1 elasticity

7/31/2019 1 Elasticity

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Elasticity


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Why Economists Use ElasticityAn elasticity is a unit-free measure.

By comparing markets using elasticitiesit does not matter how we measure theprice or the quantity in the twomarkets.

Elasticities allow economists to quantifythe differences among markets withoutstandardizing the units of

measurement.


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What is an Elasticity? Measurement of the percentage change

in one variable that results from a 1%

change in another variable.

Can come up with many elasticities.

We will introduce four.

three from the demand function

one from the supply function


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2 VIP Elasticities Price elasticity of demand: how

sensitive is the quantity demanded to a

change in the price of the good.

Price elasticity of supply: how sensitiveis the quantity supplied to a change in

the price of the good. Often referred to as own price

elasticities.


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Examples of Own Price

Demand Elasticities When the price of gasoline rises by 1% the

quantity demanded falls by 0.2%, so gasoline

demand is not very price sensitive. Price elasticity of demand is -0.2 .

When the price of gold jewelry rises by 1%the quantity demanded falls by 2.6%, so

jewelry demand is very price sensitive.

Price elasticity of demand is -2.6 .


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ElasticityA measure of the responsiveness of one

variable (usually quantity demanded or

supplied) to a change in anothervariable

Most commonly used elasticity: price

elasticity of demand, defined as:

Price elasticity of demand =


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Price elasticity of demand Demand is said to be:

elastic when Ed > 1,

unit elastic when Ed = 1, and

inelastic when Ed < 1.


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Perfectly elastic demand

This meansthat at thesame price forthe item, theconsumer is

willing to buymore andmore even atthat sameprice.


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Perfectly inelastic demand

If quantitydemanded iscompletelyunaffectedby a price

change


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Elasticity & slope a price increase from $1 to $2 represents a 100%

increase in price,

a price increase from $2 to $3 represents a 50%increase in price,

a price increase from $3 to $4 represents a 33%increase in price, and

a price increase from $10 to $11 represents a 10%increase in price.

Notice that, even though the price increases by $1 ineach case, the percentage change in price becomessmaller when the starting value is larger.


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Elasticity along a linear demand

curve


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Arc elasticity measure

where:


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Example Suppose that quantity demanded falls from

60 to 40 when the price rises from $3 to $5.

The arc elasticity measure is given by:

In this interval, demand is inelastic (since elasticity < 1).


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Elasticity and total revenue Total revenue = price x quantity

What happens to total revenue if the

price rises?



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Elasticity and TR (cont.)

A reduction in price will lead to:

an increase in TR when demand is elastic. a decrease in TR when demand is inelastic.

an unchanged level of total revenue when

demand is unit elastic.



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In a similar manner, an increase in price will

lead to: a decrease in TR when demand is elastic.

an increase in TR when demand is inelastic.

an unchanged level of total revenue when demand

is unit elastic.



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Price discrimination different customers are charged

different prices for the same product,

due to differences in price elasticity ofdemand

higher prices for those customers whohave the most inelastic demand

lower prices for those customers whohave a more elastic demand.


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Price discrimination (cont.) customers who are willing to pay the

highest prices are charged a high price,

and customers who are more sensitive to

price differentials are charged a low

price.


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Determinants of price

elasticityPrice elasticity is relatively high when:

close substitutes are available,

the good or service is a large share ofthe consumer's budget, and

a longer time period is considered.


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Cross-price elasticity of

demand The cross-price elasticity of demand

between two goodsjand kis defined

as:


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Cross-price elasticity (cont.)

cross-price elasticity is positive if and

only if the goods are substitutes cross-price elasticity is negative if and

only if the goods are complements.


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Income elasticity of demand

A good is a normal good if incomeelasticity > 0.

A good is an inferior good if incomeelasticity < 0.


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Income elasticity of demand

A good is a luxury good if incomeelasticity > 1.

A good is a necessity good if incomeelasticity < 1.


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Price elasticity of supply


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Perfectly inelastic supply


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Perfectly elastic supply


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Determinants of supply

elasticity short run - period of time in which

capital is fixed

all inputs are variable in the long run

supply will be more elastic in the longrun than in the short run since firms

can expand or contract their capital inthe long run.


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Tax incidence distribution of the burden of a tax

depends on the elasticities of demand

and supply. When supply is more elastic than

demand, consumers bear a larger share

of the tax burden. Producers bear a larger share of the

burden of a tax when demand is more

elastic than supply.


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Estimating Demand for Medical Care

Quantity demanded = f( ) out-of-pocket price

real income

time costs prices of substitutes and complements

tastes and preferences

profile state of health

quality of care


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Income Elasticity of Demand: Normal Good demand rises as

income rises and vice versa

Inferior Good demand falls asincome rises and vice versa


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Elasticity Cross Elasticity:

The responsiveness of demand

of one good to changes in the price of arelated good eithera substitute or a complement

Xed =% Qd of good t

__________________

% Price of good y


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Elasticity Goods which are complements:

Cross Elasticity will have negative sign

(inverse relationship between the two)

Goods which are substitutes:

Cross Elasticity will have a positive sign

(positive relationship between the two)


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Elasticity Price Elasticity of Supply:

The responsiveness of supply to changesin price

If Pes is inelastic - it will be difficult for suppliersto react swiftly to changes in price

If Pes is elastic supply can react quickly tochanges in price

Pes =% Quantity Supplied____________________

% Price


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Determinants of Elasticity Time period the longer the time under

consideration the more elastic a good is likely to be

Number and closeness of substitutes

the greater the number of substitutes,the more elastic

The proportion of income taken up by theproduct the smaller the proportion the moreinelastic

Luxury or Necessity - for example,addictive drugs


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Importance of Elasticity Relationship between changes

in price and total revenue

Importance in determiningwhat goods to tax (tax revenue)

Importance in analysing time lags in

production Influences the behaviour of a firm


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market failureDefinition A condition in which a market does not efficiently

allocate resources to achieve the greatest possibleconsumer satisfaction. The four main market failures

(1) public good,

(2) market control,

(3) externality, and

(4) imperfect information.In each case, a market acting without any government

imposed direction, does not direct an efficientamount of our resources into the production,distribution, or consumption of the good.


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Whay health market fails? Information asymmetry Healthcare is difficult and expensive to commodify

Excess capacity is needed for market choice to work(waiting list)

Exit from the market is very difficult-interdendent

Market entry is prohibitively expensive

Problems with private insurance systems (poor get

lowest and rich get the best) Price signals don't work (risk pooling is needed)

Medical professionalism is anti-market


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Why Health Market Fails? Patients want local services

Markets provide for wants rather than needs

Need for specialty clusters, high volumeworkload and regional and national planning

First duty of investor owned firms is to theirshareholders, not patients


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Summary

Health care characterized by info. asymmetrysuppliers better informed than consumers

Suppliers (professionals) therefore act as patientsagent, making decisions for them

Creates potential for supplier-induced demand(demand in excess of what patient would chose)

Extent SID depends on structure of healthsystem, especially financial incentives

SID not always a bad thing may increase

ff

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