SECTION 3: ELASTICITIES€¦ · Web viewGive reasons for your answers. The first one has been...

LSSS 231 LO3: ELASTICIESPrepared by Linda Habibi Teachers: Ms. Linda/Mr. Mahmoud

NAME: ____________ SECTION: _____ELASTICITIES

(Learning Outcome 3)

PRICE ELASTICITY OF DEMAND (PED)

When we studied demand in Learning Outcome 2, we saw that when Price rises, Quantity

demanded _______ (rises/falls) and vice versa. We call this the law of __Demand_______ and

there exists a(n) ___________(positive/ inverse) relationship between Price and Quantity

Demanded.

In order to measure how much Quantity Demanded changes when there is a change in Price, we

use a concept called Price Elasticity of Demand.

Price Elasticity of Demand (PED): measures the responsiveness of quantity demanded to a

change in price.

Let’s look at two cases in the following diagrams

1) Elastic Demand

a. Which curve has the flatter slope? ____

b. If there is a price change, in which diagram will Quantity demanded change by

the greatest amount? ______

c. If Quantity demanded is very responsive to a change in Price, the good is

elastic.

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Diagram A Diagram BP P


2) Inelastic Demand

a. Which curve has the steeper slope? _B___

b. If there is a price change, in which diagram will Quantity demanded change by

the smallest amount? ___B___

c. If Quantity demanded is NOT very responsive to a change in Price, the good is

inelastic.

There are 3 ways we can decide how responsive quantity demanded is to a change in the Price:

1) Characteristics of Price Elasticity of Demand (PED)2) PED Formula3) TR test

1) Characteristics of Price Elasticity of Demand (PED)

The following characteristics make a good ELASTIC meaning that Quantity demanded is very

responsive to a change in price or INELASTIC meaning that Quantity demanded is NOT very

responsive to a change in price:

1. Availability of Substitutes :

- If there exists few or no close substitutes then the good is Inelastic. E.g oil and

cigarettes

- If there exists many close substitutes then the good is elastic. E.g. beef

2. % of income (Y):

- If the good takes up a small % of Y then the good is Inelastic e.g. matches

- If the good takes up a large % of Y then the good is elastic e.g. a luxury car

3. Necessity versus Luxury:

- If the good is a Necessity then it is Inelastic.

- If the good is a Luxury then it is elastic.

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4. Urgency of purchase

- If the purchase of the good is Urgent then it’s Inelastic.; e.g. a life saving operation.

- If the purchase of the good is NOT Urgent then it’s elastic; e.g. cosmetic surgery.

5. The width of the category :

- The wider the category of a good; e.g. pants, the more inelastic the demand.

- The narrower the category of a good; e.g. Rock and Republic brand of jeans, the more

elastic the demand.

6. Time

- The longer the period of time, the easier it is to make adjustments in purchases (easier

to find substitutes); hence, the longer the period of time the more elastic the demand.

- The shorter the period of time, the more difficult it is to make adjustments in

purchases (harder to find substitutes); hence, the shorter the period of time the more

inelastic the demand.

Exercise: Summary of characteristics

Elastic Inelastic

Substitutes e.g. beef Few Substitutes e.g. oil

Large % of Income e.g. luxury car

Small % of incomee.g. matches

Luxurye.g. cosmetic surgery

Necessitye.g. life saving surgery

Not urgent e.g. cosmetic surgery

Urgente.g. life saving surgery

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Narrow category- e.g. apples Wider category e.g. fruit

Longer time period Shorter time period

Exercise: Identify if the following goods are elastic or inelastic and why by using the above list of characteristics.

GOOD OR SERVICE ELASTIC OR INELASTIC WHY?Salt

An operation to remove a ruptured appendix

Lamb

A European vacation

Insulin for Diabetics

Insulin at one of four pharmacies

Louis Vuitton handbags

Cosmetic surgery

A yacht

alalali tuna

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2) Calculating PED

Price elasticity of demand compares the percentage change in quantity demanded with the

percentage change in price that caused it.

