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.): Q2-Q1 Q2+Q1 P2-P1 P2+P1 c. Types of elasticity, defined by the coefficient calculated Infinite Elasticity: A tiny change in price causes an unlimited change in Quantity 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 becomes. 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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