increase in the quantity of savings. The evidence on the supply curve of financial capital is controversial but, at least in the short run, the elasticity of savings with respect to the interest rate appears fairly inelastic.

Expanding the Concept of Elasticity The elasticity concept does not even need to relate to a typical supply or demand curve at all. For example, imagine that you are studying whether the Internal Revenue Service should spend more money on auditing tax returns. The question can be framed in terms of the elasticity of tax collections with respect to spending on tax enforcement; that is, what is the percentage change in tax collections derived from a percentage change in spending on tax enforcement?

With all of the elasticity concepts that have just been described, some of which are listed in Table 5.4, the possibility of confusion arises. When you hear the phrases “elasticity of demand” or “elasticity of supply,” they refer to the elasticity with respect to price. Sometimes, either to be extremely clear or because a wide variety of elasticities are being discussed, the elasticity of demand or the demand elasticity will be called the price elasticity of demand or the

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“elasticity of demand with respect to price.” Similarly, elasticity of supply or the supply elasticity is sometimes called, to avoid any possibility of confusion, the price elasticity of supply or “the elasticity of supply with respect to price.” But in whatever context elasticity is invoked, the idea always refers to percentage change in one variable, almost always a price or money variable, and how it causes a percentage change in another variable, typically a quantity variable of some kind.

Income elasticity of demand = % change in Qd% change in income

Cross-price elasticity of demand = % change in Qd of good A% change in price of good B

Wage elasticity of labor supply = % change in quantity of labor supplied% change in wage

Wage elasticity of labor demand = % change in quantity of labor demanded% change in wage

Interest rate elasticity of savings = % change in quantity of savings% change in interest rate

Interest rate elasticity of borrowing = % change in quantity of borrowing% change in interest rate

Table 5.4 Formulas for Calculating Elasticity

That Will Be How Much? How did the 60% price increase in 2011 end up for Netflix? It has been a very bumpy ride.

Before the price increase, there were about 24.6 million U.S. subscribers. After the price increase, 810,000 infuriated U.S. consumers canceled their Netflix subscriptions, dropping the total number of subscribers to 23.79 million. Fast forward to June 2013, when there were 36 million streaming Netflix subscribers in the United States. This was an increase of 11.4 million subscribers since the price increase—an average per quarter growth of about 1.6 million. This growth is less than the 2 million per quarter increases Netflix experienced in the fourth quarter of 2010 and the first quarter of 2011.

During the first year after the price increase, the firm’s stock price (a measure of future expectations for the firm) fell from about $300 per share to just under $54. In 2015, however, the stock price is at $448 per share. Today, Netflix has 57 million subscribers in fifty countries.

What happened? Obviously, Netflix company officials understood the law of demand. Company officials reported, when announcing the price increase, this could result in the loss of about 600,000 existing subscribers. Using the elasticity of demand formula, it is easy to see company officials expected an inelastic response:

= –600,000/[(24 million + 24.6 million)/2]$6/[($10 + $16)/2]

= –600,000/24.3 million$6/$13 = –0.0250.46 = –0.05

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In addition, Netflix officials had anticipated the price increase would have little impact on attracting new customers. Netflix anticipated adding up to 1.29 million new subscribers in the third quarter of 2011. It is true this was slower growth than the firm had experienced—about 2 million per quarter.

Why was the estimate of customers leaving so far off? In the 18 years since Netflix had been founded, there was an increase in the number of close, but not perfect, substitutes. Consumers now had choices ranging from Vudu, Amazon Prime, Hulu, and Redbox, to retail stores. Jaime Weinman reported in Maclean’s that Redbox kiosks are “a five-minute drive for less from 68 percent of Americans, and it seems that many people still find a five-minute drive more convenient than loading up a movie online.” It seems that in 2012, many consumers still preferred a physical DVD disk over streaming video.

What missteps did the Netflix management make? In addition to misjudging the elasticity of demand, by failing to account for close substitutes, it seems they may have also misjudged customers’ preferences and tastes. Yet, as the population increases, the preference for streaming video may overtake physical DVD disks. Netflix, the source of numerous late night talk show laughs and jabs in 2011, may yet have the last laugh.

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constant unitary elasticity

cross-price elasticity of demand

elastic demand

elastic supply

elasticity

elasticity of savings

inelastic demand

inelastic supply

infinite elasticity

perfect elasticity

perfect inelasticity

price elasticity

price elasticity of demand

price elasticity of supply

tax incidence

unitary elasticity

wage elasticity of labor supply

zero inelasticity

KEY TERMS

when a given percent price change in price leads to an equal percentage change in quantity demanded or supplied

the percentage change in the quantity of good A that is demanded as a result of a percentage change in good B

when the elasticity of demand is greater than one, indicating a high responsiveness of quantity demanded or supplied to changes in price

when the elasticity of either supply is greater than one, indicating a high responsiveness of quantity demanded or supplied to changes in price

an economics concept that measures responsiveness of one variable to changes in another variable

the percentage change in the quantity of savings divided by the percentage change in interest rates

when the elasticity of demand is less than one, indicating that a 1 percent increase in price paid by the consumer leads to less than a 1 percent change in purchases (and vice versa); this