PED = % change in Qd % change in P

PED = Change in Qd divided Change in P Sum of Qd’s / 2 by Sum of P’s / 2

= Qd 2 - Qd1 dividedP2 - P1Qd1 + Qd2 / 2 by P1 + P2 /2

(Note: PED will always be negative but ignore the negative sign. PED will always be negative

because an increase in price will lead to a decrease in quantity demanded and an decrease in

price will lead to an increase in quantity demanded.)

Interpreting PED coefficients:

INELASTIC

If answer is between 0 and -1: the relationship is inelastic. We take the absolute value, therefore:

PED < 1 then the good is INELASTIC

- Hence a 1% change in price will result in a less than 1% change in Qd. We say Qd is NOT

very responsive to a change in price. % change in Price > % change in Qd

- Example: If PED = 0.5, then a 1% change in P will lead to a 0.5% change in Qd.

The Demand curve is drawn more vertical. Draw an inelastic demand curve.

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ELASTIC

If the answer is between -1 and infinity: the relationship is elastic. We take the absolute value, therefore:

PED > 1 then the good is ELASTIC

- Hence a 1% change in price will result in a greater than 1% change in Qd. We say Qd is VERY

responsive to a change in Price. % change in Price < % change in Qd

- E.g.: If PED = 2, it means that a 1% change in P will cause a 2% change in Qd.

- For an elastic good, the Demand curve is drawn flatter. Draw an elastic demand curve.

For example, look at the following demand schedule:

PRICE OF THE GOOD QUANTITY DEMANDED PER WEEK$5 200$4 220

Assume the price falls from $5 to $4, calculate the PED.

% change in Quantity demanded = Qd 2 - Qd1 Qd1 + Qd2 / 2

= 220 – 200 200 + 220/2

= .095

% change in Price = P2 - P1P1 + P2 /2

= $4 - $5$5 + $4/2

= - .22

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PED = % change in Qd = .095 % change in P - .22

PED = - 0.43

Ignore the negative sign therefore /– 0.43/ = 0.43. 0.43 is less than 1 so the good is INELASTIC. A 1% change in price will cause a 0.43% change in quantity demanded.Exercise: Using the formula Below is the demand schedule for tins of al alali tuna

Price of tuna per tin Market demand per week4 Dhs 20003 Dhs 3000

1. Calculate the price elasticity of demand when price falls from 4 Dhs to 3 Dhs.

2. Comment on its value. Is the demand for al alali tuna elastic or inelastic?

3. What will the demand curve for tuna look like? Draw a simple diagram to show this.

Exercise: Predicting the effect a % change in price will have on quantity demanded

Predict the effect that the following percentage price changes might have on the percentage

change in quantity demanded in each case. Give reasons for your answers. The first one has been

done for you as an example

% change in price Predicted percentage change in quantity demanded

Reason Elastic or inelastic

A 20% increase in Emirates Airlines fares

Qd would decrease more than 20% There are substitutes i.e. other airlines

Elastic b/c % change in price % change in Qd

A 30% increase in

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the price of saltA 10% increase in the price of expensive jewelry

Some Special Demand Curves

Unit elasticity

- A percentage change in the price of a good will cause an equal percentage change in the

quantity demanded.

- A 1% change in price will result in exactly a 1% change in Qd.

- PED = 1

- The Demand curve is drawn as a rectangular hyperbola . Draw a unit elastic demand

curve.

Unitary Demand Curve

Perfectly Inelastic Demand

What do you think would happen to the quantity demanded if the price of insulin (a drug that

diabetics must have to survive) increases by 100%? _________________ Why?

_______________________________

- If a rise or fall in the price of a good causes no change in the quantity demanded of that

good, demand is said to be perfectly inelastic.

- A 1% change in price will result in exactly a 0% change in Qd.

- Therefore PED = 0

- For example: life saving drugs, highly addictive drugs. The demand curve is drawn

perfectly vertical. Draw a perfectly inelastic demand curve.

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Perfectly Inelastic Demand Curve

Perfectly elastic demand

- If a good is only demanded at one particular price, then demand is said to be infinitely

price elastic.

