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MB MC
Elasticity
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 2
The price of wheat tripled in 2007 due to a small decrease in supply. This is evidence that the demand for wheat is:A. Income inelastic
B. Income elastic
C. Greater than supply
D. Price elastic
E. Price inelastic
Quiz on readings
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 3
Farm incomes in response to drought
Total ‘consumer’ expenditure = P*Q
Before drought:50*100=500
After drought90*90 = 810
Total expenditure= Total farmer revenue
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 4
Price Elasticity of Demand
ElasticityA measure of the extent to which quantity
demanded and quantity supplied respond to variations in price, income, and other factors.
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 5
Why does it matter?
Agriculture How quickly can ag output respond to prices? How much is demand for food affected by prices?
Natural resources Can the supply respond to price changes? How does demand respond?
Health care 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?
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 6
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?
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 7
Price Elasticity of Demand
Formal definition
∆Q/Q∆P/P
By convention, we drop the negative sign
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 8
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
Total revenue for Intervale farmers increases
Price Elasticity of Demand
32
6
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 9
Price Elasticity of Demand
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
When is
> 1: elastic
< 1: inelastic
= 1: unit elastic
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 10
So What? Oil supply
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 11
Oil prices
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 12
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/barrelQuantity demanded = 62.948 bil. barrels/day, then
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 13
Elasticity of demand and volatility
Price Inelastic demandSmall changes in quantity supplied lead to
large changes in price.Fluctuations in supply lead to fluctuations
in economy: INSTABILITYInstability makes it very difficult to plan or
invest, and undermines quality of lifeFood and oil in 2007/2008
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 14
Elasticity and Total Expenditure
Total Expenditure = P x QMarket demand measures the quantity (Q)
at each price (P) Total Expenditure = Total Revenue
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 15
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
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 16
Price Elasticity of Demand Elasticity of domestic manufacturing jobs
that can be exported to Mexico.Originally
Wage = $10/hrQuantity demanded = 10,000 jobs/year
New Price = $10.50/hrQuantity demanded = 8,000 jobs/year, then
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 17
Determinants of Price Elasticity of Demand
The more essential, the less elasticHow essential is agriculture?
William Nordhaus, Thomas Schelling, Wilfred Beckerman
How essential are natural resources? Robert Solow
Substitution PossibilitiesLots of substitutes for domestic jobs, few
substitutes for oil. Budget Share
What share of income is spent on food? Time- elasticity increases over time
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 18
A Graphical Interpretation of Price Elasticity of Demand
Quantity
Pri
ce
P
D
A
Q
P - P
Q + Q
Q
P
Slope = ∆y/∆x= ∆P/∆Q
So ∆Q/Q = P * ∆Q ∆P/P Q ∆P
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 19
D1
D2
12
4 6 12
6
4
Price Elasticity and the Steepness of the Demand Curve
Quantity
Pri
ce
What is the price elasticity ofdemand when P = $4?
If two demand curves have a point in common, the steeper curve must be less elastic with respect to price at that point
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 20
Price Elasticity Regions along a Straight-Line Demand Curve
Quantity
Pri
ce
b/2
a/2
a
b
1
1
1
ObservationPrice elasticity varies at every point along a straight-line demand curve
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Natura l Capita l S tocks
Ma
rgin
al
Va
lue
The Demand Curve for Essential and Non-substitutable Resources (e.g. Critical Natural Capital)
Valuable:Large change in Q, Small change in PElastic/inelastic
Critical: Perfectly
inelastic demand
Important: inelastic demand
Quantity of Essential Resource
Marg
inal valu
e
Demand curve for essential resources
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 22
Perfectly Elastic Demand Curve
Quantity
Pri
ce
What’s an example of this?
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 23
Perfectly Inelastic Demand Curve
Quantity
Pri
ce
)0 y (elasticit demand
inelasticPerfectly
What’s an example of this?
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
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?
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 25
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
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 26
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
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 27
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
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 28
Income Elasticity of Demand
Normal GoodsIncome elasticity is positive
Inferior GoodsIncome elasticity is negative
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 29
The Price Elasticity of Supply
Price Elasticity of SupplyThe percentage change in the quantity
supplied that occurs in response to a 1 percent change in price
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Price Elasticity of Supply for Oil
Oil price Jan. 2005=$40, July 2008=$127Percent change = 219%
Oil production Jan. 2005 = 84179 thousand barrels/day
July 2008 = 86671 Percent change = 3%
Elasticity = 3%/219% = 1/73=.0135
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 31
A Perfectly Inelastic Supply Curve
Quantity of land in Manhattan
(1,000s of acres)
Pri
ce (
$/ac
re)
0
S
Elasticity = 0 at everypoint along a verticalsupply curve
What is the price elasticity of supply of land within the borough limits of Manhattan?
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 32
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
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 33
Determinants of Supply ElasticityFlexibility of inputsMobility of inputsAbility to produce substitute inputsTime
The Price Elasticity of Supply
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Chapter 4: Elasticity Slide 34
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?
Elasticity