Hill – Mankiw 9th Edn Chapter 5: Elasticity and Its Application
Mankiw, N. G. (2021) Principles of microeconomics (9th ed.)
Principles of economics (9th ed.)
Mason, OH: South-Western Cengage Learning.
University of New Brunswick, Saint John campus
Saint John, New Brunswick, Canada
Chapter 5 – Elasticity and Its Application
Here are some things to consider when reading this chapter.
- The limited usefulness of the elasticity of demand
The perfectly competitive firm does not need to know the elasticity of demand in the market; it uses only the market price to make its decision about how much to supply. Firms that are price makers need to know the nature of the demand for their product to determine a profit maximizing price (as will be seen in Chapter 15 where monopoly is introduced).
Mankiw gives examples of elasticities of demand for specific products, such as Cheerios, a breakfast cereal, but notes that they should not be taken too seriously. The estimates “require some assumptions about the world, and these assumptions might not be true in practice” (p. 91). As well, the elasticity is different at different points along the demand curve. It also changes over time as buyers have more ability to respond to a change in price.
As John Komlos observes, “Most firms have only a vague notion of the price elasticity of demand for their products, so they are satisficing with respect to the price they charge” (2019: 104). The idea of satisficing in this case is that firms set a price based on rules of thumb that they expect will yield a satisfactory outcome, but not the pure profit maximizing outcome that would be possible if information were perfect.
The concept of satisficing was introduced by Herbert Simon (winner of the 1978 Nobel Memorial Prize in Economics) as an alternative to the standard assumption that individuals have the information to make optimal decisions. Simon considered that it would be rational to make choices that are likely to meet or exceed some goal – a certain level of profits in the case of firms. (Mankiw mentions the idea briefly in Chapter 22, p. 458).
Nevertheless, the concept of the price elasticity of demand is important for some economic policy questions. For example, if a carbon tax were introduced to raise the price of gasoline and diesel fuels, by how much would demand decline in the short term and in the long term? Policy makers would need estimates in trying to meet emissions reduction goals.
- The limited usefulness of the elasticity of supply
Unlike with the elasticity of demand, Mankiw’s text gives no examples of estimates of the elasticity of market supply. As briefly noted in the Commentary on Chapter 4, supply curves only exist in markets that are perfectly competitive, and virtually none are.
Up to this point, Mankiw has not yet explained that the supply curve of a perfectly competitive firm reflects its marginal cost– the cost of producing an extra unit of its good or service. The explanation given in Chapter 4 for the upward sloping market supply curve was simply that producers would find it more profitable to produce more if the market price were higher.
In this chapter Mankiw (p. 98) describes “a typical case for an industry in which firms have factories with a limited capacity for production”. A higher and higher price is required to induce each of them to produce more up to their capacity. An even higher price is required to induce them to expand capacity. This is an attempt to tell a story of increasing marginal costs to justify the picture of the upward sloping supply curve. The Commentary for Chapter 13 on Costs of Production examines this case. It will claim that the evidence does not support the story Mankiw tells.
- The supply and demand examples
There are three applications of supply and demand: a wheat market, the world oil market, and a market for illegal drugs. As discussed in the Commentary for the previous chapter, significant buyer power in the wheat market makes a different model of a market (oligopsony) a better tool of analysis for most questions. What about the other two markets?
The world market for oil has large national producers, many of them members of the OPEC cartel, whose decisions have a significant effect of the world price, as Mankiw discusses. Can a change in OPEC policy really be described as shifting a supply curve in a perfectly competitive market?
The markets for many illegal drugs such as heroin or cocaine are supplied by organized crime which prefers to operate local or regional monopolies so that prices can be kept on high. As the analysis in Chapter 15 on monopoly will show, an increase in a monopolist’s costs leads to a price increase. This would happen if border authorities interdicted more drugs, a case Mankiw examines.
In this, as in the other cases, does it matter that the market in question does not fit the strict requirements of a perfectly competitive market? Why not use the supply and demand model if the events being analysed would lead to a change in prices and quantities in the direction that a more descriptively realistic model would also predict?
There are two possible responses. First, we don’t know that an alternative model will also produce the same prediction unless it is actually examined. We will see that this is an issue in some of the policies examined in the next chapter. This then raises the critical issue of which model is most appropriate and how the predictions of the models can be tested against the evidence.
Second, by ignoring the question of model selection and treating the supply and demand model as a generic model that can be applied to almost any market, one of the text’s central themes – that the market economy is guided towards an efficient outcome by the invisible hand working its magic –is reinforced. That would be all very well if this story were true, but is it?
Komlos, John (2019) Foundations of Real-World Economics: What Every Economics Student Needs to Know, Second Edition, Routledge.