Download Micro Lecture 6: Elasticity Applications

Micro Lecture 6: Elasticity Applications
Review: Price Elasticities
Price Elasticity of Demand
=
Percent change in the quantity demanded resulting
from a 1 percent change in the price
Price Elasticity of Supply
=
Percent change in the quantity supplied resulting
from a 1 percent change in the price
Example of a Persistent Surplus – Minimum Wage Legislation
To investigate the effect of minimum wage legislation, consider
the market for low skilled labor. We place the wage rate (the
“price” of labor) on the vertical axis and the quantity of labor on
the horizontal axis as shown in figure 6.1. Now, let us interpret
the market demand curve and supply curve in the context of the
labor market.
The market demand curve for low skilled labor answers a series
of hypothetical questions:
How many low skilled workers would firms hire (the
quantity of labor demanded), if the wage were ____?
It is easy to understand why the demand curve for labor is
downward sloping. As the wage increases, labor becomes more
expensive, and firms response by hiring fewer workers.
Market for Low Skilled Workers
Wage ($/hour)
Workers
Workers
12.00
actually hired
seeking a job
S
8.00
Equilibrium
4.00
D
Workers
Figure 6.1: Low skilled labor market
What about the market supply curve? The market supply curve
for labor answers a series of hypothetical questions:
How low skilled workers would seek a job (the quantity of labor supplied), if the wage were ____?
We have drawn the market supply curve as an upward sloping curve. As the wage increases, households are
enticed to work more hours.
We estimate that the equilibrium wage for low skilled labor is about $4.00 per hour as illustrated on Figure 4.7:
If wage equaled $4.00 per hour
ã
é
Quantity of labor
Quantity of labor
=
demanded
supplied


Low skilled
Low skilled
workers firms
=
workers
actually hiring
seeking a job
é
ã
No low skilled workers are unemployed
If the wage were $4.00 per hour the quantity of labor demand equals the quantity of labor supplied. Everyone
who seeks a job can find one; hence, there is no unemployment.
2
Currently, the Federal minimum wage is $7.25 per hour. That is, by
law the wage paid by employers cannot fall below $7.25 per hour.
In Massachusetts it is $8.00 per hour. That is, in Massachusetts all
low skilled labor must be paid at least $8.00 per hour. While there
may be some dispute about the precise value of the equilibrium
wage in the low skilled labor market, few if any argue that it is
below the minimum wage as illustrated in figure 6.2. In other
words, while some believe that the equilibrium wage is not exactly
$4.00 per hour as we have suggested, virtually everyone believes
that it is substantially less than $8.00. This is key point. The relative
positions of the equilibrium wage and the minimum wage are
accurately depicted in figure 4.8. What are the ramifications of this?
Minimum wage legislation only affects the labor market whenever
the minimum wage exceeds the equilibrium wage.
Market for Low Skilled Workers
Wage ($/hour)
Workers
Workers
12.00
actually hired
seeking a job
S
8.00
Unemployed
Equilibrium
≈4.00
D
Workers
Figure 6.2: Low skilled labor market
Minimum wage equals 8.00 per hour
ã
é
Quantity of labor
Quantity of labor
<
demanded
supplied


