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Elasticity and Its Application

This article explores the concept of elasticity and its applications in demand and supply analysis. It covers the computation of price elasticity of demand and supply, cross-price elasticity of demand, and the determinants of price elasticity. It also discusses the significance of elasticity in understanding the responsiveness of quantity demanded and supplied to changes in price. Real-world examples related to oil markets and other goods are provided.

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Elasticity and Its Application

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  1. 5 Elasticity and Its Application

  2. The Elasticity of Demand (own) • Computing the price elasticity of demand • Percentage change in quantity demanded • Divided by percentage change in price • Use absolute value (drop the minus sign) • It’s always negative (own-price) • Midpoint method • Two points: (Q1, P1) and (Q2, P2)

  3. The Elasticity of Demand • Cigarettes (US)[41] • -0.3 to -0.6 (General) • -0.6 to -0.7 (Youth) – proportion of income? • Soft drinks • -0.8 to -1.0 (general)[51] (broadly defined) • -3.8 (Coca-Cola)[52] (narrow) • -4.4 (Mountain Dew)[52] (narrow) • Car fuel[45] • -0.25 (Short run) (same car – reduce trips) • -0.64 (Long run) (new car?)

  4. The Elasticity of Demand • Cross-price elasticity of demand • Measure of how much the quantity demanded of one good responds • To a change in the price of another/different good • [∆Qx/Qx] / [∆Py/Py ] • Sign matters -> tells whether substitute or complement • Magnitude (<1 or >1) -> how “good” a substitute/essential a complement • Substitutes: Positive cross-price elasticity • >1 -> “close” or good substitute as big shift with small price change • Complements: Negative cross-price elasticity • >1 -> “essential” to be used/consumed together (cars and gas)

  5. The Elasticity of Supply • Price elasticity of supply • Measure of how much the quantity supplied of a good responds • To a change in the price of that good • Percentage change in quantity supplied • Divided by the percentage change in price • Depends on the flexibility of sellers to change the amount of the good they produce

  6. The Elasticity of Supply • Price elasticity of supply • Elastic supply • Quantity supplied responds substantially to changes in the price • Inelastic supply • Quantity supplied responds only slightly to changes in the price • Determinant of price elasticity of supply • Time period • Supply is more elastic in long run

  7. The Elasticity of Supply • Computing price elasticity of supply • Percentage change in quantity supplied • Divided by percentage change in price • Variety of supply curves • Supply is perfectly inelastic • Elasticity =0 • Supply curve – vertical • Supply is perfectly elastic • Elasticity = infinity • Supply curve – horizontal

  8. The Elasticity of Supply • Variety of supply curves • Unit elastic supply • Elasticity =1 • Elastic supply • Elasticity >1 • Inelastic supply • Elasticity < 1

  9. 5 The price elasticity of supply (a, b) • Perfectly inelastic supply: • Elasticity = 0 (b) Inelastic supply: Elasticity < 1 Price Price Supply 1. an 1. an Supply • A 22% • increase • in price… • An • increase • in price… 2. … leads to a 10% increase in quantity supplied $5 $5 2. …leaves the quantity supplied unchanged 4 4 100 110 0 0 100 Quantity Quantity The price elasticity of supply determines whether the supply curve is steep or flat. Note that all percentage changes are calculated using the midpoint method.

  10. Applications of Supply, Demand, & Elasticity • Why did OPEC fail to keep the price of oil high? • 1970s: OPEC reduced supply of oil • Increase in prices 1973-1974 and 1971-1981 • Short-run: supply is inelastic • Decrease in supply: large increase in price • 1982-1990 – price of oil decreased • Long-run: supply is elastic • Decrease in supply: small increase in price

  11. 8 A reduction in supply in the world market for oil (a) The Oil Market in the Short Run (b) The Oil Market in the Long Run 2. … leads to a large increase in price 1. In the long run, when supply and demand are elastic, a shift in supply. . . 1. In the short run, when supply and demand are inelastic, a shift in supply. . . 1. an 1. an Price Price 2. … leads to a small increase in price S1 S2 S2 S1 P1 P2 P2 P1 Demand Demand Quantity Quantity 0 0 When the supply of oil falls, the response depends on the time horizon. In the short run, supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve shifts from S1 to S2, the price rises substantially. By contrast, in the long run, supply and demand are relatively elastic, as in panel (b). In this case, the same size shift in the supply curve (S1 to S2) causes a smaller increase in the price.

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