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COLLUSION AND EFFICIENCY: Colluding oligopolistic firms generally produce less output and charge a higher price than would be the case for a perfectly competitive industry. In essence, colluding oligopolistic firms function just as if a market were monopolized. The price charged by the colluding firms is higher than the marginal cost of production. The equality between price and marginal cost is THE key indication that resources are allocated efficiently and that society's resources are being used to generate the highest possible level of satisfaction. Because the colluding firms control the market like a monopoly, the market demand curve is THE demand curve for the colluding firms's. With a negatively-sloped demand curve, price is greater than marginal revenue. And because a profit-maximizing firm equates marginal revenue with marginal cost, the price charged by the colluding firms when the maximize industry profit is greater than marginal cost.

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ELASTICITY:

The relative response of one variable to changes in another variable. Elasticity is commonly used in the study of market exchanges to identify the relative response of quantity (demanded and supplied) to changes in price. The phrase "relative response" is best interpreted as the percentage change, such as, the percentage change in quantity measured against the percentage change in price. The most common notions of elasticity are the price elasticity of demand and the price elasticity of supply. Other notable economic elasticities are the income elasticity of demand and the cross elasticity of demand.
The concept of elasticity is used throughout the study of economics, but is perhaps most important in the analysis of markets. It provides quantitative structure to the concepts of demand and supply, making it possible to summarize each side of the market into single elasticity measures, the demand curve on one side and the supply curve on the other.

Although elasticity most often surfaces in the study of markets, it is applied to a wide range of economic topics involving a connection or cause-and-effect relation between two variables. The analysis of short-run production by a firm often finds use for elasticity of substitution between labor and capital inputs. The analysis of monetary policy employs the interest rate elasticity of investment expenditures.

Stretchability

Elasticity is essentially the notion of stretchability, that is, how easily a particular variable is to stretch. Some variables are hard to stretch, meaning a great deal of force must be applied to induce changes. Other variables are stretched quite easily, with little force needed to entice changes.

Suppose, for example, that Duncan Thurly, as Sergent at Arms of the Shady Valley Bungee Association, has been charged with installing and testing the bungee straps for the 12th Annual Bungee Jump Off. As the first one to plunge 500 feet from a bridge, he is admittedly concerned that the appropriate bungee straps are used.

Options include:

  • Steel, which has some stretchability, but not a lot. A great deal of force is needed to induce changes in the steel. The jumpers are likely to end up with a sudden, spine-snapping, joint-separating stop.

  • Leather, which has more stretchability than steel, but once again, probably not enough.

  • Rubber, which is relatively stretchable, would seem to be an ideal candidate. However, Duncan must make sure that the rubber is not too stretchable. If so, then the jumpers are bound to have an unscheduled meeting with a pile of jagged rocks.
While this notion of stretchability is extremely important for bungee jumping, it is analogously important to economics and market exchanges. For markets, the force of gravity is replaced by changes in price and the plummeting body is replaced by changes in quantity.

Elastic and Inelastic: Dog Eats Homework

To illustrate this concept of elasticity, consider the predicament of Maurice Finkelstein. Suppose that Maurice tells Professor Grumpinkston, his economics instructor, that a dog ate his homework. Based on this extremely flimsy explanation Professor Grumpinkston raises Maurice's course grade from a D to an A. Because very little effort went into Maurice's grade change, Professor Grumpinkston's grade-changing actions can be considered very "elastic" (that is, responsive to Maurice's request for a higher grade).

Alternatively, suppose that Maurice has eyewitness accounts from the five most reputable citizens of Shady Valley, provides an affidavit from three veterinarian's attesting to the homework contents of the dog's stomach, and replays a videotape of the actual dog-eating-homework debacle. If Professor Grumpinkston changes Maurice's grade from a D to a D+, then he is not very "elastic."

Professor Grumpinkston's response to Maurice's dog story suggests that elasticity can be generally classified as either elastic or inelastic.

  • Elastic: This exists if small changes in one variable cause relatively large changes in another variable. An elastic relationship between two variables is a very responsive, or stretchable, relationship.

  • Inelastic: This exists if large changes in one variable cause relatively small changes in another variable. An inelastic relationship between two variables is not a very responsive, or stretchable, relationship.

Taking Measures

The elasticity relation between two variables, such as price and quantity, is often summarized by a single number, the coefficient of elasticity. The coefficient of elasticity is a numerical measure of the relative response of one variable (A) to changes in another variable (B). The general formula for the coefficient of elasticity between variables A and B is given as:
coefficient of
elasticity
=percentage change
in variable B
percentage change
in variable A
The coefficient of elasticity is measured in a number different ways. One of the more common measures, especially at the introductory level of economic instruction is the midpoint formula.
midpoint
elasticity
=(B2 - B1)
(B2 + B1)/2
÷(A2 - A1)
(A2 + A1)/2
The first term on the right-hand side of the equation is the percentage change in variable B. The second term is the percentage change in variable A. The individual items are interpreted as this: A1 is the initial value of A before any changes, A2 is the ending value after A changes, B1 is the initial value of B before any changes, and B2 is the ending value after B changes.

Demand and Supply

Market exchanges are fertile soil for the study of elasticity. Prices change. Quantities change. How much and why they change is always useful information. A number of elasticities exist to provide this information. The two most important elasticities capture the demand curve and the law of demand on one side of the market and the supply curve and the law of supply on the other.
  • Price Elasticity of Demand: At the top of the list is the price elasticity of demand. This is the relative response of quantity demanded to changes in the price. More specifically, it is the percentage change in quantity demanded to a percentage change in price.

