Elasticity and the Law of Demand

JDN 2457289 EDT 21:04

This will be the second post in my new bite-size format, the first one that’s in the middle of the week.

I’ve alluded previously to the subject of demand elasticity, but I think it’s worth explaining in a little more detail. The basic concept is fairly straightforward: Demand is more elastic when the amount that people want to buy changes a large amount for a small change in price. The opposite is inelastic.

Apples are a relatively elastic good. If the price of apples goes up, people buy fewer apples. Maybe they buy other fruit instead, such as oranges or bananas; or maybe they give up on fruit and eat something else, like rice.

Salt is an extremely inelastic good. No matter what the price of salt is, at least within the range it has been for the last few centuries, people are going to continue to buy pretty much the same amount of salt. (In ancient times salt was actually expensive enough that people couldn’t afford enough of it, which was particularly harmful in desert regions. Mark Kulansky’s book Salt on this subject is surprisingly compelling, given the topic.)
Specifically, the elasticity is equal to the proportional change in quantity demanded, divided by the proportional change in price.

For example, if the price of gas rises from $2 per gallon to $3 per gallon, that’s a 50% increase. If the quantity of gas purchase then falls from 100 billion gallons to 90 billion gallons, that’s a 10% decrease. If increasing the price by 50% decreased the quantity demanded by 10%, that would be a demand elasticity of -10%/50% = -1/5 = -0.2

In practice, measuring elasticity is more complicated than that, because supply and demand are both changing at the same time; so when we see a price change and a quantity change, it isn’t always clear how much of each change is due to supply and how much is due to demand. Sophisticated econometric techniques have been developed to try to separate these two effects (in future posts I plan to explain the basics of some of these techniques), but it’s difficult and not always successful.

In general, markets function better when supply and demand are more elastic. When shifts in price trigger large shifts in quantity, this creates pressure on the price to remain at a fixed level rather than jumping up and down. This in turn means that the market will generally be predictable and stable.

It’s also much harder to make monopoly profits in a market with elastic demand; even if you do have a monopoly, if demand is highly elastic then raising the price won’t make you any money, because whatever you gain in selling each gizmo for more, you’ll lose in selling fewer gizmos. In fact, the profit margin for a monopoly is inversely proportional to the elasticity of demand.

Markets do not function well when supply and demand are highly inelastic. Monopolies can become very powerful and result in very large losses of human welfare. A particularly vivid example of this was in the news recently, when a company named Turing purchased the rights to a drug called Daraprim used primarily by AIDS patients, then hiked the price from $13.50 to $750. This made enough people mad that the CEO has since promised to bring it back down, though he hasn’t said how far.

That price change was only possible because Daraprim has highly inelastic demand—if you’ve got AIDS, you’re going to take AIDS medicine, as much as prescribed, provided only that it doesn’t drive you completely bankrupt. (Not an unreasonable fear, as medical costs are the leading cause of bankruptcy in the United States.) This raised price probably would bankrupt a few people, but for the most part it wouldn’t affect the amount of drug sold; it would just funnel a huge amount of money from AIDS patients to the company. This is probably part of why it made people so mad; that and there would probably be a few people who died because they couldn’t afford this new expensive medication.

Imagine if a company had tried to pull the same stunt for a more elastic good, like apples. “CEO buys up all apple farms, raises price of apples from $2 per pound to $100 per pound.” What’s going to happen then? People are not going to buy any apples. Perhaps a handful of the most die-hard apple lovers still would, but the rest of us are going to meet our fruit needs elsewhere.

For most goods most of the time, elasticity of demand is negative, meaning that as price increases, quantity demanded decreases. This is in fact called the Law of Demand; but as I’ve said, “laws” in economics are like the Pirate Code: They’re really more what you’d call “guidelines”.
There are three major exceptions to the Law of Demand. The first one is the one most economists talk about, and it almost never happens. The second one is talked about occasionally, and it’s quite common. The third one is almost never talked about, and yet it is by far the most common and one of the central driving forces in modern capitalism.
The exception that we usually talk about in economics is called the Giffen Effect. A Giffen good is a good that’s so cheap and such a bare necessity that when it becomes more expensive, you won’t be able to buy less of it; instead you’ll buy more of it, and buy less of other things with your reduced income.

It’s very hard to come up with empirical examples of Giffen goods, but it’s an easy theoretical argument to make. Suppose you’re buying grapes for a party, and you know you need 4 bags of grapes. You have $10 to spend. Suppose there are green grapes selling for $1 per bag and red grapes selling for $4 per bag, and suppose you like red grapes better. With your $10, you can buy 2 bags of green grapes and 2 bags of red grapes, and that’s the 4 bags you need. But now suppose that the price of green grapes rises to $2 per bag. In order to afford 4 bags of grapes, you now need to buy 3 bags of green grapes and only 1 bag of red grapes. Even though it was the price of green grapes that rose, you ended up buying more green grapes. In this scenario, green grapes are a Giffen good.

