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Quiz on readings

The price of wheat tripled in 2007 due to
a small decrease in supply. This is
evidence that the demand for wheat is:
A.
B.
C.
D.
E.
Income inelastic
Income elastic
Greater than supply
Price elastic
Price inelastic
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 2
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Farm incomes in response to
drought
Total ‘consumer’
expenditure = P*Q
Before drought:
50*100=500
After drought
90*90 = 810
Total expenditure=
Total farmer revenue
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 3
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Price Elasticity of Demand

Elasticity

A measure of the extent to which quantity
demanded and quantity supplied respond
to variations in price, income, and other
factors.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 4
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Why does it matter?

Agriculture



Natural resources



Can the supply respond to price changes?
How does demand respond?
Health care


How quickly can ag output respond to prices?
How much is demand for food affected by prices?
Essential drugs, procedures
Community development

Land values, rent and housing
o

Supply and demand for housing
Drugs and crime
o
What happens when we reduce the supply of drugs?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 5
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Price Elasticity of Demand

General definition
A measure of the responsiveness of the
quantity demanded of a good to a change
in the price of that good
 How does your demand for food (or beer,
cigarettes) change in response to an
increase in price?

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 6
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Price Elasticity of Demand

Formal definition
Percentage Change in Quantity Demanded
Percentage Change in Price
∆Q/Q
∆P/P
By convention, we drop the negative sign
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 7
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Price Elasticity of Demand

Example: The price of Intervale organic produce
falls by 2% and the quantity demanded increases by
6%

Then the price elasticity of demand for
local organic produce is
6
 3
2

Total revenue for Intervale farmers
increases
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 8
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Price Elasticity of Demand
> 1: elastic
When
Percentage Change in Quantity Demanded
Percentage Change in Price
is < 1: inelastic
= 1: unit elastic


Elastic demand: total revenue and price move
in opposite directions, revenue and quantity
move in same direction
Inelastic demand: total revenue and price
move in same direction, revenue and quantity
in opposite directions
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 9
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So What? Oil supply
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 10
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Oil prices
Oil Prices in Inflation Adjusted 2008 US$ per Barrel
$120
$100
Price
$80
$60
$40
average price = $28.87
$20
median price = $20.80
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Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
ChapterYear
4: Elasticity
Slide 11
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Price Elasticity of Demand

What is the elasticity of demand for oil?

Originally (1978)
 Price
= $46/barrel
 Quantity demanded = 63.332 billion barrels day

New (1980)
 Price
= $97/barrel
 Quantity demanded = 62.948 bil. barrels/day, then
% Change in Q 0.6
1
=
=~
: Inelastic
% Change in P 110
183
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 12
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Elasticity of demand and volatility

Price Inelastic demand
Small changes in quantity supplied lead to
large changes in price.
 Fluctuations in supply lead to fluctuations
in economy: INSTABILITY
 Instability makes it very difficult to plan or
invest, and undermines quality of life
 Food and oil in 2007/2008

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 13
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Elasticity and Total Expenditure

Total Expenditure = P x Q


Market demand measures the quantity (Q)
at each price (P)
Total Expenditure = Total Revenue
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 14
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Inelastic demand and profits






Lower supply = greater profit
How do profit maximizing industries respond?
OPEC cartel
California’s electricity crisis
Exxon profits in 2008: $45.2 billion
What’s the elasticity of demand for water?



How many choices of water supply do you have?
Bechtel corporation and Cochabamba
World Bank, IMF and developing nations
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 15
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Price Elasticity of Demand

Elasticity of domestic manufacturing jobs
that can be exported to Mexico.

Originally
 Wage
= $10/hr
 Quantity demanded = 10,000 jobs/year

New
 Price
= $10.50/hr
 Quantity demanded = 8,000 jobs/year, then
% Change in Quantity 20
= : Elastic
% Change in Price
5
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 16
MB MC

