EME 810
Solar Resource Assessment and Economics

5.5 Price Elasticity of Demand

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Reading Assignment

  • J.R. Brownson, Solar Energy Conversion Systems (SECS), Chapter 9: Measure & Estimation of the Solar Resource (Focus on The Value, Reserve, and Elasticity of Light.)

When we are "thinking on the margin," what do we mean? When an incremental change occurs in the price of a SECS or in the alternative price of electricity from the grid, how do we respond? Do we jump in, or do we wait and see?

Elasticity of Demand

In economics, the measured response (in the market) of how the quantity of a product in demand is changed by the incremental change in the price of that product is termed price elasticity of demand. The demand is considered elastic if a small change (like a decrease) in price leads to people demanding more of the product. The demand in considered to be inelastic if a large change (again, a decrease) in price does not lead to people demanding more of the product. The elasticity of demand for solar power will depend on a few general rules, and we will try to contain our examples to solar scenarios for a client or group of stakeholders.

Criteria for Elasticity

The price of PV just changed. What do you do? Do you go out and invest in a PV system for your roof, or do you wait and see? Clients and consumers (us too!) are influenced by several criteria. The four main factors affecting the price elasticity of demand are:

  1. availability of close substitutes;
  2. whether the form of energy is a necessity or luxury;
  3. how large a share of a consumer's income the good will consume; and
  4. the time horizon over which the change occurs.

First, one evaluates the availability of close substitutes for the particular SECS of interest. If the desired useful energy form or technology has many available close substitutes, then it will be easier for clients/stakeholders to switch among goods for the same desired feature, and the demand will tend to be elastic.

Next, we ask, is the energy form a necessity or a luxury? Our electricity from the coal/nuclear power plant is typically a necessity right (and thus inelastic)? Is there anything about residential PV that seems to be a luxury to families? When did mobile phones stop being a luxury and become a necessity in modern society?

What share of income can an individual or firm (as clients) devote to paying off a loan for solar technologies or directly purchasing a SECS? If a SECS consumes a large share of my income, what tradeoffs will I need to consider (what will I have to give up in return)?

Finally, when making decisions for energy systems, we must consider the time horizon, or the period of evaluation. For energy consumers, when the cost of energy (in dollars per kilowatt-hour, $\$/kWh$) goes up briefly (on the order of hours or days, or for one month) there's not much that they can do to respond. As such, the price elasticity of demand is said to be inelastic for shorter time horizons. In contrast, when the period of evaluation is framed in terms of decades, as is done for PV systems that have productive life cycles of 30-50 years, then the client perspective can shift and become more elastic. When you buy a house, you're in it for the long-term, right? Similar thinking with SECSs.

Video Perspectives

And now for two short perspectives on the Price Elasticity of Demand to complement the reading. Please watch the following two videos: "Episode 16: Elasticity of Demand" by Dr. Mary J. McGlasson, and "Elasticity - Characteristics that determine elasticity" (Dr. McGlasson is an economics faculty at the Chandler-Gilbert Community College.) I want you to think about solar energy and the resource units derived from the conversion of shortwave light.

Elasticity of Demand
Click Here for Transcript of Elasticity of Demand Video

PRESENTER: There are many types of elasticity. In particular, I'll focus on the price elasticity of demand. Before I get into specific discussion of elasticity, let me ask you a question. If a business wants to generate more revenue, should it raise the price of its product or lower the price of its product?

I ask because I have a friend who runs a children's bookstore, and when she found out that I was an economist, she asked me this question. Well, actually, she asked if she should be giving an educator discount, but what this really meant, was that she wanted to know if she should discount, or lower, her prices.

So, generally, what would you say? Should a business owner increase prices or decrease prices, in order to generate more revenue?

The answer-- as usual-- is, it depends. Think about it. When your local electric company wants to raise more revenue, it will enact a rate increase. Yet, when an airline wants to quickly generate additional revenue, it will cut ticket prices. Which approach is correct? They both are.

Here's the issue. If I raise my prices, I know that quantity demanded, or the willingness to purchase on the part of my consumers, will drop-- that's just the law of demand. But what the law of demand doesn't tell me is how much the quantity demanded will drop.

