Elasticity

  • If 100 shoes demanded at $20, when price is 40, quantity demanded falls to 40

    • P1=20, Q1=100, P2=40, Q2=40

    • Elastic

  • Determinants of price elasticity of demand

    • Necessities vs luxuries

      • Necessities are more inelastic, luxuries are more elastic

    • Availability of close substitutes

      • More substitutes -> more elastic

      • Less substitutes -> less elastic

    • Defining the market broadly or narrowly

      • Defining only Colgate vs all toothpaste

        • All toothpaste = inelastic

        • Just Colgate = elastic (people will switch brands if the price increases)

    • Time horizon

      • Short run vs long run

        • Long run: can change products because there is more time, more elastic

        • Short run: more inelastic

          • Example: method you use to heat home - can't change that quickly, but in the long run it can be switched

    • Fraction of income spent

      • If it's a small fraction, inelastic

        • Example: salt - small changes in price won't affect consumers

      • If it's a large fraction, elastic

        • Ex: if rent goes up a lot, you're probably going to move

    • Brand loyalty

      • Lower loyalty: more elastic

      • Higher loyalty: less elastic

    • Example: if the price of gas rises by 20%, by how much will you reduce gas consumption in the next 6 months?

      • Inelastic - in the US gas is a necessity, and it’s a short time horizon

      • In the next 6 years? Slightly more elastic, because of the longer time horizon

      • Only BP rises? Elastic, because you can just buy other brands

  • Price elasticity estimates:

    • Restaurant meals

      • Elastic

    • Electricity

      • inelastic

    • Theater

      • inelastic

    • Green peas

      • elastic

    • Automobiles

      • Elastic, over a longer time horizon

    • Air travel (business)

      • inelastic

    • Air travel (personal)

      • elastic

    • Coffee

      • inelastic

    • Shoes

      • inelastic

    • Beer

      • inelastic

  • Total revenue = price of good x quantity sold

  • Total revenue and elasticity

    • Elastic: price and total revenue move in opposite directions

    • Inelastic: price and total revenue move in the same direction

    • Unit elastic demand: when price changes, total revenue stays the same

  • Example: if the bacteria used to produce insulin becomes more expensive, does the total consumer expenditure on insulin rise or fall?

    • Supply decreases because of input prices, thus increasing the price

    • Insulin is inelastic - it is a necessity

    • Total revenue rises, because demand is inelastic and price has increased

  • Example: in 91, DC levied a 10% luxury tax on buying boats above $100,000 in the US, hypothesizing that it would yield $31 million in tax revenue

    • However, it was soon repealed

    • Elasticity of boats is high - people just went to Europe and bought boats

    • Only raised $16.6 million and 7,600 jobs in the industry were lost

  • Elasticity: measure of the responsiveness of quantity demanded or supplied to a change in determinants

  • Income elasticity: measures how much quantity demanded responds to change in consumer's income

    • (Q1-Q2/Q1+Q2)/(I1-I2/I1+I2)

    • How would the quantity demanded respond to a change in consumer's income for a normal good?

      • Quantity demanded would increase

    • How would it respond to a change in income for a inferior good?

      • Quantity demanded would decrease

  • Cross-price elasticity of demand: measures how much the quantity demanded responds to a change in another good

    • Neither of these use absolute value - can be negative

    • With substitutes, positive elasticity

    • With complements, negative elasticity

  • Price elasticity of supply: measures how much the quantity supplied of a good responds to a change in price

    • Elastic supply: quantity responds substantially to price changes

    • Inelastic supply: quantity responds minimally to changes

    • Equation: % change in Q/% change in P

    • Curves work the same as with demand

    • Do NOT use absolute value

  • Price elasticity of supply determinants:

    • Time horizon

      • Longer time: more elastic

      • Shorter time: less elastic

    • Availability of close substitutes/flexibility for inputs

      • Close substitutes, ability to change formula of product

      • Close input substitutes: more elastic

      • No close inputs: less elastic

  • Examples of near perfect inelastic supply:

    • Beachfront property (the amount of beach can't change)

    • Land in Manhattan

    • Anything one-of-a-kind (like the Mona Lisa)

  • Examples of near perfect elastic supply:

    • Water, in some places

    • Digital products (e-books, software)

    • Currency exchange

    • Retailers in highly competitive markets

  • Price volatility: common in markets where supply is highly inelastic and demand curves fluctuate sharply

    • Example: electricity. Supply is basically fixed. If demand increases significantly, prices can ride dramatically

  • Supply bottlenecks: common in markets where supply is highly inelastic

    • Example: star players on sports teams. They get paid hundreds of millions for a contract and supply uniquely essential inputs in the production process

  • In market economies, prices are the signals that guide decisions and allocate scarce resources