Principles of microeconomics: Elasticity lecture

Lecture on elasticity for microeconomic principles

1. Principles of Microeconomics Elasticity Econ 201(04) / Fall 2024 Rob Oxoby / Department of Economics

2. Market Responses For law of demand, a price increase implies a reduction in quantity demanded. Moreover, demand curve for complements and substitutes will shift. From the perspective of a policy maker, need to know not only direction of change but also the magnitude of the change Easy to do if you know the demand curve, but we often don’t know the complete shape of the the demand relation. Elasticity measures how buyers and sellers respond to changes in market conditions. Own price elasticity, cross price elasticity, income elasticity, etc.

3. Market Responses Consider cigarettes Taxed to reduce consumption (health implications) Problematic among young consumers (addition issues) What type of things affect the responsiveness of consumers to a price increase (e.g., a new tax)? Addicted or not Income Price of related goods Availability of substitutes

4. Elasticity of Demand Price elasticity of demand: A measure of how much the quantity demanded of a good responds to a change in the price of that good The percentage change in quantity demanded divided by the percentage change in price. Determinants of elasticity (responsiveness) Availability of close substitutes Necessity vs. luxury Time horizon (short vs. long run) Definition of the market (specific vs. general goods)

5. Elasticity of Demand For example, suppose a 10% increase results in a decrease in the quantity demanded of 20%.

6. Elasticity of Demand §5-1c introduces the “midpoint method” for finding elasticity of demand For example, at point A : the price is $4 and the quantity demanded is 120, while at point B the price is $6 and the quantity demanded is 80. Calculating elasticity from point A to point B yields 50% price increase and 33% quantity decrease. Elasticity is - 0.66 From point B to A yields 33% price decrease and 50% quantity increase. Elasticity is – 1.5

7. Elasticity of Demand Using the midpoint of the change (p=5, q=100), we can get a consistent elasticity From A to B, price rises by 40% (increase of 2 divided by midpoint) and quantity demanded falls by 40% (decrease of 40 divided by midpoint). Elasticity is -1 From B to A, price rises by 40% (decrease of 2 divided by midpoint) and quantity demanded falls by 40% (increase of 40 divided by midpoint). Elasticity is -1

8. Elasticity of Demand

9. Elasticity of Demand Demand curves are often grouped according to elasticity. Demand is elastic when absolute value of elasticity is greater than 1: quantity moves proportionately more than the price. Demand is inelastic when absolute value of elasticity is less than 1: quantity moves proportionately less than the price. If absolute value of elasticity is equal to 1 (quantity moves same proportion as price) demand is unit elastic.

10. Elasticity of Demand

11. Elasticity of Demand

12. Elasticity of Demand

13. Elasticity of Demand As an aside, let’s think about this more rigorously. Percentage change in quantity is given by Percentage change in price is given by Putting them together: =  

14. Elasticity of Demand So elasticity is given by First component is the (inverse) slope of demand curve: how does quantity respond to a change in price. The second component is dependent on the state of the market price and quantity: If consumption is relatively low, relatively easy to have a significant (percentage) change If consumption is relatively high, relatively difficult to change consumption.  

15. Elasticity of Demand Consider a linear demand curve given by Q = 14 – 2 P Constant slope, but elasticity is not constant. If P = 2 then Q = 10. Elasticity is (inelastic) If P = 6 then Q = 2. Elasticity is (elastic) Elasticity is ratio of percentage changes in the two variables Yields better predictions (and mathematically less cumbersome) than midpoint method.  

16. Revenue Implications Total revenue in a market is the price times the quantity sold. TR = P x Q

17. Revenue Implications Q: How does total revenue change as one moves along the demand curve? A: Depends on the price elasticity of demand.

18. Revenue Implications When demand is inelastic (elasticity less than 1), a price increase leads to a smaller quantity decrease. Therefore total revenue rises. When demand is elastic (greater than 1), price increase leads to a larger quantity decrease. Therefore total revenue falls. If demand is unit elastic (elasticity equal to 1), a price increase leads to a same percentage size quantity decrease and total revenue remains constant.