  • Price Elasticity of Supply: On the other side of the market is the price elasticity of supply. This is the relative response of quantity supplied to changes in the price. It is analogously specified as the percentage change in quantity supplied to a percentage change in price.
Two other common elasticities, both from the demand side of the market, are also commonly studied.
  • Income Elasticity of Demand: This is the relative response of demand to changes in income, or the percentage change in demand to a percentage change in income. This elasticity quantifies the buyers' income demand determinant.

  • Cross Elasticity of Demand: This is the relative response of demand to changes in the price of another good, or the percentage change in the demand for one good due to a percentage change in the price of the other good. This elasticity quantifies the other prices demand determinant.
While these four elasticities are those most commonly used and studied, other lesser known market-related elasticities can be identified, including the resource price elasticity of supply and cross elasticity of supply. In fact, any cause-and-effect relation in the market that can be quantified can be quantified with elasticity.

A Range of Elasticity

The price elasticity of demand and the price elasticity of supply are both commonly divided into one of five elasticity alternatives--perfectly elastic, relatively elastic, unit elastic, relatively inelastic, and perfectly inelastic--depending on the relative response of quantity to price. These five alternatives form a continuum of possibilities.

AlternativeCoefficient (E)
Perfectly ElasticE = ∞
Relatively Elastic1 < E < ∞
Unit ElasticE = 1
Relatively Inelastic0 < E < 1
Perfectly InelasticE = 0
The chart to the right displays the five alternatives based on the coefficient of elasticity (E). The negative value obtained when calculating the price elasticity of demand is ignored to allow for comparison with the price elasticity of supply.

  • Perfectly Elastic: The top of the chart begins with perfectly elastic, given by E = ∞. Perfectly elastic means an infinitesimally small change in price results in an infinitely large change in quantity demanded or supplied.

  • Relatively Elastic: The second category is relatively elastic, in which the coefficient of elasticity falls in the range 1 < E < ∞, between one and infinity. With relatively elastic demand and supply, relatively small changes in price cause relatively large changes in quantity. Quantity is very responsive to price. The percentage change in quantity is greater than the percentage change in price.

  • Unit Elastic: The third category is unit elastic, in which the coefficient of elasticity is E = 1. In this case, any change in price is matched by an equal relative change in quantity. The percentage change in quantity is equal to the percentage change in price. Unit elastic is essentially a dividing line or boundary between elastic and inelastic.

  • Relatively Inelastic: The fourth category is relatively inelastic, in which the coefficient of elasticity falls in the range 0 < E < 1, between zero and one. With relatively inelastic demand and supply, relatively large changes in price cause relatively small changes in quantity. Quantity is not very responsive to price. The percentage change in quantity is less than the percentage change in price.

  • Perfectly Inelastic: The final category presented in this chart is perfectly inelastic, given by E = 0. Perfectly inelastic means that quantity demanded or supplied are unaffected by any change in price. The quantity is essentially fixed. It matters not how much price changes, quantity does not budge.

Three Determinants

Three factors that affect the numerical value of elasticity, especially the price elasticity of demand and price elasticity of supply are the availability of substitutes, time period of analysis, and proportion of budget. A given good can have a different price elasticity (both demand and supply) if these determinants change. The first two determinants are important to both price elasticity of demand and price elasticity of supply, while the third relates specifically to the price elasticity of demand.
  • Availability of Substitutes: The ease of substitution between goods, both in consumption and production, has a big effect on elasticity. The ease with which buyers can find substitutes-in-consumption affects the price elasticity of demand and the ease with which sellers can switch resources to substitutes-in-production affects the price elasticity of supply. The general rule is that goods with a greater availability of substitutes is more sensitive to price changes. With more substitutes available, buyers and sellers can easily respond to price changes.

  • Time Period of Analysis: The longer the time period of analysis, the more responsive quantities are to price changes, for both price elasticity of demand and price elasticity of supply. Brief periods do not allow buyers and sellers the time needed to adjust consumption and production decisions to price changes. Buyers need time to find substitutes-in-consumption. Sellers need time to find resources used for substitutes-in-production. Longer time periods allow buyers and sellers the time needed to find alternatives.

  • Proportion Of Budget: The price elasticity of demand depends on the proportion of the budget that buyers devote to a good. The rule is this: The larger the portion, the more responsive quantity demanded is to price changes. A house, for example, is a BIG budget item for most normal human beings. A relatively small change, say 1 percent on a $100,000 house, can make a BIG difference in the buyer's decision to buy. As such, relatively small changes in price are likely to induce relatively large changes in quantity demanded.

<= ELASTIC SUPPLYELASTICITY ALTERNATIVES =>


Recommended Citation:

ELASTICITY, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: September 20, 2018].


Check Out These Related Terms...

     | elastic | inelastic | price elasticity of demand | price elasticity of supply | income elasticity of demand | cross elasticity of demand | coefficient of elasticity | elasticity alternatives | elasticity determinants |


Or For A Little Background...

     | market | price | quantity | demand | supply | law of demand | demand curve | law of supply | supply curve | determinants | cause and effect | variables |


And For Further Study...

     | elasticity and demand slope | elasticity and supply intercept | demand elasticity and total expenditure | buyers' income, demand determinant | other prices demand determinant |


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