- That is a small change in price will cause quantity demanded to fall to zero, that is,

quantity demanded will change by an infinite amount.

- PED = infinity (PED = )

- For example, one farmer’s produce e.g. Farmer Jones’ red apples.

- The demand curve is drawn horizontal. Draw a perfectly elastic demand curve.

Perfectly Elastic Demand Curve

3) Total Revenue Test

A firm calculates its total revenue, that is the amount it receives from selling its goods by

using the following formula:

Price X Quantity = Total Revenue

P X Q = TR

(Note: Total revenue and profit are NOT the same thing!)

A firm would like to know if an increase in price will cause their total revenue to fall or

rise.

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The effect of a price change on total revenue depends on by how much quantity

demanded changes – that is it depends on the good’s PED. If quantity demanded

decreases a lot due to a change in price (PED 1), revenue will tend to fall. If quantity

demanded decreases a little due to a change in price (PED 1), revenue will tend to rise.

Use the above diagram to answer the following questions.

1. Calculate TR when the price is £5.


3. What happens to TR when the price is lowered?

4. Is the good elastic or inelastic?

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Exercise: TR test for elasticityExercise: TR test for elasticity

Price

Quantity Demanded (000s)

D

£5

100

£3

140

Total Revenue


5. Should the business decrease the price? Why or why not?




3. What happens to TR when the price is lowered?



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Exercise: Calculate TRExercise: Calculate TR

Price (£)

Quantity Demanded

10

D

5

5

6





3. What happens to TR after the price decrease?



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Exercise: Calculate TRExercise: Calculate TR

Price (£)

Quantity Demanded

D

10

5 20

7


Exercise: What happens to total revenue?

Below is a demand schedule for bread.

PRICE PER LOAF OF BREAD QUATITY DEMANDED PER

MONTH

Total revenue

2.5 Dhs 10,0002.0 Dhs 10,500

1. Calculate the total revenue for a loaf of bread by filling in the third column in the table

above.

2. When price decreased from 2.5 Dhs to 2.0 Dhs per loaf, what happened to Total

Revenue?

3. Would you advise bread producers to cut the price of bread? Why or why not?

4. Using the information above, we can conclude that if demand is INELASTIC, total

revenue will ________ (decrease/increase/stay the same) when price is decreased and

total revenue will __________________ (decrease/increase/stay the same) when price is

increased.

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Fill in the following table to summarize the relationship between Total Revenue and Elasticity

From the information you learned in exercises 1, 2, and 3, fill in the following table by deciding if

TR increases or

TR decreases or

TR doesn’t change

when the good is Elastic, Inelastic or Unit Elastic and price increases or decreases. Elastic has been completed for you.

Elastic Inelastic Unit Elastic Price Increase

TR DecreasesPrice Decrease

TR Increases

Can you make a general statement about TR and Price based on the above table:

1) If the good is ELASTIC, Price and total revenue move in ____________ (the same direction, opposite directions or there is no change in TR).

2) If the good is INELASTIC, Price and total revenue move in ____________ (the same direction, opposite directions or there is no change in TR).

3) If the good is UNIT ELASTIC, Price and total revenue move in ____________ (the same direction, opposite directions or there is no change in TR).

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Summary of the Total Revenue Test

Total Revenue = Price X Quantity

The following table shows the relationship between Elasticity and Total Revenue

_____________________________________________________________Price Unitary PriceElastic Elastic InelasticDemand Demand Demand

Price P X Q = TR P X Q TR P X Q = TRIncrease (no change in TR)

Price P X Q = TR P X Q = TR P X Q = TRDecrease ( no change in TR)

P and TR move No change in TR P and TR moveIn OPPOSITE b/c in SAME Directions b/c %P = %Qd direction b/c%P %Qd %P %Qd

_____________________________________________________________(Note: The size of the arrows indicates how large or small the change in price compared to change in quantity demanded.)