19. Revenue Implications Let’s think about drug dealing (addictive drugs). How does a drug dealer operate? New users have very elastic demand curves. Why? Therefore charge low price to these consumers. Free samples, low cost to consumers Addicts have very inelastic demand curves. Why? Therefore charge higher price to these consumers. Higher direct price and imposition of costs related to dealing.

20. Quick Review Consider a demand curve represented by the following equation: Qd = 200 - 2 p Suppose p = 10. What is the price elasticity of demand? What if p = 80? Qd = 180 → E(10) = -1/9 Qd = 40 → E(80) = -4 Suppose prices rose by 20%. What will be the effect on the quantity demanded? ∆Q(10) = -2.22% → Qd = 176 ∆Q(80) = -80% → Qd = 8

21. Other Demand Elasticities Income elasticity of demand: measure of how much quantity demanded responds to a change in consumers’ income The percentage change in quantity demanded divided by the percentage change in income. Cross-price elasticity of demand: measure of how much quantity demanded of one good 1 responds to change in the price of good 2 The percentage change in quantity demanded of good 1 divided by the percentage change in the price of good 2

22. Elasticity of Supply Price elasticity of supply: Measure of how much quantity supplied responds to change in price of the good The percentage change in quantity supplied divided by the percentage change in price

23. Elasticity of Supply Supply of a good is elastic if percentage change in quantity supplied is more than percentage change in the price. inelastic if percentage change in quantity supplied is less than percentage change in the price. What are the determinants of the elasticity of supply?

24. Elasticity of Supply In most markets, a key determinant of price elasticity of supply is the time period being considered. Consider short run supply (e.g., capital is fixed in a production process). All responses to price are due to changes in, say, labour . Consider lung run supply (e.g., labour and capital are both variable) Responses to price changes can be accommodated by changes in labour and capital. Supply is usually more elastic in the long run than in the short run.

25. Elasticity of Supply Example: Consider the market for beachfront property and new cars Elasticity of supply Supply of beachfront property is inelastic Supply of new cars is elastic Suppose population doubles, resulting in doubling of demand for both goods For which good will the price change the most? For which good will the quantity change the most?

26. Elasticity of Supply Beachfront property (inelastic supply): P Q D 1 S Q 1 P 1 A D 2 B Q 2 P 2

27. Elasticity of Supply New cars (elastic supply): P Q D 1 S Q 1 P 1 A D 2 Q 2 P 2 B

28. Elasticity of Supply When supply is inelastic , quantity doesn’t respond very much so the increase in demand has a larger effect on price than on quantity. When supply is elastic , quantity responds significantly so the increase in demand has a larger effect on quantity than on price.

29. FIGURE 5.5 The Price Elasticity of Supply

30. FIGURE 5.5 ( continued ) The Price Elasticity of Supply

31. FIGURE 5.5 ( continued ) The Price Elasticity of Supply

32. FIGURE 5.6 How the Price Elasticity of Supply Can Vary

33. Putting Supply and Demand Together When we think about government policies or any market changes, we can’t think of supply and demand separately. Quantitative responses (based on elasticities) of both supply and demand are important when considering the effects of a policy Let’s consider tax incidence: the degree to which a given tax policy affects consumer and producers. Consumers respond according to price elasticity of demand Producers respond according to price elasticity of supply Central question: how are the effects of a tax borne by each group?

34. Tax Incidence The burden of a tax is divided between consumers and producers. Tax is imposed (paid by either consumers or producers) How much each group responds will affect the extent to which they bear the tax. Examples: cigarette taxes, gasoline taxes, sales taxes, income taxes,…. Consider two markets: Elastic supply and inelastic demand Inelastic supply and elastic demand

35. Opioid Epidemic Calgary opioid overdoses (reported) April 2023: 186 April 2024: 90 Alberta: 3,139 (2016-2020) On distribution side, street prices for synthetic opioids have fallen ($20 fentanyl, 200mcg) and purity/quality/dosage has become less certain.

