Elasticity

In response to an assignment dealing with the concept of elasticity.

Elasticity is always a tricky concept. The definitions provided in textbooks are technical and difficult to grasp, so I would like to think about what is really happening when we talk about elasticity.

In the 1870s, economist finally figured out value through the use of marginal analysis. Before that time, many great economists had advanced mistaken concepts about value. Adam Smith and David Ricardo advocated the labor theory of value, arguing that the value of something was determined by the amount of labor needed to create the item. Karl Marx ran with this theory and logically concluded that profits and rents must simply be the theft of value created by workers. His analysis later plunged one third of the world's population into 70 plus years of communist hell. Other economists argued that value must be related to utility (usefulness), but these economists had no way to measure that utility. We now understand that utility is a subjective concept and is measured independently in the mind of each individual.

So, let’s think about the value of houses in the housing market. There is no "objective" value for any given house. I may really like my house. I like my neighbors. I like my kids’ friends. I like their school. I like the location. Subjectively, I might decide that I would not sell my house for less than $300,000. However, there are sales taking place for similar houses in my neighborhood at $200,000. Why?

Well, I may subjectively value my house at $300,000. The guy across the street may subjectively value his similar house at $500,000. But, a couple of people in the neighborhood subjectively value their similar houses at $200,000 or less.

Likewise, there are buyers looking at the houses in our neighborhood. Some may say that the place really stinks. In their minds, they would not pay more than $100,000 for a house in my area. Others may subjectively think $150,000 or $200,000 or $250,000. Thus, transactions will only take place within that area where the subjective value of some sellers overlaps with the subjective value of some buyers. In other words, transactions take place within a range where sellers believe that they are receiving more money than their subjective valuation of the house and buyers believe there are paying less than their subjective value of the house. This is the Win-Win zone.

Values at Which Transactions Take Place

As the price moves up or down, the number of buyers and sellers moving into the Win-Win zone will change, based on their own subject values of the homes in my area. If a 10% increase in price increases the number of sellers by 20%, then the price elasticity of supply is elastic. If the number of new sellers is 5%, then it is inelastic. We have unitary elasticity, only if the number of new sellers is the same as the increase in price, which in this case would be 10%. This same analysis can be done on the buyers’ side. If a 10% drop in price brings in more than a 10% increase in the number of buyers, then the price elasticity of demand is elastic. If the price drop brings in fewer buyers, then it is inelastic.

For simplification purposes, this example assumes one buyer per transaction and that all transactions are for the same amount of money. However, elasticity is measured by revenues. Thus, this is more complicated if participants in the market change the frequency of their transactions or the amount that they spend per transaction.

		January 1, 2006 *Elasticity - What is Happening at the Margin?*
	In response to an assignment dealing with the concept of elasticity. Elasticity is always a tricky concept. The definitions provided in textbooks are technical and difficult to grasp, so I would like to think about what is really happening when we talk about elasticity. In the 1870s, economist finally figured out value through the use of marginal analysis. Before that time, many great economists had advanced mistaken concepts about value. Adam Smith and David Ricardo advocated the labor theory of value, arguing that the value of something was determined by the amount of labor needed to create the item. Karl Marx ran with this theory and logically concluded that profits and rents must simply be the theft of value created by workers. His analysis later plunged one third of the world's population into 70 plus years of communist hell. Other economists argued that value must be related to utility (usefulness), but these economists had no way to measure that utility. We now understand that utility is a subjective concept and is measured independently in the mind of each individual. So, let’s think about the value of houses in the housing market. There is no "objective" value for any given house. I may really like my house. I like my neighbors. I like my kids’ friends. I like their school. I like the location. Subjectively, I might decide that I would not sell my house for less than $300,000. However, there are sales taking place for similar houses in my neighborhood at $200,000. Why? Well, I may subjectively value my house at $300,000. The guy across the street may subjectively value his similar house at $500,000. But, a couple of people in the neighborhood subjectively value their similar houses at $200,000 or less. Likewise, there are buyers looking at the houses in our neighborhood. Some may say that the place really stinks. In their minds, they would not pay more than $100,000 for a house in my area. Others may subjectively think $150,000 or $200,000 or $250,000. Thus, transactions will only take place within that area where the subjective value of some sellers overlaps with the subjective value of some buyers. In other words, transactions take place within a range where sellers believe that they are receiving more money than their subjective valuation of the house and buyers believe there are paying less than their subjective value of the house. This is the Win-Win zone. Values at Which Transactions Take Place As the price moves up or down, the number of buyers and sellers moving into the Win-Win zone will change, based on their own subject values of the homes in my area. If a 10% increase in price increases the number of sellers by 20%, then the price elasticity of supply is elastic. If the number of new sellers is 5%, then it is inelastic. We have unitary elasticity, only if the number of new sellers is the same as the increase in price, which in this case would be 10%. This same analysis can be done on the buyers’ side. If a 10% drop in price brings in more than a 10% increase in the number of buyers, then the price elasticity of demand is elastic. If the price drop brings in fewer buyers, then it is inelastic. For simplification purposes, this example assumes one buyer per transaction and that all transactions are for the same amount of money. However, elasticity is measured by revenues. Thus, this is more complicated if participants in the market change the frequency of their transactions or the amount that they spend per transaction.