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14.01SC Principles of Microeconomics, Fall 2011

Transcript Lecture 3: Elasticity
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PROFESSOR: So today what we're going to do is continue our discussion of supply and demand. This is
sort of introduction week, if you will. We've kind of talked about supply and demand, and you guys,
rightly, immediately were on to where do those curves come from. And that's what we'll start next
week. But what I want to do today is talk some more about what determines the shapes of supply and
demand curves and just think about an overview of how we think about supply and demand interacting
in a market and what determines how responsive individuals and firms are to prices.
And, once again, remember everyone should have a handout that you should have picked up in the back
on your way in. So everyone should have a handout. What we talked about last time was the sort of
qualitative effects, the qualitative version of the supply and demand model. We talked about what
happens when a supply curve shifts, what happens when a demand curve shifts. We talked about how
either a supply shock or a demand shock could lead to the price being increased. But they could have
very different effects on quantity, et cetera.
What we didn't talk about is how big these effects are. I made up some numbers. I threw them on the
graphs. But I didn't talk about where the size of those effects come from. And where they come from is
the shapes of the supply and demand curve. And that's what we'll talk about today is what determines
the shapes of supply and demand curves. And that will be the focus of today's lecture. I'll talk both
theoretically about what determines these shapes and empirically about how economists go about
figuring out the shapes of supply and demand curves.
So, to think about this, let's start with Figure 3-1, which is a standard market diagram we had last time.
With an initial equilibrium at point E1, with an initial price P1 and a quantity Q1. That's the equilibrium
that's stable. Because at that price P1, consumers demand Q1 units, and suppliers are willing to provide
Q1 units. So that's a stable equilibrium.
Now we have some supply shift. Last time we talked about somehow a pork-specific drought. That leads
the supply to shift inward. So the supply curve rises to S2. At that new price, initially, you would have
excess demand. But quickly the price increases to shut off that excess demand. And you end up with a
new equilibrium with a higher price, P2, and a lower quantity Q2, and new equilibrium point E2. OK?
And we talked that through last time.
What I want to talk about this time is well, what determines the size of that shift from Q1 to Q2 and that
price increase from P1 to P2? What's going to determine it is the elasticity of supply and demand. The
elasticity of supply and demand is how much do supply and demand respond? Do the quantities
supplied and the quantities demanded respond when the price changes?
When we say, how elastic is demand, what we mean is how sensitive to price is the quantity demanded.
Or, alternatively, what is the slope of that demand curve? So the slope of the demand curve will be the
sensitivity of quantity demanded to the price consumers face. And that will determine the market
responsiveness.
In economics, it's always true that the best way to think about things is to go to extremes. You have to
remember that extremes don't exist in the real world. But it's a useful teaching device to think about
extremes.
So let's think about one extreme case in Figure 3-2. Let's think about the case of perfectly inelastic
demand. Perfectly inelastic demand, that's where there's no elasticity of demand. What that means is
that demand for a good is unchanged regardless of the price. So perfectly inelastic demand is a case
where demand for the good is unchanged regardless of the price. That would lead you to have a vertical
demand curve at a given quantity. What this says is regardless of the price, people always demand Q.
Can anyone tell me what would cause demand to be perfectly inelastic? In what types of situations
would demand be-- it's never perfectly inelastic-- would demand be relatively inelastic? Yeah?
AUDIENCE: [INAUDIBLE PHRASE].
PROFESSOR: It's all about substitutes. When there's no substitutes, when there's nowhere to go, it
doesn't matter what the price is. When there's no substitutes, demand will be perfectly inelastic,
because you have to have Q. It doesn't matter what the price is. Because there's no substitute for that
good. So if you wanted amount Q of that good for any reason, you're always going to want that amount
Q no matter the price.
So a perfectly inelastic good would have no substitutes. So you'd always want Q no matter what. Can
anyone think of an example? There's no perfectly inelastic good in the world. But what sorts of goods?
Yeah?
AUDIENCE: Medicines.
PROFESSOR: Medicines. Now, not necessarily all medicines. So give me an example of a medicine which
would be more or less inelastic. So I don't even need a medical name. What sort of treatments?
AUDIENCE: Like heart attack maybe?
PROFESSOR: Yeah, something which is sort of lifesaving. The best thing that we often use is insulin for
diabetics. Diabetics without getting that insulin to manage their diabetes will die. That seems like that's
something where there's not a whole lot of substitutes. The substitute is dying. So basically that's where
demand is relatively inelastic. Or a heart transplant, when you get a heart transplant or any kind of
transplant, you have medicine you take so you don't reject the transplanted organ. That sort of medicine
demand should be very inelastic.
Elastic drug, well, our favorite example is always Viagra. It's something where you'd think that you can
probably survive without it. And people would want less Viagra if you charged a lot more for it than if
you charged less for it. So elasticity is going to be about substitutability. And that's going to determine
inelastic demand.
Now, what happens with inelastic demand when there's a supply shock? When supply increases, what
happens? Well, in that case, there can never be excess demand, because demand doesn't change. So all
that happens is price just increases. If there's inelastic demand, and there's a supply shock, then all that
happens is an increase in price and no change in quantity. So with inelastic demand, quantity doesn't
change for a price increase. Price just goes up. From a supply shock, prices just goes up.
Now, let's consider the opposite. Let's look at Figure 3-3 and think about perfectly elastic demand.
Perfectly elastic demand is demand where consumers, essentially, don't care about the quantity. They
just care about the price. That is, there are infinitely good substitutes. A perfectly elastically demanded
good would be one where there are, essentially, perfect substitutes. An inelastic good is where there's
no substitute. A perfectly elastic good would be where there's perfect substitutes.
Technically, if a good is perfectly elastically demanded, then you are completely indifferent between
that good and a substitute. Well, if you're completely indifferent, then if the price changed at all, you
would immediately switch. And so the price can't change.
What's an example? Once again, there's no good example of a perfectly elastic good. Yeah?
AUDIENCE: Candy.
PROFESSOR: What?
AUDIENCE: Candy.
PROFESSOR: Candy. OK. So you've got your Wrigley's gum. I like the sugar-free, minty gum. You've got
Orbit and Eclipse. And I go to the store, and they're all pretty much the same price. If Orbit was more
than Eclipse, I just buy Eclipse. They're the same. They're minty gum. It doesn't make a difference. So
basically the price is the same.
If there's a supply shock, I don't know, they're made with the same shit. But let's say that Eclipse has
some magic ingredient. And let's say the Eclipse magic ingredient got more expensive, so the supply
curve shifted up. Well, Eclipse could not respond by raising its price. Because I just switched to Orbit.
Or we often think of McDonald's and Burger King. Now, they're less perfect substitutes, but pretty
perfect. If McDonald's started charging $10 for a hamburger, you wouldn't go there anymore. You'd go
to Burger King.
So if there's a supply shock to a provider that's facing a perfectly elastic demand curve, they cannot
raise their price, because people will just switch. So quantity will fall a lot. Because if I'm supplying
Eclipse gum, and it suddenly costs a lot more to produce Eclipse gum, but I can't raise my price, because
I will lose all my business to Orbit, I'm just going to produce a lot less Eclipse. Because I'm losing money
now.