Source: Microeconomic Theory, Texas A&M University
Tags: elasticity, price elasticity of demand, elastic demand, inelastic demand, Alfred Marshall, markup pricing, price discrimination, versioning, information goods, network externalities, complements, substitutes, normal good, inferior good, Uber surge pricing, ECO 101
Elasticity measures how responsive demand is to a change in price. It drives nearly every pricing decision in this course: the more elastic demand is, the lower the optimal markup. This set of notes also covers price discrimination, versioning, information goods, and the economics of platforms like Amazon's Kindle and Uber, all of which rely on understanding how customers respond to price.
Price elasticity of demand (Ep)
A measure of how much quantity demanded changes in response to a change in price. Elastic means demand is very responsive; inelastic means it is relatively unresponsive.
Elastic demand
Demand where a price increase causes a proportionally larger fall in quantity demanded. Customers have substitutes or do not view the good as a necessity.
Inelastic demand
Demand that is relatively unresponsive to price changes. The good may be a necessity or have few substitutes.
Normal good
A good for which an increase in income increases its unit sales.
Inferior good
A good for which an increase in income decreases its unit sales.
Complements
Goods that are consumed together. When the price of one falls, demand for the other rises. Example: coffee and sugar, smartphones and data plans.
Substitutes
Goods that can replace each other. When the price of one rises, demand for the other increases. Example: airline seats and train seats.
Price discrimination
When a seller charges different prices for the same good or service to different customers or in different contexts.
Versioning
A company offers different versions of its product (e.g. standard and deluxe). Customers self-select into the version that matches their willingness to pay.
Information goods
Goods where the cost of production is dominated by a large fixed cost (creating the content) and the marginal cost of distribution is near zero. Examples: software, e-books, digital media.
Network externality
The value of a product increases as more people use it. Important: simply watching someone use a product does not create a network externality. The benefit must come from mutual participation in the network (e.g. both people being on the same messaging platform).
Surge pricing
Dynamic pricing that raises prices during periods of high demand, as practised by Uber. The stated rationale is to incentivise more drivers to come online and meet demand.
Alfred Marshall invented the concept of elasticity.
Demand tends to be more elastic in the long run than in the short run, because buyers can find more substitutes over time.
"Inelastic demand" means demand is relatively unresponsive to price.
Demand is affected by multiple factors, including price and income.
Supply is affected by multiple factors, including prices of inputs and the number of sellers.
When the price of smartphones decreases, the demand for data plans (a complement) increases.
If the price of a substitute good increases significantly, demand for the competing good increases.
A firm with market power sets price using the elasticity-based markup formula:
P = MC / (1 + 1/Ep)
Example: MC = $60, Ep = −5.
P = 60 / (1 + 1/(−5)) = 60 / (1 − 0.2) = 60 / 0.8 = $75.
Key insight: the more elastic demand is (larger absolute value of Ep), the lower the optimal markup. With very elastic demand, the firm cannot charge much above cost.
Occurs when a seller charges different prices for the same good or service.
The least price-sensitive customers do not receive the greatest discounts. It is the other way around: the most price-sensitive customers get the discounts to capture their business.
For a multiproduct firm (e.g. an airline with business and pleasure seats), the profit-maximising rule is to set prices so that the marginal revenue from the last business seat equals the marginal revenue from the last pleasure seat.
The company offers different versions of its product and lets customers self-select.
This is a form of second-degree price discrimination.
A software company that charges a low price for a standard version and a higher price for a deluxe version is practising versioning (the quiz flags a nuance here: the question's phrasing about the standard version being "low price" was marked false, likely because the standard version is not priced low as a loss leader but rather is a stripped-down version that extracts value from lower-willingness-to-pay customers).
Characteristics of information goods:
High fixed cost of creation, near-zero marginal cost of distribution.
Allow a large amount of customisation.
Providers face problems similar to those of multiproduct firms.
Free content can be viable as long as other revenue methods exist (e.g. advertising).
Information goods providers face a problem most similar to a pure seller who maximises revenue, because marginal costs are negligible.
Search engines do not charge users a fee; they earn revenue from advertising.
