Chapter 5 - Krugman_Wells_CH05 pg109-134 3:18 PM Page 109 >...

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DRIVE WE MUST chapter 109 5 N EARLY 1998, L UIS T ELLEZ HELD A secret meeting with his Saudi Arabian counterpart. Tellez was Mexico’s oil minister, the government official who decided how many barrels of oil Mexico would produce and sell to other countries. The purpose of the secret meeting? To increase their earnings, or rev- enues, from selling oil by raising the world price of oil, which had fallen 50 percent over the previous two years. This low world price was creating serious problems for both governments, which depended on revenue from oil sales. But a plan to raise oil prices would not succeed unless other oil- exporting countries were also willing to commit to reduc- tions in oil production. Why was it necessary to reduce production? Why not just raise prices? Because by the law of demand , a price increase leads to a fall in the quantity demanded. So if out- put didn’t also fall, there would soon be a surplus of oil on the mar- ket, pushing the price right back down again. To make the plan work, Tellez had to persuade his fellow oil ministers to produce less. But how much less? If consumers responded to the price increase by using a lot less oil, output would have to fall by a large amount. And Elasticity >> I Alden Pellet/The Image Works What you will learn in this chapter: The definition of elasticity, a measure of responsiveness to changes in prices or incomes The importance of the price elasticity of demand, which measures the responsiveness of the quantity demanded to price The meaning and importance of the income elasticity of demand, a measure of the responsiveness of demand to income The significance of the price elasticity of supply, which measures the responsiveness of the quantity supplied to price What factors influence the size of these various elasticities How elasticity affects the inci- dence of a tax, the measure of who bears its burden if output fell by a large enough amount in response to the price increase, revenue would decline, not increase. The crucial question for Tellez, then, was how respon- sive the quantity of oil demanded was to changes in the price of oil. But how do we define responsiveness? The answer, and what Tellez needed to know in this case, is a particular number: the price elasticity of demand . In this chap- ter, we will show how the price elasticity of demand is measured and why it is the best measure of how the quantity demanded responds to changes in price. We will then see that the price elasticity of demand is only one of a family of related concepts, including the income elasticity of demand and the price elasticity of supply . Finally, we will see how elasticities are used to deter- mine who bears the greater share of the burden of a tax—producers or consumers.
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