Elasticity and Revenue

II.  Elasticity of Demand and Price Discrimination (Last Word)

(A)  Price Discrimination

PRICE DISCRIMINATION is the practice of selling a specific product at more than one price when price differences are not justified by cost differences.  For example: textbook publishers will sell their textbooks abroad at a lower price than in the United States.

There are other examples mentioned in the textbook:  movie prices (daytime matinees vs. evening/weekend), airline tickets and Saturday stay over, etc.  Other examples include businesses lowering (or raising) their prices for exports, utilities charging industry less than residential customers, etc.

The goal of price discrimination is to maximize revenue and profits by discriminating among customers and charging different prices.

 

(B) Price Discrimination and Elasticity

What lies behind this price discrimination is different elasticities:  for example personal travel is more price elastic than business travel, so a firm would want to charge a higher price for the more inelastic segment (business travelers).  I should note that in the wake of all the online meetings during the pandemic, the demand for business travel will probably drop AND the price elasticity of demand for business travel could rise, putting a dent into airline revenues and profits.

In addition the firm needs to have some market power or ability to raise prices because of limited competition, and the good or service cannot be resold (otherwise there will be arbitrage between the market segments:  people will buy the low cost goods and resell them in the high-price market segment).

This is why corporations want strong “intellectual property rights” laws, so they can use price discrimination to maximize their profits, such as banning the import of textbooks.  This allows them to sell the same textbook for much more in the United States as compared to abroad without worrying about arbitrage, that is someone buying the cheaper foreign textbooks and then reselling them in the United States.

 

(C) Price Discrimination vs. Discrimination, Subsidies, and Product Differentiation

Note that price discrimination is different from discrimination based on race, gender, national origin, etc.  For example refusing to sell to a customer on account of their race is discrimination and illegal, but not what economists call price discrimination - which is legal in the US. 

However sometimes there is overlap.  For example, charging more for women’s clothes to be dry-cleaned is both price discrimination and discriminatory against women.

Also, note that price discrimination is different from subsidies, for example cheaper public transportation for students and elderly, which is a form of income transfer.  What is different is the motivation, the intention is not to get more students and elderly to ride the bus to increase profits but as a subsidy to a low income group (the same goes for special low-income rates for telephone and utilities).

Another marketing strategy that can be combined with price discrimination is product differentiation.  Many companies do this.  For example a car company having many models of cars, a cell phone company having different models, etc.  While these products are different, so are not pure price discrimination, the price differences are not entirely explained by cost differences, so that there is a certain amount of price discrimination mixed in.

 

III.   Price Elasticity of Supply

(A) Definition:

PRICE ELASTICITY OF SUPPLY measures the responsiveness, or sensitivity, of the quantity supplied to changes in price.

 Note no negative sign.

1. If the % change in Qs > % change in P, then Es > 1, and supply is ELASTIC.

2. If the % change in Qs < % change in P, then Es < 1, and supply is INELASTIC.

 

(B)  Midpoint Formula

As with elasticity of demand, elasticity of supply is best calculated using the midpoint formula. 

Note that there is no negative sign on elasticity of supply, since price and quantity always change in the same direction, that is as price goes up, the quantity supplied goes up.

 

(B)  Graphs

As with elasticity of demand, a supply curve with a steeper slope will be more inelastic, as quantity changes less than the change in price. 

When curve is vertical, then the % change in Qs is zero since  quantity doesn’t change at all with price, and Es = 0.  This is PERFECTLY INELASTIC supply and shown in the graph by supply curve 1.  

An example the elasticity of supply of housing in urban areas is very inelastic.  Es housing << 1.  This is supply curve 2.

 

2.  If the supply curve is flat, then the % change in P is zero, so that the Elasticity of demand is infinite.  This is  perfectly elastic supply. (Es1 ⇒ infinity) 

As with demand, a supply curve that is almost flat will represent very elastic supply, as the quantity changes a lot with a small change in price.  Es2 >> 1.  An example of extremely elastic is the long run supply of bagels. 

(Note:  Elasticity of supply also changes along a linear supply curve, so Es is not the inverse of the slope either, unless the curve goes through the origin)

 

(C)  Determinants of Elasticity of Supply

The main determinant of the elasticity of supply is the period of time.

1. The MARKET PERIOD is that period of time where more of a good cannot be produced – so sellers can only respond with the stock on hand.  If a good is perishable, then this will be a very short time, and somewhat longer if the good can be stored.

