Can Costs Be Passed on to Consumers?
Most businesses face a day-to-day struggle to figure out ways to produce at a lower cost, as one pathway to their goal of earning higher profits. However, in some cases, the price of a key input over which the firm has no control may rise. For example, many chemical companies use petroleum as a key input, but they have no control over the world market price for crude oil. Coffee shops use coffee as a key input, but they have no control over the world market price of coffee. If the cost of a key input rises, can the firm pass those higher costs along to consumers in the form of higher prices? Conversely, if new and less expensive ways of producing are invented, can the firm keep the benefits in the form of higher profits, or will the market pressure them to pass the gains along to consumers in the form of lower prices? The price elasticity of demand plays a key role in answering these questions.
Imagine that as a consumer of legal pharmaceutical products, you read a newspaper story that a technological breakthrough in the production of aspirin has occurred, so that every aspirin factory can now make aspirin more cheaply than it did before. What does this discovery mean to you? This figure illustrates two possibilities. In figure (a), the demand curve is drawn as highly inelastic. In this case, a technological breakthrough that shifts supply to the right, from S0 to S1, so that the equilibrium shifts from E0 to E1, creates a substantially lower price for the product with relatively little impact on the quantity sold. In figure (b), the demand curve is drawn as highly elastic. In this case, the technological breakthrough leads to a much greater quantity being sold in the market at very close to the original price. Consumers benefit more, in general, when the demand curve is more inelastic because the shift in the supply results in a much lower price for consumers.
Passing along Cost Savings to Consumers
Producers of aspirin may find themselves in a nasty bind here. The situation shown in this figure, with extremely inelastic demand, means that a new invention may cause the price to drop dramatically while quantity changes little. As a result, the new production technology can lead to a drop in the revenue that firms earn from sales of aspirin. However, if strong competition exists between producers of aspirin, each producer may have little choice but to search for and implement any breakthrough that allows it to reduce production costs. After all, if one firm decides not to implement such a cost-saving technology, it can be driven out of business by other firms that do.
Since demand for food is generally inelastic, farmers may often face the situation in figure (a). That is, a surge in production leads to a severe drop in price that can actually decrease the total revenue received by farmers. Conversely, poor weather or other conditions that cause a terrible year for farm production can sharply raise prices so that the total revenue received increases. The Clear It Up box discusses how these issues relate to coffee.
Coffee is an international crop. The top five coffee-exporting nations are Brazil, Vietnam, Colombia, Indonesia, and Ethiopia. In these nations and others, 20 million families depend on selling coffee beans as their main source of income. These families are exposed to enormous risk, because the world price of coffee bounces up and down. For example, in 1993, the world price of coffee was about 50 cents per pound; in 1995 it was four times as high, at $2 per pound. By 1997 it had fallen by half to $1.00 per pound. In 1998 it leaped back up to $2 per pound. By 2001 it had fallen back to 46 cents a pound; by early 2011 it went back up to about $2.31 per pound. By the end of 2012, the price had fallen back to about $1.31 per pound.
The reason for these price bounces lies in a combination of inelastic demand and shifts in supply. The elasticity of coffee demand is only about 0.3; that is, a 10% rise in the price of coffee leads to a decline of about 3% in the quantity of coffee consumed. When a major frost hit the Brazilian coffee crop in 1994, coffee supply shifted to the left with an inelastic demand curve, leading to much higher prices. Conversely, when Vietnam entered the world coffee market as a major producer in the late 1990s, the supply curve shifted out to the right. With a highly inelastic demand curve, coffee prices fell dramatically. This situation is shown in figure (a).
Elasticity also reveals whether firms can pass higher costs that they incur on to consumers. Addictive substances tend to fall into this category. For example, the demand for cigarettes is relatively inelastic among regular smokers who are somewhat addicted; economic research suggests that increasing the price of cigarettes by 10% leads to about a 3% reduction in the quantity of cigarettes smoked by adults, so the elasticity of demand for cigarettes is 0.3. If society increases taxes on companies that make cigarettes, the result will be, as in figure (a), that the supply curve shifts from S0 to S1. However, as the equilibrium moves from E0 to E1, these taxes are mainly passed along to consumers in the form of higher prices. These higher taxes on cigarettes will raise tax revenue for the government, but they will not much affect the quantity of smoking.
If the goal is to reduce the quantity of cigarettes demanded, it must be achieved by shifting this inelastic demand back to the left, perhaps with public programs to discourage the use of cigarettes or to help people to quit. For example, anti-smoking advertising campaigns have shown some ability to reduce smoking. However, if demand for cigarettes was more elastic, as in figure (b), then an increase in taxes that shifts supply from S0 to S1 and equilibrium from E0 to E1 would reduce the quantity of cigarettes smoked substantially. Youth smoking seems to be more elastic than adult smoking—that is, the quantity of youth smoking will fall by a greater percentage than the quantity of adult smoking in response to a given percentage increase in price.
Passing along Higher Costs to Consumers