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.
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)
1 0
1 0
1
Q Q Run
P P Rise
SLOPE
!
= "
!
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
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.
% %
%
%
Change in Q Change n P
e
i
Q
P
=
=
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.
[ ]
1 0
1 0
%
2
X X
X
X X
!
"
+
# $
% &
' (
Slope and Elasticity of Oil Demand
US$/BBL BBL (Mil) 1/Slope Elasticity
P Q %P %Q !Q!P %!Q%!P
40 31,312.8
0.118 -0.007 -259.273 -0.061
45 31088.6
0.105 -0.006 -6217.720 -0.061
50 30889.43
0.095 -0.006 -6177.887 -0.061
55 30710.37
0.087 -0.005 -6142.073 -0.061
60 30,547.8
0.080 -0.005 -6109.559 -0.061
65 30399.01
0.074 -0.005 -6079.801 -0.061
70 30261.9
0.069 -0.004 -6052.379 -0.061
75 30134.8
0.065 -0.004 -6026.961 -0.061
80 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
Perfectly Inelastic
Demand (Insulin)
Perfectly Elastic
Demand (Clear Pepsi)
P
Q
D
D
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)

Salt -.1
Coffee -.25
Tobacco -.45
Movies -.9
Housing -1.2
Restaurant Meals -2.3
Price Elasticities of Other Goods
A demand curve is classified as INELASTIC
if the elasticity is between 0 and -1
A demand curve is classified as
ELASTIC if the elasticity is less than -1
Unit elasticity (elasticity equal to -1) is
the cutoff point
The revenues generated by a firm along any point
of the demand schedule are equal to the product
of quantity demanded and price

R = PQ
D

Raising prices has two counter-veiling effects:
1. a direct positive impact on revenues because each
good sold generates more revenue.
2. a negative indirect impact because fewer goods will
be sold.
Which is stronger?

Elasticity and Revenues
Effect of price change on revenues
Changes in revenues are approximately
%R ! %P+%Q
Divide through by %P to get the total impact
%
1
%
Demand
R
e
P
= +
% % % %
1
% % % %
R P Q Q
P P P P
= + = +
0
Demand
e <
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
0
10
20
30
40
50
60
70
80
20000 25000 30000 35000 40000 45000 50000
Q
P
Short-term Long-term
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.
1 0
1 0
1 0
2
1 0
2
%
%
0
S S
S S
S
Q Q
P P
Q Q
Q
P P P
+
+
!
=
!
>
Price
Elasticity of
Supply = e
S

Elasticities: Supply
Perfectly Inelastic Supply
(Van Gogh Paintings)
Perfectly Elastic
Supply (Foot
Massage)
P
Q
S
S
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
0
10
20
30
40
50
60
70
80
18000 23000 28000 33000 38000
Q
P
Short-term Long-term
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
change in equilibrium price.
A 1% shift out in the supply curve leads to a
change in equilibrium price.

1
%
S D
e e !
1
%
S D
e e
!
!
Examples
Elasticity of demand for oil is e
D
= -.061
and elasticity of supply is e
S
= .04. World
oil demand goes up by 1%. How much does
the price change?
Answer:
1 1 1
1 % % % 9.90%
.04 .061 .101
S D
e e
! = = =
" "
Example 2
What would happen to oil prices for Geo-
Political 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)
Supply Supply' Demand
30 29893.38 28428.61 31867.11
35 30078.28 28604.44 31568.86
40 30239.36 28757.63 31312.77
45 30382.16 28893.44 31088.6
50 30510.48 29015.46 30889.43
55 30627.02 29126.29 30710.37
60 30733.8 29227.84 30547.8
65 30832.36 29321.57 30399.01
70 30923.89 29408.62 30261.9
75 31009.35 29489.89 30134.8
80 31089.51 29566.12 30016.4
85 31164.99 29637.9 29905.6
90 31236.32 29705.74 29801.51
95 31303.95 29770.06 29703.39
100 31368.24 29831.2 29610.59
105 31429.56 29889.51 29522.57
A 4.9% shift in the supply schedule

