Principles of Microeconomics / Unit 4 MIC 0315 worked example, 60 to 90 seconds
Passing a Cost Change Through
The idea
When supply shifts, elasticity of demand decides how the change divides between price and quantity. Shift supply right against inelastic demand and the price falls a lot while quantity rises a little, so buyers capture most of the cost saving and sellers' revenue can fall. Shift supply right against elastic demand and quantity rises a lot while the price falls a little. Reverse the shift and the same rule gives a large price rise with inelastic demand and a small one with elastic demand.
In practice
Worked example: a bumper harvest shifts the supply of wheat right. With inelastic food demand, the price drops from six dollars to four while quantity rises from one million to one million one hundred thousand bushels; revenue falls from six million to four million four hundred thousand. The same shift in an elastic market, restaurant meals, cuts the price from twenty dollars to nineteen while quantity rises from one million to one million two hundred thousand; revenue rises from twenty million to twenty-two million eight hundred thousand.
Where people slip
This is why a good harvest can hurt farmers as a group and why a tax on an inelastic good is paid mostly by buyers. The error is to reason from the shift alone: the same shift produces opposite revenue results in the two markets, and only elasticity tells which.
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