Low skilled
Low skilled
workers firms
<
workers
actually hiring
seeking a job
é
ã
Some low skilled workers are unemployed
As a consequence of the minimum wage, firms hire fewer low skilled workers and the number who want a job.
Some low skilled workers who would like to work at the minimum wage will not be fortunate enough to find a
job. This is what we mean by unemployment, isn’t it?
Goal of minimum wage legislation
Minimum wage legislation is designed to help low skilled workers. That is, it is designed to increase the
earned income of low skilled workers.
How well does the legislation meet the goal?
Who is helped by the minimum wage?
 Low skilled workers who are fortunate enough to find a job are helped. If you have a job, you
are better off at the higher minimum wage than would be at the lower equilibrium wage. At
the higher wage you earn more income.
Who is not helped by the minimum wage?
 Firms who hire low skilled workers are hurt because they must pay their low skilled workers a
wage that is greater than the equilibrium wage.
 Low skilled workers who are not fortunate enough to find a job are clearly not helped. For
lack of a better term, call these individuals frustrated workers. Workers are helped by
minimum wage legislation only if they can actually find a job. Frustrated workers are hurt by
a minimum wage because they do not even have the option of deciding whether or not they
wish to accept a job – there are no firms willing hire them at the minimum wage.
3
So is the goal met? Well our conclusions are mixed. Some low skilled workers indeed earn more, while
others cannot find a job and earn nothing at all. This leads us to the next question:
Question: How does the minimum wage affect the earnings of low skilled labor as a group?
This is an important question to answer. Many advocates of a higher
minimum wage claim that a higher minimum wage will trigger
another effect, an indirect earnings effect, which mitigates the direct
effect that we described above. In their view, a higher minimum
wage will not increase low skilled unemployment because the
income earned by low skilled workers as a group would rise. They
continue by arguing that since workers will have more income, they
will purchase more goods causing firms to increase production of
goods. To produce more goods firms will hire more workers.
Claim of many advocates of a higher minimum wage: A
higher minimum wage will not increase low skilled
unemployment as a consequence of the indirect earnings effect.
The key step in their argument is the assertion that a higher minimum
wage will increase the income of low skilled labor as a group which
brings us to our next question.
Question: How can we determine the effect that the minimum
wage has on low skilled labor as a group?
Claim of many who advocate a
higher minimum wage:
Higher minimum wage

Increases income earned by low
skilled workers as a group

Low skilled workers purchase
more goods

Firms produce more goods

Employment rises

Indirect earnings effect mitigates
the rise in unemployment caused
by the direct effect of a higher
minimum wage
The answer to this question depends on the elasticity of demand for labor. To understand why, note that
total earnings equal the wage times the quantity of labor firms hire, the quantity of labor demanded:
Total Earnings
=
Wage

Quantity of Labor Demanded
How does minimum wage legislation affect this equation? The wage increases and the quantity of labor
demanded by firms decreases.
Wage 
Quantity of Labor Demanded


In general, we cannot tell what happens to total earnings. It depends on the elasticity of demand for labor:
Total Earnings
=
If demand were elastic

