Page 74 - Microeconomics, Fourth Edition

c02demandandsupplyanalysis.qxd 6/14/10 1:39 PM Page 48

48 CHAPTER 2 DEMAND AND SUPPLY ANALYSIS
when the price rises, so will the total revenue, but a higher price will generally reduce
the quantity demanded. Thus, the “benefit” of the higher price is offset by the “cost”
due to the reduction in quantity, and businesses must generally consider this trade-off
when they think about raising a price. If the demand is elastic (the quantity demanded
is relatively sensitive to price), the quantity reduction will outweigh the benefit of the
higher price, and total revenue will fall. If the demand is inelastic (the quantity
demanded is relatively insensitive to price), the quantity reduction will not be too
severe, and total revenue will go up. Thus, knowledge of the price elasticity of demand
can help a business predict the revenue impact of a price increase.

DETERMINANTS OF THE PRICE ELASTICITY OF DEMAND
Price elasticities of demand have been estimated for many products using statistical tech-
niques. Table 2.1 presents these estimates for a variety of food, liquor, and tobacco products
in the United States, while Table 2.2 presents estimates for various modes of transporta-
tion. What determines these elasticities? Consider the estimated elasticity of 0.107 for
cigarettes in Table 2.1, which indicates that a 10 percent increase in the price of cigarettes
would result in a 1.07 percent drop in the quantity of cigarettes demanded. This tells us
that cigarettes have an inelastic demand: When the prices of all the individual brands of
cigarettes go up (perhaps because of an increase in cigarette taxes), overall consumption of
cigarettes is not likely to be affected very much. This conclusion makes sense. Even
though consumers might want to cut back their consumption when cigarettes become
more expensive, most would find it difficult to do so because cigarettes are habit forming.
In many circumstances, decision makers do not have precise numerical estimates
of price elasticities of demand based on statistical techniques. Consequently, they have
to rely on their knowledge of the product and the nature of the market to make edu-
cated conjectures about price sensitivity.

TABLE 2.1 Estimates of the Price Elasticity of Demand for Selected Food,
Tobacco, and Liquor Products
Product Estimated Q,P
Cigars 0.756
Canned and cured seafood 0.736
Fresh and frozen fish 0.695
Cheese 0.595
Ice cream 0.349
Beer and malt beverages 0.283
Bread and bakery products 0.220
Wine and brandy 0.198
Cookies and crackers 0.188
Roasted coffee 0.120
Cigarettes 0.107
Chewing tobacco 0.105
Pet food 0.061
Breakfast cereal 0.031
Source: Emilio Pagoulatos and Robert Sorensen, “What Determines the Elasticity of Industry
Demand,” International Journal of Industrial Organization, 4 (1986): 237–250.