Elasticity

Elasticity

Why Economists Use Elasticity An elasticity is a unit-free measure. By comparing markets using

elasticities it does not matter how we measure the price or the quantity in the two markets.

Elasticities allow economists to quantify the differences among markets without standardizing the units of measurement.

What is an Elasticity? Measurement of the percentage

change in one variable that results from a 1% change in another variable.

Can come up with many elasticities. We will introduce four.

three from the demand function one from the supply function

2 VIP Elasticities Price elasticity of demand: how

sensitive is the quantity demanded to a change in the price of the good.

Price elasticity of supply: how sensitive is the quantity supplied to a change in the price of the good.

Often referred to as “own” price elasticities.

Examples of Own Price Demand Elasticities When the price of gasoline rises by 1%

the quantity demanded falls by 0.2%, so gasoline demand is not very price sensitive. Price elasticity of demand is -0.2 .

When the price of gold jewelry rises by 1% the quantity demanded falls by 2.6%, so jewelry demand is very price sensitive. Price elasticity of demand is -2.6 .

Elasticity A measure of the responsiveness

of one variable (usually quantity demanded or supplied) to a change in another variable

Most commonly used elasticity: price elasticity of demand, defined as:

Price elasticity of demand =

Price elasticity of demand Demand is said to be:

elastic when Ed > 1, unit elastic when Ed = 1, and inelastic when Ed < 1.

Perfectly elastic demand

This means that at the same price for the item, the consumer is willing to buy more and more even at that same price.

Perfectly inelastic demand

If quantity demanded is completely unaffected by a price change

Elasticity & slope

a price increase from $1 to $2 represents a 100% increase in price,

a price increase from $2 to $3 represents a 50% increase in price,

a price increase from $3 to $4 represents a 33% increase in price, and

a price increase from $10 to $11 represents a 10% increase in price.

Notice that, even though the price increases by $1 in each case, the percentage change in price becomes smaller when the starting value is larger.

Elasticity along a linear demand curve

Quantity/Time

Demand Curve Showing Different Elasticities

$12

11

10

9

8

7

6

5

4

3

2

1

Pri

ce

Elas

tic

dem

and

0 10 20 30 40 50 60 70 80 90 100 120

Uni

t Ela

stic

Inel

astic

de

man

d

Arc elasticity measure

where:

Example Suppose that quantity demanded falls from 60 to

40 when the price rises from $3 to $5. The arc elasticity measure is given by:

In this interval, demand is inelastic (since elasticity < 1).

Elasticity and total revenue Total revenue = price x quantity What happens to total revenue if

the price rises?


Elasticity and TR (cont.)

A reduction in price will lead to: an increase in TR when demand is elastic. a decrease in TR when demand is inelastic. an unchanged level of total revenue when

demand is unit elastic.



In a similar manner, an increase in price will lead to: a decrease in TR when demand is elastic. an increase in TR when demand is inelastic. an unchanged level of total revenue when

demand is unit elastic.



Price discrimination different customers are charged

different prices for the same product, due to differences in price elasticity of demand

higher prices for those customers who have the most inelastic demand

lower prices for those customers who have a more elastic demand.

Price discrimination (cont.) customers who are willing to pay

the highest prices are charged a high price, and

customers who are more sensitive to price differentials are charged a low price.

Determinants of price elasticity

Price elasticity is relatively high when:

close substitutes are available, the good or service is a large share

of the consumer's budget, and a longer time period is considered.

Cross-price elasticity of demand The cross-price elasticity of

demand between two goods j and k is defined as:

Cross-price elasticity (cont.)

cross-price elasticity is positive if and only if the goods are substitutes

cross-price elasticity is negative if and only if the goods are complements.

Income elasticity of demand

A good is a normal good if income elasticity > 0.

A good is an inferior good if income elasticity < 0.

Income elasticity of demand

A good is a luxury good if income elasticity > 1.

A good is a necessity good if income elasticity < 1.

Price elasticity of supply

Perfectly inelastic supply

Perfectly elastic supply

Determinants of supply elasticity short run - period of time in which

capital is fixed all inputs are variable in the long

run supply will be more elastic in the

long run than in the short run since firms can expand or contract their capital in the long run.

Tax incidence distribution of the burden of a tax

depends on the elasticities of demand and supply.

When supply is more elastic than demand, consumers bear a larger share of the tax burden.

Producers bear a larger share of the burden of a tax when demand is more elastic than supply.

Estimating Demand for Medical Care

Quantity demanded = f( … ) out-of-pocket price real income time costs prices of substitutes and complements tastes and preferences profile state of health quality of care

Income Elasticity of Demand: Normal Good – demand rises as

income rises and vice versa

Inferior Good – demand falls as income rises and vice versa

Elasticity Cross Elasticity: The responsiveness of demand

of one good to changes in the price of a related good – either a substitute or a complement

Xed = % Δ Qd of good t__________________% Δ Price of good y

Elasticity Goods which are complements:

Cross Elasticity will have negative sign (inverse relationship between the two)

Goods which are substitutes: Cross Elasticity will have a positive

sign (positive relationship between the two)

Elasticity Price Elasticity of Supply:

The responsiveness of supply to changes in price

If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price

If Pes is elastic – supply can react quickly to changes in price

Pes = % Δ Quantity Supplied____________________

% Δ Price

Determinants of Elasticity Time period – the longer the time under

consideration the more elastic a good is likely to be

Number and closeness of substitutes – the greater the number of substitutes, the more elastic

The proportion of income taken up by the product – the smaller the proportion the more inelastic

Luxury or Necessity - for example, addictive drugs

Importance of Elasticity Relationship between changes

in price and total revenue Importance in determining

what goods to tax (tax revenue) Importance in analysing time lags

in production Influences the behaviour of a firm

market failure Definition A condition in which a market does not efficiently

allocate resources to achieve the greatest possible consumer satisfaction. The four main market failures

(1) public good, (2) market control, (3) externality, and (4) imperfect information. In each case, a market acting without any government

imposed direction, does not direct an efficient amount of our resources into the production, distribution, or consumption of the good.

Whay health market fails? “Information asymmetry” Healthcare is difficult and expensive to commodify Excess capacity is needed for market choice to work

(waiting list) Exit” from the market is very difficult-interdendent Market “entry” is prohibitively expensive Problems with private insurance systems (poor get

lowest and rich get the best) Price signals don't work (risk pooling is needed) Medical professionalism is anti-market

Why Health Market Fails? Patients want local services Markets provide for wants rather than

needs Need for specialty clusters, high volume

workload and regional and national planning

First duty of investor owned firms is to their shareholders, not patients

Summary

Health care characterized by info. asymmetry – suppliers better informed than consumers

Suppliers (professionals) therefore act as patient’s agent, making decisions for them

Creates potential for supplier-induced demand (demand in excess of what patient would chose)

Extent SID depends on structure of health system, especially financial incentives

SID not always a ‘bad thing’ – may increase efficiency in some circumstances

Elasticity

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