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. 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 often prefer elasticity to slope in real world 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 Economists prefer to measure price impacts in terms of elasticity since it is unit free (everything is measured in percentages) and a better match for empirical demand schedules.
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.
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 Perfectly Inelastic Demand (Insulin) Perfectly Elastic Demand (Clear Pepsi) P Q D D
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) Salt-.1 Coffee-.25 Tobacco-.45 Movies-.9 Housing-1.2 Restaurant Meals-2.3 Price Elasticities of Other Goods
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) is the cutoff point
The revenues generated by a firm along any point of the demand schedule are equal to the product of quantity demanded and price R = PQ 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
Effect of price change on revenues Changes in revenues are approximately %R %P+%Q Divide through by %P to get the total impact
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.
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 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 –(J.C.B. Cooper, OPEC Review, 2003)
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. Price Elasticity of Supply = e S
Elasticities: Supply Perfectly Inelastic Supply (Van Gogh Paintings) Perfectly Elastic Supply (Foot Massage) P Q S S
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.
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.
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.
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.
Examples Elasticity of demand for oil is e D = -.061 and elasticity of supply is e S =.04. World oil demand goes up by 1%. How much does the price change? Answer:
Example 2 What would happen to oil prices for Geo- Political reasons there were a shut-down of Iranian oil production and there was an inward shift in the oil supply curve of 4.9%?
A shift in the supply schedule ( Spreadsheet ) 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?
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.
Range of Income Elasticities 0 1 Inferior Goods Normal Goods Income Elastic (Luxury Goods) Income Inelastic (Necessities)
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 increase by 5%? RegionIncome Elasticity China0.7 OECD0.4 ROW0.6 Income Elasticity of Oil
Example What would the oil price change be in the long run, if world income went up permanently by 10% and no shift in supply curve?
Changes in Prices of Other Goods For any good there are two types of other goods which are relevant to its demand 1.Substitutes: Those other goods which can take the place of the good of interest (bacon vs. ham) 2.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 SubstitutesComplements
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 elasticity estimates to calculate changes in equilibrium prices from shifts in demand or supply curves. Use cross-price elasticities or income elasticities to calculate size of shifts in the demand curve caused by external events.