Elasticities

Quantitative Measurement
Chap. 4
 Measuring the Impact of Price on
Quantity Demanded
• A natural way of measuring impact of a price
change is to measure the change in quantity
demanded relative in size to the change in prices.
Q QD D
Run
1 0
  d
P1  P0 Rise

Q QS S
Run
1

0
s
P1  P0 Rise
 Economists often prefer elasticity to
slope in real world
• This measure is the inverse of the SLOPE of
the demand curve which is constant when the
demand curve is linear (as often depicted in
textbooks)
• Economists typically do not measure the price
impact using slope for 2 reasons.
1. Slope as a measure is not unit free, so price impacts
are not comparable across types of goods or
currency.
2. Empirical demand curves tend not to have constant
slope or constant elasticity, but constant elasticity
functions are a better approximation.
 Elasticity: The % impact on quantity
demanded of a 1% change in price

%Change in Q
%Change in P

e 
D %Q D
0 e 
S %Q S
0
%P %P
 Midpoint Method
• If you want to
calculate a %
difference between %X 
 X1  X 0 
two points which is  X1  X 0 
 2 
the same regardless of
which you designate
as the reference point
(denominator), you
can use the average of
the two points as the
reference point.
Slope and Elasticity of Oil Demand
P Q %P %Q e
60 83,033.06
15.38% -1.54% -0.10
70 81,762.92
13.33% -1.34% -0.10
80 80,678.38
11.76% -1.18% -0.10
90 79,733.70
10.53% -1.05% -0.10
100 78,898.04
9.52% -0.95% -0.10
110 78,149.63
8.70% -0.87% -0.10
120 77,472.59
8.00% -0.80% -0.10
130 76,854.95
7.41% -0.74% -0.10
140 76,287.50
6.90% -0.69% -0.10
150 75,762.98
 What determines price elasticity?
Availability of Substitutes
• A price increase will lead to a shift away from
the use of a product and toward other products.
• Elasticity will be stronger the more readily
available are substitutes for a good.
– Particular brand of goods may have more elastic
demand than broader category. Dairy Farm Milk may
have better substitutes than Milk.
– Some necessity goods like medicines may have no
good substitutes and be demand inelastic. Frivolous
goods might easily be foregone.
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 What determines price elasticity?
Availability of Substitutes
• A price increase will lead to a shift away from
the use of a product and toward other products.
• Elasticity will be stronger the more readily
available are substitutes for a good.
– Particular brand of goods may have more elastic
demand than broader category. Dairy Farm Milk may
have better substitutes than Milk.
– Some necessity goods like medicines may have no
good substitutes and be demand inelastic. Frivolous
goods might easily be foregone.
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 Elasticities Extreme

P Perfectly Inelastic
Demand (Insulin)

D
Perfectly Elastic
Demand (Clear Pepsi)

Q
 Comparisons of Demand Price
Elasticities
• Oil has very
inelastic demand. Price Elasticities of Other Goods
– Estimate of Salt -.1
elasticity of demand
Coffee -.25
for oil in the US is
-.061 Tobacco -.45
J.C.B. Cooper, OPEC Review, 2003)
Movies -.9
Housing -1.2
Restaurant Meals -2.3
A demand curve is classified as INELASTIC
if the elasticity is between 0 and -1

Unit elasticity (elasticity equal to -1) is

the cutoff point

A demand curve is classified as

ELASTIC if the elasticity is less than -1
 Elasticity and Revenues
• The revenues generated by a firm along any point
of the demand schedule are equal to the product
of quantity demanded and price

R = P∙QD

• Raising prices has two counter-veiling effects:

– a direct positive impact on revenues because each
good sold generates more revenue.
– a negative indirect impact because fewer goods will
be sold.
• Which is stronger?
 Effect of price change on revenues
• Changes in revenues are approximately
%R ≈ %P+%Q
• Divide through by %P to get the total impact
D
% R % P %Q %Q
   1
%P %P %P %P

%R  1 e Demand
%P
e Demand
0
 Price Elasticity & Revenues
• If the price elasticity of demand is
– exactly UNITY, a price rise has no effect on
total revenue
– ELASTIC, a price rise will decrease revenues.
– INELASTIC elastic, a price rise will increase
revenues.
Demand Curves

Elastic Unit Inelastic

Supply Curves

Price Elasticity
 Upward Sloping Supply Curves
• The supply curve slopes up because some
factors are fixed and other factors have
decreasing returns.
• The greater share of factors of production
are flexible, the more elastic the supply
curve will be.
• Estimates of oil supply elasticity are low.
Elasticity of Supply in Oil Market
P Q %P %Q e
60 80,059.86
15.38% 1.54% 0.10
70 81,303.55
13.33% 1.34% 0.10
80 82,396.49
11.76% 1.18% 0.10
90 83,372.72
10.53% 1.05% 0.10
100 84,255.78
9.52% 0.95% 0.10
110 85,062.66
8.70% 0.87% 0.10
120 85,806.03
8.00% 0.80% 0.10
130 86,495.60
7.41% 0.74% 0.10
140 87,138.99
6.90% 0.69% 0.10
150 87,742.26
 Elasticity of Supply
• Elasticity of supply curve depends on the
ability of production sector to ramp up
supply without increasing the marginal cost
of production.
• A good that is produced with readily
available factors w/o a need for time
consuming investment will have an elastic
supply curve.
 Elasticities: Supply

Perfectly Inelastic Supply

P
(Van Gogh Paintings)

Perfectly Elastic S
Supply (Foot
Massage)

Q
 Elasticities and Equilibrium Effects
• Strength of impact on demand shifts on
quantity vs. price depends on elasticity of
both supply curve.
– Imagine elasticity of supply were completely
inelastic, then an increase in demand will
increase only price and have no effect on
quantity.
– Imagine elasticity of supply was completely
elastic, an increase in demand will increase only
quantity and have no effect on price.
Steeper (less elastic) supply curve means that a demand shift
will have a smaller impact on quantity and bigger impact on
price. .

