Elasticities
Will the China's trade balance (export-import) deteriorate if Renminbi (RMB) appreciates (say, from 1USD = 8.1RMB to 1USD = 7.8RMB)? An appreciation of RMB will make China's imports less expensive and hence an increase in quantity demanded for import from the United States, and possibly other countries. At the same time, China's Exports become more expensive to the United States and other countries, and hence quantity demanded for export from China may decrease. The impact of RMB appreciation on the trade balance depends on the responsiveness of import demand and export demand to the appreciation. The Chinese government need to access the responsiveness of trade balance to an appreciation of RMB before deciding on whether and how much it should let RMB appreciate. The government would like to discourage smoking by 5%. How much sales tax should the government impose on cigarette? A local bank is considering to lower interest rate to attract more customers to borrow from the bank. rate. A local restaurant would like to raise price of its set meal. To determine the impact of the change on its revenue, it will need to estimate how responsive customers will react to the change in price. The per capita income is estimated to increase by 10% next year. How would this change in income aect the demand for dierent kinds of products? To answer any of these questions, we need to know how responsive the quantity demanded is to the change in prices. To determine the change of interest rate, it has to know how responsive the demand for loan is to the change in interest
change in price. This measure is called the price elasticity of demand, i.e.,
%Q %P
This measure is unit free and thus allow us to compare the responsiveness of quantity demand across markets, when necessary.
Example 7. When the price was $2 per apple, 4000 apples were sold. When the price is changed to $3 per
apple, 3000 apples were sold. What is the price elasticity of demand? The information can be summarized as Price Old New Quantity
P0 = $2 Q0 = 4000 P1 = $3 Q1 = 3000
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%Q =
Q1 Q0 3000 4000 100% = 100% = 25% Q0 4000 P1 P0 32 100% = 100% = 50% P0 2 = %Q 25% = = 0.5 %P 50%
%P =
Example 8. When the price was $3 per apple, 3000 apples were sold. When the price is changed to $2 per
apple, 4000 apples were sold. What is the price elasticity of demand? The information can be summarized as Price Old New Quantity
P0 = $3 Q0 = 3000 P1 = $2 Q1 = 4000
%Q =
4000 3000 Q1 Q0 100% = 100% = 33.33% Q0 3000 P1 P0 23 100% = 33.33% 100% = P0 3 = %Q 33.33% = = 1 %P 33.33%
%P =
From the two examples above, we can make several observations. First, the price elasticity of demand is always negative. This is so because the demand is downward sloping. Second, for two given price-quantity pairs, very dierent price elasticity of demand can result when a dierent price-quantity pair is treated as the initial (or original) price-quantity pair. This dierence is caused by the dierence in denominators in computing the percentage changes. That is why some economists would prefer to compute
%Q = %P =
initial one.
Obviously, with this measure, the resulted elasticity will be the same whatever price-quantity pair we use as the Yet, an alternative is to look at a small change in price, non-zero),
P1
P0 ,
i.e., approximately
P = P1 P0 . P1 = P2 = P . 1
slope
When
P,
i.e.,
Q/Q = P/P
Q P
P Q
P Q
For instance, using the formula, we can compute the price elasticity of demand at point A shown in the diagram below.
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P = 10 0.5Q
for
0 Q 20.
demand at
P =1?
And
P = 8? P = 0.5 Q
From the linear demand curve, we can verify that at any price-quantity pair slope We can compute
Q P = 1 18 P =8 4
Q P
2 2
1/9 4
The example shows that the price elasticity of demand diers across price-quantity pairs on a linear demand curve. If we use Excel to compute the price elasticity of demand for dierent points on a demand curve, we will be able to verify that the quantity demanded becomes more responsive to a given change in prices (i.e., more elastic, and more negative) as the price-quantity pair moves in the northwest direction along the demand curve. The price elasticity of demand equals -1 at the midpoint of the demand curve.