Network externalities: the value of a product rises as more people use it. "Jack uses Word; Jill gains a network externality by watching Jack use Word" is false, because merely observing someone use a product is not a network externality. The benefit comes from both people being on the same platform or standard.
Amazon Kindle and e-books:
Jeff Bezos wanted to make the Kindle the dominant platform for e-books. The claim that e-books are sold by Barnes & Noble (exclusively) is false.
When Amazon lowered the price of the Kindle, e-book sales increased, but the price of the Kindle remained the same after the cut. (The quiz statement is about what happened after the price reduction.)
The claim that Kindle prices have been rising over the years is false.
Pedro's fish (elasticity example):
When Pedro raised the price of fish, he found demand was elastic (quantity demanded fell substantially).
The quiz states "two of the reasons why fish demand is elastic is that it has substitutes and it is not a necessity" as false. Fish does have substitutes (other protein sources), but it can be considered a necessity in some contexts. The false marking likely hinges on the "not a necessity" claim.
Ferry demand (elasticity example):
When the ferry price increased, passengers found other transport or stayed in the city. The quiz marks the statement that "demand for the ferry was elastic" as false, and also marks "passengers did not find taking the ferry a necessity" as false.
This suggests that in the quiz's framing, the ferry had inelastic demand overall or the drop was overstated. Pay attention to how the question is phrased in context.
Uber surge pricing:
The main subject of the article: consumers complain about very high Uber prices during snowstorms and similar events.
The Uber boss says prices are raised during tough times to entice drivers to come out and meet high demand.
The claim that "Uber cannot meet consumer demand because it maximises revenue instead of the number of rides" is false.
Kendra Perry (pricing strategist):
Does not suggest giving everything away for free during COVID because customers cannot afford to buy.
One of her recommendations that is not correct (per the quiz): "never break the service into two parts, that will damage continuity."
The statement "last-minute airline seats are always heavily discounted" is false. Airlines often charge a premium for last-minute bookings, because last-minute travellers (often business travellers) tend to have inelastic demand.
Formula | What it does |
|---|---|
P = MC / (1 + 1/Ep) | Optimal markup price given marginal cost and elasticity |
Ep = (% change in Qd) / (% change in P) | Price elasticity of demand |
MR(business) = MR(pleasure) | Multiproduct pricing rule for airlines |
⚠️ Know the markup formula and be able to plug in numbers. MC = $60 and Ep = −5 giving P = $75 is a direct exam calculation.
⚠️ More elastic demand means a lower optimal price. This is the intuition behind the markup formula.
⚠️ Demand is more elastic in the long run than the short run. Reason: buyers find more substitutes over time.
⚠️ Network externality requires mutual participation, not just observation. The "Jack and Jill" example is a classic trick question.
⚠️ Information goods providers behave like pure sellers (maximise revenue) because marginal cost is approximately zero.
⚠️ The least price-sensitive customers do not get the biggest discounts. Price-sensitive customers do.
⚠️ Versioning means offering different versions and letting customers self-select. Know this definition.
Q: Which economist invented the concept of elasticity?
A: Alfred Marshall.
Q: Is demand more elastic in the long run or the short run?
A: The long run, because buyers can find more substitutes over time.
Q: A firm has MC = $60 and Ep = −5. What is the optimal price?
A: $75. Using P = MC / (1 + 1/Ep) = 60 / (1 − 0.2) = 60 / 0.8 = 75.
Q: What is price discrimination?
A: When a seller charges different prices for the same good or service.
Q: What is the best description of an inferior good?
A: An increase in income decreases its unit sales.
Q: Coffee and sugar are examples of what type of goods?
A: Complements.
Q: What is versioning?
A: Offering different versions of a product so customers can self-select the version that matches their willingness to pay.
Q: True or false: information goods allow a large amount of customisation.
A: True.
Q: In a pure selling problem, what is true about variable costs?
A: They are zero or so low they can be ignored.
Q: For a profit-maximising markup, what happens as demand becomes more elastic?
A: The price falls (the markup shrinks).
Q: If the price of a substitute good increases significantly, what happens to demand for the competing good?
A: It increases.
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