Chapter 5: Elasticity: A Measure of Response

Start Up: Raise Fares? Lower Fares? What’s a Public Transit Manager To Do?

Imagine that you are the manager of the public transportation system for a large metropolitan area. Operating costs for the system have soared in the last few years, and you are under pressure to boost revenues. What do you do?

An obvious choice would be to raise fares. That will make your customers angry, but at least it will generate the extra revenue you need—or will it? The law of demand says that raising fares will reduce the number of passengers riding on your system. If the number of passengers falls only a little, then the higher fares that your remaining passengers are paying might produce the higher revenues you need. But what if the number of passengers falls by so much that your higher fares actually reduce your revenues? If that happens, you will have made your customers mad and your financial problem worse!

Maybe you should recommend lower fares. After all, the law of demand also says that lower fares will increase the number of passengers. Having more people use the public transportation system could more than offset a lower fare you collect from each person. But it might not. What will you do?

Your job and the fiscal health of the public transit system are riding on your making the correct decision. To do so, you need to know just how responsive the quantity demanded is to a price change. You need a measure of responsiveness.

Economists use a measure of responsiveness called elasticity. Elasticity is the ratio of the percentage change in a dependent variable to a percentage change in an independent variable. If the dependent variable is y, and the independent variable is x, then the elasticity of y with respect to a change in x is given by:

Equation 5.1

 \displaystyle  e_{y,x} = \frac{\% \: change \: in \: y}{\% \: change \: in \: x}

A variable such as y is said to be more elastic (responsive) if the percentage change in y is large relative to the percentage change in x. It is less elastic if the reverse is true.

As manager of the public transit system, for example, you will want to know how responsive the number of passengers on your system (the dependent variable) will be to a change in fares (the independent variable). The concept of elasticity will help you solve your public transit pricing problem and a great many other issues in economics. We will examine several elasticities in this chapter—all will tell us how responsive one variable is to a change in another.

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