Elasticity

Elasticity is a measure of responsiveness. It tells how much one thing changes when you change something else that affects it.

For example, the elasticity of demand tells us how much the quantity demanded changes when the price changes. The elasticity of demand measures the responsiveness of quantity demanded to changes in the price charged.

Elasticity = Responsiveness

The following discussion mostly uses the elasticity of demand for its examples. The elasticity concept can be used for other things, too, like supply or income.

Elastic and Inelastic

Elasticity is a noun. The adjective form, "elastic," means something is highly responsive to changes in something else. For example, elastic demand means that the quantity demanded changes a lot when the price changes. Inelastic demand means that the quantity demanded does not change much when the price changes. In class, we'll get more precise about where to draw the line between elastic and inelastic. For now, though, let's start with the qualitative idea:

Elastic = Responsive

Inelastic = Unresponsive

By the way, if this usage of "elasticity" as "responsiveness" seems peculiar, it's because it is peculiar. Economists are about the only people who use "elasticity" this way. But, if you want to understand economists, you need to understand "elasticity." I suppose you could find an analogy between the elasticity of demand and the elasticity of rubber, but that would be stretching it.

"Elastic" and "inelastic" can be used to describe supply or demand. Let's use them with demand.

In each of the following examples, choose whether you would expect demand to be elastic or inelastic.

Don't worry, for now, about the precise mathematical definition of what's elastic and what's inelastic. Choose "Elastic demand" if you think that buyers will buy somewhat less if the price goes up, or somewhat more if the price goes down. Choose "Inelastic demand" if you think that the buyers will buy about the same amount if the price goes up or down.

A patient is given a presciption for a drug to control high blood pressure. The patient's insurance doesn't cover drugs, or has a high deductible, so the patient must pay out of pocket for the drug.
Elastic demand Inelastic demand

An unconscious bleeding man is brought to a hospital emergency room.
Elastic demand Inelastic demand

A family has a high-deductible health insurance policy. This means that the family must pay all its medical bills until it has spent, maybe, \$6000. Suppose that the family has not spent that much on medical care yet, and now one of the children has an earache. What would their demand be like for an office visit to get this checked out?
Elastic demand Inelastic demand

In general, if the decision-maker has an incentive to spend less on some product
and
if there is a lower-price alternative or substitute for that product, then demand is more ...
Elastic Inelastic

If the decision-maker is spending somebody else's money,
or
if there is no lower-price alternative or substitute for the product, then demand is more ...
Elastic Inelastic

What difference does demand elasticity make?

Consider the following graph and table.
```                          INELASTIC DEMAND

Price

6|                                        F
5|                                        E
4|                                        D
3|                                        C
2|                                        B
1|                                        A
:....:....:....:....:....:....:....:....:....:....:....:....:
0    5   10   15   20   25   30   35   40   45   50   55   60  Quantity

A         B         C         D         E         F
Price             \$1        \$2        \$3        \$4        \$5        \$6
Quantity          40        40        40        40        40        40```

Is the title "INELASTIC DEMAND" correct?
Yes No

The graph and table again:

```                          INELASTIC DEMAND

Price

6|                                        F
5|                                        E
4|                                        D
3|                                        C
2|                                        B
1|                                        A
:....:....:....:....:....:....:....:....:....:....:....:....:
0    5   10   15   20   25   30   35   40   45   50   55   60  Quantity

A         B         C         D         E         F
Price             \$1        \$2        \$3        \$4        \$5        \$6
Quantity          40        40        40        40        40        40```

On the above graph, the points on the graph form a vertical line. This line definitely does not slope gradually down from left to right. Regardless of whether the price is \$1 or \$6 or anything between, the amount sold will be the same, 40 units. Like any extreme, it's hard to find a real life example, but emergency medical treatment for severe trauma in the sole hospital in a region might fit this model. Lower health care prices will not encourage people to go get themselves shot or run over, nor will higher prices keep customers away.

The traditional medical model, also known as the Rule of Rescue, implies that demand should be inelastic. If health care professionals provide what they judge that the patient "needs" regardless of cost, and if the patient is unable to object or is fully insured or both, then demand will be inelastic.

Pricing when demand is price-inelastic

If demand for your product is inelastic, what should you do with your price?

For example, suppose the demand curve in the graph above applies to you, and right now you're charging \$2. If your sole goal is profit, should you raise your price, keep it the same, or lower it?
Raise the price. Keep the price at \$2. Lower the price.

