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Quantitative Measurement
Chap. 4
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.
Q QD D
Run
1 0
d
P1 P0 Rise
Q QS S
Run
1
0
s
P1 P0 Rise
Economists often prefer elasticity to
slope in real world
• 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)
• 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
%Change in Q
%Change in P
e
D %Q D
0 e
S %Q S
0
%P %P
Midpoint Method
• If you want to
calculate a %
difference between %X
X1 X 0
two points which is X1 X 0
2
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.
Slope and Elasticity of Oil Demand
P Q %P %Q e
60 83,033.06
15.38% -1.54% -0.10
70 81,762.92
13.33% -1.34% -0.10
80 80,678.38
11.76% -1.18% -0.10
90 79,733.70
10.53% -1.05% -0.10
100 78,898.04
9.52% -0.95% -0.10
110 78,149.63
8.70% -0.87% -0.10
120 77,472.59
8.00% -0.80% -0.10
130 76,854.95
7.41% -0.74% -0.10
140 76,287.50
6.90% -0.69% -0.10
150 75,762.98
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.
World Bank Tobacco Download
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.
World Bank Tobacco Download
Elasticities Extreme
P Perfectly Inelastic
Demand (Insulin)
D
Perfectly Elastic
Demand (Clear Pepsi)
Q
Comparisons of Demand Price
Elasticities
• Oil has very
inelastic demand. Price Elasticities of Other Goods
– Estimate of Salt -.1
elasticity of demand
Coffee -.25
for oil in the US is
-.061 Tobacco -.45
J.C.B. Cooper, OPEC Review, 2003)
Movies -.9
Housing -1.2
Restaurant Meals -2.3
A demand curve is classified as INELASTIC
if the elasticity is between 0 and -1
R = P∙QD
%R 1 e Demand
%P
e Demand
0
Price Elasticity & Revenues
• 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
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.
• Estimates of oil supply elasticity are low.
Elasticity of Supply in Oil Market
P Q %P %Q e
60 80,059.86
15.38% 1.54% 0.10
70 81,303.55
13.33% 1.34% 0.10
80 82,396.49
11.76% 1.18% 0.10
90 83,372.72
10.53% 1.05% 0.10
100 84,255.78
9.52% 0.95% 0.10
110 85,062.66
8.70% 0.87% 0.10
120 85,806.03
8.00% 0.80% 0.10
130 86,495.60
7.41% 0.74% 0.10
140 87,138.99
6.90% 0.69% 0.10
150 87,742.26
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.
Elasticities: Supply
Perfectly Elastic S
Supply (Foot
Massage)
Q
Elasticities and Equilibrium Effects
• Strength of impact on demand shifts on
quantity vs. price depends on elasticity of
both supply curve.
– Imagine elasticity of supply were completely
inelastic, then an increase in demand will
increase only price and have no effect on
quantity.
– Imagine elasticity of supply was completely
elastic, an increase in demand will increase only
quantity and have no effect on price.
Steeper (less elastic) supply curve means that a demand shift
will have a smaller impact on quantity and bigger impact on
price. .
P S1
1
S2
P1** 2
P2** 0
P*
D’
D
Q
Q *
Q1 **
Q2 **
Steeper (less elastic) demand curve means that a supply shift
will have a smaller impact on quantity and bigger impact on
price. .
P S’
1
S
P1** 2
P2** 0
P*
D2
D1
Q
Q1 **
Q2** Q
*
Excise taxes
• We can think of the supply curve as the
price that producers would charge to
produce a certain quantity of the product.
• We can think of the excise tax as an
additional surcharge added on top of that
price.
The add on tax is like a shift up in the supply curve
P Swith tax
S
tax
Q
Tax of course affects quantity demanded can define equilibrium
here. Price goes up for consumer but price going to producer
goes down. .
P Swith tax
S
P*after tax tax
.
P to producer
*
Q
Q *
• Imagine a market for gasoline. Refinery
capacity is limited so supply curve is
inelastic.
• The government adds a surcharge on to gas,
what happens to the market?
Tax of course affects quantity demanded can define equilibrium
here.
.
S
P
P*pre tax .
D
Q
Q
*
With a very inelastic supply curve, the post tax price does not
rise by very much but the price that the produer receives drops
sharply.
.
S’ S
P
P*post tax
P*pre tax .
P*to producer
D
Q
Q *
Price Elasticity and Time
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 demand 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
Short-term Long-term
Q
Oil Suply Curves
Short-term Long-term
P
Q
Demand Shifters
0 1
Complements Substitutes
Learning Outcome
• Students should be able to:
• Calculate an elasticity given two points on a
supply or demand curve.
• Use demand elasticities to calculate price
elasticity of revenue.
• Use cross-price elasticities or income
elasticities to calculate size of shifts in the
demand curve caused by external events.
Discussion Question
• As noted in class, recent years have been ones of
extremely high oil prices. This has had a number of
economic effects outside the petroleum industry. One
interesting example has been the price of corn tortillas in
Mexico which have risen rapidly.
– How would the price of oil affect the price of corn? Why would
these two goods be substitutes?
– What would be the effect of changes in the price of corn on
prices of tortillas?
– Which elasticities would be helpful to us in estimating the
quantitative effect of oil price changes on tortilla prices?