When the price elasticity of demand at a price-quantity pair is smaller than -1, the demand is said to be elastic, meaning that the quantity demanded is relative responsive to the change in price. When the price elasticity of demand at a price-quantity pair is larger than -1, the demand is said to be inelastic, meaning that the quantity demanded is not very responsive to the change in price. When the price elasticity of demand at a price-quantity pair equals to -1, the demand is said to be unit elastic.
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The formula of price elasticity of demand suggests that at the intersection of two linear demand curves, the price elasticity of demand for the atter linear demand curve is more elastic than the one that is steeper.
1
slope
1 2 1 < 2 1
= = <
1
slope1
1
slope2
1
slope2
slope1
That is, price elasticity of demand of demand curve 1 is more elastic (more negative) if only if the slope of demand curve 1 is less negative. The slope of demand curve 1 is less negative only if it is atter. To conclude, at the intersection point, the demand curve with a atter slope has more elastic price elasticity of demand.
=P Q
We are interested in knowing how total revenue will change when price changes. The impact of price changes on total revenue can be decomposed as
T R
= P1 Q1 P0 Q0 = = (P0 + P ) (Q0 + Q) P0 Q0 P Q0 + P0 Q + P Q = P0 Q0 + P Q0 + P0 Q + P Q P0 Q0
When
and
Q are small, the product P Q will be very small and hence may be ignored, i.e., assumed
to be zero. Hence,
T R = P Q0 + P0 Q
Thus a change of total revenue comes from two sources: (1) The change of total revenue solely due to the change in price. That is, when quantity demand is held xed or unresponsive to the change in prices, total revenue will change by the amount of
P Q0 .
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(2) The change of total revenue due to the change in quantity demanded. Quantity demanded falls as price increases. Total revenue falls by
P0 Q
The resulted change in total revenue depends on the contribution of these two parts and hence the how responsive
(i.e.,
Q)
is to the change of
(i.e.,
P ),
When the price elasticity of demand is elastic, an increase in price is going to cause a relative big fall in quantity demanded, negative. An increase in price (i.e.,
P Q0
P0 Q
T R
will be
P Q0
small positive big positive Consequently,
P > 0) P0 Q
T R
negative positive
= 1, P Q0
will oset by
P0 Q.
T R
P Q=k
where
is a constant. Thus, a demand curve with unit price elasticity of demand at all price-quantity pairs
can be written as
P =
or
k = kQ1 Q k = kP 1 P
Q=
Taking natural logarithm, we have
ln(Q),
i.e.,
ln(Q) = 1. ln(P )
It is not a coincidence that this number is the same as the value of price elasticity of demand. It turns out, mathematically but less rigorously, we can write
1
ln(x) =
Hence,
x . x
=
elasticity of demand.
This understanding allows us to generalize our analysis to write demand function with any constant price
Mathematically,
d ln(x) 1 = . dx x
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Qx = 0 + 1 Px
the price elasticity of demand will change with price-quantity pairs. The report of of elasticities without reference to any price-quantity pair suggests that constant-elasticity demand function is often assumed in the estimation, i.e.,
ln Qx = 0 + 1 ln Px +
where
Qx
x , Px
x,
and
Example 10. A recent study has reported the following empirical estimation of demand function
ln(Qd ) = 1000 0.5 ln(Px ) + 1.2 ln(Py ) 3.4 ln(Pz ) 0.2 ln(I) + v x
What is the own price elasticity of demand? To obtain the own price elasticity of demand, we only need to determine how changes in
ln(Px )
will aect
ln(Qd ). x
0.5.