The exception that is talked about occasionally and occurs a lot in real life is the Veblen Effect. Whereas a Giffen good is a very cheap bare necessity, a Veblen good is a very expensive pure luxury.

The whole point of buying a Veblen good is to prove that you can. You don’t buy a Ferrari because a Ferrari is a particularly nice automobile (a Prius is probably better, and a Tesla certainly is); you buy a Ferrari to show off that you’re so rich you can buy a Ferrari.

On my previous post, jenszorn asked: “Much of consumer behavior is irrational by your standards. But people often like to spend money just for the sake of spending and for showing off. Why else does a Rolex carry a price tag for $10,000 for a Rolex watch when a $100 Seiko keeps better time and requires far less maintenance?” Veblen goods! It’s not strictly true that Veblen goods are irrational; it can be in any particular individual’s best interest is served by buying Veblen goods in order to signal their status and reap the benefits of that higher status. However, it’s definitely true that Veblen goods are inefficient; because ostentatious displays of wealth are a zero-sum game (it’s not about what you have, it’s about what you have that others don’t), any resources spent on rich people proving how rich they are are resources that society could otherwise have used, say, feeding the poor, curing diseases, building infrastructure, or colonizing other planets.

Veblen goods can also result in a violation of the Law of Demand, because raising the price of a Veblen good like Ferraris or Rolexes can make them even better at showing off how rich you are, and therefore more appealing to the kind of person who buys them. Conversely, lowering the price might not result in any more being purchased, because they wouldn’t seem as impressive anymore. Currently a Ferrari costs about $250,000; if they reduced that figure to $100,000, there aren’t a lot of people who would suddenly find it affordable, but many people who currently buy Ferraris might switch to Bugattis or Lamborghinis instead. There are limits to this, of course: If the price of a Ferrari dropped to $2,000, people wouldn’t buy them to show off anymore; but the far larger effect would be the millions of people buying them because you can now get a perfectly good car for $2,000. Yes, I would sell my dear little Smart if it meant I could buy a Ferrari instead and save $8,000 at the same time.

But the third major exception to the Law of Demand is actually the most important one, yet it’s the one that economists hardly ever talk about: Speculation.

The most common reason why people would buy more of something that has gotten more expensive is that they expect it to continue getting more expensive, and then they will be able to sell what they bought at an even higher price and make a profit.

When the price of Apple stock goes up, do people stop buying Apple stock? On the contrary, they almost certainly start buying more—and then the price goes up even further still. If rising prices get self-fulfilling enough, you get an asset bubble; it grows and grows until one day it can’t, and then the bubble bursts and prices collapse again. This has happened hundreds of times in history, from the Tulip Mania to the Beanie Baby Bubble to the Dotcom Boom to the US Housing Crisis.

It isn’t necessarily irrational to participate in a bubble; some people must be irrational, but most people can buy above what they would be willing to pay by accurately predicting that they’ll find someone else who is willing to pay an even higher price later. It’s called Greater Fool Theory: The price I paid may be foolish, but I’ll find someone who is even more foolish to take it off my hands. But like Veblen goods, speculation goods are most definitely inefficient; nothing good comes from prices that rise and fall wildly out of sync with the real value of goods.

Speculation goods are all around us, from stocks to gold to real estate. Most speculation goods also serve some other function (though some, like gold, are really mostly just Veblen goods otherwise; actual useful applications of gold are extremely rare), but their speculative function often controls their price in a way that dominates all other considerations. There’s no real limit to how high or low the price can go for a speculation good; no longer tied to the real value of the good, it simply becomes a question of how much people decide to pay.

Indeed, speculation bubbles are one of the fundamental problems with capitalism as we know it; they are one of the chief causes of the boom-and-bust business cycle that has cost the world trillions of dollars and thousands of lives. Most of our financial industry is now dedicated to the trading of speculation goods, and finance is taking over a larger and larger section of our economy all the time. Many of the world’s best and brightest are being funneled into finance instead of genuinely productive industries; 15% of Harvard grads take a job in finance, and almost half did just before the crash. The vast majority of what goes on in our financial system is simply elaborations on speculation; very little real productivity ever enters into the equation.

In fact, as a general rule I think when we see a violation of the Law of Demand, we know that something is wrong in the economy. If there are Giffen goods, some people are too poor to buy what they really need. If there are Veblen goods, inequality is too large and people are wasting resources competing for status. And since there are always speculation goods, the history of capitalism has been a history of market instability.

Fortunately, elasticity of demand is usually negative: As the price goes up, people want to buy less. How much less is the elasticity.

5 thoughts on “Elasticity and the Law of Demand

  1. […] We’ll also have a demand curve, which is a graph of the maximum price the employer is willing to pay for each hour, if the employee works that many hours. We generally assume that the demand curve slopes downward, meaning that the employer is willing to pay less for each hour if the employee works more hours. The reason is that most activities have diminishing marginal returns, so each extra hour of work generally produces less output than the previous hour, and is therefore not worth paying as much for. (This too is an oversimplification, as I discussed previously in my post on the Law of Demand.) […]

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