Elasticities, Supply & Demand

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Elasticities

Quantitative Measurement



Measuring the Impact of Price on

Quantity Demanded

• A natural way of measuring impact of a pricechange 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

1Q Q Run

P P Rise SLOPE

!

= "

!



Elasticity: The % impact on quantity

demanded of a 1% change in price

• Economists prefer to measure price impacts interms 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 ofwhich you designate

as the reference point

(denominator), youcan 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 DemandUS$/BBL BBL (Mil) 1/Slope Elasticity

P Q %P %Q !

Q÷ !P %

!Q÷%

!P40 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

-.061J.C.B. Cooper, OPEC Review, 2003)

Salt -.1Coffee -.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) isthe cutoff point



•

The revenues generated by a firm along any pointof the demand schedule are equal to the productof quantity demanded and price

R = P·Q 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 orto adjust consumption behavior in responseto a change in prices.

• The long-run response to a price rise islarger than the short-run. Price elasticity ofdemand is more negative in the long runthan in the short run.

.



Oil Demand much more elastic in

long run than short-runPrice Elasticity of Demand

Short-term Long-term

Germany -0.024 -0.274Japan -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




Supply Curves

Price Elasticity



Upward Sloping Supply Curves

• The supply curve slopes up because somefactors 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

+

+

!

=!

>PriceElasticity of

Supply = eS



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 costof production.

• A good that is produced with readily

available factors w/o a need for timeconsuming 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




Elasticity and Equilibrium PriceChanges



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 De e!

1%

S De e

!

!



Examples

• Elasticity of demand for oil is eD = -.061

and elasticity of supply is eS = .04. World

oil demand goes up by 1%. How much doesthe price change?

• Answer:

1 1 11 % % % 9.90%.04 .061 .101

S De 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 aninward 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?



Income Elasticity

• We measure the effect of income ondemand 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 isnegative.



Range of Income

Elasticities

0 1

Inferior Goods

Normal Goods

Income Elastic

(Luxury Goods)

Income Inelastic

(Necessities)



Example

• What would the oil price change be in the

long run, if world income went up

permanently by 10% and no shift in supplycurve?



Changes in Prices of Other Goods

• For any good there are two types of othergoods which are relevant to its demand

1. Substitutes: Those other goods which cantake the place of the good of interest(bacon vs. ham)

2. Complements: Those other goods whoseuse will enhance the value of the good ofinterest. (bacon and eggs)

What are substitutes and complements for oil



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

SubstitutesComplements



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 ifIranian 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," saidJoseph 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 inverserelationship between the price of a good and thequantity that consumers would like to purchase. Reason:

• Consumers have limited income.

• The price that consumers will pay for an extragood 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 thegood before.

R t ti f H th ti l Oil



Representation of a Hypothetical Oil

Demand Schedule

0

20

40

60

80

100

120

29000 29500 30000 30500 31000 31500 32000

Q

PUS$/bbl Mil. BblP 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 30134.880 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 priceis at least as large of the extra cost of producingit (marginal cost).

• Producers have decreasing returns to productionand therefore increasing costs. To induce them to

produce greater amounts, they must becompensated for these increasing costs withhigher prices.



Why do supply curves slope up?

• Firms will only increase supply when pricesrise because their costs as production increases.

• Producing extra goods generates increasing

costs because some inputs are fixed and theflexible 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.

i f h i l il l



Representation of a Hypothetical Oil Supply

Schedule

US$/bbl Mil. BblP 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 theamount that consumers want to buy is equal tothe amount that sellers want to sell (Q*).

Excess Supply If P were above equilibrium, sellerswould want to sell more goods than buyers wouldwant to buy. Competition between sellers wouldforce 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.

C i i M k E ilib i



Competitive Market Equilibrium(Geometry)

SDP

Q

P*

Q*



Excess Supply

SDP

Q

P*

Q*

P



Excess Demand

SDP

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 30016.485 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 priceon 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 isinelastic.

STRICT DEFINITION TO COME



Shifting Curves/Changing Equilibrium

• Changes in equilibrium result from shifts in

either the demand or supply schedule. Wethink of shifts in the curves as changes insupply or demand that are caused by factors

other than changes in the price of the good. – Shifts in the demand curve lead to movementsalong the supply curve resulting in changes in

prices and quantities that move in the same

direction. – Shifts in the supply curve lead to movementsalong 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



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 hift i th d d h d l



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 31517.2285 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 demandschedule

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 ondemand. .

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



A Shift in the Supply Curve is a Movement

along the Demand curve- Price and Quantity Move in opposite Directions

SDP

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 scheduleshifts in/up.

• Equilibrium price rises/Equilibrium quantity falls.• At the current price level, there is a situation of

excess demand. As consumers, scramble to getmore oil, producers are able to raise prices.

• Higher prices induce i) some cutbacks in oil use;and ii) some additional production from othersources; until supply is equal to demand.

Elasticities, Supply & Demand

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