Elasticity and Its Application 5 Elasticity and Its Application

The Elasticity of Demand (own) Computing the price elasticity of demand Percentage change in quantity demanded Divided by percentage change in price Use absolute value (drop the minus sign) It’s always negative (own-price) Midpoint method Two points: (Q1, P1) and (Q2, P2)

The Elasticity of Demand Cigarettes (US)[41] -0.3 to -0.6 (General) -0.6 to -0.7 (Youth) – proportion of income? Soft drinks -0.8 to -1.0 (general)[51] (broadly defined) -3.8 (Coca-Cola)[52] (narrow) -4.4 (Mountain Dew)[52] (narrow) Car fuel[45] -0.25 (Short run) (same car – reduce trips) -0.64 (Long run) (new car?)

The Elasticity of Demand Cross-price elasticity of demand Measure of how much the quantity demanded of one good responds To a change in the price of another/different good [∆Qx/Qx] / [∆Py/Py ] Sign matters -> tells whether substitute or complement Magnitude (<1 or >1) -> how “good” a substitute/essential a complement Substitutes: Positive cross-price elasticity >1 -> “close” or good substitute as big shift with small price change Complements: Negative cross-price elasticity >1 -> “essential” to be used/consumed together (cars and gas)

Good Good with Price Change XED Butter Margarine +0.81 Beef Pork +0.28 Entertainment Food -0.72

The Elasticity of Supply Price elasticity of supply Measure of how much the quantity supplied of a good responds To a change in the price of that good Percentage change in quantity supplied Divided by the percentage change in price Depends on the flexibility of sellers to change the amount of the good they produce

The Elasticity of Supply Price elasticity of supply Elastic supply Quantity supplied responds substantially to changes in the price Inelastic supply Quantity supplied responds only slightly to changes in the price Determinant of price elasticity of supply Time period Supply is more elastic in long run

The Elasticity of Supply Computing price elasticity of supply Percentage change in quantity supplied Divided by percentage change in price Variety of supply curves Supply is perfectly inelastic Elasticity =0 Supply curve – vertical Supply is perfectly elastic Elasticity = infinity Supply curve – horizontal

The Elasticity of Supply Variety of supply curves Unit elastic supply Elasticity =1 Elastic supply Elasticity >1 Inelastic supply Elasticity < 1

The price elasticity of supply (a, b) 5 The price elasticity of supply (a, b) Perfectly inelastic supply: Elasticity = 0 (b) Inelastic supply: Elasticity < 1 1. an Price 1. an Price Supply 100 Supply An increase in price… A 22% increase in price… 2. … leads to a 10% increase in quantity supplied $5 $5 110 4 4 100 2. …leaves the quantity supplied unchanged Quantity Quantity The price elasticity of supply determines whether the supply curve is steep or flat. Note that all percentage changes are calculated using the midpoint method.

Applications of Supply, Demand, & Elasticity Why did OPEC fail to keep the price of oil high? 1970s: OPEC reduced supply of oil Increase in prices 1973-1974 and 1971-1981 Short-run: supply is inelastic Decrease in supply: large increase in price 1982-1990 – price of oil decreased Long-run: supply is elastic Decrease in supply: small increase in price

A reduction in supply in the world market for oil 8 A reduction in supply in the world market for oil (a) The Oil Market in the Short Run (b) The Oil Market in the Long Run 1. an Price 1. In the short run, when supply and demand are inelastic, a shift in supply. . . 1. an Price 1. In the long run, when supply and demand are elastic, a shift in supply. . . S2 S1 Demand S2 S1 P2 Demand 2. … leads to a large increase in price P2 P1 P1 2. … leads to a small increase in price Quantity Quantity When the supply of oil falls, the response depends on the time horizon. In the short run, supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve shifts from S1 to S2, the price rises substantially. By contrast, in the long run, supply and demand are relatively elastic, as in panel (b). In this case, the same size shift in the supply curve (S1 to S2) causes a smaller increase in the price.