Elasticities Quantitative Measurement
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Elasticities
Quantitative Measurement
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Measuring the Impact of Price on
Quantity Demanded
• A natural way of measuring impact of a pricechange is to measure the change in quantity
demanded relative in size to the change in prices.
• 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)
1 0
1 0
1Q Q Run
P P Rise SLOPE
!
= "
!
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Elasticity: The % impact on quantity
demanded of a 1% change in price
• Economists prefer to measure price impacts interms of elasticity since it is unit free(everything is measured in percentages) and a better match for empirical demand schedules.
% %
%
%
Change in Q Change n P
e
i
Q P
= ÷
=
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Midpoint Method
• If you want to
calculate a %
difference between
two points which is
the same regardless ofwhich you designate
as the reference point
(denominator), youcan use the average of
the two points as the
reference point.
[ ]1 0
1 0
%
2
X X X
X X
!"
+# $
% &' (
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Slope and Elasticity of Oil DemandUS$/BBL BBL (Mil) 1/Slope Elasticity
P Q %P %Q !
Q÷ !P %
!Q÷%
!P40 31,312.8
0.118 -0.007 -259.273 -0.061
45 31088.6
0.105 -0.006 -6217.720 -0.061
50 30889.43
0.095 -0.006 -6177.887 -0.061
55 30710.37
0.087 -0.005 -6142.073 -0.061
60 30,547.8
0.080 -0.005 -6109.559 -0.061
65 30399.01
0.074 -0.005 -6079.801 -0.061
70 30261.9
0.069 -0.004 -6052.379 -0.061
75 30134.8
0.065 -0.004 -6026.961 -0.061
80 30,016.4
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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.
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Elasticities Extreme
Perfectly Inelastic
Demand (Insulin)
Perfectly Elastic
Demand (Clear Pepsi)
P
Q
D
D
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Comparisons of Demand Price
Elasticities
• Oil has very
inelastic demand.
– Estimate of
elasticity of demand
for oil in the US is
-.061J.C.B. Cooper, OPEC Review, 2003)
Salt -.1Coffee -.25
Tobacco -.45
Movies -.9
Housing -1.2
Restaurant Meals -2.3
Price Elasticities of Other Goods
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A demand curve is classified as INELASTIC
if the elasticity is between 0 and -1
A demand curve is classified as
ELASTIC if the elasticity is less than -1
Unit elasticity (elasticity equal to -1) isthe cutoff point
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•
The revenues generated by a firm along any pointof the demand schedule are equal to the productof quantity demanded and price
R = P·Q D
• Raising prices has two counter-veiling effects:
1. a direct positive impact on revenues because each
good sold generates more revenue.2. a negative indirect impact because fewer goods will
be sold.
• Which is stronger?
Elasticity and Revenues
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Effect of price change on revenues
• Changes in revenues are approximately
%R ! %P+%Q
• Divide through by %P to get the total impact
% 1%
Demand R e P
= +
% % % %1
% % % %
R P Q Q
P P P P = + = +
0 Demand e <
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• 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.
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Demand Curves
Elastic Unit Inelastic
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Elasticity of Demand
Short-term vs. Long-term
• It takes time to find substitutes for goods orto adjust consumption behavior in responseto a change in prices.
• The long-run response to a price rise islarger than the short-run. Price elasticity ofdemand is more negative in the long runthan in the short run.
.
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Oil Demand much more elastic in
long run than short-runPrice Elasticity of Demand
Short-term Long-term
Germany -0.024 -0.274Japan -0.071 -0.357
Korea -0.094 -0.178
USA -0.061 -0.453
– (J.C.B. Cooper, OPEC Review, 2003)
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Oil Demand Curves
0
10
20
30
40
50
60
70
80
20000 25000 30000 35000 40000 45000 50000
Q
P
Short-term Long-term
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Supply Curves
Price Elasticity
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Upward Sloping Supply Curves
• The supply curve slopes up because somefactors 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.
