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3/15/05 3:09 PM Page 117 chapter 500_12489_Ch05_117-143 5 >> Elasticity DRIVE WE MUST I 1998, LUIS TELLEZ HELD A if output fell by a...

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>> chapter 117 5 Elasticity DRIVE WE MUST Charted Media What you will learn in this chapter: TThe definition of elasticity , a measure of responsiveness to changes in prices or income 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 the 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. N EARLY 1998, LUIS TELLEZ HELD A secret meeting with his Saudi Arabian counterpart. Mr Tellez was Mexico’s oil minister, the government offi- cial who decided how many barrels of oil Mexico would produce and sell to other countries. The purpose of the secret meet- ing? To increase their earnings, or revenues, 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 gov- ernments, which depended on revenue from oil sales. But a plan to raise oil prices would not suc- ceed 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 I Gassing up: A hard habit to break. 500_12489_Ch05_117-143 3/15/05 3:09 PM Page 117
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118 PART 2 SUPPLY AND DEMAND Defining And Measuring Elasticity Luis Tellez, who is a trained economist, knew that to calculate the cut in oil output needed to achieve his price target, he would have to know the price elasticity of demand for oil. The Price Elasticity of Demand Figure 5-1 shows a hypothetical world demand curve for oil. At a price of $20 per barrel, world consumers would demand 10 million barrels of oil per day (point A ); at a price of $21 per barrel, the quantity demanded would fall to 9.9 million barrels (point B ). Figure 5-1, then, tells us the response of the quantity demanded to a particular change in the price. But how can we turn this into a measure of price responsiveness? The answer is to calculate the price elasticity of demand . The price elasticity of demand compares the percent change in quantity demanded to the percent change in price as we move along the demand curve. As we’ll see later in this chapter, the reason economists use percent changes is to get a measure that doesn’t depend on the units in which a good is measured (say, litres versus barrels of oil). But before we get to that, let’s look at how elasticity is calculated. To calculate the price elasticity of demand, we first calculate the percent change in the quantity demanded and the corresponding percent change in the price as we move along the demand curve. These are defined as follows: (5-1) % change in quantity demanded 100 and (5-2) % change in price 100 In Figure 5-1, we see that when the price rises from $20 to $21, the quantity demanded falls from 10 million to 9.9 million barrels, yielding a change in the Change in price Initial price Change in quantity demanded Initial quantity demanded Figure 5-1 D 10 9.9 $21 20 Price of oil (per barrel) A 0 Quantity of oil (millions of barrels per day) B The World Demand for Oil At a price of $20 per barrel, the world quantity of oil demanded is 10 million barrels per day (point A ). When price rises to $21 per barrel, world demand falls to 9.9 million barrels per day (point B ). 500_12489_Ch05_117-143 3/15/05 3:09 PM Page 118
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