When I raise my price, will my customers be very sensitive to the price increase? Cutting back a lot on their purchases? This would be bad for me because I'd lose a lot of revenue. But if I raise my price and my customers only buy a little bit less, not reacting too much to the price increase, this is good. I'd see increased overall revenue.

So, the crucial issue here is to find out how sensitive my customers will be to a price change. Elasticity is a measure of sensitivity, or responsiveness, to price. In equation form, the elasticity of demand, or ED, is equal to the percentage change in quantity demanded over the percentage change in price. Because demand exhibits an inverse or negative relationship, elasticity of demand will be a negative number.

I use percentage change to measure elasticity, rather than absolute change. Let me illustrate why.

If I tell you that product price has gone up by $1, this would be the absolute change. Is this a big change or a small change?

It depends. What's the product? More to the point, what was the original price?

Look, say we're talking about a pack of gum. Originally, the price was 1 dollar, now it's 2 dollars. This represents an absolute change of 1 dollar, but is it a big change or a small change? It's actually a pretty big change-- price doubled, or increased, by 100%.

What if we're talking about a textbook, rather than a pack of gum? Originally, the price was 100 dollars, now it's 101 dollars. This is still an absolute change of 1 dollar, but is it a big change or a small change?

In this case, it's a small change. Price has increased by 1%.

Bottom line is, that we need to know not only the dollar amount of the price change, but also, how this compares to where we started.

Now, technically, the formula for elasticity of demand is the percentage change in quantity demanded over the percentage change in price, which can be found by taking the ratio of the difference between the new and the old quantities over the average of the new and the old quantities, all over the ratio the difference between the new and the old price over the averages of the new and the old prices.

Frankly, I've found that if I use this version of the elasticity formula, students' eyes glaze over. People get so hung up on the math that they lose sight of the intuition and what elasticity means, so I'll be sticking to the slightly easier form and will frame my questions for you accordingly.

How would you actually use this formula? Take a look at this article about the Clinton administration's proposed cigarette tax policy. If you look at the last paragraph, you'll find enough information to determine the elasticity of demand for youth smoking. Remember, elasticity of demand is the percentage change in quantity demanded over the percentage change in price.

The article states that for every 10% increase in price, there is a 7% decrease in youth smoking. This means that elasticity of demand-- according to the formula-- is minus 7% over plus 10%, or negative 0.7.

OK. Now what do I do? I know that the elasticity of demand for youth smoking is minus 0.7, but what does it mean? The critical component to look at when dealing with elasticity of demand is the magnitude-- how big is this number?

The bigger the number, the more people respond to the price. The smaller the number, the less people respond to price. The fact that the number is negative only signifies that demand is a negative or inverse relationship between price and quantity demanded.

Since I care about the size of the elasticity number, rather than the sign, let's make things easier and just look at the absolute value-- or the size only-- of elasticity of demand. In this example, the absolute value of the elasticity of demand is 0.7. Again, what does this number really mean? What does it tell us?

Ultimately, the key value where elasticity is concerned is one, in the case of youth demand for cigarettes, the size of the elasticity figure is less than one. Since elasticity of demand equals the percentage change in quantity demanded over the percentage change in price, this means that the absolute value of this ratio is less than one.

It follows then, in order for this ratio to be less than one, it must be the case that the size of the price change is greater than the size of the quantity change.

What this tells me, is that it takes a relatively large price change to initiate a relatively small quantity demanded reaction. In other words, if the elasticity of demand is less than one, people don't react much to price changes. They're insensitive to price changes or their demand is inelastic.

Question-- does this make sense that where cigarettes are concerned, people don't react much to price changes?

Note that the article specifies data for youth smoking. Do you think that youth sensitivity to cigarette prices is any different from adult sensitivity? Which group would respond more to a price change-- youth smokers or adult smokers?

If you thought that youth smokers would respond more to a price change than adult smokers, you're right. Adults tend to have more disposable income so a price increase affects them less. In addition, the nicotine addiction is likely to be stronger for someone who's been smoking longer. This means that the size of elasticity for adults will be even smaller than the magnitude of the elasticity of demand for youth smokers, indicating a smaller reaction to any price change.

One last question for you, regarding inelastic demand. If the absolute value of the electricity of demand is less than one-- that is, people don't respond much to a price change-- would you raise your price or lower your price, to generate more revenue?