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.
Range of Income
Elasticities
0
1
Inferior Goods
Normal Goods
Income Elastic
(Luxury Goods)
Income Inelastic
(Necessities)
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%?
Region Income
Elasticity
China 0.7
OECD 0.4
ROW 0.6
Income Elasticity of Oil
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
Substitutes Complements
Supply and Demand
Gas prices at record high
West Texas Intermediate (Bbl)
0.000
10.000
20.000
30.000
40.000
50.000
60.000
70.000
80.000
J
a
n
-
0
1
J
a
n
-
0
2
J
a
n
-
0
3
J
a
n
-
0
4
J
a
n
-
0
5
J
a
n
-
0
6
U
S
$
Prices of Oil
and Gasoline
continue to
climb!
What
happens if
Iranian oil is
taken
offline?
August 25, 2005
Rising Price of Oil Pushes S.&P. to Negative
Territory
By ERIC DASH
Oil prices climbed to another record yesterday,
driving stocks lower and leaving the Standard &
Poor's 500-stock index down for the year.
All three major market gauges closed lower
yesterday; the S.&. P.'s loss meant that for the first
time since July 7, all three were in negative territory
for the year. "Once oil decided that it was going to
move higher and stay higher, that just took the
starch out of any buyers in the stock market," said
Joseph Liro, the chief equity strategist at Stone &
McCarthy, an economic research firm in Princeton.
"Oil is just the biggest single depressant on the
market except for the oil stocks."
To think about commodity prices,
economists first think about the theory of
competitive markets
Competitive Markets have many buyers and
many sellers who compete without barriers
preventing rivals from entering or leaving
the market.
Participants in competitive markets are
price takers, agents who behave as if their
own behavior has no effect on market
prices.
Law of Demand: There is always an inverse
relationship between the price of a good and the
quantity that consumers would like to purchase.
Reason:
Consumers have limited income.
The price that consumers will pay for an extra
good will be no greater than the extra benefit
that they receive from it.
People face diminishing returns from consuming
any given good.
Each extra good consumed generates less
marginal benefit than the good before
Consumers will be willing to pay less for each
extra good than they were willing to pay for the
good before.
Representation of a Hypothetical Oil
Demand Schedule

0
20
40
60
80
100
120
29000 29500 30000 30500 31000 31500 32000
Q
P
US$/bbl Mil. Bbl
P Q
30 31867.11
35 31568.86
40 31312.77
45 31088.6
50 30889.43
55 30710.37
60 30547.8
65 30399.01
70 30261.9
75 30134.8
80 30016.4
85 29905.6
90 29801.51
95 29703.39
100 29610.59
Law of Supply: There is a positive relationship
between the price of a good and the quantity
producers bring to the market.
In a competitive market place, producers are
willing to sell an extra good as long as the price
is at least as large of the extra cost of producing
it (marginal cost).
Producers have decreasing returns to production
and therefore increasing costs. To induce them to
produce greater amounts, they must be
compensated for these increasing costs with
higher prices.