For example if you were scalping some tickets any tickets not sold will be without value.

During the market period, the supply will be perfectly inelastic (Es = 0) and the supply curve will be vertical.  With perfectly inelastic supply, the quantity is determined by supply and the price is determined by demand.  More demand raises the price but does not increase the quantity – for example, scalping tickets again.  Thus ban on increasing prices following a natural disaster where there is a fixed quantity that can be supplied.  Raising prices won't bring any more supply, it just transfers money from buyers to sellers.

 

2. The SHORT RUN is the period where production facilities are fixed, but more can be produced by more intensive use.  Supply is more elastic than in the market period.  This is the typical period for which supply curves are shown.     

For example, if you were a baker, you could work longer hours and/or hire more help to bake more bread, but ultimately your production would be constrained by the number of ovens that you had. 

In the short run both price and quantity are both determined by supply and demand.               

 

3. The LONG RUN is the period of time where all inputs needed for production can be varied, in particular more land, factories, etc. could be acquired.  Supply in the long run is most elastic.

For a baker, in the long run she could increase the number of ovens or build a second bakery to handle an increase in demand, so supply could grow to meet demand with little increase in price.

Note that in the long run, the supply (cost considerations) determine the price, and demand determines how much is produced.   (For examples, bagels)   

 

Note that the actual time for these periods will vary depending on how easy it is to shift resources from producing one good to another.

Also, there are other determinants not discussed in text.  For example the  existence of substitutes in production such as corn and wheat will make supply more elastic (as farmers can switch from one crop to another).

 

(D)  Applications of Elasticity of Supply

1.  Antiques and Reproductions:

The supply of antiques is very inelastic, since an increase in price leads to very little or no increase in the quantity supplied.

The price of an antique goes  up over time as the demand increases with population and income growth, but supply hardly increases:

On the other hand, the supply of reproductions is very elastic, since an increase in price leads to a large increase in the quantity supplied.   

The price of reproductions does not grow much over time even with a large increase in demand. 

 

IV.   Consumer and Producer Surplus

(A) Consumer Surplus: 

Remember, most buyers would be willing to pay more than the market rate.  For example, how many of you have a cell phone?  And of those who do, how many of you would drop cell phone service altogether (not switch) if the price went up by $1 a month?  $5?  $10?

Since almost everyone would be willing to pay at least a little more for goods and services that we purchase, then consumers benefit from competitive markets that establish a single price for all the goods.   This benefit is what is what economists call CONSUMER SURPLUS.

Looking at the supply and demand graph, consumer surplus is the difference between the demand curve (which shows how much the consumer would be willing and able to pay), and the market price (which is what they actually pay).

(graph of Consumer Surplus)

Note that price and consumer surplus are inversely related:  the lower the price, the larger the area under the demand curve, and the greater the consumer surplus.  Thus, everything else the same, consumers will be better off with lower prices. 

However higher prices would mean less consumer surplus, as the area under the demand curve shrinks.  Why?  Some consumers won’t be able to buy, so they lose out, and others will have to pay more.  So, ceteris parabis, higher prices means consumers are worse off.  (Note that this is the assuming that demand stays the same.  If incomes also rose, there would be an increase in demand, and possibly no change in consumer surplus)

 

(B)  Producer Surplus

In the same way, most producers are willing to sell for less than the market price.  Remember, supply and demand assumes a competitive market with many small firms.  Each firm’s costs will be slightly different (for example farmers costs per bushel of wheat will differ depending on the productivity of land, the weather, and luck), so only the last, or marginal firm’s costs will equal the market price.

Looking  at the supply and demand graph, producer surplus is the difference between the supply curve  (which shows how much they producer would be willing to accept), and the market price (which is what they actually get).

(graph of Producer Surplus)

Note that price and producer surplus are directly related:  higher the price, the larger the area above the supply curve, and the greater the producer surplus.  In other words, the higher the price, the greater the difference between what sellers are willing to accept and what they are paid.  Thus, everything else the same, sellers will be better off with higher prices. 

However lower prices would mean less producer surplus, as the area above the supply curve shrinks.  Why?  Some producers won’t be able to sell, so they lose out, and others will have to accept less.  So, ceteris parabis, lower prices means producers are worse off.  (Note that this is the assuming that supply stays the same.  If costs fall, there would be an increase in supply, and possibly no change in producer surplus)