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Exercise Calculating Total Revenue and determining inelastic, elastic or unit elasticity

Directions: For each problem, complete the math and circle the correct answer. Then write whether the product has an elastic, inelastic or unit elastic demand between the two prices. The first problem is completed for you:

1. Price rises from $5 to $6. Quantity demanded decreases from 15 to 10.

Old Price X Quantity demanded = old total revenue$5 X 15 = $75

New Price X Quantity demanded = new total revenue$6 X 10 = $60

Price increased and Total Revenue decreased therefore the good is elastic.

2. Price falls from $8 to $10. Quantity demanded decreases from 10 to 8.

Old Price X Quantity demanded = old total revenue X = _______

New Price X Quantity demanded = new total revenue X = ___________

Price ________ and Total Revenue ________ therefore the good is ______.

3. Price falls from $6.50 to $6.00. Quantity demanded decreases from 100 to 200.

Old Price X Quantity demanded = old total revenue X = _______

New Price X Quantity demanded = new total revenue X = __________

Price ________ and Total Revenue ________ therefore the good is ______.

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Elasticity and A Downward Sloping Linear Demand Curve

Let’s look at elasticity in the following table. Given the following table, determine over which

price range demand is elastic, inelastic or unit elastic.

Elasticity and a downward sloping demand curve

TABLE 3.2ELASTICITY & A LINEAR DEMAND CURVE

PRICE QUANTITY TOTALELASTICITY

(PED coefficient)USD DEMANDED REVENUE

(000) USD33 0 0

21.0030 4 120

6.3327 8 216

3.40 _(1)___________24 12 288

2.1421 16 336

1.4418 20 360

1.00 (2)_____________15 24 360

0.6912 28 336

0.479 32 288 _(3)______________

0.296 36 216

0.163 40 120

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1. Over the price range $30 to $21, Price ___________ (decreased/increased) and Total

Revenue _______ (decreased/increased/stayed the same), hence over this price range

PED is_________ (elastic/inelastic/unit elastic). Also the PED coefficient is _______

(greater than/equal to/ less than) one.

2. Over the price range $18 to $15, price __________ (decreased/increased) and Total

Revenue ______________ (decreased/increased/stayed the same), hence over this price

range PED is ________ (elastic/inelastic/unit elastic). Also the PED coefficient is

_______ (greater than/equal to/ less than) one

3. Over the price range $12 to $6, Price _________ (decreased/increased)

And Total Revenue ________ (decreased/increased/stayed the same); hence over this

price range PED is ________________ elastic/inelastic/unit elastic). Also the PED

coefficient is _______ (greater than/equal to/ less than) one

4. Therefore we can conclude that the price elasticity of demand (PED) ____________

(increases/decreases/stays the same) as we move down a linear demand curve.

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5. A Total Revenue diagram and a linear Demand curve diagram are drawn below and show

the changes in elasticity. Note the x-axis in both diagrams are labeled quantity and use

the same scale. In the top diagram, graph a demand curve. Lined up under the a total

revenue curve is the demand curve.

Study the diagrams and answer the following questions:a. When TR is at maximum, PED _______ , and it is the _______ on the demand curve.b. At prices above the mid-point of the demand curve, PED is ___ 1, and Demand is

_____________.c. At prices below the mid-point of the demand curve, PED is ___ 1, and Demand is

_____________.

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d. A downward sloping linear demand curve has elasticity that ______ (increases, stays the same, decreases) as we move down along the demand curve.

Exercise: Applying Elasticity to Real World Situations

Instructions: Each of the following stories contains an assumption about elasticity of demand. For each story:

i. State whether the assumption made about the elasticity of demand is correct or is wrong.

ii. Justify your answer.