If demand were inelastic

w L
wL falls

Indirect earnings effect reduces
employment
w L

wL rises

Indirect earnings effect reduces
employment
4
What does the wage elasticity of demand equal? Is demand elastic or inelastic? Empirical studies differ:2
Study
Welch and Cunningham (1978)
Baxen and Martin (1991)
Anderson (1977)
Grant (1979)
Hamermesh (1982)
Group
Teens
Young
16-24
14-24
14-24
M < 21
F < 18
M < 21
F < 21
Layard (1982)
Lewis (1985)
Wage elasticity
1.34
.51
7.14
9.68
.59
1.25
.31
1.80
4.58
Table 6.1
Table 6.1 reports that the estimates of wage elasticity are mixed. Some studies suggest that the demand for
low skilled labor is inelastic others suggest it is elastic. Accordingly, we cannot come to a definitive
conclusion regarding the effect of minimum wage legislation on the earnings of low skilled workers as a
group. Note that a majority of the estimates suggest that the demand for low skilled labor is elastic,
however. While it is possible that the indirect earnings effect could mitigate or even entirely offset the
direct impact of a rise in the minimum wage, it is far from certain.
2
Hamermesh, Daniel. 1993. Labor Demand. Princeton and Chichester, U.K.: Princeton University Press.
5
Effect of the First Persian Gulf War on Crude Oil Prices
Prior to Iraq’s invasion of Kuwait on August 2, 1990,
approximately 65 million barrels of crude oil were
produced in the world per day. The price of crude oil was
about $17 per barrel. Kuwait and Iraq produced 5 of the
65 million barrels.3
Price ($/barrel)
S
17
The Security Council of the United Nations responded to
the invasion by passing a resolution requiring nations to
boycott Iraqi oil. The Security Council’s action
succeeded: no Iraqi or Kuwaiti oil reached world markets.
D
65
Quantity
(millions of barrels per day)
Common sense suggests that the price of crude oil should
rise and the quantity fall as a consequence of the boycott.
We use demand and supply analysis to be more specific.
First, consider figure 6.3 which illustrates the world
market for crude oil prior to the Iraqi invasion.
Claim: While the quantity decreases, it decreases by less
than 5 million barrels. Figure 6.4 justifies the claim. The
boycott of Iraqi and Kuwaiti oil shifted the supply curve to
the left by 5 million barrels. While the equilibrium
quantity decreased, it decreased by less than 5 million.
Figure 6.3: World market for crude oil
Price ($/barrel)
S’
S
5
17
Next, consider the price of crude oil.
At the old equilibrium price of $17 per barrel, a 5 million
barrel shortage exists:
When the price is $17 per barrel
Quantity demanded
Quantity supplied
65 million barrels
60 million barrels
é
ã
5 million barrel shortage
5
D
60
65
Quantity
(millions of barrels per day)
Figure 6.4: World market for crude oil
Market forces will cause the price to increase. But would you expect the price of oil to rise by $.10 per barrel,
$.20 per barrel, $1.00 per barrel, $10.00 per barrel or some other amount?
Question: Can we be more specific about the price?
Claim: We can be more specific by applying the price elasticities:
 Price elasticity of demand = .05
 Price elasticity of supply = .10
We will not see how.
In response to a shortage, the price of oil rises, we
move along the demand and supply curves, increasing
the quantity supplied and decreasing the quantity
demanded:
3
When the price rises
Quantity demanded
Quantity supplied
Less than
More than
65 million barrels
60 million barrels
é
ã
Less than 5 million barrel shortage
Crude oil production and price data from U.S. Energy Information Administration. Note that liberties were taken
simplify the arithmetic.
6
We begin by reviewing the definitions of the price elasticity of demand and supply:
Percent change in the quantity demanded resulting
Price Elasticity of Demand =
from a 1 percent change in the price
Price Elasticity of Supply
=
Percent change in the quantity supplied resulting
from a 1 percent change in the price
At the old equilibrium price, $17 per barrel, a 5 million barrel shortage exists. Since elasticities are defined in
terms of percentages, however, we must transform the 5 million barrel shortage into a percentage. 5 million
from a total of 65 million is about 7.5 percentage points:
5
65 = .0769…  7.5%
At the old equilibrium price of $17 per barrel a 7.5 percentage point shortage exists; consequently, The price
will rise until the 7.5 percentage point shortage gap disappears. How much of a price rise will be needed?
Well, let us try a few scenarios:
Recall that the price elasticity of demand equals .05 and the
When the price rises by 1 percentage point
price elasticity of supply .10, Therefore, if the price were to rise
Quantity demanded
Quantity supplied
by 1 percentage point,
Decreases by .05
Increases by .10
 the quantity demanded would decrease by .05
percentage points
percentage points
percentage points since the elasticity of demand is .05.
é
ã
 the quantity supplied would increase by .10 percentage
Shortage decreases by .15 percentage points
points since the elasticity of supply is .10.
A 1 percentage point price increase would reduce the shortage, but is not nearly enough to eliminate the entire
7.5 percentage point gap. We need a larger price increase.
When the price rises by 10 percentage points
What about a 10 percentage point price increase?
Quantity demanded
Quantity supplied
 the quantity demanded would decrease by 0.5
Decreases by .5
Increases by 1.0
percentage points.
percentage points
percentage point
 the quantity supplied would increase by 1.0 percentage
é
ã
point.
Shortage decreases by 1.5 percentage points
A 10 percentage point price increase reduces the gap by 1.5
percentage point, one fifth of the 7.5 percentage point gap. We are one fifth of the way there.
A 50 percentage point price increase will close the entire 7.5
percentage point gap:
 the quantity demanded would decrease by 2.5 percent.
 the quantity supplied would increase by 5.0 percent.
Table 6.2 provides a summary:
Price
Quantity demanded
up by
decreased by
1%
.05%
10%
0.5%
50%
2.5%
Quantity supplied
increased by
.10%
1.0%
5.0%
Table 6.2
When the price rises by 50 percentage points
Quantity demanded
Quantity supplied
Decreases by 2.5
Increases by 5.0
percentage points
percentage points
é
ã
Shortage decreases by 7.5 percentage points
Portion of gap
eliminated
.15%
1.5%
7.5%
Accordingly, the price increases by an estimated 50 percent:
$17  50% = $8.50
We estimate that the price rises from $17 to $25.50 as a consequence of the Iraqi invasion and the Security
Council’s action. In fact, the price rose to about $27 in August.