1 0
1 0
1 0
2
1 0
2
%
% 0
S S
S S
S Q Q
P P
Q Q
Q P P P
+
+
!
=!
>PriceElasticity of
Supply = eS
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Elasticities: Supply
Perfectly Inelastic Supply
(Van Gogh Paintings)
Perfectly Elastic
Supply (Foot
Massage)
P
Q
S
S
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Elasticity of Supply
• Elasticity of supply curve depends on the
ability of production sector to ramp up
supply without increasing the marginal costof production.
• A good that is produced with readily
available factors w/o a need for timeconsuming investment will have an elastic
supply curve.
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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.
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Oil Supply Curves
0
10
20
30
40
50
60
70
80
18000 23000 28000 33000 38000
Q
P
Short-term Long-term
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Elasticity and Equilibrium PriceChanges
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Changes in Equilibrium
• When events cause a supply or demand
curve to shift, the equilibrium price will
shift. But how much?• Knowledge of elasticities can provide the
answer to this question.
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Equilibrium Change in Price
• A 1% shift out in the demand curve leads to a
change in equilibrium price.
• A 1% shift out in the supply curve leads to a
change in equilibrium price.
1%
S De e!
1%
S De e
!
!
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Examples
• Elasticity of demand for oil is eD = -.061
and elasticity of supply is eS = .04. World
oil demand goes up by 1%. How much doesthe price change?
• Answer:
1 1 11 % % % 9.90%.04 .061 .101
S De e
! = = =
" "
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Example 2
• What would happen to oil prices for Geo-
Political reasons there were a shut-down of
Iranian oil production and there was aninward shift in the oil supply curve of
4.9%?
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A shift in the supply schedule
(Spreadsheet )
Supply Supply' Demand
30 29893.38 28428.61 31867.11
35 30078.28 28604.44 31568.86
40 30239.36 28757.63 31312.77
45 30382.16 28893.44 31088.6
50 30510.48 29015.46 30889.43
55 30627.02 29126.29 30710.37
60 30733.8 29227.84 30547.8
65 30832.36 29321.57 30399.01
70 30923.89 29408.62 30261.9
75 31009.35 29489.89 30134.8
80 31089.51 29566.12 30016.4
85 31164.99 29637.9 29905.6
90 31236.32 29705.74 29801.51
95 31303.95 29770.06 29703.39
100 31368.24 29831.2 29610.59
105 31429.56 29889.51 29522.57
A 4.9% shift in the supply schedule
At the new supply curve
there is excess demand for
oil.
• Excess demand will
induce additional supply
and cut back in demand.
What is the new
equilibrium?
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Income Elasticity
• We measure the effect of income ondemand 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 isnegative.
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Range of Income
Elasticities
0 1
Inferior Goods
Normal Goods
Income Elastic
(Luxury Goods)
Income Inelastic
(Necessities)
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Example
• What would the oil price change be in the
long run, if world income went up
permanently by 10% and no shift in supplycurve?
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Changes in Prices of Other Goods
• For any good there are two types of othergoods which are relevant to its demand
1. Substitutes: Those other goods which cantake the place of the good of interest(bacon vs. ham)
2. Complements: Those other goods whoseuse will enhance the value of the good ofinterest. (bacon and eggs)
What are substitutes and complements for oil
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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
SubstitutesComplements
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Supply and Demand
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Gas prices at record high
West Texas Intermediate (Bbl)
0.000
10.000
20.000
30.000
40.000
50.000
60.000
70.000
80.000
J a n - 0 1
J a n - 0 2
J a n - 0 3
J a n - 0 4
J a n - 0 5
J a n - 0 6
U S $
Prices of Oil
and Gasoline
continue to
climb!
What
happens ifIranian oil is
taken
offline?
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August 25, 2005
Rising Price of Oil Pushes S.&P. to Negative
Territory
By ERIC DASH Oil prices climbed to another record yesterday,
driving stocks lower and leaving the Standard &
Poor's 500-stock index down for the year.
