Question

Many industry-wide studies of the elasticity of demand for cigarettes (an industry dominated by a few firms with tremendous market power) indicate a price elasticity near – 0.5. Yet, our study of market power tells us that a firm with any market power at all should never operate at a point on its demand curve where demand is inelastic. How can you reconcile these apparently contradictory statements?

Answer 1

The elasticity of demand measures the percentage change in quantity demanded due to the percentage change in price. The elasticity of demand depends on several factors such as the time frame of measuring the price change, the availability of substitutes, the type of good, the percentage of income spent on the good, etc.

The price elasticity of demand is likely to be more elastic for a good which has several substitutes and lower for a good with fewer substitutes. The cigarette as good without a brand name does not have many substitutes, this means, at the industry level, there is a fewer substitute available for the generic good "cigarettes". Therefore, industry-wide elasticity for cigarettes can be inelastic (-0.5).

However, for each firm within the industry producing the good has many substitutes available. Each firm producing cigarettes compete with each other within an industry. Thus, each firm faces relatively elastic demand curves and they as profit-maximizing firms produce at the elastic part of the demand curve.