Lecture 3

2023-03-23

MIT OCW 14.01SC L3 - Elasticity

MIT OCW 14.01SC - Lec 3 (Youtube)

  • What determines the size supply/demand shifts?

  • What is the shape of the supply/demand curve?

  • Consider a Supply shift supply curve shifts from S1 to S2 (supply reduces)

    • Size of shift determined by Elasticity.
    • Elasticity of demand = how senstiive is demand to a price change? = slope of demand curve
    • Similarly Elasticity of supply = slope of supply curve.
    • Perfectly Inelastic Demand
      • Demand does not change with price change
      • Straight vertical line on price-qty diagram. Straight vertical line on price-qty diagram.
      • Example: when there are no substitutes.
        • Some Medicine / treatments - e.g. insulin for diabetics.
        • Example of elastic demand: viagra.
      • What happens in case of supply shock?
        • If supply decreases(?) There cannot be excess demand. The price increases. No change in qty.
    • Perfectly Elastic Demand.
      • Straight horizontal line on price-qty diagram. Straight horizontal line on price-qty diagram.
      • Where consumers don't care about quantity, but only about price.
      • Example: There are infinitely good substitutes.
        • E.g. Candy. Orbit and Eclipse. McDonalds and Burger King.
        • If price of Orbit increases people would buy Eclipse.
        • If there is a supply shock, price could not change, only qty supplied would change.

  • Elasiticity (\epsilon) = (dQ/Q)/(dP/P) = (dQ/dP)*(P/Q). (should be negative) (percent change in qty / percent change in price)

    • Perfectly Inelastic Demand: elasticity = 0.
    • Perfectly Elastic Demand: elasticity = -infinite.
    • (*) units: dimensionless
    • (*) dimensional analysis check:
      dQ/dP = (change in no of candies demanded) / (change in price per candy) = candies / ($ per candy) = candies^2 / $
      P/Q = (price per candy / candies demanded in total) = $ / candies^2

  • Peek ahead about Producer theory:

    • Revenue R = Q * P (unit: $)
    • dR/dP = d(Q*P)/dP = dQ/dP * P + Q dP/dP = E * Q + Q = Q * (1+E) (unit: $/($/candy) = candy!)
    • (dR/R)/(dP/P) = (dR/dP) * (P/R) = Q(1+E)*P/R = (1+E)
    • If Elasticity > -1, producer benefits by raising price.
      • Obviously, Elasticity = -1 means raising 1% price = losing 1% qty = equilibrium (ignoring 2nd order terms)
      • If Elasticity is more than that, that would mean raising 1% price = losing more than 1% qty = losing revenue overall => producer should lower prices!
      • If Elasticity is less than that => producer should raise prices!
      • But then why isn't price always 0 or infinity? coming up next lectures.

  • How do we find elasticities?

    • Main topic of Emperical Economics.
    • Fundamental conundrum: Distinguishing correlation from causation.
      • Example: Students who took SAT prep courses scored less on average.
    • Imagine we have to estimate elasticity of demand.
      • Need to make sure that it is a supply shift that is causing price and qty to shift and not demand shift.
      • Need to make sure to measure the right slope. Suuply and demand shifts
    • To measure elasticity of demand we need a supply shock that does not affect demand.
    • One good example is govt intervention that affects producers but not demand. E.g. Producer tax. Producer tax causing supply shift
    • Shaded area = amount govt raised = depends directly on elasticity of demand.
    • Inelastic good = more money raised. E.g. Insulin.
    • RAND experiment to find elasticity of demand of healthcare.
      • Found that healthcare demand is elastic but not as much as previously thought. (Elasticity about -0.2).
      • Also found that people who used less healthcare were not sicker as a result.
      • It may be a good decision to have people paying for their healthcare (instead of their insurance providers).