All three major market gauges closed lower
yesterday; the S.&. P.'s loss meant that for the first
time since July 7, all three were in negative territory
for the year. "Once oil decided that it was going to
move higher and stay higher, that just took the
starch out of any buyers in the stock market," saidJoseph Liro, the chief equity strategist at Stone &
McCarthy, an economic research firm in Princeton.
"Oil is just the biggest single depressant on the
market except for the oil stocks."
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To think about commodity prices,
economists first think about the theory of
competitive markets
• Competitive Markets have many buyers and
many sellers who compete without barriers
preventing rivals from entering or leaving
the market.
• Participants in competitive markets are
price takers, agents who behave as if their
own behavior has no effect on market
prices.
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Law of Demand: There is always an inverserelationship between the price of a good and thequantity that consumers would like to purchase. Reason:
• Consumers have limited income.
• The price that consumers will pay for an extragood will be no greater than the extra benefit
that they receive from it.• People face diminishing returns from consuming
any given good.
• Each extra good consumed generates less
marginal benefit than the good before• Consumers will be willing to pay less for each
extra good than they were willing to pay for thegood before.
R t ti f H th ti l Oil
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Representation of a Hypothetical Oil
Demand Schedule
0
20
40
60
80
100
120
29000 29500 30000 30500 31000 31500 32000
Q
PUS$/bbl Mil. BblP Q
30 31867.11
35 31568.86
40 31312.77
45 31088.6
50 30889.43
55 30710.37
60 30547.8
65 30399.01
70 30261.9
75 30134.880 30016.4
85 29905.6
90 29801.51
95 29703.39
100 29610.59
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Law of Supply: There is a positive relationship
between the price of a good and the quantity
producers bring to the market.• In a competitive market place, producers are
willing to sell an extra good as long as the priceis at least as large of the extra cost of producingit (marginal cost).
• Producers have decreasing returns to productionand therefore increasing costs. To induce them to
produce greater amounts, they must becompensated for these increasing costs withhigher prices.
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Why do supply curves slope up?
• Firms will only increase supply when pricesrise because their costs as production increases.
• Producing extra goods generates increasing
costs because some inputs are fixed and theflexible factors of production will have
diminishing returns.
– Example: A busy McDonalds can sell more burgers by adding more McWorkers, but effectiveness of
workers is limited by amount of Cash registers,
Ovens, and ultimately Space.
i f h i l il l
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Representation of a Hypothetical Oil Supply
Schedule
US$/bbl Mil. BblP Q
30 29893.38
35 30078.28
40 30239.36
45 30382.16
50 30510.48
55 30627.02
60 30733.8
65 30832.36
70 30923.89
75 31009.35
80 31089.51
85 31164.99
90 31236.32
95 31303.95
100 31368.24
0
20
40
60
80
100
120
2 9 8 9
3
3 0 1 4 3
3 0 3 9
3
3 0 6 4
3
3 0 8 9
3
3 1 1 4 3
3 1 3 9
3
Q
P
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Equilibrium
• Equilibrium in the competitive market occurs
when the price is set at a level (P*) such that theamount that consumers want to buy is equal tothe amount that sellers want to sell (Q*).
Excess Supply If P were above equilibrium, sellerswould want to sell more goods than buyers wouldwant to buy. Competition between sellers wouldforce prices down.
Excess Demand If P were below equilibrium,customers would want to buy more goods than
people would want to sell. Competition between buyers would force prices up.
C i i M k E ilib i
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Competitive Market Equilibrium(Geometry)
SDP
Q
P*
Q*
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Excess Supply
SDP
Q
P*
Q*
P
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Excess Demand
SDP
Q
P*
Q*
P
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Market Equilibrium
(Spreadsheet Problem)
Supply Demand
30 29893.38 31867.11
35 30078.28 31568.86
40 30239.36 31312.77
45 30382.16 31088.6
50 30510.48 30889.43
55 30627.02 30710.37
60 30733.8 30547.8
65 30832.36 30399.01
70 30923.89 30261.9
75 31009.35 30134.8
80 31089.51 30016.485 31164.99 29905.6
90 31236.32 29801.51
95 31303.95 29703.39
100 31368.24 29610.59
At what price and quantity (to
closest $5) will the oil market
clear?