Why do supply curves slope up?
Firms will only increase supply when prices
rise because their costs as production increases.
Producing extra goods generates increasing
costs because some inputs are fixed and the
flexible factors of production will have
diminishing returns.
Example: A busy McDonalds can sell more burgers
by adding more McWorkers, but effectiveness of
workers is limited by amount of Cash registers,
Ovens, and ultimately Space.
Representation of a Hypothetical Oil Supply
Schedule
US$/bbl Mil. Bbl
P Q
30 29893.38
35 30078.28
40 30239.36
45 30382.16
50 30510.48
55 30627.02
60 30733.8
65 30832.36
70 30923.89
75 31009.35
80 31089.51
85 31164.99
90 31236.32
95 31303.95
100 31368.24
0
20
40
60
80
100
120
2
9
8
9
3
3
0
1
4
3
3
0
3
9
3
3
0
6
4
3
3
0
8
9
3
3
1
1
4
3
3
1
3
9
3
Q
P
Equilibrium
Equilibrium in the competitive market occurs
when the price is set at a level (P*) such that the
amount that consumers want to buy is equal to
the amount that sellers want to sell (Q*).
Excess Supply If P were above equilibrium, sellers
would want to sell more goods than buyers would
want to buy. Competition between sellers would
force prices down.
Excess Demand If P were below equilibrium,
customers would want to buy more goods than
people would want to sell. Competition between
buyers would force prices up.
Competitive Market Equilibrium
(Geometry)
S D
P
Q
P*
Q*
Excess Supply
S D
P
Q
P*
Q*
P
Excess Demand
S D
P
Q
P*
Q*
P
Market Equilibrium
(Spreadsheet Problem)
Supply Demand
30 29893.38 31867.11
35 30078.28 31568.86
40 30239.36 31312.77
45 30382.16 31088.6
50 30510.48 30889.43
55 30627.02 30710.37
60 30733.8 30547.8
65 30832.36 30399.01
70 30923.89 30261.9
75 31009.35 30134.8
80 31089.51 30016.4
85 31164.99 29905.6
90 31236.32 29801.51
95 31303.95 29703.39
100 31368.24 29610.59
At what price and quantity (to
closest $5) will the oil market
clear?
Elasticity: The Concept
How strong is the effect of a change in price
on the change in quantity supplied or
quantity demand.
If the price effect is strong, we say the
supply/demand schedule is elastic.
If the price effect is weak, we say it is
inelastic.
STRICT DEFINITION TO COME
Shifting Curves/Changing Equilibrium
Changes in equilibrium result from shifts in
either the demand or supply schedule. We
think of shifts in the curves as changes in
supply or demand that are caused by factors
other than changes in the price of the good.
Shifts in the demand curve lead to movements
along the supply curve resulting in changes in
prices and quantities that move in the same
direction.
Shifts in the supply curve lead to movements
along the demand curve resulting in changes in
prices and quantities that move in different
directions.
What shifts a demand curve?
1. Changes in consumer preferences
2. Changes in consumer income
3. Changes in the prices of other goods.
Hypothetical Demand Shift
Consider that there is an increase in consumer income
sufficiently large that oil demand would increase by 5% if
the price level stayed the same. This event will increase
the demand for oil at any given price level. Demand
schedule shifts out/up.
Equilibrium price and quantity rise.
At the old price level, there is a situation of excess
demand. As consumers, scramble to get more oil,
producers are able to raise prices.
Higher prices induce i) some cutbacks in oil use; and ii)
some additional production until supply is equal to
demand.
A Shift in the Demand Curve: A parallel increase in
the demand schedule at every price point.
Equilibrium Effect: Movement along the supply curve
S
D
P
Q
P*
Q*
P**
Q**
D!
Shift in the
demand curve
A shift in the demand schedule
(Spreadsheet)
Supply Demand Demand'
30 29893.38 31867.11 33460.47
35 30078.28 31568.86 33147.31
40 30239.36 31312.77 32878.41
45 30382.16 31088.6 32643.03
50 30510.48 30889.43 32433.9
55 30627.02 30710.37 32245.88
60 30733.8 30547.8 32075.19
65 30832.36 30399.01 31918.96
70 30923.89 30261.9 31774.99
75 31009.35 30134.8 31641.54
80 31089.51 30016.4 31517.22
85 31164.99 29905.6 31400.88
90 31236.32 29801.51 31291.59
95 31303.95 29703.39 31188.56
100 31368.24 29610.59 31091.12
A 5% shift in the demand
schedule
If price stayed constant,
demand for oil would
increase 5%.
But to get producers to
produce more, price must
go up which will have a
counter-veiling effect on
demand. .
What is the new equilibrium
price?
Shifts in Supply Curves
Supply curves represent the extra cost of
producing a good which increases in the
number of goods produced. But other factors
may affect cost besides scale.
Cost Shifters
1. Changes in resource prices
2. Changes in Technology
3. Nature and Political Disruptions
4. Changes in Taxes on Producers
A Shift in the Supply Curve is a Movement
along the Demand curve-
Price and Quantity Move in opposite Directions
S D
P
Q
P*
Q*
P**
Q**
S!
Equilibrium Effects of an Decrease in
Supply
When there is some disruption, oil companies
produce less at any given price. Supply schedule
shifts in/up.
Equilibrium price rises/Equilibrium quantity falls.
At the current price level, there is a situation of
excess demand. As consumers, scramble to get
more oil, producers are able to raise prices.
Higher prices induce i) some cutbacks in oil use;
and ii) some additional production from other
sources; until supply is equal to demand.