4.3: Rubber Band Theory

Elasticity is a general term in microeconomics. It relates to how suppliers and demanders react to a change in a determinant (e.g., price, income, labor costs, expectations, etc.).

We will focus on demand elasticities. And of all the demand elasticities, we will examine, in detail, price elasticity (sometimes referred to as price elasticity of demand).

Based on the law of demand, we know what direction quantity demanded will take when the price of the good is changed.

Figure 1

But what we do not know is the magnitude of the change in price or demand.

Figure 2

From a business perspective, this is critical information if one is to determine how a price change will impact revenues.

Why is Price Elasticity an Important Concept?

Prices represent revenue to a business. And since total revenue represents half of the profit equation (total revenue – total cost = profit) it is clear that a business owner must carefully analyze how the customer will respond to a change in price.

Price elasticity helps a business owner calculate the impact a price change will have on revenues.

How to Set Up the Rubber Band Theory

The Rubber Band Theory determines if consumers are sensitive (price elastic) or insensitive (price inelastic) to a change in price. We determine price sensitivity by observing how price change impacts total revenue.

Step 1: At the top of a blank piece of paper, write the total revenue equation with some space between the variables.

TR = P x Q

Step 2: Under the total revenue equation, write a giant “P” and “TR”

TR = P x Q

P

TR

Step 3: Choose a direction for a price change (up or down) and draw the appropriate arrow next to each letter “P” signifying the direction of the price change.

TR = ↑ P x Q

↑ P

TR

Step 4: Based on the law of demand, we know that quantity demanded will fall (↓Q) but the questions is: How much will quantity demanded fall? A little or a lot? Let’s just say, for this example, that quantity demanded fell by a larger magnitude than the increase in price. Draw a down arrow next to “Q” reflecting this situation.

Step 5: Based on the magnitude of the price and quantity changes, what do you think will happen to total revenue (TR)? If a store increases the price of a good, let’s say only 1%, and the demand for that good falls, let’s say 20%, then any gain in revenue by raising price (P) will be wiped out by the huge fall in demand (Q). Therefore, we have established that total revenue (TR) will fall. Draw a down arrow next to both representations of total revenue (TR).

Step 6: This is where the concept of the rubber band comes into play. Draw an ellipse around the arrows next to the giant “P” and “TR”.

Now, picture those arrows moving in the direction in which they are pointing. Imagine the arrows pushing against the rubber band and causing it to stretch. If the rubber band stretches, then this good is price elastic (elastic = stretch).

What if we raised the price (P) and there was only a small fall in demand (Q)? Even if the fall in demand is small, it is still obeying the law of demand (↑ P → ↓Q). But what impact will this have on total revenue (TR)?

Since the price increase did not chase away too many customers, demand did not fall very far (at least in relation to the percent increase in price). This would cause total revenue to increase.

Since the arrows in the rubber band and pointing in the same direction, they will not cause the rubber band to stretch. If the rubber band does not stretch, then this good is price inelastic (inelastic = no stretch).

Knowing price elasticity of demand is like knowing how your customer will react to a change in price. From a business point of view, anything that will tell you how an action will affect your revenue is a very important tool.