# Elasticities

Quantitative Measurement Chap. 4

Measuring the Impact of Price on Quantity Demanded
• A natural way of measuring impact of a price change is to measure the change in quantity demanded relative in size to the change in prices.

Q Q P  P0 1
D 1

D 0

Run   d Rise
S 1 S 0

Q Q Run  s P  P0 Rise 1

Economists often prefer elasticity to slope in real world
• This measure is the inverse of the SLOPE of the demand curve which is constant when the demand curve is linear (as often depicted in textbooks) Economists typically do not measure the price impact using slope for 2 reasons.
1. Slope as a measure is not unit free, so price impacts are not comparable across types of goods or currency. 2. Empirical demand curves tend not to have constant slope or constant elasticity, but constant elasticity functions are a better approximation.

Elasticity: The % impact on quantity
demanded of a 1% change in price
%Change in Q %Change in P

%Q e  0 %P
D D

%Q e  0 %P
S S

Midpoint Method
• If you want to calculate a % difference between two points which is the same regardless of which you designate as the reference point (denominator), you can use the average of the two points as the reference point.

 X1  X 0  %X 

 X1  X 0   2 

Slope and Elasticity of Oil Demand
P 60 70 80 90 100 110 120 130 140 150 Q %P %Q e 83,033.06 15.38% -1.54% 81,762.92 13.33% -1.34% 80,678.38 11.76% -1.18% 79,733.70 10.53% -1.05% 78,898.04 9.52% -0.95% 78,149.63 8.70% -0.87% 77,472.59 8.00% -0.80% 76,854.95 7.41% -0.74% 76,287.50 6.90% -0.69% 75,762.98 -0.10 -0.10 -0.10 -0.10 -0.10 -0.10 -0.10 -0.10 -0.10

What determines price elasticity? Availability of Substitutes
• A price increase will lead to a shift away from the use of a product and toward other products. • Elasticity will be stronger the more readily available are substitutes for a good.
– Particular brand of goods may have more elastic demand than broader category. Dairy Farm Milk may have better substitutes than Milk. – Some necessity goods like medicines may have no good substitutes and be demand inelastic. Frivolous goods might easily be foregone.

What determines price elasticity? Availability of Substitutes
• A price increase will lead to a shift away from the use of a product and toward other products. • Elasticity will be stronger the more readily available are substitutes for a good.
– Particular brand of goods may have more elastic demand than broader category. Dairy Farm Milk may have better substitutes than Milk. – Some necessity goods like medicines may have no good substitutes and be demand inelastic. Frivolous goods might easily be foregone.

Elasticities Extreme
P
Perfectly Inelastic Demand (Insulin)

D
Perfectly Elastic Demand (Clear Pepsi)

D Q

Comparisons of Demand Price Elasticities
• Oil has very inelastic demand.
– Estimate of elasticity of demand for oil in the US is -.061
J.C.B. Cooper, OPEC Review, 2003)

Price Elasticities of Other Goods Salt Coffee Tobacco Movies Housing Restaurant Meals -.1 -.25 -.45 -.9 -1.2 -2.3

A demand curve is classified as INELASTIC if the elasticity is between 0 and -1
Unit elasticity (elasticity equal to -1) is the cutoff point

A demand curve is classified as ELASTIC if the elasticity is less than -1

Elasticity and Revenues
• The revenues generated by a firm along any point of the demand schedule are equal to the product of quantity demanded and price
R = P∙QD

Raising prices has two counter-veiling effects:
– a direct positive impact on revenues because each good sold generates more revenue. a negative indirect impact because fewer goods will be sold.

Which is stronger?

Effect of price change on revenues
• Changes in revenues are approximately %R ≈ %P+%Q • Divide through by %P to get the total impact

% R % P %Q %Q    1 %P %P %P %P

D

%R
e
Demand

0

%P

 1 e

Demand

Price Elasticity & Revenues
• If the price elasticity of demand is
– exactly UNITY, a price rise has no effect on total revenue – ELASTIC, a price rise will decrease revenues. – INELASTIC elastic, a price rise will increase revenues.

Demand Curves

Elastic

Unit

Inelastic

Supply Curves
Price Elasticity

Upward Sloping Supply Curves
• The supply curve slopes up because some factors are fixed and other factors have decreasing returns. • The greater share of factors of production are flexible, the more elastic the supply curve will be. • Estimates of oil supply elasticity are low.

Elasticity of Supply in Oil Market
P 60 70 80 90 100 110 120 130 140 150 Q %P %Q e 80,059.86 15.38% 1.54% 81,303.55 13.33% 1.34% 82,396.49 11.76% 1.18% 83,372.72 10.53% 1.05% 84,255.78 9.52% 0.95% 85,062.66 8.70% 0.87% 85,806.03 8.00% 0.80% 86,495.60 7.41% 0.74% 87,138.99 6.90% 0.69% 87,742.26 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10

Elasticity of Supply
• Elasticity of supply curve depends on the ability of production sector to ramp up supply without increasing the marginal cost of production. • A good that is produced with readily available factors w/o a need for time consuming investment will have an elastic supply curve.

Elasticities: Supply
P
Perfectly Inelastic Supply (Van Gogh Paintings)

Perfectly Elastic S Supply (Foot Massage)

S Q

Elasticities and Equilibrium Effects
• Strength of impact on demand shifts on quantity vs. price depends on elasticity of both supply curve.
– Imagine elasticity of supply were completely inelastic, then an increase in demand will increase only price and have no effect on quantity. – Imagine elasticity of supply was completely elastic, an increase in demand will increase only quantity and have no effect on price.