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Elasticity: The Concept
• How strong is the effect of a change in priceon the change in quantity supplied or
quantity demand.• If the price effect is strong, we say the
supply/demand schedule is elastic.
• If the price effect is weak, we say it isinelastic.
STRICT DEFINITION TO COME
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Shifting Curves/Changing Equilibrium
• Changes in equilibrium result from shifts in
either the demand or supply schedule. Wethink of shifts in the curves as changes insupply or demand that are caused by factors
other than changes in the price of the good. – Shifts in the demand curve lead to movementsalong the supply curve resulting in changes in
prices and quantities that move in the same
direction. – Shifts in the supply curve lead to movementsalong the demand curve resulting in changes in
prices and quantities that move in different
directions.
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What shifts a demand curve?
1. Changes in consumer preferences
2. Changes in consumer income
3. Changes in the prices of other goods.
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Hypothetical Demand Shift
• Consider that there is an increase in consumer income
sufficiently large that oil demand would increase by 5% if
the price level stayed the same. This event will increase
the demand for oil at any given price level. Demand
schedule shifts out/up.• Equilibrium price and quantity rise.
• At the old price level, there is a situation of excess
demand. As consumers, scramble to get more oil,
producers are able to raise prices.
• Higher prices induce i) some cutbacks in oil use; and ii)
some additional production until supply is equal to
demand.
A Shift in the Demand Curve: A parallel increase in
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A Shift in the Demand Curve: A parallel increase in
the demand schedule at every price point.
Equilibrium Effect: Movement along the supply curve
S
D
P
Q
P*
Q*
P**
Q**
D!
Shift in the
demand curve
A hift i th d d h d l
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A shift in the demand schedule
(Spreadsheet )
Supply Demand Demand'
30 29893.38 31867.11 33460.47
35 30078.28 31568.86 33147.31
40 30239.36 31312.77 32878.41
45 30382.16 31088.6 32643.03
50 30510.48 30889.43 32433.9
55 30627.02 30710.37 32245.88
60 30733.8 30547.8 32075.19
65 30832.36 30399.01 31918.96
70 30923.89 30261.9 31774.99
75 31009.35 30134.8 31641.54
80 31089.51 30016.4 31517.2285 31164.99 29905.6 31400.88
90 31236.32 29801.51 31291.59
95 31303.95 29703.39 31188.56
100 31368.24 29610.59 31091.12
A 5% shift in the demandschedule
If price stayed constant,
demand for oil would
increase 5%.
But to get producers to
produce more, price must
go up which will have a
counter-veiling effect ondemand. .
What is the new equilibrium
price?
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Shifts in Supply Curves• Supply curves represent the extra cost of
producing a good which increases in the
number of goods produced. But other factors
may affect cost besides scale.
• Cost Shifters
1. Changes in resource prices
2. Changes in Technology
3. Nature and Political Disruptions
4. Changes in Taxes on Producers
A Shift in the Supply Curve is a Movement
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A Shift in the Supply Curve is a Movement
along the Demand curve- Price and Quantity Move in opposite Directions
SDP
Q
P*
Q*
P**
Q**
S!
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Equilibrium Effects of an Decrease in
Supply
• When there is some disruption, oil companies produce less at any given price. Supply scheduleshifts in/up.
• Equilibrium price rises/Equilibrium quantity falls.• At the current price level, there is a situation of
excess demand. As consumers, scramble to getmore oil, producers are able to raise prices.
• Higher prices induce i) some cutbacks in oil use;and ii) some additional production from othersources; until supply is equal to demand.