More Price Elasticity
The concept of elasticity can
help explain some situations that at first glance may seem
puzzling. If American farmers all have excellent harvests,
they may have a very poor year financially. They may be
better off if they all have mediocre harvests. If a bus
company decides it needs more revenue and tries to get it by
raising fares, its revenues may decrease rather than
In the case of the farmers, the key to their problem is
that the demand curve for their products is quite inelastic.
This means that if the harvest is unusually good, a large
drop in price is necessary to encourage consumers to use the
additional grain. If the elasticity coefficient is .5, for
example, and the harvest is 10% larger than the previous
year, then a 20% drop in prices will occur (assuming that
the many things that we keep constant in drawing the demand
curve have remained constant). Because this price reduction
more than offsets the effect of the larger harvest, the
average farmer's income drops.
For the bus company, the key is that demand is elastic.
For example, suppose that the elasticity is 1.5. Then, if
price is raised by 10%, quantity (ridership) must drop by
15%. But the drop in ridership more than offsets the
increase in price, and so revenue will drop.
Just as we can measure how responsive buyers are to a
change in price, we can measure how responsive sellers are.
This measurement, the price elasticity of supply, has
the same formula as price elasticity of demand, only the
quantity in the formula will refer to the quantity that
sellers will sell.
As with demand elasticity, supply elasticity depends on
the amount of time available for adjustment. In the very
short run, there may be no adjustments sellers can make,
which would mean a perfectly vertical supply curve. For
example, if on December 1 the price of apples doubles, there
will be minimal effect on the number of apples available to
the consumer. Producers cannot make adjustments until a new
growing season begins. In the short run producers can use
their facilities more or less intensively. In the apple
example, they can vary the amounts of pesticides and the
amount of labor they use to pick the apples. Finally, in the
long run, not only can producers change their facilities,
but they can also leave the industry or new producers may
enter it. In our apple example, new orchards can be planted
or old ones destroyed.
Now comes the technical stuff, a discussion on how
to compute price elasticity.