Elasticity Basics – Review: Demand and Supply Curves Market demand curve: How many cans of beer would consumers purchase (the quantity demanded), if the price of beer were _____, given that everything else relevant to the demand for beer remains the same? P Market supply curve: How many cans of beer would firms produce (the quantity supplied), if the price of beer were _____, given that everything else relevant to the supply of beer remains the same? Surplus S P* Shortage D Q Q* Equilibrium: Quantity Demanded = Quantity Supplied Market Forces push the actual price to the equilibrium price. If Actual Price < Equilibrium Price If Actual Price > Equilibrium Price Shifts versus Movements along a Curve  Change in something OTHER THAN the price of beer ITSELF  Change in the price of beer ITSELF  The slopes of the demand and supply curves for beer capture the effect of a change in the BEER PRICE itself; a change in the price of beer leads to a MOVEMENT ALONG the demand and supply curves for beer. The demand curve for beer can SHIFT ONLY if something that affects demand OTHER THAN the BEER PRICE changes. The supply curve for beer can SHIFT ONLY if something that affects supply OTHER THAN the BEER PRICE changes.

Elasticity Basics Advice for the AMTRAK The Vermonter is an AMTRAK train that travels from Washington, D.C. to St. Albans, VT, with continuing bus service to Montreal, Quebec. The following two individuals are considering ways to increase the revenues generated from Vermonter ticket sales. P Mr. A: “The Vermonter is operating with empty seats. To increase revenues, AMTRAK should fill the empty seats by lowering ticket prices.” Ms. B: “That would be disastrous! Lower ticket prices will lead to lower, not higher, revenues. Your policy would make a bad situation worse.” 39.00 D Question: In general, what happens to the total revenue collected when the price falls? Q Total Revenues = Price  Quantity Demanded ?   Question: What additional information do we need to address this question?

Price Elasticity of Demand If the quantity demanded is very sensitive to the price If the quantity demanded is not very sensitive to the price  Demand is Elastic  Demand is Inelastic Unit Elastic  1 percent change in price causes the quantity demanded to change by more than 1 percent  1 percent change in price causes the quantity demanded to change by exactly 1 percent  1 percent change in price causes the quantity demanded to change by less than 1 percent  Price elasticity of demand greater than 1  Price elasticity of demand equals 1  Price elasticity of demand less than 1 Price Elasticity of Demand = Percent change in the quantity demanded resulting from a 1 percent change in the price Two Warnings: Elasticity always refers to percent changes; elasticity differs from the slope – more later. Inelastic demand means that the quantity demanded is not very sensitive to the price; it does not mean that the quantity demanded is not at all sensitive to the price. If the quantity demanded is not at all sensitive to the price we say that demand is perfectly inelastic.

Total Revenues = Price  Quantity Demanded = P  Q Advice for the AMTRAK revisited Mr. A: “The Vermonter is operating with empty seats. To increase revenues, AMTRAK should fill the empty seats by lowering ticket prices.” Ms. B: “That would be disastrous! Lower ticket prices will lead to lower, not higher, revenues. Your policy would make a bad situation worse.” Total Revenues = Price  Quantity Demanded = P  Q   Demand is Elastic Demand is Inelastic  If the quantity demanded is very sensitive to the price  If the quantity demanded is not very sensitive to the price  P Q  P Q  TR = PQ rises  TR = PQ falls

Quantity (millions of bushels) Farming Paradox Mr. A: “Good weather and bountiful harvests are bad for the farming community. Inclement weather and poor harvests are good because the total revenue collected by farmers will rise.” Mr. B: “You can't be serious. Have you gone crazy?" Wheat Market: 2010-2011 Year Price ($ per bushel) Quantity (millions of bushels) 2010 5.10 2,205 2011 7.45 2,000 U.S. Springs Wheat Data By TOM POLANKEK And MARK PETERS Wall Street Journal – August 18, 2011 The U.S. Department of Agriculture quietly released estimates it usually keeps under wraps … Traders caught on to the new data set, posted on the USDA's web site, earlier this week and latched on to figures indicating that the size of the nation's prized fall wheat crop could be smaller than expected. …. prices have soared this week. Supplies of this wheat … have tightened since a historic drought hurt the spring harvest in states like Texas and Oklahoma. Question: Does the WSJ article cite any information suggesting that the demand curve shifted? Question: Does the WSJ article cite any information suggesting that the supply curve shifted? P S2011 7.50 2011 No. Yes. S2010 7.00 6.50 6.00 5.50 2010 5.00 D Q 2,000 2,050 2,100 2,150 2,200