Determinants of Price Elasticity of
Demand
The more essential, the less elastic

How essential is agriculture?
 William

How essential are natural resources?
 Robert

Lots of substitutes for domestic jobs, few
substitutes for oil.
Budget Share


Solow
Substitution Possibilities


Nordhaus, Thomas Schelling, Wilfred Beckerman
What share of income is spent on food?
Time- elasticity increases over time
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 17
A Graphical Interpretation
of Price Elasticity of Demand
MB MC
Slope = ∆y/∆x= ∆P/∆Q
So ∆Q/Q = P * ∆Q
∆P/P
Q ∆P
A
Price
P
æ P öæ 1 ö
Pr ice elasticity at A = ç ÷ç
÷
è Q øè slope ø
P
P-
P
Q
D
Q
Q+
Q
Quantity
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 18
MB MC
12
Price Elasticity and the
Steepness of the Demand Curve
What is the price elasticity of
demand when P = $4?
D1
If two demand
curves have a
point in
common, the
steeper curve
must be less
elastic with
respect to price
at that point
Price
6
4
D2
4
6
12
Quantity
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 19
Price Elasticity Regions along
a Straight-Line Demand Curve
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Observation
Price elasticity varies at
every point along a straightline demand curve
a
 1
Price
 1
 1
a/2
b/2
b
Quantity
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 20
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value
Marginal
Marginal Value
The Demand Curve for Essential and Non-substitutable
Resources (e.g. Critical Natural Capital)
Critical:
Perfectly
inelastic demand
Important:
inelastic
demand
Valuable:
Large change in Q,
Small change in P
Elastic/inelastic
Demand curve
for essential resources
Quantity
of Essential
Resource
Natural
Capital Stocks
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
MB MC
Perfectly Elastic Demand Curve
Perfectly elastic
Price
demand (elasticity = ¥)
Quantity
What’s an example of this?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 22
MB MC
Perfectly Inelastic Demand Curve
Perfectly inelastic
Price
demand (elasticity  0)
Quantity
What’s an example of this?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 23
MB MC
Implications of inelastic demand for GNP

GNP essentially sums PxQ across all final
goods and services in an economy





What’s the optimal marginal value for essential
resources provided freely by nature?
What happens to total expenditures on food
or energy production when Q goes down?
What happens to their share in GNP?
Does GNP measure costs or benefits?
Does it make sense to try and maximize
GNP?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
MB MC
Cross-price elasticity of demand

The percentage by which quantity
demanded of the first good changes in
response to a 1 percent change in the
price of the second good
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 25
MB MC
Cross-Price Elasticity of Demand

Substitute Goods



When the cross-price elasticity of demand is
positive
Price of oil goes up, demand for ethanol goes up
Complement Goods


When the cross-price elasticity of demand is
negative
Price of oil goes up, demand for big cars goes
down
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 26
MB MC
Income Elasticity of Demand is:

The percentage by which

A. quantity demanded changes in response to a 1
percent change in income

B. price changes in response to a 1 percent change in
income

C. quantity supplied changes in response to a 1
percent change in income

D. income changes in response to a 1% change in
quantity demanded

E. income changes in response to a 1% change in
price
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 27
MB MC
Income Elasticity of Demand

Normal Goods


Income elasticity is positive
Inferior Goods

Income elasticity is negative
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 28
MB MC
The Price Elasticity of Supply

Price Elasticity of Supply

The percentage change in the quantity
supplied that occurs in response to a 1
percent change in price
æ P öæ 1 ö
Price elasticity of supply = ç ÷ç
÷
è Q øè slope ø
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 29
MB MC
Price Elasticity of Supply for Oil

Oil price Jan. 2005=$40,
July 2008=$127


Oil production Jan. 2005 = 84179
thousand barrels/day
July 2008 = 86671


Percent change = 219%
Percent change = 3%
Elasticity = 3%/219% = 1/73=.0135
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
MB MC
A Perfectly Inelastic Supply Curve
What is the price elasticity of supply of land
within the borough limits of Manhattan?
Price ($/acre)
S
Elasticity = 0 at every
point along a vertical
supply curve
0
Quantity of land in Manhattan
(1,000s of acres)
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 31
MB MC
Highly inelastic supply curves

How elastic is the supply of agricultural
output?





Tree crops
Annual crops
Milk
Beef
How elastic is the supply curve for natural
resources?


Renewable
Non-renewable
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 32
MB MC
The Price Elasticity of Supply

Determinants of Supply Elasticity
Flexibility of inputs
 Mobility of inputs
 Ability to produce substitute inputs
 Time

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 33
MB MC
Elasticity

What do you think?
How do elasticity of supply and demand
affect price volatility?
 Should the price and quantity of things like
agriculture, electricity and water be left to
the market?

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 34