A lot of empirical studies reported estimates of elasticities. (1) Lance et al. (2004) estimated the demand for Cigarettes in China and Russia and found that the price elasticity estimates in China and Russia range from 0 to -0.15. Thus, raising prices to reduce smoking in poorer countries (such as china and Russia) may not be very eective. (2) Bishop, Liu and Meng (2007) estimate cigarette price and income elasticities for urban China, 1995. They nd an overall cigarette price elasticity of 0.5, which lies between previous estimates. This implies that a 10% increase in price would result in a decline in cigarette consumption of 4.5 billion packs and would raise Y34 billion in additional tax revenue. (3) Mocan, Tekin and Zax (2004) uses a data set that consists of detailed characteristics of 6,407 urban households from People's Republic of China to investigate the determinants of the demand for medical care. Income elasticity is around 0.3, indicating medical care is a necessity. Medical care demand is price inelastic, and price elasticity is larger in absolute value for poorer households. This suggests that while total revenue from provision of health care can be increased by raising the price of care in the inelastic segment of the demand curve, this would increase the inequality in access to medical care. (4) Using cointegration analysis (a sophisticated econometric technique), Cheung and Thomson (2004) found that the long-run income elasticity of demand for gasoline of China was 0.97, implying that the future growth rate of gasoline consumption will be close to the growth rate of the economy. (5) Kwack, Ahn, Lee and Yang (2007) found that the price elasticity estimate of China's import demand is 0.5, whereas the export-share-weighted average of the price elasticities of 29 foreign import demands is 0.7.
increases, and there is no substitutes for good x, we have no where to turn but to
x.
purchasing power only. (Remember the downward sloping demand curve is driven by both substitution eects and income eect.) When the decrease in quantity demanded for good
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tends to be limited. Take the extreme case that we consume only one good (say crabs), i.e., we spend all our income in our consumption of crabs only. If crabs sell for $1 per crab and we have $10 as nominal income, we will consume 10 crabs. If the price of crabs rises to $2 per crab, we will consume 5 crabs. The price elasticity of demand will appear to be
has many substitutes, an increase in the price of good will encourage us to switch to its substitutes.
For instance, we may consume green peas among the many vegetables. When the price of green peas increases, we will tend to switch to other type of vegetables. The availability of numerous substitutes for green peas makes the quantity demand for green peas responsive to the change in the price of green peas. To conclude, the responsiveness of quantity demanded to changes in price of the good increases with the availability of substitutes.
driven by income eect as well as the substitution eect. When price of good x increases, our purchasing power (or real income) falls and so will be our quantity demanded of good x. We can easily see the extreme case of spending all our income on one good. We can consider the extreme case when we spending very little on a good y. When our expenditure on good y is very small relative to our total income, an increase in the price of good y will not lower our purchasing power by very much, and hence the income eect will appears small. That is, the reduction in the quantity demanded for good y due to income eect will be relatively small. Salt is a good example. Our expenditure on salt is so small that an increase in price of salt will lead to a very small reduction of quantity demanded for salt, if any. To conclude, the responsiveness of quantity demanded to changes in price of the good increases with the expenditure share of income on the good.
people will take advantage to buy more on the sale day. The reason is that we tend to buy more when we expect the price to rise. On the other hand, if we know that the price will lower the price by 20% from now on, there is Thus, the response to the sale is bigger, the shorter the sales.
4.5.4. Time.
by buying a more energy ecient air-conditioners or by reducing the time of using air-conditioners. Suppose the purchase of a more energy ecient air-conditioners is the only mean to reduce the quantity demanded for electricity. Suppose there is a distribution of families who have bought air-conditioners at dierent time. When there is an increase in the price of electricity, will the family which had just bought a new air-conditioner buy a new more energy ecient one? Probably not. As time passes, the family may purchase a new more energy ecient one. Thus, generally, the price elasticity of demand increases with the time horizon. The long the time horizon we are allowed to respond, the bigger the response. Recall that market is dened in a given period, so is the market demand. Thus, the longer period a market is dened, the more responsive is the quantity demanded to a change in price.
Example. The price of battery in airport area is the same as the price of battery in grocery store. Which of
the followings are the likely reason for a higher price elasticity demand for battery in grocery store than in airport area.
