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25 April, 2016 - 09:12

Suppose the price of electricity rises tomorrow morning. What will happen to the quantity demanded?

The answer depends in large part on how much time we allow for a response. If we are interestedin the reduction in quantity demanded by tomorrow afternoon, we can expect that the response will bevery small. But if we give consumers a year to respond to the price change, we can expect the responseto be much greater. We expect that the absolute value of the price elasticity of demand will be greater when more time is allowed for consumer responses.

Consider the price elasticity of crude oil demand. Economist John C. B. Cooper estimated shortandlong-run price elasticities of demand for crude oil for 23 industrialized nations for the period 1971–2000. Professor Cooper found that for virtually every country, the price elasticities were negative,and the long-run price elasticities were generally much greater (in absolute value) than were the shortrun price elasticities. His results are reported in Table 5.1. As you can see, the research was reported in a journal published by OPEC (Organization of Petroleum Exporting Countries), an organization whosemembers have profited greatly from the inelasticity of demand for their product. By restricting supply,OPEC, which produces about 45% of the world’s crude oil, is able to put upward pressure on the price of crude. That increases OPEC’s (and all other oil producers’) total revenues and reduces total costs.

Table 5.1 Short- and Long-Run Price Elasticities of the Demand for Crude Oil in 23 Countries For most countries, price elasticity of demand for crude oil tends to be greater (in absolute value) in the long run than in the short run.

Country Short

Run Price Elasticity of Demand Long

Run Price Elasticity of Demand

Australia

−0.034

−0.068

Canada

−0.041

−0.352

China

0.001

0.005

Denmark

−0.026

−0.191

Finland

−0.016

−0.033

France

−0.069

−0.568

Germany

−0.024

−0.279

Greece

−0.055

−0.126

Iceland

−0.109

−0.452

Ireland

−0.082

−0.196

Italy

−0.035

−0.208

Japan

−0.071

−0.357

Korea

−0.094

−0.178

Netherlands

−0.057

−0.244

New Zealand

−0.054

−0.326

Norway

−0.026

−0.036

Portugal

0.023

0.038

Spain

−0.087

−0.146

Sweden

−0.043

−0.289

Switzerland

−0.030

−0.056

United Kingdom

−0.068

−0.182

United States

−0.061

−0.453

 

Source: John C. B. Cooper, “Price Elasticity of Demand for Crude Oil: Estimates from 23 Countries,” OPEC Review: Energy Economics & Related Issues, 27:1 (March 2003): 4. The estimates are based on data for the period 1971–2000, except for China and South Korea, where the period is 1979–2000. While the price elasticities for China and Portugal were positive, they were not statistically significant.

KEY TAKEAWAYS

  • The price elasticity of demand measures the responsiveness of quantity demanded to changes in price; it is calculated by dividing the percentage change in quantity demanded by the percentage change in price.
  • Demand is price inelastic if the absolute value of the price elasticity of demand is less than 1; it is unit price elastic if the absolute value is equal to 1; and it is price elastic if the absolute value is greater than 1.
  • Demand is price elastic in the upper half of any linear demand curve and price inelastic in the lower half. It is unit price elastic at the midpoint. When demand is price inelastic, total revenue moves in the direction of a price change.
  • When demand is unit price elastic, total revenue does not change in response to a price change. When demand is price elastic, total revenue moves in the direction of a quantity change.
  • The absolute value of the price elasticity of demand is greater when substitutes are available, when the good is important in household budgets, and when buyers have more time to adjust to changes in the price of the good.

TRY IT!

You are now ready to play the part of the manager of the public transit system. Your finance officer has justadvised you that the system faces a deficit. Your board does not want you to cut service, which means that you cannot cut costs. Your only hope is to increase revenue. Would a fare increase boost revenue?

You consult the economist on your staff who has researched studies on public transportation elasticities. Shereports that the estimated price elasticity of demand for the first few months after a price change is about−0.3, but that after several years, it will be about −1.5.

Explain why the estimated values for price elasticity of demand differ.

Compute what will happen to ridership and revenue over the next few months if you decide to raise fares by 5%. Compute what will happen to ridership and revenue over the next few years if you decide to raise fares by5%.

What happens to total revenue now and after several years if you choose to raise fares?

