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Elasticity
Why Economists Use Elasticity
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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?
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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.
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three from the demand function
one from the supply function
2 VIP Elasticities
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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
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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
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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
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Demand is said to be:
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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
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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
Demand Curve Showing Different Elasticities
$12
11
Price
10
9
8
7
6
5
4
3
2
1
0
10
20 30 40 50
60
70 80 90 100
120
Quantity/Time
Arc elasticity measure
where:
Example
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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
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Total revenue = price x quantity
What happens to total revenue if the
price rises?
Price elasticity of demand =
Elasticity and TR (cont.)
Price elasticity of demand =
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A reduction in price will lead to:
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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.
Elasticity and TR (cont.)
Price elasticity of demand =
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In a similar manner, an increase in price will
lead to:
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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.
Elasticity and TR (cont.)
Price discrimination
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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.)
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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
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The cross-price elasticity of demand
between two goods j and k is defined
as:
Cross-price elasticity (cont.)
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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
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A good is a normal good if income
elasticity > 0.
A good is an inferior good if income
elasticity < 0.
Income elasticity of demand
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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
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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
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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
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Quantity demanded = f( … )
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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:
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Normal Good – demand rises as
income rises and vice versa
Inferior Good – demand falls as
income rises and vice versa
Elasticity
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Cross Elasticity:
The responsiveness of demand
of one good to changes in the price of a
related good – either
a substitute or a complement
% Δ Qd of good t
__________________
Xed =
% Δ Price of good y
Elasticity
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Goods which are complements:
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Cross Elasticity will have negative sign
(inverse relationship between the two)
Goods which are substitutes:
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Cross Elasticity will have a positive sign
(positive relationship between the two)
Elasticity
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Price Elasticity of Supply:
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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
%
Δ Quantity Supplied
____________________
Pes =
% Δ Price
Determinants of Elasticity
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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
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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.
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Whay health market fails?
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“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 difficultinterdendent
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
Why Health Market Fails?
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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
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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