Tying It Together
This chapter was about the calculations that businesses make every day as they experiment with their prices and other factors to maximize their profits. If you lower your prices, will total revenue go up or down? Should you try introducing a new product at a lower price point, or will that cannibalize the sales of your other products? Where should you open your next store so as to get the mix of customers most likely to be receptive to your products? Should you pursue a high- or low-price strategy? It’s not enough to know how sensitive demand for your product is to its own price. You also need to know how sensitive demand will be to the prices of other products and to household incomes.
Answering these questions requires numbers. It’s not enough to know whether sales will go up or down; real businesses need to know by how much. And that’s what elasticity does: It allows you to forecast how much quantities will change under different market conditions.
Every elasticity is about the same thing—measuring the responsiveness of quantity to various changes in market conditions. We’ve really introduced only one concept in this chapter: Elasticity measures the percent change in quantity following a 1% change in some other factor. And this means that you only need to remember one formula:
That other factor could be the price of your good, the price of another good, or income. (And if there were other factors you thought mattered, you could also calculate their elasticities, too.)
In every case, the bigger the number in absolute value, the more elastic the good is, which means it’s more responsive. For the price elasticity of demand and supply, you saw that whether the elasticity (in absolute value terms) is bigger or smaller than 1 tells you something important—whether the percent change in quantity will be bigger or smaller than the percent change in price.
For the cross-price elasticity of demand and the income elasticity of demand, whether the elasticity is positive or negative tells you something important about the type of good it is. But underneath it all, elasticity is just about one big idea: measuring how responsive people’s decisions are to changing conditions.