Steeper (less elastic) supply curve means that a demand shift will have a smaller impact on quantity and bigger impact on . price.

P
1

S1
2

S2

P1** P2** P*
0

D’ D
Q
*

Q1

**

Q2

**

Q

Steeper (less elastic) demand curve means that a supply shift will have a smaller impact on quantity and bigger impact on . price.

P
1

S’
2

S

P1** P2** P*

0

D2 D1
Q1
**

Q2** Q

*

Q

Excise taxes
• We can think of the supply curve as the price that producers would charge to produce a certain quantity of the product. • We can think of the excise tax as an additional surcharge added on top of that price.

The add on tax is like a shift up in the supply curve

. P
tax

Swith tax S

Q

Tax of course affects quantity demanded can define equilibrium here. Price goes up for consumer but price going to producer . goes down.

P
P*after tax P to producer
*

Swith tax S
tax .

Q

*

Q

• Imagine a market for gasoline. Refinery capacity is limited so supply curve is inelastic. • The government adds a surcharge on to gas, what happens to the market?

Tax of course affects quantity demanded can define equilibrium here.

.

P

S

P*pre tax

.

D
Q
*

Q

With a very inelastic supply curve, the post tax price does not rise by very much but the price that the produer receives drops sharply.

.

S’ P
P*post tax P*pre tax P*to producer

S

.

D
Q
*

Q

Price Elasticity and Time

Elasticity of Demand Short-term vs. Long-term
• It takes time to find substitutes for goods or to adjust consumption behavior in response to a change in prices. • The long-run demand response to a price rise is larger than the short-run. Price elasticity of demand is more negative in the long run than in the short run. .

Oil Demand much more elastic in long run than short-run
Price Elasticity of Demand Short-term Long-term Germany -0.024 -0.274 Japan -0.071 -0.357 Korea -0.094 -0.178 USA -0.061 -0.453
–(J.C.B. Cooper, OPEC Review, 2003)

Price Elasticity of Supply
• Firms also find it easier to adjust production in the long-run than the short run. Long-run price elasticity of supply is typically greater than short-run • OECD study suggests price elasticity of oil supply is .04 in short run and .35 in long run.

Oil Dempand Curves
P

Short-term

Long-term

Q

Oil Suply Curves
P
Short-term Long-term

Q

Demand Shifters
Income Elasticity/ Cross Price Elasticity

Income Elasticity
• We measure the effect of income on demand for a good as % effect on demand of a 1% increase in income. • For normal goods, income elasticity is positive. • For inferior goods income elasticity is negative.

Luxuries vs. Necessities
• There are two types of normal goods. • Luxuries take up an increasing share of income as your income grows.
– Luxuries are income elastic - the income elasticity of luxuries is greater than 1.

• Necessities take up a declining share of income as your income grows.
– Necessities are income inelastic – the income elasticity of luxuries is less than 1.

Inferior Goods

Range of Income Elasticities
Normal Goods

0
Income Inelastic (Necessities)

1
Income Elastic (Luxury Goods)

Income Elasticity of Oil
Region China OECD ROW Income Elasticity 0.7 0.4 0.6

Source: OECD study

• Assume a world income elasticity of .5 and an increase of world income equal to 10%. Demand shifts out by 5%. • Would oil production supplied increase by 5%?

Inferior Goods and Giffen Goods
• Giffen Goods are goods that are so inferior that the Law of Demand does not apply. • Example: Noodles in poorer parts of China. Noodles are a big chunk of the household budget. When prices of noodles go down, that frees up extra money for other spending. With extra money, you might buy more meat. Then, you need fewer noodles. Price of noodles drops and demand for noodles drops!

Changes in Prices of Other Goods
• For any good there are two types of other goods which are relevant to its demand 2. Substitutes: Those other goods which can take the place of the good of interest (bacon vs. ham) 3. Complements: Those other goods whose use will enhance the value of the good of interest. (bacon and eggs)
What are substitutes and complements for oil

Substitutes vs. Complements
• A good is defined as a “Substitute” when a rise in its price leads to a shift out/up in the demand curve for the good of interest. • A good is defined as a “Complement” when a rise in its price leads to a shift in/down in the demand curve for the good of interest.

Cross Price Elasticity
• Cross price elasticity is the % effect on the quantity demanded of a % change in another price.
– Goods with positive cross-price elasticities are called substitutes – Goods with negative cross price elasticities are called complements

0
Complements Substitutes

Learning Outcome
• Students should be able to: • Calculate an elasticity given two points on a supply or demand curve. • Use demand elasticities to calculate price elasticity of revenue. • Use cross-price elasticities or income elasticities to calculate size of shifts in the demand curve caused by external events.

Discussion Question
• As noted in class, recent years have been ones of extremely high oil prices. This has had a number of economic effects outside the petroleum industry. One interesting example has been the price of corn tortillas in Mexico which have risen rapidly.
– – – How would the price of oil affect the price of corn? Why would these two goods be substitutes? What would be the effect of changes in the price of corn on prices of tortillas? Which elasticities would be helpful to us in estimating the quantitative effect of oil price changes on tortilla prices?