Elasticity in Areas Other Than Price

Expanding the Concept of Elasticity

The elasticity concept does not even need to relate to a typical supply or demand curve at all. For example, imagine that you are studying whether the Internal Revenue Service should spend more money on auditing tax returns. We can frame the question in terms of the elasticity of tax collections with respect to spending on tax enforcement; that is, what is the percentage change in tax collections derived from a given percentage change in spending on tax enforcement?

With all of the elasticity concepts that we have just described, some of which are in Table, the possibility of confusion arises. When you hear the phrases “elasticity of demand” or “elasticity of supply,” they refer to the elasticity with respect to price. Sometimes, either to be extremely clear or because economists are discussing a wide variety of elasticities, we will call the elasticity of demand or the demand elasticity the price elasticity of demand or the “elasticity of demand with respect to price.” Similarly, economists sometimes use the term elasticity of supply or the supply elasticity, to avoid any possibility of confusion, the price elasticity of supply or “the elasticity of supply with respect to price.” However, in whatever context, the idea of elasticity always refers to percentage change in one variable, almost always a price or money variable, and how it causes a percentage change in another variable, typically a quantity variable of some kind.

Income elasticity of demand=% change in Qd% change in income
Cross-price elasticity of demand=% change in Qd of good A% change in price of good B
Wage elasticity of labor supply=% change in quantity of labor supplied% change in wage
Wage elasticity of labor demand=% change in quantity of labor demanded% change in wage
Interest rate elasticity of savings=% change in quantity of savings% change in interest rate
Interest rate elasticity of borrowing=% change in quantity of borrowing% change in interest rate
Formulas for Calculating Elasticity

That Will Be How Much?

How did the 60% price increase in 2011 end up for Netflix? It has been a very bumpy ride.

Before the price increase, there were about 24.6 million U.S. subscribers. After the price increase, 810,000 infuriated U.S. consumers canceled their Netflix subscriptions, dropping the total number of subscribers to 23.79 million. Fast forward to June 2013, when there were 36 million streaming Netflix subscribers in the United States. This was an increase of 11.4 million subscribers since the price increase—an average per quarter growth of about 1.6 million. This growth is less than the 2 million per quarter increases Netflix experienced in the fourth quarter of 2010 and the first quarter of 2011.

During the first year after the price increase, the firm’s stock price (a measure of future expectations for the firm) fell from about $33.60 per share per share to just under $7.80. By the end of 2016, however, the stock price was at $123 per share. Today, Netflix has more than 86 million subscribers million subscribers in fifty countries.

What happened? Obviously, Netflix company officials understood the law of demand. Company officials reported, when announcing the price increase, this could result in the loss of about 600,000 existing subscribers. Using the elasticity of demand formula, it is easy to see company officials expected an inelastic response:

=–600,000/[(24 million + 24.6 million)/2]$6/[($10 + $16)/2]=–600,000/24.3 million$6/$13=–0.0250.46=–0.05

In addition, Netflix officials had anticipated the price increase would have little impact on attracting new customers. Netflix anticipated adding up to 1.29 million new subscribers in the third quarter of 2011. It is true this was slower growth than the firm had experienced—about 2 million per quarter.

Why was the estimate of customers leaving so far off? In the more than two decades since Netflix had been founded, there was an increase in the number of close, but not perfect, substitutes. Consumers now had choices ranging from Vudu, Amazon Prime, Hulu, and Redbox, to retail stores. Jaime Weinman reported in Maclean’s that Redbox kiosks are “a five-minute drive for less from 68 percent of Americans, and it seems that many people still find a five-minute drive more convenient than loading up a movie online.” It seems that in 2012, many consumers still preferred a physical DVD disk over streaming video.

What missteps did the Netflix management make? In addition to misjudging the elasticity of demand, by failing to account for close substitutes, it seems they may have also misjudged customers’ preferences and tastes. Yet, as the population increases, the preference for streaming video may overtake physical DVD disks. Netflix, the source of numerous late night talk show laughs and jabs in 2011, may yet have the last laugh.