Case in Point: Elasticity and Stop Lights

We all face the situation every day. You are approaching an intersection. The yellow light comes on. You know that you are supposed to slow down, but you are in a bit of a hurry. So, you speed up a little to try to make the light. But the red light flashes on just before you get to the intersection. Should you risk it and go through?

Many people faced with that situation take the risky choice. In 1998, 2,000 people in the United States died as a result of drivers running red lights at intersections. In an effort to reduce the number of drivers who make such choices, many areas have installed cameras at intersections. Drivers who run red lights have their pictures taken and receive citations in the mail. This enforcement method, together with recent increases in the fines for driving through red lights at intersections, has led to an intriguing application of the concept of elasticity. Economists Avner Bar-Ilan of the University of Haifa in Israel and Bruce Sacerdote of Dartmouth University have estimated what is, in effect, the price elasticity for driving through stoplights with respect to traffic fines at intersections in Israel and in San Francisco.

In December 1996, Israel sharply increased the fine for driving through a red light. The old fine of 400 shekels (this was equal at that time to $122 in the United States) was increased to 1,000 shekels ($305). In January 1998, California raised its fine for the offense from $104 to $271. The country of Israel and the city of San Francisco installed cameras at several intersections. Drivers who ignored stoplights got their pictures taken and automatically received citations imposing the new higher fines. We can think of driving through red lights as an activity for which there is a demand—after all, ignoring a red light speeds up one’s trip. It may also generate satisfaction to people who enjoy disobeying traffic laws. The concept of elasticity gives us a way to show just how responsive drivers were to the increase in fines. Professors Bar-Ilan and Sacerdote obtained information on all the drivers cited at 73 intersections in Israel and eight intersections in San Francisco. For Israel, for example, they defined the period January 1992 to June 1996 as the “before” period. They compared the number of violations during the before period to the number of violations from July 1996 to December 1999—the “after” period—and found there was a reduction in tickets per driver of 31.5 per cent. Specifically, the average number of tickets per driver was 0.073 during the period before the increase; it fell to 0.050 after the increase. The increase in the fine was 150 per cent. (Note that, because they were making a “before” and “after” calculation, the authors used the standard method described in the Heads Up! on computing a percentage change—i.e., they computed the percentage changes in comparison to the original values instead of the average value of the variables.) The elasticity of citations with respect to the fine was thus −0.21 (= −31.5%/150%).
The economists estimated elasticities for particular groups of people. For example, young people (age 17–30) had an elasticity of −0.36; people over the age of 30 had an elasticity of −0.16. In general, elasticities fell in absolute value as income rose. For San Francisco and Israel combined, the elasticity was between −0.26 and −0.33.

In general, the results showed that people responded rationally to the increases in fines. Increasing the price of a particular behavior reduced the frequency of that behavior. The study also points out the effectiveness of cameras as an enforcement technique. With cameras, violators can be certain they will be cited if they ignore a red light. And reducing the number of people running red lights clearly saves lives.

Source: Avner Bar-Ilan and Bruce Sacerdote. “The Response of Criminals and Non-Criminals to Fines.” Journal of Law and Economics, 47:1 (April 2004): 1–17.

ANSWERS TO TRY IT ! PROBLEMS

The absolute value of price elasticity of demand tends to be greater when more time is allowed for consumers to respond. Over time, riders of the commuter rail system can organize car pools, move, or otherwise adjust to the fare increase.

Using the formula for price elasticity of demand and plugging in values for the estimate of price elasticity (−0.5) and the percentage change in price (5%) and then rearranging terms, we can solve for the percentage change in quantity demanded as: eD = %Δ in Q/%Δ in P; −0.5 = %Δ in Q/5%; (−0.5) (5%) = %Δ in Q = −2.5%. Ridership falls by 2.5% in the first few months.

Using the formula for price elasticity of demand and plugging in values for the estimate of price elasticity over a few years (−1.5) and the percentage change in price (5%), we can solve for the percentage change in quantity demanded as eD = %Δ in Q/%Δ in P ; −1.5 = %Δ in Q/5%; (−1.5)(5%) = %Δ in Q = −7.5%. Ridership falls by 7.5% over a few years.

Total revenue rises immediately after the fare increase, since demand over the immediate period is price inelastic. Total revenue falls after a few years, since demand changes and becomes price elastic.