Elasticity (part two) Krzysztof Kołodziejczyk, PhD

Elasticity (part two) Krzysztof Kołodziejczyk, PhD

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Agenda 1. Price elasticity of demand 2. Extreme cases of elasticity 3. Elasticity and pricing 4. Elasticity in the long-term and short-term 5. Elasticity in areas other than price

Elasticity keywords price elasticity of demand income elasticity of demand cross-price elasticity of demand elastic inelastic unitary pricing passing costs on to consumers normal good inferior good short run / long run

Elasticity todays questions What is price elasticity? How to calculate and interpret price elasticity of demand What are the extreme cases of elasticity of demand? What is the link between elasticity of demand and pricing? What are the differences between price elasticity in the short term and long term? What about elasticities caused by other determinants than price?

The differences between price elasticity in the short term and long term micro in theory In the market for goods and services, quantity demanded are often relatively slow to react to changes in price in the short run (inelastic), but they react more substantially in the long run (more elastic). Elasticities are often lower in the short run than in the long run.

The differences between price elasticity in the short term and long term micro in practice Example: consumption of energy in the short term o you can carpool or riding a bike to work occasionally (if the price of gasoline goes up) o you can adjust your home thermostat by a few degrees (if the cost of energy rises) But that is about all you can do!

The differences between price elasticity in the short term and long term micro in practice Example: consumption of energy in the long term o you can purchase a car that will drive more miles on one liter of fuel, o you can choose a job that is closer to where you live, o you can buy more energy-efficient home appliances, or install more insulation in your home. As a result, the elasticity of demand for energy is somewhat inelastic in the short run but much more elastic in the long run.

The differences between price elasticity in the short term and long term micro in practice Think about other products or services where demand is relatively inelastic in the short term and relatively more elastic in the long run. How is this possible? Justify the answer. (10 minutes)

The differences between price elasticity in the short term and long term micro in practice one more, historical example (https://www.khanacademy.org): In 1973, the price of crude oil was $12 per barrel and total consumption in the US economy was 17 million barrels per day. That year, the nations who were members of the Organization of Petroleum Exporting Countries (OPEC), cut off oil exports to the United States for six months because the Arab members of OPEC disagreed with US support for Israel. OPEC did not bring exports back to their earlier levels until 1975 a policy that can be interpreted as a shift of the supply curve to the left in the US petroleum market.

The differences between price elasticity in the short term and long term micro in practice one more, historical example: crude oil market in the short term The shift of supply to the left from S 0 to S 1 The new equilibrium (E 1 ) has a higher price and a lower quantity than the original equilibrium (E 0 ) Image credit: Figure 4 in "Elasticity and Pricing" by OpenStaxCollege, CC BY 4.0

The differences between price elasticity in the short term and long term micro in practice one more, historical example: crude oil market in the long term The shift of supply to the left from S 0 to S 1 The new equilibrium (E 1 ) has a higher price and a lower quantity than the original equilibrium (E 0 ) Image credit: Figure 4 in "Elasticity and Pricing" by OpenStaxCollege, CC BY 4.0

The differences between price elasticity in the short term and long term micro in practice one more, historical example: crude oil market in the long term Image credit: Figure 4 in "Elasticity and Pricing" by OpenStaxCollege, CC BY 4.0

Elasticity in areas other than price micro in theory Quantity demanded depends on more than just price, it also depends on income, prices of related goods, and so on. Similarly, quantity supplied depends on the cost of production and other factors, as well as on price. Elasticity can be measured for any determinant of supply and demand, that is measurable, not just the price.

Elasticity in areas other than price micro in theory The income elasticity of demand (YED) is the percentage change in quantity demanded divided by the percentage change in income. o For most products the income elasticity of demand is positive. So, a rise in income will cause an increase in the quantity demanded. These goods are referred to as normal goods. o For a few goods, the income elasticity of demand is negative. An increase in income might mean that a person will purchase less of the good. these goods are called inferior goods.

Elasticity in areas other than price micro in theory The income elasticity of demand o A higher level of income for a normal good causes the demand curve to shift to the right. How far the demand shifts depends on the income elasticity of demand. A higher income elasticity means a larger shift. o However for an inferior good, a higher level of income causes the demand curve shifts to the left. Again, how much it shifts depends on how large the negative income elasticity is.

Elasticity in areas other than price micro in practice Why does a firm want to know YED? sales forecasting - a firm can forecast the impact of a change in income on sales volume and sales revenue; pricing policy - knowing YED helps the firm decide whether to raise or lower price following a change in consumer incomes. If incomes are falling and YED is positive, a reduction in price might help compensate for the reduction in demand; investment decisions the demand for normal goods increases when the economy is expanding, the demand decreases when the economy is falling. Conversely, the demand for inferior goods is counter-cyclical.

Elasticity in areas other than price micro in practice The income elasticity of demand Source: The Global Diamond Industry 2015: Growth Perspectives amid Short-Term Challenges

Elasticity in areas other than price micro in practice The income elasticity of demand Source: The Global Diamond Industry 2015: Growth Perspectives amid Short-Term Challenges

Elasticity in areas other than price micro in theory Cross-price elasticity of demand (XED) is the responsiveness of demand for one product to a change in the price of another product. Many products are related, and XED indicates just how they are related. o Substitute goods have positive cross-price elasticities of demand. If good A is a substitute for good B then a higher price for B will mean a greater quantity consumed of A. o Complement goods have negative cross-price elasticities of demand. If good A is a complement for good B then a higher price for B will mean a lower quantity consumed of A.

Elasticity in areas other than price micro in practice Example: substitutes o If the price of Coca Cola increases from 50p to 60p per can, and the demand for Pepsi Cola increases from 1m to 2m per year, the XED between the two products is: + (%) 100 / + (%) 20 = (+) 5.0 o Because the coefficient is greater than one, they are regarded as close substitutes. Example: complements o if the price of cinema tickets increases from 5.00 to 7.50, and the demand for popcorn decreases from 1000 tubs to 700, the XED between the two products will be: - (%) 30 / + (%) 50 = (-) 0.6 o Because the coefficient is less than one, they are regarded as not particularly complementary.

Elasticity in areas other than price micro in practice Why does a firm want to know XED? Knowing the XED of its own and other related products enables the firm to map out its market. Mapping allows a firm to calculate how many rivals it has, and how close they are. It also allows the firm to measure how important its complementary products are to its own products. This knowledge allows the firm to develop strategies to reduce its exposure to the risks associated with price changes by other firms, such as a rise in the price of a complement or a fall in the price of a substitute.

Elasticity in areas other than price micro in theory Wage elasticity of labor demand = % change in wage / % change in quantity of labor demanded Interest rate elasticity of borrowing = % change in interest rate / % change in quantity of borrowing

Conclusion I the long run we ve got usually more alternatives than in the short term (more choice). That s why our demand is more elastic. Knowing elasticities could be very useful for each company.