Question

Combine the price markup rule with the formula relating the cost function to scale elasticity to express the relationship between scale elasticity, demand elasticity, and price set by a

monopolist.

Answer 1

Elasticity is tailor-made for empirical investigation. That is, this 3-part sequence of events-and-effects you mention in your question (price->demand->revenue) is really a statement about probabilities. Like a theory that remains to be seen, there is little about this sequence that is true per se. To be proved or disproved, as within a laboratory setting, probabilistic outcomes can be estimated, but methods that deviate from fixed experimental conditions need to be controlled. Neither part of the sequence is sufficient to cause the other part to happen, nor if one part happens, is it necessary for the other part to exist! So for example, a price rise without a demand change, or a revenue increase without an increase in sales, both of these can happen. Elasticity is a “human-inspired” idea for certain. Therefore, price change -> demand changes -> revenue change does not, at all, run in guaranteed lockstep, and certainly is not bounded by deterministic features.

If you will regard elasticity itself as a theory, you may find yourself much more willing to search instances of its real-world existence in numbers. That is, let's take an example. OK, avocados were exactly $1 apiece yesterday when I went to Safeway. I was a big customer because I had to prepare guacamole for our HS band, so I bought all the avocados Safeway had - 300 of them, for ... $300.00. It turns out that I demanded and purchased the entire quantity available at Safeway yesterday. What, no discount? No, because a discount would complicate this example. Yet I will tell you shortly, the world is a messy place to be reliant on theory; society rarely conforms to the elegant expectations of theory, and for economic theory, what we do, when we try to apply this stuff to living, is to assume away the things that we cannot, real-life, represent. When these assumptions keep theory from being properly tested, that’s not science.

Now comes the big ingredient which is TIME, and the delayed observation of change. Today I go to Safeway because it turns out I’ll need even more avocados. But now they are $1.10 a piece, a 10% increase in price. The definition of elasticity is how that 10% increase in price affects the demand for a supply on hand. I won’t tell you how many I bought because the answer, from a silly arithmetic ratio, is meaningless. It’s only one store; I could have gone to a substitute outlet. But say that because Safeway knew I was going to buy all those avocados yesterday, they ordered a new shipment for today – plenty more avocados for that store.

A good analyst will pick out all the assumptions from the above paragraph that affect elasticity. The nature of the good, for example (cigarettes, for example, are more inelastic than avocados), the outlet and supply, the initial price, the location of the outlet, discounts, and then, of course, more assumptions related to demand, namely separability of commodities. If you have a first- stage tenuous relationship between price and purchase, it is necessary to have a third stage tenuous relationship between purchase and revenue. Sometimes even within the elasticity formula there is a time mis-match, whereby the price changed long ago, but people still think that applies to a current demand. It’s bizarre, man! Bedrock assumptions in Economics may have literally trained us (that is, people who drank the Koolaid) to make poor decisions, or to properly evaluate social phenomena where they impinge on livelihoods.

The supply and demand curves you see in traditional Economics - you know, where a nice equilibrium price is depicted at the intersection - this is PURE theory. Most other traditional Economics curves are, too, because what they are doing is aggregating curves, making envelopes, without controlling for the different shapes and locations (mass) of each curve. It’s confusing for young people especially (I know, my son has already had two courses of Econ in college, and they’re still teaching the same old theory.) because they think this is what it’s really like in the world, but then they start trying to figure out how to allocate their allowance, and realize it’s much, much more complicated than the perfect competition world. The world of the maximizing consumer is a fiction, about as true, and about as useful, as any other of Grimm’s fairy tales.