1. The Ministry of Health is proposing a large increase in the tax on cigarettes. They say, “We are not proposing these taxes to raise revenue for the government but to discourage the filthy habit of smoking. If the prices of cigarettes go up, most people will quit using them. After all, no one needs to smoke.”

iii. _____________________________________

iv. ______________________________________

_______________________________________________________________

2. The government in Jordan opposed a price increase for water during a recent drought. The government claimed that there is no substitute for water, and that the demand for water is perfectly inelastic so that an increase in the price of water would result in exactly the same quantity of water being used as before the price went up.

i. _____________________________________

ii. ______________________________________

_______________________________________________________________

3. Mr. Transit, a world traveler, says if the airlines want to attract more passengers, they should lower fares for business travelers as well as for economy class (vacationers). Both groups should respond equally to a price decrease.

i. _____________________________________

ii. ______________________________________

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Some other measures of elasticity of demand:

INCOME ELASTICITY OF DEMAND (YED)

We mentioned earlier that changes in people’s incomes would affect demand. By how much a

change in income causes the quantity demanded of a good or service to change is known as

income elasticity of demand.

Income Elasticity of Demand measures how responsive Quantity demanded is to a change in

Income.

Formula: % change in Qd = YED % change in Y

NORMAL GOODS (POSITIVE YED)

- Most goods and services are called normal goods because quantity demanded rises as

income rises and vice versa.

% change in Qd = + YED % change Y

- If YED is POSITIVE then the good is a NORMAL GOOD.

- Examples of normal goods include most goods; i.e., cars, DVD players, etc.

INFERIOR GOODS (NEGATIVE YED)

- In the case of a few goods, called inferior goods, quantity demanded falls as income

rises and vice versa.

- If YED is NEGATIVE then the good is an INFERIOR GOOD.

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% change in Qd = - YED % change Y

- Examples of inferior goods include public transport and second hand clothing.

Exercise: Income elasticity of demand (YED)

1. If people’s income increases what will happen to the demand for public transport? ____. Since public transport is a(n) _____ good, YED will be ___.

2. If people’s income decreases what will happen to the demand for cinemas? ____. Since cinemas are a _____ good, YED will be _______.

3. The income of a consumer rises from $100 to $120 while demand for the product falls by 40%. The good has ________ (positive/negative) income elasticity and is therefore a (n) ___________ (normal/inferior) good.

4. The income of consumers rises by 4% and the quantity demanded of Good Z increases by 2%. Is this good an inferior or a normal good?

CROSS ELASTICITY OF DEMAND (XED)

Another important factor that affects the demand for one good is the prices of other related

goods. E.g. If the price of butter increases what do you think will happen to the quantity

demanded of margarine? _____________

Cross Elasticity of Demand measures how responsive Quantity demanded of one good is to

a Price change of another related good (substitute or complement).

Formula: % change in Qd of good t = XED % change in P of good y

SUBSTITUTES (POSITIVE XED)

- If the two goods are SUBSTITUTES, for example, butter and margarine, a rise in the

piece of one will cause a rise in the quantity demanded for the other.

% change in Qd of margarine = + XED

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% change in P of butter

- If producers of butter increase the Price of butter then Qd for margarine will increase.

- A positive into a positive yields + XED (and vice versa).

- Therefore XED for substitutes will be POSITIVE.

COMPLEMENTS (NEGATIVE XED)

If the price of petrol increases what do you think will happen to the quantity demanded of cars?

_____________

- If the two goods are COMPLEMENTS, for example, cars and petrol, a rise in the price

of one will cause a fall in the price of its complement.

% change in Qd of cars = - XED % change in P of petrol

- If the price of petrol increases then the Qd for cars will decrease. A positive into a

negative yields - XED (and vice versa)

- Therefore XED for complements will be NEGATIVE.

Exercise: Cross elasticity of demand (XED)

1. If the price of hot dogs increases what will happen to the quantity demanded of hot dog buns? ______. Since these two goods are _______, XED will be _______.

2. If the price of good X increases 2%, the quantity demanded of good Y decreases by 1.5%. Are Good X and Good Y complements or substitutes?

3. If the price of Coke increases what will happen to the quantity demanded of Pepsi? ____. Since these two goods are _____, XED will be _______.

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4. The cross elasticity of demand for a product is –5; therefore, the goods are ____________. A 1% increase in the price of one good will cause a _____ % _____ (increase/decrease/no change) in the quantity demanded of the other good.

