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- Today, we begin to discuss elasticity and its applications. This is going to
take us a few lectures because the material is a little bit involved and
also, I'm going to be honest, the material can be a little bit tedious. There's
some formulas that we're going to have to learn how to use and memorize and so
forth. However, the applications are really fascinating. Moreover, elasticity
is going to come back again and again. We're going to use it when we do taxes and
subsidies, we're going to use it again when we do monopoly. This is just another
one of those foundational concepts that is going to pay to learn well the first time
we do it. Let's get started. Demand curves slope down. In other words, when the price
goes up the quantity demanded goes down, when the price goes down the quantity
demanded goes up. Pretty simple. But how much does quantity demanded change when
the price changes? When the price goes down, does the quantity demanded increase
by a lot or by a little? That's the concept that elasticity is going to help
us to understand. Here's the basic terminology. A demand curve is said to be
elastic when an increase in price reduces the quantity demanded by a lot. And
similarly, when a decrease in price increases the quantity demanded by a lot.
That's an elastic curve. The quantity is changing a lot in response to the price.
When the same increase in price reduces the quantity demanded just a little or
when the same decrease in price increases the quantity demanded just a little, then
the demand curve is said to be inelastic or less elastic or not elastic. The
elasticity of demand is going to be a measure of how responsive the quantity
demanded is to a change in the price. Here's an example. Let's start with this
demand curve which we're going to see is an inelastic demand curve. Notice that
when the price increases from $40 to $50 that the quantity demanded goes down by
just a little, by five units from 80 units to 75 units. Now consider the following,
suppose we had a demand curve like this. This turns out to be an elastic demand
curve. Notice that the same $10 increase in price now reduces the quantity demanded
from 80 units to 20 units. On the elastic demand curve, the quantity demanded is
much more responsive to the price than it is on the inelastic demand curve. On a
demand curve where the quantity demanded is responsive to the price, that's called
an elastic demand. On a demand curve when the quantity demanded isn't responsive or
is less responsive to the price, that's an inelastic demand or a more inelastic
demand, a less elastic demand. Now you may have noticed on the previous diagrams that
the inelastic curve had the higher slope. That is it was more vertical while the
elastic curve was the more horizontal curve. We haven't defined elasticity
technically yet. When we do so, you'll be able to see that elasticity is not the
same as slope. However, they are related. For the purposes of this class, if you
follow a simple rule you're going to be fine. The rule is this, if two linear
demand or supply curves run through a common point, then at any given quantity
the curve that is flatter, more horizontal, that's the more elastic curve.
So if you're going to draw two demand curves which we're going to have to do
many times in this class. Let's say they run through a common point. The flatter
one is the more elastic curve, that will work fine for you. What determines whether
a demand curve is more or less elastic? The key determinant is the availability of
substitutes. As we'll see in a minute, the more substitutes the more elastic the
curve. We can also give some more specific examples that are closely related to the
number of substitutes. The time horizon, a longer time horizon is going to make the
curve more elastic. The category of product, a broad category is going to be
less elastic. A specific category, more elastic. Necessities versus luxuries.
Luxuries are going to be more elastic. The purchase size, bigger purchase sizes are
going to be more elastic. Now I've gone through those quickly so don't worry if
you haven't followed them all right away. I'm going to go through them now each in
turn and explain the details. The availability of substitutes is really the
key determinant of how elastic a demand curve is. The idea is pretty intuitive. If
there's lots of substitutes for a good then when the price of that good goes up,
people are going to switch from it, the good whose price is increased towards the
substitutes. They're going to buy the substitutes instead. That means that when
a good with lots of substitutes, when the price of that good goes up, the quantity
demanded is going to go down a lot as people switch to the substitutes. On the
other hand, if we have a good which has very few substitutes then consumers are
going to find it harder to adjust when the price has changed. In particular, if the
price goes up and there are very few substitutes, consumers aren't going to be
able to switch out of that good into another good. So the quantity demanded is
going to remain fairly constant. It's not going to fall a lot when the good
has few substitutes. Let's test your understanding with some quick examples.
Oil, Brazilian coffee, insulin, Bayer Aspirin. Which of these goods have an
elastic demand? Which of them have an inelastic demand? Let's start with oil.
