Elasticity

Why Economists Use Elasticity 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? 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. three from the demand function one from the supply function

2 VIP Elasticities 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 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 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 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 Demand is said to be: 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 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

Quantity/Time Demand Curve Showing Different Elasticities $ Price Elastic demand Unit Elastic Inelastic demand

Arc elasticity measure where:

Example 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 Total revenue = price x quantity What happens to total revenue if the price rises? Price elasticity of demand =

Elasticity and TR (cont.) A reduction in price will lead to: 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. Price elasticity of demand =

Elasticity and TR (cont.) In a similar manner, an increase in price will lead to: 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. Price elasticity of demand =

Elasticity and TR (cont.)

Price discrimination 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.) 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 The cross-price elasticity of demand between two goods j and k is defined as:

Cross-price elasticity (cont.) 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 A good is a normal good if income elasticity > 0. A good is an inferior good if income elasticity < 0.

Income elasticity of demand 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 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 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 Quantity demanded = f( … ) 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: Normal Good – demand rises as income rises and vice versa Inferior Good – demand falls as income rises and vice versa

Elasticity Cross Elasticity: The responsiveness of demand of one good to changes in the price of a related good – either a substitute or a complement Xed = % Δ Qd of good t __________________ % Δ Price of good y

Elasticity Goods which are complements: Cross Elasticity will have negative sign (inverse relationship between the two) Goods which are substitutes: Cross Elasticity will have a positive sign (positive relationship between the two)

Elasticity Price Elasticity of Supply: 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 Pes = % Δ Quantity Supplied ____________________ % Δ Price

Determinants of Elasticity 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 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.

Whay health market fails? “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 difficult- interdendent 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 needed) Medical professionalism is anti-market

Why Health Market Fails? 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 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