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University of South Carolina, Arnold School of Public Health, Dept. of Health Services Policy and Management Courses and Curricula, Economics Interactive Tutorials Feb. 26, 2006

Economics Interactive Tutorial (Instructions)

Elasticity

Copyright © 1985, 1988, 1991, 1996, 1998, 2006 Samuel L. Baker

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 and Inelastic

Elasticity is a noun. The adjective form, "elastic," means something is highly responsive to changes in something else. For example, elastic demand means that the quantity demanded changes a lot when the price changes. Inelastic demand means that the quantity demanded does not change much when the price changes. In class, we'll get more precise about where to draw the line between elastic and inelastic. For now, though, let's start with the qualitative idea:

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. In none of these examples will the demand be as elastic as the demand for gasoline at a particular gas station on a street with many gas stations. Drivers will flock to a gas station with a price a few pennies below its neighbors' prices, and will abandon a gas stations with a price a few pennies higher. 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 ...

What difference does demand elasticity make?

Consider the following graph and table.
                          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        40
Is 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        40
The 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      $240
Revenue equals Price times Quantity.
If your demand is inelastic, the more you charge, the more revenue you take in, since the amount you sell doesn't go down.  Therefore, if profit is your goal, you should raise price when demand is inelastic.

This leads directly to the standard

Economists' Critique of Health Insurance

as health insurance was in the U.S. from the 1940's to the late 1980's.

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.

Making Demand More Elastic

In a market system, demand becomes elastic if consumers are price conscious and if they have an alternative. Here's an example of how this affects the seller's price:

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         0
If 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.

Below is a demand graph, and below that is a corresponding table. Press the Change Elasticity button to see how elasticity changes depending on competition. Click repeatedly to cycle through the three possibilities. Then stop at the third one, which shows what happens if there is partial customer loyalty, so that some customers will buy your product even if its price is a little higher than the competitor's.

Customer loyalty makes the market more stable. In the market labelled "Some loyalty," what price gives you the highest revenue? (Revenue = Price times Quantity)

In the market with "Some loyalty," 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 there's much less chance of a price cutting war. You certainly won't start one by cutting your price.

For providers of health care, physicians, other practitioners, and hospitals, 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 are 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 demand will be less elastic. If it can do that without dependence on particular providers, it can really make some money, because it keeps its customers loyal while forcing the providers to compete with each other for the insurer's patients.

Health Savings Accounts -- The Best Way to Make Demand 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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