P S1
1
S2
P1** 2

P2** 0

P*
D’

D
Q
Q *
Q1 **
Q2 **
Steeper (less elastic) demand curve means that a supply shift
will have a smaller impact on quantity and bigger impact on
price. .

P S’
1
S
P1** 2

P2** 0

P*

D2
D1

Q
Q1 **
Q2** Q
*
 Excise taxes
• We can think of the supply curve as the
price that producers would charge to
produce a certain quantity of the product.
• We can think of the excise tax as an
additional surcharge added on top of that
price.
The add on tax is like a shift up in the supply curve

P Swith tax
S
tax

Q
Tax of course affects quantity demanded can define equilibrium
here. Price goes up for consumer but price going to producer
goes down. .

P Swith tax
S
P*after tax tax

.
P to producer
*

Q
Q *
• Imagine a market for gasoline. Refinery
capacity is limited so supply curve is
inelastic.
• The government adds a surcharge on to gas,
what happens to the market?
Tax of course affects quantity demanded can define equilibrium
here.
.
S
P

P*pre tax .

D
Q
Q
*
With a very inelastic supply curve, the post tax price does not
rise by very much but the price that the produer receives drops
sharply.
.
S’ S
P

P*post tax
P*pre tax .

P*to producer

D
Q
Q *
Price Elasticity and Time
 Elasticity of Demand
Short-term vs. Long-term
• It takes time to find substitutes for goods or
to adjust consumption behavior in response
to a change in prices.
• The long-run demand response to a price
rise is larger than the short-run. Price
elasticity of demand is more negative in the
long run than in the short run.
.
Oil Demand much more elastic in
long run than short-run
Price Elasticity of Demand
Short-term Long-term
Germany -0.024 -0.274
Japan -0.071 -0.357
Korea -0.094 -0.178
USA -0.061 -0.453

–(J.C.B. Cooper, OPEC Review, 2003)

 Price Elasticity of Supply
• Firms also find it easier to adjust production in
the long-run than the short run. Long-run price
elasticity of supply is typically greater than
short-run
• OECD study suggests price elasticity of oil
supply is .04 in short run and .35 in long run.
 Oil Dempand Curves
P

Short-term Long-term
Q
 Oil Suply Curves

Short-term Long-term
P

Q
 Demand Shifters

Income Elasticity/ Cross Price

Elasticity
 Income Elasticity
• We measure the effect of income on
demand for a good as % effect on demand
of a 1% increase in income.
• For normal goods, income elasticity is
positive.
• For inferior goods income elasticity is
negative.
 Luxuries vs. Necessities
• There are two types of normal goods.
• Luxuries take up an increasing share of income as
your income grows.
– Luxuries are income elastic - the income elasticity of
luxuries is greater than 1.
• Necessities take up a declining share of income as
your income grows.
– Necessities are income inelastic – the income elasticity
of luxuries is less than 1.
China’s Emerging Middle Class Download
Inferior Goods
Range of Income
Elasticities
Normal Goods

0 1

Income Inelastic Income Elastic

(Necessities) (Luxury Goods)
Income Elasticity of Oil
• Assume a world
Region Income income elasticity of
Elasticity .5 and an increase
China 0.7 of world income
OECD 0.4 equal to 10%.
ROW 0.6 Demand shifts out
Source: OECD study
by 5%.
• Would oil
production supplied
increase by 5%?
 Inferior Goods and Giffen Goods
• Giffen Goods are goods that are so inferior that
the Law of Demand does not apply.
• Example: Noodles in poorer parts of China.
Noodles are a big chunk of the household
budget. When prices of noodles go down, that
frees up extra money for other spending. With
extra money, you might buy more meat. Then,
you need fewer noodles. Price of noodles drops
and demand for noodles drops!
 Changes in Prices of Other Goods
• For any good there are two types of other
goods which are relevant to its demand
2. Substitutes: Those other goods which can
take the place of the good of interest
(bacon vs. ham)
3. Complements: Those other goods whose
use will enhance the value of the good of
interest. (bacon and eggs)
What are substitutes and complements for oil
Substitutes vs. Complements
• A good is defined as a “Substitute”
when a rise in its price leads to a shift
out/up in the demand curve for the
good of interest.

• A good is defined as a “Complement”

when a rise in its price leads to a shift
in/down in the demand curve for the
good of interest.
 Cross Price Elasticity
• Cross price elasticity is the % effect on the
quantity demanded of a % change in another
price.
– Goods with positive cross-price elasticities are
called substitutes
– Goods with negative cross price elasticities are
called complements

Complements Substitutes
 Learning Outcome
• Students should be able to:
• Calculate an elasticity given two points on a
supply or demand curve.
• Use demand elasticities to calculate price
elasticity of revenue.
• Use cross-price elasticities or income
elasticities to calculate size of shifts in the
demand curve caused by external events.
 Discussion Question
• As noted in class, recent years have been ones of
extremely high oil prices. This has had a number of
economic effects outside the petroleum industry. One
interesting example has been the price of corn tortillas in
Mexico which have risen rapidly.
– How would the price of oil affect the price of corn? Why would
these two goods be substitutes?
– What would be the effect of changes in the price of corn on
prices of tortillas?
– Which elasticities would be helpful to us in estimating the
quantitative effect of oil price changes on tortilla prices?