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 = 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.
An unconscious bleeding man is brought to a hospital emergency room.
A patient is given a presciption for a drug to control high blood pressure.
The patient's insurance doesn't cover drugs, so the patient must pay out
of pocket.
A hospital in-patient has insurance that will pay all charges.
What would the demand be like for nurse-administered propoxyphene (Darvon), a pain-reliever?
A senior signs up with a managed care plan to get the Medicare drug benefit.
Even though the senior is locked in for a year, the plan can, at any time, change which drugs it will pay for,
based on the plan's judgement about a drug's effectiveness and price relative to other drugs that do about the same thing.
For members of that plan, what might the demand for the Darvon be like?
Darvon's cheapest alternative might be acetomenophen (Tylenol) in this case.
A family has a high-deductible health insurance policy. The effect is that the family pays for
primary care office visits out of pocket. Now, one of their children has an earache. What would their demand be like
for an office visit to get this checked out?
In general, if the decision-maker has an incentive to spend less on some product
and
if there is an adequate substitute for that product, then demand is more ...
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 40Is the title "INELASTIC DEMAND" correct?
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 prices will not encourage people to go get themselves shot or run over, nor will higher prices keep customers away.
A demand graph that's a vertical line represents completely inelastic demand. Let's change the title accordingly:
COMPLETELY 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 40The traditional medical model implies completely inelastic demand. 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.
If demand for your product is inelastic, what should you do with your
price? For example, suppose right now you're charging $2. If your
sole goal is profit, should you raise your price, keep it the same, or
lower it?
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 $240Revenue equals Price times Quantity.
This leads directly to the standard
With inelastic demand, there's always an incentive to raise prices. Economists argue that insurance made demand inelastic, and inelastic demand led to rapid price increases.
Suppose that the market in the example above gets a new competitor, who charges $3.50. Suppose also that price is the consumer's only consideration (no quality difference, no customer loyalty to a particular company). Then the 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 0If 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.
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.
One thing is for sure: 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.
The applet below shows the two graphs you've just seen and a third graph. By clicking the Change Elasticity button, you can cycle through the graphs and see how they compare.
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. In this third diagram and table, what price gives you the highest revenue? (Remember, Revenue is Price multiplied by Quantity.)
In the market with product differentiation, thanks to the way I rigged the numbers, your highest revenue comes when you charge a price a bit higher than your competitor. This means that no are not going to start a price war by cutting your price below your competitor's price.
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 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. They can pay providers less, while maintaining the prices ("premiums") they charge employers and the public. Managed care companies want providers' 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 and maintain something that it can credibly call "quality," then its own demand becomes less elastic, while the providers' demand becomes more elastic.
The currently trendy idea in health care finance is the Health Savings Account. This is an insurance policy with a high deductible, typically in the thousands of dollars. To make this decidedly uncomprehensive insurance more palatable to consumers, the Federal government makes 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 Health Savings Accounts, which banks get paid to administer.
Advocates of Health Savings Accounts call 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?
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?
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