Well, the demand for electricity is inelastic. When the price changes, people tend to purchase about the same amount of electricity. We don't like the rate increases, but other than trying to conserve a bit here or there, we continue to consume the electricity. This means that the electric company could raise prices quite a bit and not see very much decrease in the quantity demanded. As a result, total revenue-- price per unit times the number of units sold-- will increase overall.

What if the absolute value of the elasticity had been greater than one? That would mean that the absolute value of the percent change in quantity demanded over the percent change in price is greater than one, which could only be true if the size of the quantity change is greater than the size of the price change. So, having a value of the elasticity that's greater than one, indicates a relatively large quantity demanded reaction, to a relatively small price change or demand is elastic.

Question-- if it's a case that demand is elastic, would you raise your price or lower your price, in order to generate more revenue? Answer-- demand for airline tickets is fairly elastic, meaning that customers react a lot to fairly small price changes; so, by decreasing prices a little bit, the airlines will see a relatively large increase in quantity demanded or ticket sales. Overall, this would yield greater total revenue.

Is it possible for elasticity of demand to be equal to one? Technically, it is. If so, the size of the quantity change is going to be equal to the size of the price change. The changes exactly offset one another. That is, a 10% increase in price, results in a 10% decrease in quantity demanded, and there would be no change in total revenue.

Next time, characteristics that determine elasticity of demand.

Credit: Dr. Mary J. McGlasson
Elasticity - Characteristics that determine elasticity
Click Here for Transcript of Elasticity Characteristics video

Hi everybody! It’s Dr. McGlasson. I’m here, ready for my weekly fill-up on my car.  

You may have noticed that gas prices tend to fluctuate a lot. Today, I'm looking at 2.72 point 9 a gallon, and the question is, am I going to react very much to that?

One thing that I didn’t address in my video that you watched on elasticity is the characteristics that determine elasticity of demand.

One of them is: is the product a luxury or a necessity? Well, for me, I need to drive to work, I need to drive to get my daughter to school, I need to drop her off at the babysitter, so I have to have the gasoline. So, my demand would be inelastic.

The second one would be: are there a lot of substitutes for gasoline? And frankly, for my old car, a 1997, it's not going to run on anything but gas, so I don't have any substitute goods that I could purchase.

The third one would be: what's the share in my budget? Now, for other people, this may be different, if they make less money than I do, but I do have a doctorate. I do have a pretty good job, and the gas prices aren’t a huge share of my budget, so it doesn’t make a big difference when the prices fluctuate a bit.

The last one is time: how much time is available to make the purchase? When I’m running on empty; I don’t have a lot of time to think about it, so I need to get my gasoline and I'm not going to worry about the price.

So, you tell me, is my demand going to be elastic or inelastic?

Dr. Mary J. McGlasson

Self-check questions:

1. As a luxury, you were able to purchase an electric car. The use of PV powered electricity is a direct substitute for the electricity from the coal-dominated power grid. A loan payment on a PV system would allow you to substitute your fuel costs, and would not consume a large share of your family income. How would you describe the demand for a PV system?

Click for answer...

ANSWER:Elastic

2. How do we describe the demand when a small change in price elicits a large change in demand? (Elastic or Inelastic)

Click for answer.

ANSWER: Elastic
 

3. For the case of using electricity in your home, a large change in price would not strongly influence your demand on the short term. How would you describe the demand?

Click for answer.

ANSWER: Inelastic

4. For the case of planning for long-term electricity use in your home, a loan payment on a PV system would allow you to avoid electricity costs (which are now high), and would not consume a large share of your family income. How would you describe the demand?

Click for answer.

ANSWER: Elastic

5. When driving a car, you currently use gasoline, which is highly priced. The use of PV powered electricity is not a direct substitute for gasoline. How would you describe the demand for a PV system?

Click for answer.

ANSWER: Inelastic

6. As a luxury, you were able to purchase an electric car. The use of PV powered electricity is a direct substitute for the electricity from the coal-dominated power grid. A loan payment on a PV system would allow you to substitute your fuel costs, and would not consume a large share of your family income. How would you describe the demand for a PV system?

Click for answer.

ANSWER: Elastic