Transcript Supply and Demand

Elasticities
Quantitative Measurement
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.
Q1  Q0
Run 1


SLOPE
P1  P0
Rise
• 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 often prefer elasticity to
slope in real world
•
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
%
Q
e
%P
 %Change in Q  %Change in P
• Economists prefer to measure price impacts in
terms of elasticity since it is unit free
(everything is measured in percentages) and a
better match for empirical demand schedules.
Midpoint Method
• If you want to
calculate a %
difference between
two points which is
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.
X1  X 0 

%X 
 X1  X 0 
 2 
Slope and Elasticity of Oil Demand
US$/BBL BBL (Mil)
P
Q
%P
40
45
%Q
1/Slope Elasticity
ΔQ÷ΔP %ΔQ÷%ΔP
31,312.8
0.118
-0.007
-259.273
-0.061
0.105
-0.006
-6217.720
-0.061
0.095
-0.006
-6177.887
-0.061
0.087
-0.005
-6142.073
-0.061
0.080
-0.005
-6109.559
-0.061
0.074
-0.005
-6079.801
-0.061
0.069
-0.004
-6052.379
-0.061
0.065
-0.004
-6026.961
-0.061
31088.6
50 30889.43
55 30710.37
60
30,547.8
65 30399.01
70
75
80
30261.9
30134.8
30,016.4
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.
Elasticities Extreme
P
Perfectly Inelastic
Demand (Insulin)
D
Perfectly Elastic
Demand (Clear Pepsi)
D
Q
Comparisons of Demand Price
Elasticities
• Oil has very
inelastic demand.
– Estimate of
elasticity of demand
for oil in the US is .061
J.C.B. Cooper, OPEC Review, 2003)
Price Elasticities of Other Goods
Salt
Coffee
-.1
-.25
Tobacco
-.45
Movies
-.9
Housing
Restaurant Meals
-1.2
-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.
2. a negative indirect impact because fewer goods will
be sold.
1.
•
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
% R % P %Q
%Q


 1
%P %P %P
%P
%R
e
Demand
0
%P
 1 e
Demand
• 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
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 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)
Oil Demand Curves
P
80
70
60
50
40
30
20
10
0
20000
25000
30000
35000
Short-term
40000
Long-term
45000
50000
Q
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.
S
S
Q1  Q0
Price
S
Q1S  Q0S
%Q
2

Elasticity of
%P
P1  P0
Supply = eS
P1  P0
2
0
Elasticities: Supply
P
Perfectly Inelastic Supply
(Van Gogh Paintings)
Perfectly Elastic S
Supply (Foot
Massage)
S
Q
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.
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 Supply Curves
Short-term
Long-term
P 80
70
60
50
40
30
20
10
0
18000
23000
28000
33000
38000
Q
Elasticity and Equilibrium Price
Changes
Changes in Equilibrium
• When events cause a supply or demand
curve to shift, the equilibrium price will
shift. But how much?
• Knowledge of elasticities can provide the
answer to this question.
Equilibrium Change in Price
• A 1% shift out in the demand curve leads to a
1
% change in equilibrium price.
eS  eD
• A 1% shift out in the supply curve leads to a
1
% change in equilibrium price.
S
D
e e
Examples
• Elasticity of demand for oil is eD = -.061
and elasticity of supply is eS = .04. World
oil demand goes up by 1%. How much does
the price change?
• Answer:
1
1
1
1 S
%
%
%  9.90%
D
e e
.04  .061
.101
Example 2
• What would happen to oil prices for GeoPolitical reasons there were a shut-down of
Iranian oil production and there was an
inward shift in the oil supply curve of
4.9%?
A shift in the supply schedule
(Spreadsheet)
A 4.9% shift in the supply schedule
30
35
40
45
50
55
60
65
70
75
80
85
90
95
100
105
Supply
29893.38
30078.28
30239.36
30382.16
30510.48
30627.02
30733.8
30832.36
30923.89
31009.35
31089.51
31164.99
31236.32
31303.95
31368.24
31429.56
Supply'
28428.61
28604.44
28757.63
28893.44
29015.46
29126.29
29227.84
29321.57
29408.62
29489.89
29566.12
29637.9
29705.74
29770.06
29831.2
29889.51
Demand
31867.11
31568.86
31312.77
31088.6
30889.43
30710.37
30547.8
30399.01
30261.9
30134.8
30016.4
29905.6
29801.51
29703.39
29610.59
29522.57
At the new supply curve
there is excess demand for
oil.
• Excess demand will
induce additional supply
and cut back in demand.
What is the new
equilibrium?
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.
Inferior Goods
Range of Income
Elasticities
Normal Goods
1
0
Income Inelastic
(Necessities)
Income Elastic
(Luxury Goods)
Income Elasticity of Oil
Region
China
Income
Elasticity
0.7
OECD
0.4
ROW
0.6
Source: OECD study
• Assume a world
income elasticity
of .5 and an
increase of world
income equal to
10%. Demand
shifts out by 5%.
• Would oil
production
increase by 5%?
Example
• What would the oil price change be in the
long run, if world income went up
permanently by 10% and no shift in supply
curve?
Changes in Prices of Other Goods
•
For any good there are two types of other
goods which are relevant to its demand
1. Substitutes: Those other goods which can
take the place of the good of interest
(bacon vs. ham)
2. 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
0
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 elasticity estimates to calculate changes in equilibrium
prices from shifts in demand or supply curves.
• Use cross-price elasticities or income elasticities to
calculate size of shifts in the demand curve caused by
external events.