Elasticity and Comparative Statics
Notes 2'--Chapter 5
S2
P
S1
P
P2
1. Inelastic demand and
supply—Supply falls
Gasoline is a good example. Say
a hurricane knocks out several
gasoline refineries and supply falls
by 10%. Because of inelastic—
steep—demand, the small leftward
shift along the Q axis forces us to
slide a long way up the demand
curve. So we get a small
decrease in Q but a huge increase
in P.
P1
D
S2
2. Inelastic demand and
supply—Supply rises
Cotton is a good example. Say
good weather produces a bumper
crop and supply rises by 5%.
Because of inelastic—steep—
demand, the small rightward shift
along the Q axis forces us to slide
a long way down the demand
curve. So we a small decrease in
Q produces a big decrease in P.
P1
P2
D
Q
Q2 Q1
Q1 Q2
Why? Because η is very low for gasoline, around -.25, i.e., -1/4. This means
that it takes a 4% increase in price to bring about a 1% fall in quantity demanded.
So a 10% fall in supply will require a 40% increase in price to induce consumers
to cut back their consumption by 10%. (See article on next page.)
P
S2
S1
S1
P2
P1
D
3. Elastic demand and inelastic
supply—Supply falls
The luxury tax of 1990 imposed a
10% excise on luxury yachts,
among other goods. Because of
highly elastic—flat—demand and
inelastic—steep—supply, effect of
the leftward shift in the S curve is
borne almost entirely by a
decrease in quantity. And—big fall
in Q, small rise in P → big drop in
incomes. (See article on next
page.)
Why? Demand for luxury
yachts is highly elastic
because there are lots of other
things rich people can spend
Q
their loot on. But supply
Q2 Q1
elasticity is very low
because yacht building is a highly specialized industry. Yacht builders can’t
easily switch over to producing something else in the short run.
Q
As a result, since
Total Revenue = P * Q
a small rise in Q that brings about
a big fall in P reduces farmers
incomes.
Why? Because η is very low for cotton, around -.2, i.e., -1/5. This means that it
takes a 5% decrease in price to bring about a 1% increase in quantity demanded.
So a 5% larger harvest will require a 25% decrease in price to induce consumers
to buy all that cotton.
Elasticity doesn’t “repeal” the laws of demand and supply, but it
does determine how great the effect of a price change will be.
True or False: “Gasoline is perfectly inelastic. When the price of gasoline goes up, quantity demanded doesn’t change.”
What's the Price Elasticity of Demand for Gasoline? (Hint: It isn't zero)
By Mike Moffatt, (Edited and Abridged) See original at http://economics.about.com/od/priceelasticityofdemand/a/gasoline_elast.htm
What is the price elasticity of demand for gasoline? Is it zero? That is, if the price of gasoline rises 10%, what happens to the quantity demanded of gasoline?
We do not have to just theorize about how people may respond to a rise in gas hikes, we can look at studies which determine what the price elasticity of
demand for gasoline is. There are two good meta-analyses which examine the work of many different studies on the matter. One is Explaining the variation
in elasticity estimates of gasoline demand in the United States: A meta-analysis by Molly Espey, published in Energy Journal. Espey examined 101 different
studies and found that in the short-run (defined as 1 year or less), the average price-elasticity of demand for gasoline is -0.26. That is, a 10% hike in the price
of gasoline lowers quantity demanded by 2.6%. In the long-run (defined as longer than 1 year), the price elasticity of demand is -0.58; a 10% hike in gasoline
causes quantity demanded to decline by 5.8% in the long run.
Another meta-analysis was conducted by Phil Goodwin, Joyce Dargay and Mark Hanly and given the title Review of Income and Price Elasticities in the
Demand for Road Traffic. They summarize their findings on the price-elasticity of demand of gasoline as follows:
If the real price of fuel goes, and stays, up by 10%, the result is a dynamic process of adjustment such that:
a) The volume of traffic will go down by about 1% within about a year, building up to a reduction of about 3% in the longer run (about five years or so).
b) The volume of fuel consumed will go down by about 2.5% within a year, building up to a reduction of over 6% in the longer run.
The reason why fuel consumed goes down by more than the volume of traffic, is probably because price increases trigger more efficient use of fuel (by a
combination of technical improvements to vehicles, more fuel -conserving driving styles, and driving in easier traffic conditions).
Further consequences of the price increase are:
c) Efficiency of use of fuel goes up by about 1.5% within a year, and around 4% in the longer run.
d) The total number of vehicles owned goes down by less than 1% in the short run, and 2.5% in the longer run.
True or False: “We can always get more revenue by taxing the rich. They can afford it, and it doesn’t hurt anybody else.”
From Pierce, Greg. “Inside Politics: A hard-earned lesson.” The Washington Times, January 7, 2003
"Starting in 1991, Washington levied a 10 percent tax on cars valued above $30,000, boats above $100,000, jewelry and furs above $10,000 and private
planes above $250,000. Democrats like Ted Kennedy and then-Senate Majority Leader George Mitchell crowed publicly about how the rich would finally be
paying their fair share and privately about convincing President George H.W. Bush to renounce his 'no new taxes' pledge," the newspaper said in an editorial.
"But it wasn't long before even those die-hard class warriors noticed they'd badly missed their mark. The taxes took in $97 million less in their first year than
had been projected — for the simple reason that people were buying a lot fewer of these goods. Boat building, a key industry in Messrs. Mitchell and
Kennedy's home states of Maine and Massachusetts, was particularly hard hit. Yacht retailers reported a 77 percent drop in sales that year, while boat
builders estimated layoffs at 25,000. With bipartisan support, the tax was repealed in 1993,”