36. Opioid Epidemic: Causes Large agreement on over-prescription for opioid-based pain medications during 1990s (OxyContin, Percocet, Vicodin), many subsidized by insurance 1991: 76 million per year prescriptions in U.S. 2011: 219 million per year 2016: 292 million per year Addiction and end of prescription (due to physician or loss of insurance) led many to pursue substitute opioids (heroin, fentanyl, carfentanil ) Distributional and demographic issues (cf. crack epidemic in 1980s)

37. Opioid Crisis : Traditional Policy What are the costs of the epidemic? Health care, labour market, prevention/enforcement, poverty, crime Family effects, trauma, mental health, infant health “War on Drugs” Mitigating inflow of drugs (imports and domestic manufacturing) Fundamentally, supply-based (shifting supply curve to the left) 2008-12: average OxyCodone supply decreased by 59%, street prices increased 238% ( Meinhofer , 2015) What are the effects of these policies on behaviour?

38. Elasticity of Demand Consider elasticity for these drugs: What are the substitutes? Other illegal drugs, regulated substitutes, withdrawal Other pain mitigation strategies, mental health services Non-addicts (prescribed): many substitutes, subsidized cost (insurance). Elastic demand suggests significant responsiveness to price changes (up and down) Addicts: fewer substitutes Inelastic demand suggests willingness to incur higher costs Health issues, crime issues, effects on “social capital”

39. Elasticity of Demand Insured users, elasticity of prescribed drugs ranges -0.015 (opioid-based pain med.) to -0.157 (smoking deterrents; Gatwood et al, 2014) Marijuana: −0.67 and −0.79 (Davis et al, 2015) Heroin: -0.08 to -0.10 (Dave, 2006), -0.80 (Olmstead et al, 2015), -.84 to -1.5 ( Caulkins , 2001) Opioid inelasticity: fentanyl > hydromorphone (continuing heroin users) > methadone > hydromorphone (heroin abstainers; Greenwald, 2007)

40. Cross Price Elasticities (Chalmers et al, 2009) Cross price elasticities (Bickel et al, 1998): Heroin to valium: 1.02 Heroin to cocaine: 0.80

41. Other Elasticities Price elasticity of mental health services: inelastic but more elastic than general health services (Frank & McGuire, 2000) Anti-depressants and crime: -0.02 (Marcotte &Markowitz, 2009) Alcohol tax and STDs: -0.47 in short-run and -1.1 in long- run (Grossman et al, 2005) Parental drug/alcohol use increases risk of child behaviour problems, decriminalization of marijuana increases assault/robbery (Markowitz, 2000a,b)

42. Implications Supply-side policies see largest responses from non-addict (due to greater elasticity) Cf. tax incidence in case of perfectly elastic demand Incidence of supply-side policies impose large costs on addicts Cf. tax incidence in case of perfectly inelastic demand Greater (opportunity) cost borne by habitual users (more than just street price) Increasing recognition of harm mitigation strategies to treat addicts Needle exchange programs during 1980s and 1990s Supervised consumption services Introduction of (regulated) use of substitutes (e.g., methadone) What are these policies trying to accomplish?

43. Implications

44. Implications Medical marijuana: opioid prescriptions fell from 23 to 21 million daily doses in states where medicinal marijuana was available (Bradford et al, 2018). Colorado: legalization resulted in reduction in opioid deaths of 0.70 per month (Livingston et al, 2015). Gateway arguments Evidence that marijuana use raises probability of using other drugs (positive elasticity) Network effects

45. Implications Mental health services: availability of mental health services reduces opioid use and dependency (at time of prescription and illegal acquisition). Past year/lifetime mental illness is found to increase (Shaffer & Dave, 2002) Alcohol by 20%/25% Cocaine by 27%/69% Cigarettes by 86%/ 94%