Tuesday, February 15, 2011

The illogicality of plastic ear-swabs (or why some savings decisions make more sense than others)

While perusing the aisles of Safeway the other day, I pondered the rationality of my grocery selections. I bought the Q-tips brand ear swabs instead of kind with plastic stems which would have saved me about $0.70, but reluctantly opted not to buy my favorite kind of chocolate because it was selling for $3.99 rather than the frequent sale price of $2.99 a bar. I selected the grape tomatoes at $1.99 a carton instead of my preferred cherry tomatoes at $3.99 a carton, but bought a fancy bottle of salad dressing for $4.59 in spite of a myriad of cheaper alternatives.

Why did I spend the extra money on Q-tips when I could have used it to buy chocolate instead? Why forgo the expensive tomatoes but not the pricier salad dressing? The answers lie largely in the economic concept of elasticity. Price elasticity of demand describes how much a change in the price of a good affects the quantity demanded for that good. If a good has very elastic demand, then a small change in the price will have a large effect on how much of that good is demanded. Conversely, the price of a good with inelastic demand can rise substantially without having much effect on the quantity demanded. For example, my choice to stop buying chocolate bars in response to an increase in price suggests my demand for them is relatively elastic.

Cross-price elasticity of demand refers to how much a change in the price of one good affects the demand for another good. The switch from cherry to grape reflects a positive cross-price elasticity of demand, because my demand for grape tomatoes increased when the price of cherry tomatoes rose. This illustrates one determinant of elasticity: the availability of viable alternatives or substitutability. Although I do prefer cherry tomatoes to grape, it is a slight preference, so when cherry tomatoes are not on sale, I substitute grape tomatoes for cherry and save $2.

Another determinant of a good’s price elasticity is the percentage of one’s overall budget that a good requires. I eat a lot of chocolate; therefore, only buying it when it goes on sale adds up to far more savings over time than choosing to buy the generic Q-tips, which I only buy every six months or so. Because I find off-brand Q-tips mildly frustrating (the cotton doesn’t seem to stay properly attached), choosing the off-brand to save $1.40 a year would probably be one of the least worthwhile money-saving sacrifices I could make.

A third determinant of price elasticity is necessity. While food in general is perhaps the most necessary good I buy, my actual need for chocolate is (somewhat) less pressing. Reluctantly, I postponed my chocolate purchase in hopes that next time it would be on sale.

While normal people do not consider the elasticity of their demand for various grocery items, their actions are inevitably guided to some degree by the prices of alternatives, the weight of the expenditure in their overall budget, and the necessity of the good. But why stop at the checkout line? While it might be most natural to illustrate the elements of elasticity with groceries, economists believe the same decision-making behaviors apply when people buy any good or service. So, next time you’re considering whether to sacrifice or splurge on anything from cupcakes to cell phone plans, remember that some savings make more of an impact on your budget than others.

Discussion Questions:

1. Instead of talking about one type of tomatoes versus another, how does my demand for Roma tomatoes compare to my demand for tomatoes in general? How does a narrow or broad definition of a good relate to its elasticity?

2. The income elasticity of demand refers to the change in the quantity demanded that results from a change in the buyer’s income, rather than the price of the good. Suppose I got a raise. How would a dramatic increase in my income affect my demand elasticity for an expensive treat, like steak? Would the effect be the same on all goods? What about my demand for ramen noodles?

3. If the producers of a good have conducted research that suggests demand for their good is highly elastic, how might this affect their pricing decisions?

4. Recently, there have been “sin taxes” proposed in some states on a number of goods, including artificial tanning, tattoos, and sugary sodas. Economists call these Pigouvian taxes. They are taxes placed on goods that the government believes are socially unappealing. Suppose the demand for artificial tanning is very elastic, while the demand for sugary soda is not. Compare the effects of two equal sized taxes on the equilibrium market price, the equilibrium quantity consumed, and the tax revenue raised.

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