Let's see why that's so:
```                   A         B         C         D         E         F
Price             \$1        \$2        \$3        \$4        \$5        \$6
Quantity          40        40        40        40        40        40
------------------------------------------------------
Revenue         \$ 40      \$ 80      \$120      \$160      \$200      \$240```
Revenue -- how much money you bring in -- equals Price times Quantity.

If your demand is inelastic, the more you charge, the more revenue you take in, since the amount you sell doesn't go down.  Therefore, if profit is your goal, you should raise price when demand is inelastic.

Even if profit is not your only goal, if you need to support yourself partly through sales, you will be tempted to raise the price on any service for which the demand is inelastic.

This shows the problem with relying on the free give and take of supply and demand to set prices for health care services for which the demand is inelastic. With inelastic demand, there's always a reward for raising prices. That is why emergency department prices are so high.

Making Demand More Elastic

A way to have free choice for buyers and sellers but keep prices from rising forever is to make demand more elastic. In a market system, demand becomes elastic if consumers are price conscious and if they have an alternative. Here's an example of how this works to temper price increases:

Suppose that the market in our example above gets a new competitor who charges \$3.50. Let us go to the extreme of supposing also that price is the consumer's only consideration. There is no quality difference and no customer loyalty to a particular company. Then the your demand might look like this.

```    Demand -- One Competitor Who Charges \$3.50 -- Price Only Consideration
Price
6|F
5|E
4|D
3|                                        C
2|                                        B
1|                                        A
:....:....:....:....:....:....:....:....:....:....:....:....:
0    5   10   15   20   25   30   35   40   45   50   55   60  Quantity

A         B         C         D         E         F
Price             \$1        \$2        \$3        \$4        \$5        \$6
Quantity          40        40        40         0         0         0```
If you charge less than your competitor's price, you get all of the business. If you charge more than \$3.50, you get no business. Your demand is now highly elastic near the competitor's price. If there is a competitor in your market, and if the consumers care about price, then there's a definite limit to how high you can raise your price.

This can be a highly unstable market because your competitor faces the same situation. You can cut your price to \$3.49 and take away all of the business. Your competitor can then charge \$3.48 and take it all back. Each of you has the temptation to cut price on the other until one of you goes broke. You see something like this when neighboring gasoline stations have a price war.

Click on each of these radio buttons to display its graph.
Inelastic demand.
There's a competitor who charges \$3.50. There is no product differentiation. If buyers can't tell your product from your competitor's (that's what "no product differentiation" means) demand will be elastic near the competitor's price.
Demand is somewhat elastic. There's a competitor who charges \$3.50, but there is product differentiation. Some customers will buy your product even if its price is a little higher. The same goes for your competitor.

A graph will appear here when you click a button above.

When there is some product differentiation, which you can also think of as some customer loyalty, the market is more stable. A price war is less likely.

Click the "Demand is somewhat elastic" button above. Then answer this: What price gives you the highest revenue? (By the way, Revenue is Price multiplied by Quantity.)
\$1. \$2. \$3. \$4. \$5. \$6.

In this market with product differentiation, your highest revenue comes when you charge a price a bit higher than your competitor. You are not going to start a price war by cutting your price below your competitor's price. (This works this way because of how I rigged the numbers, of course.)

For providers of health care, such as physicians, other practitioners, and hospitals, there is a lot of product differentiation. Hospitals encourage this with their advertising. Their billboards say, "We're the best!" You never see a hospital billboard that says, "We're the cheapest!" Patient loyalty reduces the elasticity of demand and helps keep prices up.

Managed care and demand elasticity

Managed care health insurance companies buy service from providers and sell it to patients. They stand in the market between the providers and the patients. For managed care companies, patient loyalty to providers is a problem. Managed care companies prefer that the patients be loyal to them, not to particular providers. That way the companies can switch providers whenever they want. Managed care companies want providers' (doctors and hospitals) demand to be elastic, but their own demand to be inelastic.

This is why managed care companies have been so interested in developing measures of quality and means of quality control. If a managed care company can document something that it can credibly call "quality," then providers are more interchangeable. That makes the providers' demand more elastic.

Copayments by patients and demand elasticity

The currently trendy idea in health care finance is high-deductible health insurance. Under Obamacare, the basic mandated insurance plan is expected to have a deductible around \$6000 and a 20% copay above that up to a limit. To make this decidedly uncomprehensive insurance more palatable to consumers, the Federal government allows Health Savings Accounts, which make some of what consumers spend on health care deductible from taxable income. As a gift to the banking industry, this tax deductibility is implemented by employees and employers putting money into these accounts, which banks get paid to administer.

Near the top of this tutorial there is a question about how a deductible can make demand more elastic.

Advocates of high-copay insurance this "consumer driven" health care. But, really, is the consumer driving? Or is the consumer being driven?

In pharmaceuticals, for example, the U.S. Department of Veterans Affairs (V.A.) buys drugs at prices much lower than what seniors in Medicare Part D are paying. The difference is because the Medicare drug benefit law fragments the buyers, while the V.A. negotiates on behalf of veterans as a group.

The American Medical Association has been advocating Health Savings Accounts for years. The advantage from their point of view is that each patient negotiates with the provider as an individual. There is no group buying power.

What really empowers health care consumers?
Negotiating with providers on your own when you need care Being part of a big group, such as all veterans served by the V.A., and having the V.A. negotiate for you.

Imagine a pharmaceutical company that is deciding what price to set for a new drug. Which of these two would make the demand for that drug more price-elastic?
Each of us buys with money from our own Health Savings Account. Medicare evaluates drugs and bargains for prices.

Thanks for participating! Go to the tutorial menu page for a link to a tutorial with a more numerical approach to elasticity.