Are there lots of substitutes for oil or just a few substitutes? Just a few
substitutes, right? So if the price of oil goes up tomorrow, at that point do we all
stop driving our cars? No, there aren't very many substitutes at least in the
short run. Few substitutes that means inelastic demand for oil. What about
Brazilian coffee? Some people love Brazilian coffee but there's also
Ethiopian coffee, there's Mexican coffee, there's Guatemalan coffee. Therefore, lots
of substitutes, therefore elastic demand. Insulin, if you don't get it you're going
to die. Not many substitutes, therefore inelastic demand. What about Bayer
Aspirin? If you go to Wal-Mart you'll find Wal-Mart Aspirin. If you go to Target
there's Target Aspirin. All kinds of generic aspirins. If you understand that
aspirin is aspirin, you'll understand that there are lots of substitutes. If Bayer
tries to raise the price of its aspirin too much you'll say, "Forget it. I'm going
to go buy the substitutes." Therefore, elastic demand. The time horizon
influences the elasticity of demand for a good. And really this is just an
application of the fact that the fundamental determinant is substitutes.
Immediately following a price increase it's going to be difficult to find
substitutes. Therefore, immediately following a price increase, demand is
likely to be fairly inelastic, but over time consumers can adjust their behavior
and they can find more substitutes. For example, if the price of oil goes up
then we know that there are very few substitutes in the short run. But in the
long run what are some of the things that people would do if the price of oil stays
permanently higher? We'll drive smaller cars. They'll switch to mopeds. There's a
lot more mopeds driven in Europe for example because for decades the price of
oil has been higher in Europe due to taxes. People have adjusted. In the long
run, people will even adjust how cities are designed so that more people will live
in apartments closer to where they work if the price of oil stays high. If the price
of oil is really low, there'll be more sprawl. People will be more willing to
live far away and have a big lawn if the price of oil isn't so high. The longer the
time horizon, the more the ability to adjust. The more substitutes and thus the
more elastic the demand. Another factor determining the elasticity of demand again
based upon the fundamental question, are there lots of substitutes or just a few is
what we might call the classification of the good. The broader the classification,
the less likely consumers will be able to find a substitute. The narrower the
classification, the more likely consumers will be able to find a substitute. We've
already seen an example of this. There are more substitutes for Bayer Aspirin, a
narrow classification, than there are for aspirin, a wider classification. If the
price of Bayer Aspirin goes up, there are more substitutes, the generics. If the
price of all aspirin goes up there are fewer substitutes. Of course there are
still some like ibuprofen and acetaminophen and so forth. But the
narrower the classification, the more substitutes, the more elastic the demand.
Another example, the demand for food. A broad classification is less elastic than
the demand for lettuce, a particular type of food, a narrow classification.
Therefore the demand for lettuce would be more elastic than the demand for food. The
nature of the good in the consumer's mind can also affect the elasticity. In
particular whether the good is thought of as a necessity or as a luxury. Now don't
take these categories as somehow being out there in the world. They are more about a
person's tastes. For example, for some consumers that coffee in the morning is a
necessity. Even if the price of coffee goes up by a lot, those consumers will
still continue to consume about the same amount of coffee. Therefore those
consumers will have an inelastic demand. They'll have an inelastic demand for goods
that they consider to be necessities. The same good in someone else's mind might be
a luxury. The consumer who occasionally has a cup of coffee. If the price goes up
then they're going to be more willing to say, "Nah, I'm going to switch to tea. I'm
going to switch to something else." Depending upon how consumers regard the
good therefore as a necessity, more inelastic demand. As a luxury, more
elastic demand. The final determinant is the size of the purchase relative to a
consumer's budget. If the purchase is small relative to the budget, then
consumers may not even notice when the price goes up. And if they don't notice
they're not going to respond with a big change in the quantity demanded. On the
other hand, if we have a product which is a large part of the budget, consumers
will notice. Consumers notice when the price of automobiles goes up, that's a big
purchase. They're going to shop around a lot. They're going to try and get a big
bargain when the purchase is a large fraction of their budget. On the other
hand, when the price of toothpicks goes up by a lot, that's not such a big deal.
Consumers probably won't even notice whether toothpicks are $0.50 or a $1.
That's a 50% increase in price, but you probably don't even notice that at the
store. So small item at least in the short run
more inelastic. Bigger items, the bigger part of the budget, ones the consumer
notices, more elastic, more price sensitive. Let's summarize the
determinants of the elasticity of demand. For less elastic goods, that means fewer
substitutes. Short run, less time to adjust, necessities, small part of the
budget. Each of these factors makes the demand curve less elastic. More elastic
demand, that means more substitutes. Long run, more time to adjust. Luxuries, large
part of the budget. These factors make a demand curve more elastic. If you have to
memorize these but once you understand that elasticity means how responsive is
the quantity demanded to a change in the price, then you'll be able to recreate or
figure out these factors again. That's it for the elasticity of demand. Next time,
we're going to take a closer look at technically how do we get a number? How do
we calculate the elasticity of demand? Given some facts and figures on prices and
quantity demanded, how do we calculate with the elasticity really is? What's the
number?
- [male] If you want to test yourself, click Practice questions. Or if you're
ready to move on, just click Next Video.
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