(a) There are many other grocery stores selling the same battery (b) The quantity demand for battery is very sensitive to the price change of battery in grocery store (c) Demand for battery is highly elastic in grocery store (d) All of the above (e) None of the above
Suppose we have same types of buyers on average at both locations (airport and the grocery store) but there are many other grocery stores selling the same battery. store. So, (a) is correct. The statement many other grocery stores selling the same battery means that buyers have more choices and substitutes. Hence the demand will be more elastic at grocery
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Suppose there are equal number of stores selling the same battery at the two locations (airport and the grocery store) but the buyers at the airports are executives and the buyers at the grocery store are housewives. In this case, the price elasticity of battery in grocery store CAN STILL BE higher than the price elasticity demand for battery in airport area IF the quantity demand for battery (by housewives) is very sensitive to the price change of battery in grocery store. Of course, the corollary is that the quantity demand for battery (by executives) is very insenstive to the price change of battery at the airport. Thus, (b) is a possible explanation if people who shop at the grocery store (housewives) are dierent from those who shop at the airport (executives). of demand for battery in grocery store. In reality, both availability of substitutes and the senstivity to price changes of dierent group of buyers contribute to the higher price elasticity
d We talked about the responsiveness of Qx to Px , the own price of x. We can also talk about the responsiveness d of Qx to the price of other goods, i.e., Py or Pz . To distinguish the responsiveness of the quantity demand of good
Qd /Qd x x Px /Px
As we discussed earlier, due to the download slope of demand curves, the own price elasticity of demand is always negative.
The responsiveness of
Qd x
=
When When
Qd /Qd x x Py /Py y
to good
x x
and and
y y
Py
x,
i.e., an increase in
Qd . x
Py
y,
and
x,
i.e., a decrease in
Qd . x
The responsiveness of
Qd x
=
When When
Qd /Qd x x I/I Qd . x Qd . x
Hence, the income elasticity of Hence, the income elasticity of
x x
is a normal good, an increase in income will lead to an increase in is an inferior good, an increase in income will lead to a decrease in
x to x.
x,
Qs /Qs x x Px /Px
Since supply curve is general upward sloping, the elasticity is usually positive.
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will give suppliers the incentive to change its quantity supplied to the market.
However, how much more the suppliers can supply to the market in response to an increase in price within a given period of time depends on how quickly the suppliers can relocate some of the factors of production from other production processes (say the production processes of good
and
z)
x). x,
the
and
z)
quantity supplied tend to be more responsive to the change in the price of good
x.
For instance, the major input for the production of ordinary bicycles is steel. Steel is also used in the production of many other goods. After an increase in the price of ordinary bicycles, we can easily increase the production of ordinary bicycles by mobilizing the steel used in the production of other goods to the production of ordinary bicycles. However, the story of racing bicycles would be dierent. The major input for the production of racing bicycles is titanium alloys, which are rarely used in the production of other goods. After an increase of the price of racing bicycles, the possibility of obtaining the titanium alloys from other production processes will be small. Thus, one would expect the price elasticity of supply is more elastic for ordinary bicycles than for racing bicycles.
4.8.2. Time.
response.
Market is dened in a given period, so is the market supply. Thus, the longer period a market
is dened, the more responsive is the quantity supplied to a change in price. That is, generally, the price elasticity of supply increases with the time horizon. The long the time horizon we are allowed to respond, the bigger the
Exercise 11. What is the consumer surplus when demand is perfectly elastic?
Exercise 12. What is the consumer surplus when demand is perfectly inelastic?
