demand elasticity by S3a3DA


									I.   ELASTICITY
     A.   Issue: a change in price will cause a change in the quantity demanded, but how
          much of a change?

     Example of importance: Energy crisis in the 1970s – Lessons to learn in response to current
     price changes

     During the 1970s depletion of known stock of oil supplies and bad political relations with
     the Arab world resulted in a sharp decrease in the supply of oil. As a result, the equilibrium
     price of oil rose quite sharply. Since oil is essential to modern economies and rising oil
     prices were causing the costs of producing almost all goods to rise sharply, governments
     found it necessary to develop policies with respect to oil.

     One choice governments had to make was whether to permit the price of oil rise to the new
     equilibrium price or not. Many government's, including Canada's, controlled the price of oil
     because of the hardship high prices would cause to firms and to individuals. In Canada, the
     federal government under the Trudeau Liberals restricted the price of oil in Canada and as a
     result drastically reduced the flow of oil revenues to Alberta. (Alberta is still extremely
     unlikely to vote Liberal.)

     The first difficulty with this policy was that holding oil prices below equilibrium caused
     SHORTAGES of oil to develop.

     Considerable debate ensued about the appropriate policy. Some people believed that the
     quantity demanded would fall by very little if the price of oil rose, because oil is such a
     necessity. In addition, these people argued, the quantity supplied could not increase very
     much in response to rising prices because of the depleted stocks of oil. They were arguing
     that demand and supply were both very INELASTIC, that is the quantity demand or
     supplied changed very little as price changed. If they were right, prices would have had to
     rise to very high levels indeed in order to eliminate the shortages. They argued that the
     price should be held down to protect purchasers of oil from high prices.

     Other people argued that although quantity demanded and quantity supplied could not
     respond to prices very much in a short period of time, rising prices would cause
     considerable adjustment in the quantity demanded and supplied in time. People would
     switch from oil heat to gas, wood, or coal generated electric heat. Cars with better mileage
     would be developed. Insulation of homes, more efficient furnaces etc. would reduce the
     quantity of oil demanded. Similarly they argued that high prices would result in exploration
     and discovery of new supplies of oil. They were arguing that with a little time both demand
     and supply would be quite ELASTIC, that is the quantity demanded or supplied would
     change a great deal in response to a change in price.

     As it turned out, the policy of allowing price to rise appears to have been the correct policy.
      Higher oil prices did result in a decline in the quantity of oil demanded and a great increase
     in exploration and the discovery of new oil fields.
Clearly in developing the policies, an understanding of the ELASTICITY of the demand
and supply of oil were very important.

Similar types of concerns could be found with other issues. The government policies
regarding funding of universities is forcing Nova Scotian universities to charge ever higher
tuition rates. The government wishes to have students pay a larger portion of the costs of
their education. At the same time, we are told that the key to economic growth in the future
is a highly educated labour force. If the quantity of education demanded declines a lot as
tuition fees rise, then the government's funding policy may make it difficult to produce an
educated labour force. If the quantity of education demanded falls very little as tuition rates
rise, then the impact on the labour force may be very small. Again, the degree of
ELASTICITY of demand is a matter of concern.

B.     Demand Elasticity
       1.   Determinates of demand elasticity: there is no absolute way to determine
            elasticity, but the following factors have a large influence on it.
            a.       Substitutability: the more readily available are substitutes, the more
                     elastic demand will be, ie the more quantity demanded will change
                     when price changes. A good such as pears has many substitutes and
                     its demand will be relatively elastic, while milk has few substitutes
                     and the demand for it will be much less elastic. Necessities have few
                     substitutes and are essential to our well-being, so demand for them is
                     inelastic. Luxuries have many substitutes including not consuming
                     them, so demand for them is more elastic.
            b.       The larger the impact of spending on a good on a person's budget,
                     the more elastic demand will be. Demand for expensive goods such
                     as housing or automobiles will often be more elastic than demand for
                     cheap goods, such as pencils or toys.
            c.       Time: The more time passes, the more elastic demand will be.
                     Often adjustments to use a substitute require time. Insulating a
                     house or buying a car with better mileage can reduce the use of fuel,
                     but they required time to undertake.
       2.   Calculating the coefficient of Demand elasticity
            a.       Percentage change in quantity divided by percentage change in price.
                     Always give the absolute value of the demand elasticity. (Make the
                     answer a positive number.)
                                       Q .
                                      avg. Q
                                       P .
                                      avg. P
            b.       Alternative method is the formula (Again give the absolute value.):
c.     Types of elasticity, defined by the coefficient calculated

Infinite Elasticity: A tiny change in price causes an unlimited change in
Elastic coefficient > 1
Unit Elastic coefficient = 1
Inelastic coefficient < 1
Zero Elastic coefficient = 0
C. Supply Elasticity

       The major determinate is time: the more time passes, the more elastic supply

       1.      Market period: the commodity has been produced. Low elasticity since the
               commodity can either be placed on the market or with held from production.
                Elasticity of perishable products such as fish or strawberries will be
               especially low in the market period.
       2.      Short-run: more or less of the commodity can be produced, but at least one
               factor of production is fixed in supply. Elasticity is greater than in the
               market period, but there are constraints on the expansion of production, and
               firms may prefer to produce than to leave capital or land idle when the price
               is low.
       3.      Long-run: the quantities of all factors of production can be adjusted.
               Elasticity is very great, since if price is high more of all factors of production
               can be directed towards production of the good, and all factors can be
               withdrawn and directed to other activities when the price is low.

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