If the quantity demanded is very sensitive to the price  Demand is Elastic How is TR affected? Demand is Inelastic  If the quantity demanded is very sensitive to the price  If the quantity demanded is not very sensitive to the price TR = P × Q   Question: Is the demand for wheat elastic or inelastic?  P Q TR = PQ falls  P Q TR = PQ rises Inelastic P 7.50 Total Revenue in 2010 = 5.10  2,205 = $11,245.50 2011 Total Revenue in 2011 = 7.45  2,000 = $14,900.00 7.00 6.50 In the demand for food is inelastic. This explains the farming paradox. 6.00 5.50 2010 5.00 D Q 2,000 2,050 2,100 2,150 2,200

Demand for Appendectomies Question: What determines whether the demand for a particular good is elastic or inelastic? Answer: In reality, many factor affects a good’s demand elasticity, but perhaps the most important is the availability of substitutes. Demand for Insulin Demand for Appendectomies First, consider the demand for insulin. Question: Suppose that the price of insulin fell by 50 percent. What would happen to the quantity of insulin demanded? Price D The quantity demanded is not at all sensitive to the price. Answer: No change The demand for insulin is perfectly inelastic; the quantity demand is not affected by the price. Next, consider the demand for appendectomies. Question: Suppose our local hospital, Cooley-Dickinson, announced a special reduced price for appendectomies. What would happen to the quantity of appendectomies demanded? Quantity Answer: No change The demand for appendectomies is perfectly inelastic; the quantity demand is not affected by the price. Question: What insulin and appendectomies have in common? Answer: There are no substitutes for insulin or appendectomies.

Perfectly Inelastic Demand Warning Inelastic Demand is not the same as Perfectly Inelastic Demand  Quantity demanded not very sensitive to the price  Quantity demanded not at all sensitive to the price Other Elasticities Income Elasticity of Demand Income Elasticity of Demand = Percent change in the quantity demanded resulting from a 1 percent change in income If the quantity demanded is very sensitive to income If the quantity demanded is not very sensitive to income  Demand is Income Elastic  Demand is Income Inelastic Price Elasticity of Supply Price Elasticity of Supply = Percent change in the quantity supplied resulting from a 1 percent change in the price If the quantity supplied is very sensitive to the price If the quantity supplied is not very sensitive to the price  Supply is Elastic  Supply is Inelastic

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. 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. Question: Common sense suggests that the price of crude oil should rise and the quantity fall as a consequence of the boycott. But, can we be more specific? Market for Crude Oil Before Iraq’s invasion: 65 million barrels were produced per day and the price was $17 per barrel. P S After Iraq’s invasion: S The supply curve for oil shifts left by 5 million barrels. At the old equilibrium price, $17, a 5 million barrel shortage exists 5  Price rises until a new equilibrium is established. 17 5  Quantity falls by less than 5 million barrels. 5 D Price rises. Q Question: Can we be more specific about the price increase? 65

Claim: We can be more specific by applying the price elasticities. Market for Crude Oil P Price Elasticity of Demand = Percent change in the quantity demanded resulting from a 1 percent change in the price S = .05 S Price Elasticity of Supply = Percent change in the quantity supplied resulting from a 1 percent change in the price 5 = .10 17 5 What was the shortage in percentage terms? 5 5 D = .0769…  7.5% 65 Q 65 Price Quantity demanded Quantity supplied Portion of shortage up by decreased by increased by gap eliminated 1% .05% .10% .15% 10% 0.5 % 1.0 % 1.5% 50% 2.5 % 5.0 % 7.5% We estimate that the price of crude oil would rise by $8.50 from $17 to $25 or $26 50%  $17 = $8.50 In reality it rose from $17 to $27 in August.