PRICE ELASTICITY OF SUPPLY (PES)

Price elasticity of supply (PES) is a measure of how responsive QUANTITY SUPPLIED is

to a change in Price.

1) Inelastic PES:

If the % change in quantity supplied is less than the % change in price, we say

that supply is inelastic.

Quantity supplied is NOT very responsive to a change in price.

PES < 1and the good is inelastic.

2) Elastic PES

If the % change in quantity supplied is more than the % change in price, we say

that supply is elastic.

Quantity supplied is very responsive to a change in price.

PES > 1and the good is elastic.

Exercise: Draw two diagrams showing:

a) % change in quantity supplied is more than the % change in price? Label the diagram

elastic.

b) % change in quantity supplied is less than % change in price? Label the diagram

inelastic

a) ____________ b) _____________

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What factors affect Price Elasticity of Supply (PES)?

The most important factor that determines elasticity of supply is TIME.

The Momentary Run

How do you think a shop selling bicycles would respond if there is an increase in demand

for bicycles causing an increase in price; however, the shop must supply them

immediately? _________

We can use the example of bicycles to show how price elasticity of supply can vary over time.

Supply of most goods and services, including bikes, will be fixed at any one moment in time. For

example, a shop will only have a certain amount of bikes at any particular time. In this special

case, the supply curve is a vertical line showing that whatever the price the quantity supplied will

be the same.

In the Momentary run, Supply tends to be perfectly inelastic because suppliers have NO time

to adjust to changes in price. A 1% change in price will cause a 0% change in quantity supplied.

Draw a perfectly inelastic supply curve below.

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The Short Run

How do you think a shop selling bikes would respond if there is an increase in demand for

bikes causing an increase in price, and the shop has a short time to supply them – for

example a couple of weeks? _________

In the short run, firms can produce more goods for sale, but only by using more labor, that is, by

either working overtime or employing more workers. More bikes can be produced in existing

factories and sent to the market. However supply can only rise a little because the amount of

factories needed to make bikes are fixed in the short run.

In the Short run, Supply tends to be inelastic because it will be difficult for suppliers to react swiftly to changes in price.

Draw a diagram showing inelastic supply below.

The Long Run

How do you think a shop selling bikes would respond if there is an increase in demand for

bikes causing an increase in price, and the shop has a long time to supply them – say even

as long as a year? _________

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In the long run, firms can hire more labor, land and capital and they can even build new factories

to increase production, so in the long run, supply becomes more elastic.

In the Long run, Supply tends to be elastic because suppliers have a lot of time to adjust to changes in price.

Elastic supply shows that quantity supplied is very responsive to a change in price. Draw an

elastic supply curve below.

The following table summarizes PES according to time periods.

Time Period PES PES coefficient

Long run Elastic PES > 1

Short Run Inelastic PES < 1

Momentary Run Perfectly Inelastic PES = 0

Importance of Elasticity

Relationship between changes in price and total revenue: It is important for businesses to have some idea of what the PED is for the goods it sells because if the price is decreased, more will probably be sold, but the firm will NOT necessarily increase its total revenue. If TR will increase or decrease with a change in price depends on the good’s elasticity.

Importance in determining what goods to tax (tax revenue)

Importance in analyzing time lags in production

Influences the behavior of firms

Elasticities

We have looked at 4 basic types of elasticity:

– Price elasticity of demand

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– Price elasticity of supply– Income elasticity of demand– Cross elasticity

Exercises: Elasticities

1. The demand schedule below relates to the price of candy bars.

PRICE PER

CANDY BAR(Dhs)

Original Quantity

demandedper month

(000s)

Total Revenue

20 1015 2510 405 551 70

a. Calculate total revenue and fill in the column for total revenue.

b. Look at your table. As Price decreased from20 dhs to 15 dhs , total revenue

______ therefore the good is ________.

c. Calculate the price elasticity of demand for candy bars when the price rises from 5

Dhs to 10 Dhs. Comment on its value (elastic or inelastic).

