MBMC Elasticity

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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 drought 90*90 = 810 Total expenditure= Total farmer revenue

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 4 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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 oSupply and demand for housing Drugs and crime oWhat happens when we reduce the supply of drugs?

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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?

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 10 So What? Oil supply

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 11 Oil prices

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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 = billion barrels day New (1980)  Price = $97/barrel  Quantity demanded = bil. barrels/day, then

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 13 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 14 Elasticity and Total Expenditure Total Expenditure = P x Q Market demand measures the quantity (Q) at each price (P) Total Expenditure = Total Revenue

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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/hr  Quantity demanded = 10,000 jobs/year New  Price = $10.50/hr  Quantity demanded = 8,000 jobs/year, then

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 17 Determinants of Price Elasticity of Demand The more essential, the less elastic How essential is agriculture?  William Nordhaus, Thomas Schelling, Wilfred Beckerman How essential are natural resources?  Robert Solow Substitution Possibilities Lots of substitutes for domestic jobs, few substitutes for oil. Budget Share What share of income is spent on food? Time- elasticity increases over time

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 18 A Graphical Interpretation of Price Elasticity of Demand Quantity Price P D A Q P - P Q + Q Q P Slope = ∆y/∆x= ∆P/∆Q So ∆Q/Q = P * ∆Q ∆P/P Q ∆P

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 19 D1D1 D2D Price Elasticity and the Steepness of the Demand Curve Quantity Price What is the price elasticity of demand 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 20 Price Elasticity Regions along a Straight-Line Demand Curve Quantity Price b/2 a/2 a b Observation Price elasticity varies at every point along a straight- line demand curve

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. The Demand Curve for Essential and Non-substitutable Resources (e.g. Critical Natural Capital) Valuable: Large change in Q, Small change in P Elastic/inelastic Critical: Perfectly inelastic demand Important: inelastic demand Quantity of Essential Resource Marginal value Demand curve for essential resources

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 22 Perfectly Elastic Demand Curve Quantity Price What’s an example of this?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 23 Perfectly Inelastic Demand Curve Quantity Price What’s an example of this?

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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?

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 28 Income Elasticity of Demand Normal Goods Income elasticity is positive Inferior Goods Income elasticity is negative

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 29 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Price Elasticity of Supply for Oil Oil price Jan. 2005=$40, July 2008=$127 Percent change = 219% Oil production Jan = thousand barrels/day July 2008 = Percent change = 3% Elasticity = 3%/219% = 1/73=.0135

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 31 A Perfectly Inelastic Supply Curve Quantity of land in Manhattan (1,000s of acres) Price ($/acre) 0 S Elasticity = 0 at every point along a vertical supply curve What is the price elasticity of supply of land within the borough limits of Manhattan?

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4: Elasticity Slide 33 Determinants of Supply Elasticity Flexibility of inputs Mobility of inputs Ability to produce substitute inputs Time The Price Elasticity of Supply

MBMC Copyright c 2004 by The McGraw-Hill Companies, 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