indicates a low responsiveness by consumers to price changes

when the elasticity of supply is less than one, indicating that a 1 percent increase in price paid to the firm will result in a less than 1 percent increase in production by the firm; this indicates a low

responsiveness of the firm to price increases (and vice versa if prices drop)

the extremely elastic situation of demand or supply where quantity changes by an infinite amount in response to any change in price; horizontal in appearance

see infinite elasticity

see zero elasticity

the relationship between the percent change in price resulting in a corresponding percentage change in the quantity demanded or supplied

percentage change in the quantity demanded of a good or service divided the percentage change in price

percentage change in the quantity supplied divided by the percentage change in price

manner in which the tax burden is divided between buyers and sellers

when the calculated elasticity is equal to one indicating that a change in the price of the good or service results in a proportional change in the quantity demanded or supplied

the percentage change in hours worked divided by the percentage change in wages

the highly inelastic case of demand or supply in which a percentage change in price, no matter how large, results in zero change in the quantity; vertical in appearance

KEY CONCEPTS AND SUMMARY

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5.1 Price Elasticity of Demand and Price Elasticity of Supply Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It is computed as the percentage change in quantity demanded (or supplied) divided by the percentage change in price. Elasticity can be described as elastic (or very responsive), unit elastic, or inelastic (not very responsive). Elastic demand or supply curves indicate that quantity demanded or supplied respond to price changes in a greater than proportional manner. An inelastic demand or supply curve is one where a given percentage change in price will cause a smaller percentage change in quantity demanded or supplied. A unitary elasticity means that a given percentage change in price leads to an equal percentage change in quantity demanded or supplied.

5.2 Polar Cases of Elasticity and Constant Elasticity Infinite or perfect elasticity refers to the extreme case where either the quantity demanded or supplied changes by an infinite amount in response to any change in price at all. Zero elasticity refers to the extreme case in which a percentage change in price, no matter how large, results in zero change in quantity. Constant unitary elasticity in either a supply or demand curve refers to a situation where a price change of one percent results in a quantity change of one percent.

5.3 Elasticity and Pricing In the market for goods and services, quantity supplied and quantity demanded are often relatively slow to react to changes in price in the short run, but react more substantially in the long run. As a result, demand and supply often (but not always) tend to be relatively inelastic in the short run and relatively elastic in the long run. The tax incidence depends on the relative price elasticity of supply and demand. When supply is more elastic than demand, buyers bear most of the tax burden, and when demand is more elastic than supply, producers bear most of the cost of the tax. Tax revenue is larger the more inelastic the demand and supply are.

5.4 Elasticity in Areas Other Than Price Elasticity is a general term, referring to percentage change of one variable divided by percentage change of a related variable that can be applied to many economic connections. For instance, the income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in income. The cross-price elasticity of demand is the percentage change in the quantity demanded of a good divided by the percentage change in the price of another good. Elasticity applies in labor markets and financial capital markets just as it does in markets for goods and services. The wage elasticity of labor supply is the percentage change in the quantity of hours supplied divided by the percentage change in the wage. The elasticity of savings with respect to interest rates is the percentage change in the quantity of savings divided by the percentage change in interest rates.

SELF-CHECK QUESTIONS 1. From the data shown in Table 5.5 about demand for smart phones, calculate the price elasticity of demand from: point B to point C, point D to point E, and point G to point H. Classify the elasticity at each point as elastic, inelastic, or unit elastic.

Points P Q

A 60 3,000

B 70 2,800

C 80 2,600

D 90 2,400

E 100 2,200

Table 5.5

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Points P Q

F 110 2,000

G 120 1,800

H 130 1,600

Table 5.5

2. From the data shown in Table 5.6 about supply of alarm clocks, calculate the price elasticity of supply from: point J to point K, point L to point M, and point N to point P. Classify the elasticity at each point as elastic, inelastic, or unit elastic.

Point Price Quantity Supplied

J $8 50

K $9 70

L $10 80

M $11 88

N $12 95

P $13 100

Table 5.6

3. Why is the demand curve with constant unitary elasticity concave?

4. Why is the supply curve with constant unitary elasticity a straight line?

5. The federal government decides to require that automobile manufacturers install new anti-pollution equipment that costs $2,000 per car. Under what conditions can carmakers pass almost all of this cost along to car buyers? Under what conditions can carmakers pass very little of this cost along to car buyers?

6. Suppose you are in charge of sales at a pharmaceutical company, and your firm has a new drug that causes bald men to grow hair. Assume that the company wants to earn as much revenue as possible from this drug. If the elasticity of demand for your company’s product at the current price is 1.4, would you advise the company to raise the price, lower the price, or to keep the price the same? What if the elasticity were 0.6? What if it were 1? Explain your answer.

7. What would the gasoline price elasticity of supply mean to UPS or FedEx?

8. The average annual income rises from $25,000 to $38,000, and the quantity of bread consumed in a year by the average person falls from 30 loaves to 22 loaves. What is the income elasticity of bread consumption? Is bread a normal or an inferior good?

9. Suppose the cross-price elasticity of apples with respect to the price of oranges is 0.4, and the price of oranges falls by 3%. What will happen to the demand for apples?

REVIEW QUESTIONS

10. What is the formula for calculating elasticity? 11. What is the price elasticity of demand? Can you explain it in your own words?

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