Question:
In his book, Basic EconomicsThomas Sowell (2015) writes, “the price one producer is willing to pay for any given ingredient becomes the price other producers are forced to pay for that same ingredient” (p. 20). With that quote in mind, consider the following scenario:
The demand for drinking milk is increasing while the demand for milk in the form of cheese, ice cream, and yogurt remains the same. Assume that the supply of milk is perfectly inelastic. Explain why the elasticity of demand for milk in this alternative use determines how much milk will be diverted from this use for direct consumption.
Answer:
One of the reasons I like this quote from Sowell’s book is that it makes us consider the role that market prices play in allocating a resource to all its various uses. In this case, the price of milk provides a fixed price between those who want to drink it and those who want milk to produce cheese, ice cream, and yogurt.
Figure 1 illustrates this idea. The market demand for milk consists of different needs for milk. The interaction of the market demand for milk and the fixed supply determines the market price, which, in turn, determines how much milk consumers will buy for each consumption. Thus, the buyer who is most willing to pay for milk determines the price that all buyers must pay.
As the question indicates, the demand for drinking milk is increasing. Figure 1 shows the increase in demand as the corresponding change in the demand for drinking milk. Since market demand includes, in part, the demand for drinking milk, it also shifts to the right, so the price of milk rises to clear the market.
Figure 1: Individual and Market Demand for Milk
The question assumes that the milk supply in the market is perfectly inelastic (the vertical milk supply of the market is shown in Figure 1). Therefore, suppliers do not produce more milk despite the high price. Therefore, the amount of milk allocated to the production of cheese, ice cream, and yogurt must decrease to meet the increased demand for drinking milk.
What role does the price elasticity of demand for milk play in this alternative use in determining the amount of milk diverted from this use for drinking?
The price elasticity of demand tells us how the quantity demanded responds to changes in price. It is a measure of the percentage change in price brought about by a percentage change in price. The higher the absolute value of this ratio, the more responsive the quantity demanded is to changes in price.
Suppose that at the initial market price of milk, the price elasticity of demand for cheese is less than that for ice cream, which is less than that for yogurt. The slopes of the demand curves for milk for these different uses in Figure 1 show these different elasticities.
Note that with the high price of milk in the market, the change in the quantity demanded of milk differs for different uses of milk. For example, the quantity of milk demanded for yogurt decreases sharply while the quantity of milk demanded for cheese decreases slightly. This result is not surprising considering our assumption that the price elasticity of demand for yogurt was higher than that for cheese or ice cream.
Another reason why this result is not surprising is that, precisely, those who want to be more sensitive to price changes will have a greater response to price changes. For example, suppose there were many substitutes for milk in the production of yogurt but few substitutes for milk in the production of cheese. In this case, the percentage change in milk demand for yogurt may be greater than that for cheese since yogurt producers have more options than cheese producers.
We can extend this analysis to reveal the effects on cheese, ice cream, and yogurt prices. We can also trace how the increase in demand for drinking milk affects the prices of milk substitutes. Our answers to these questions will also depend on this price elasticity.
This question highlights the interconnected nature of markets. Incorporating the concept of elasticity allows us to deepen our understanding of the nature of this connection.
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For those interested in a formal discussion of the relationship between changes in supply, demand, prices, prices, and elasticity, see this course on the theory of supply and demand by Kevin Murphy.
Bryan Cutsinger is an assistant professor of economics in the College of Business at Florida Atlantic University and a Phil Smith Fellow at the Phil Smith Center for Free Enterprise. He is also a fellow of the Sound Money Project at the American Institute for Economic Research, and a member of the editorial board of Public Choice magazine.
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