mbmc elasticity. mbmc copyright c 2004 by the mcgraw-hill companies, inc. all rights reserved....

MB MC

Elasticity

MB MC

Copyright c 2004 by The McGraw-HillCompanies, 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

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Farm incomes in response to drought

Total ‘consumer’ expenditure = P*Q

Before drought:50*100=500

After drought90*90 = 810

Total expenditure= Total farmer revenue

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Price Elasticity of Demand

ElasticityA measure of the extent to which quantity

demanded and quantity supplied respond to variations in price, income, and other factors.

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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

o Supply and demand for housing Drugs and crime

o What happens when we reduce the supply of drugs?

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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?

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Formal definition

∆Q/Q∆P/P

By convention, we drop the negative sign

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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


32

6

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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

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So What? Oil supply

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Oil prices

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What is the elasticity of demand for oil?Originally (1978)

Price = $46/barrel Quantity demanded = 63.332 billion barrels day

New (1980)Price = $97/barrelQuantity demanded = 62.948 bil. barrels/day, then

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Elasticity of demand and volatility

Price Inelastic demandSmall changes in quantity supplied lead to

large changes in price.Fluctuations in supply lead to fluctuations

in economy: INSTABILITYInstability makes it very difficult to plan or

invest, and undermines quality of lifeFood and oil in 2007/2008

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Elasticity and Total Expenditure

Total Expenditure = P x QMarket demand measures the quantity (Q)

at each price (P) Total Expenditure = Total Revenue

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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

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Price Elasticity of Demand Elasticity of domestic manufacturing jobs

that can be exported to Mexico.Originally

Wage = $10/hrQuantity demanded = 10,000 jobs/year

New Price = $10.50/hrQuantity demanded = 8,000 jobs/year, then

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Determinants of Price Elasticity of Demand

The more essential, the less elasticHow essential is agriculture?

William Nordhaus, Thomas Schelling, Wilfred Beckerman

How essential are natural resources? Robert Solow

Substitution PossibilitiesLots of substitutes for domestic jobs, few

substitutes for oil. Budget Share

What share of income is spent on food? Time- elasticity increases over time

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A Graphical Interpretation of Price Elasticity of Demand

Quantity

Pri

ce

P

D

A

Q

P - P

Q + Q

Q

P

Slope = ∆y/∆x= ∆P/∆Q

So ∆Q/Q = P * ∆Q ∆P/P Q ∆P

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D1

D2

12

4 6 12

6

4

Price Elasticity and the Steepness of the Demand Curve

Quantity

Pri

ce

What is the price elasticity ofdemand 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

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Price Elasticity Regions along a Straight-Line Demand Curve

Quantity

Pri

ce

b/2

a/2

a

b

1

1

1

ObservationPrice elasticity varies at every point along a straight-line demand curve

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Natura l Capita l S tocks

Ma

rgin

al

Va

lue

The Demand Curve for Essential and Non-substitutable Resources (e.g. Critical Natural Capital)

Valuable:Large change in Q, Small change in PElastic/inelastic

Critical: Perfectly

inelastic demand

Important: inelastic demand

Quantity of Essential Resource

Marg

inal valu

e

Demand curve for essential resources

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Perfectly Elastic Demand Curve

Quantity

Pri

ce

What’s an example of this?

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Perfectly Inelastic Demand Curve

Quantity

Pri

ce

)0 y (elasticit demand

inelasticPerfectly

What’s an example of this?

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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?

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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

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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

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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

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Income Elasticity of Demand

Normal GoodsIncome elasticity is positive

Inferior GoodsIncome elasticity is negative

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The Price Elasticity of Supply

Price Elasticity of SupplyThe percentage change in the quantity

supplied that occurs in response to a 1 percent change in price

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Price Elasticity of Supply for Oil

Oil price Jan. 2005=$40, July 2008=$127Percent change = 219%

Oil production Jan. 2005 = 84179 thousand barrels/day

July 2008 = 86671 Percent change = 3%

Elasticity = 3%/219% = 1/73=.0135

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A Perfectly Inelastic Supply Curve

Quantity of land in Manhattan

(1,000s of acres)

Pri

ce (

$/ac

re)

0

S

Elasticity = 0 at everypoint along a verticalsupply curve

What is the price elasticity of supply of land within the borough limits of Manhattan?

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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

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Determinants of Supply ElasticityFlexibility of inputsMobility of inputsAbility to produce substitute inputsTime

The Price Elasticity of Supply

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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

mbmc elasticity. mbmc copyright c 2004 by the mcgraw-hill companies, inc. all rights reserved....

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