91 Reading: Elasticity, Costs, and Customers
Customers and Changing Costs
We can see that understanding elasticity helps a firm set a price that maximizes total revenue. What happens if the firm’s production costs change, though? And what is the impact on customers?
Most businesses are continually trying to figure out ways to produce at a lower cost, as one path to earning higher profits. It’s a challenge to do this, though, when the price of a key input over which a firm has no control rises. For example, many chemical companies use petroleum as a key input, but they have no control over the world market price for crude oil. Coffee shops use coffee as a key input, but they have no control over the world market price of coffee. If the cost of a key input rises, can the firm pass along those higher costs to consumers in the form of higher prices?
Conversely, if new and less expensive ways of producing are invented, can the firm keep the benefits in the form of higher profits, or will the market pressure them to pass along the gains to consumers in the form of lower prices? The price elasticity of demand plays a key role in answering these questions.
Imagine that, as a consumer of legal pharmaceutical products, you read a news story about a technological breakthrough in the production of aspirin: Now every aspirin factory can make aspirin more cheaply than it did before.
What does this discovery mean to the firm? Figure 1, below, illustrates two possibilities. In Figure 1 (a), the demand curve is drawn as highly inelastic. In this case, a technological breakthrough that shifts supply to the right, from S0 to S1, so that the equilibrium shifts from E0 to E1, creates a substantially lower price for the product with relatively little impact on the quantity sold. In Figure 1 (b), the demand curve is drawn as highly elastic. In this case, the technological breakthrough leads to a much greater quantity being sold in the market at very close to the original price. Consumers benefit more, in general, when the demand curve is more inelastic because the shift in the supply results in a much lower price for consumers.
Producers of aspirin may find themselves in a nasty bind here. The situation shown in Figure 1, with extremely inelastic demand, means that a new invention may cause the price to drop dramatically while quantity changes little. As a result, the new production technology can lead to a drop in the revenue that firms earn from sales of aspirin. However, if strong competition exists between producers of aspirin, each producer may have little choice but to search for and implement any breakthrough that allows it to reduce production costs.
After all, if one firm decides not to implement such a cost-saving technology, it can be driven out of business by other firms that do.
Since demand for food is generally inelastic, farmers may often face the situation in Figure 1 (a). That is, a surge in production leads to a severe drop in price that can actually