Example 13. The Price Elasticity of Demand for apartments is 1.3, while the Price Elasticity of Demand for
toothpicks is 0.4. The likely reason for the dierence is because The ans is The fraction of income spent on toothpicks is minuscule. toothpicks. Less negative, more positive means more substitutes. But not There are few substitutes for
apartments doesn't. Here, the price elasticity of demand is measured in absolute values. When the price elasticity of demand is measured in absolute values, a larger number means more elastic. I would not agree that toothpicks have very limited number of substitutes. Fingers are an obvious substitute, so is anything thin and pointy. That is, toothpicks have more substitutes than apartments. That is, substitutes cannot explain the dierence in elasticity. However, the proportion of income spent on the two goods can.
Example 14. Betsy raised the price of earrings at her boutique, and her Total Revenue from earrings increased.
a. There are too many other boutiques competing with Betsy. b. Betsy is the only seller of earrings in the neighborhood. c. There was Excess Demand for earrings at original price. d. The Demand for Betsy's earrings at the original price was Inelastic. e. The Demand for Betsy's earrings at the original price must be elastic.
Here, we are assuming implicitly that Betsy faces a demand curve. And, we observe that when she raises the price, total revenue increases. We are asked to relate this phenomenon to the choices given. We know, from the discussion of price of elasticity of demand, when we are at the inelastic region of the demand curve, an increase in price will raise total revenue. So, (d) is correct.
Karen Hittle, a student of Robert Frank, had the following observation: If you start in Kansas City and you y to Honolulu round-trip (i.e., Kansas-Honolulu-Kansas round-trip), the fare is a lot lower than if you start the same trip in Honolulu and y to Kansas City round-trip (i.e., Honolulu-Kansas-Honolulu round-trip). Passengers travel
2
CHAPTER REFERENCES
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on same planes, consuming the same fuel, the same in-ight amenities, and so on. She asked why are the fares so dierent? If you are starting in Kansas City and going to Honolulu, you are probably going on vacation. You could go lots of dierent places. You could go to Florida, to Barbados, to Cancun. Because vacationers have many destinations to choose from, airlines must compete ercely for their business. Given economies of scale inherent in larger aircraft, carriers have a strong incentive to ll additional seats by targeting lower prices to the people who are more sensitive to price vacationers. In economic jargon, the price elasticity of demand tends to be elastic. But if you are starting in Honolulu on a trip to Kansas City, you are probably not a vacationer. More likely, you either have business or family reasons for traveling. So you are probably not shopping for a destination if you are going to Kansas City. In short, the price elasticity of demand tends to be inelastic. To see why the airfares will be dierent when we have two dierent price elasticities of demand, let's assume that the airfares of the two round trips are the same initially and see whether the airlines would like to deviates from the initial airfares. As discussed earlier, the demand for the Honolulu-Kansas-Honolulu round-trip is more inelastic than the Kansas-Honolulu-Kansas round-trip. For illustration purpose, let's assume the former is inelastic and latter is elastic at the initial identical airfare. Since the costs of operation are the same for the two round trips, maximization of total revenue will ensure maximization of prot. From the discussion of relationship between elasticity, we know that airlines will get a higher total revenue if it raises the price for the market with inelastic demand, and lowers the price for the market with elastic demand. elastic demand will be lower than the market with inelastic demand. If the supply of round-trips were perfectly divisible and the demand curves were linear in the two markets, we would expect the airlines to charge dierent fares in the two dierent markets so that the price elasticity of demand is at unity.
4
Chapter References
Lance, Peter M. et al. (2004): Is Cigarette Smoking in Poorer Nations Highly Sensitive to Price? Evidence from Russia and China, Journal of Health Economics, January 2004, v. 23, iss. 1, pp. 173-89. Bishop, John A.; Liu, Haiyong; Meng, Qi (2007): Are Chinese Smokers Sensitive to Price?
China Economic
Why do we make the assumption of linearity in the demand curve? On a linear demand curve, we have price elasticity of demand
that ranges from zero to negative innity. Thus, we can choose a price and quantity pair such that the price elasticity of demand is -1. If we have a nonlinear demand with constant elasticity, say -2, there is no way we can nd a point on the demand curve that achieves -1.