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2. The cross elasticity of demand between Good A and Good B is + 2. What types of

goods are they? __________ (What is the relationship between the two goods?)

3. The cross elasticity of demand between Good X and Good Y is – 1.5. What types of

goods are they? __________ (What is the relationship between the two goods?)

4. A 10% rise in income has caused the demand for candy bars to rise. Are candy bars a

normal or inferior good? ___________ How do you know? ________

Exercise: Applying your Knowledge and Understanding Read the following article and apply the concepts you have learned.

Article: Elasticity Over Time

Reference:http://images.google.com/imgres?imgurl=http://spot.colorado.edu/~kaplan/econ2010/section4/gifs/fig42.gif&imgrefurl=http://spot.colorado.edu/~kaplan/econ2010/section4/section4-main.html&usg=__7amfJ3RCBbMYXY4qlCNihPP1NwM=&h=280&w=280&sz=7&hl=en&start=49&um=1&tbnid=60uyofVT_UNQ-M:&tbnh=114&tbnw=114&prev=/images%3Fq%3Dtotal%2Brevenue%2Band%2Binelastic%2Bdemand%26ndsp%3D18%26hl%3Den%26rls%3Dgm%26sourceid%3Dgmail%26sa%3DN%26start%3D36%26um%3D1

“OPEC was established during the 1950s by oil producing nations located throughout the world.

Until the 1970s, oil prices remained fairly steady at around $3 to $4 a barrel. As a result of the oil

embargo (restriction of oil) of 1973 and 1979, oil prices increased to over $35 a barrel, and were

soon expected to increase above $60 a barrel. Instead, by the mid-1980s, prices per barrel had

fallen to well below $20. It was during the 1970s when the combination of an inelastic good (oil

or gasoline) along with soaring prices had the most dramatic economic effects.

Gasoline is typical of a good that is inelastic in the short-run. When an automobile and energy

dependent country such as the United States was hit by soaring gasoline prices during the 1970s,

consumers had little choice in the short-run but to pay higher prices for gas, they needed to run

their mostly gas-guzzling cars.

The OPEC nations were not the only countries to benefit from very high and rising oil prices.

U.S. oil producers in Texas, Louisiana, Alaska and other states as well as gasoline and petroleum

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distributors also enjoyed soaring profits. In fact, due to rising gas prices, major U.S. gasoline

retail firms were required to pay a windfall profits tax.

However, over time the price elasticity of demand for gasoline increased (became less inelastic)

and consumption (quantity demanded) for oil became more responsive to increases in prices.

Substitutes developed such as more fuel-efficient cars and improved public transportation.

Along with reducing gasoline consumption, conservation and alternative fuels and sources of

petroleum helped to decrease the dependency on OPEC’s oil. Natural gas, coal, solar and other

alternative fuels were increasingly substituted for oil by consumers, industry and electric utilities.

The Iran-Iraq war lead to widespread cheating by OPEC members who went over their

predetermined quotas. Eventually, gasoline prices fell as oil production increased during the

1980s. Although the major gasoline companies were not enthusiastic about lowering the prices of

an inelastic good such as gasoline, an increase in market supplies of oil led to this outcome in the

United States.

The conclusion we can draw from the 1970s, characterized by quickly rising oil prices, is that

over time, elasticity increases (PED becomes less inelastic). Even for goods that are very price

inelastic such as gasoline, substitutes and alternatives in consumption develop when prices

increase.

There may be little opportunity for consumer response in the short-run, but in the long- run he or

she will often find it easier to reduce consumption of a good when its price increases by a large

amount.

As OPEC has learned, while rapidly rising prices of oil can lead to very high short-term profits,

such behavior can result in a long-run problems. For this reason, OPEC, looking at the long run

effects, have a market incentive not to increase the price of oil unreasonably high, because if

prices are too high consumers will start looking for alternative sources of oil in the long run.

Page 30 of 31


The text above is typical of the sort of article available in newspapers and magazines such as

'The Economist', 'Newsweek' and so on. You will gain a great deal from reading all manner of

relevant articles in your studies - but the secret is to read it like an economist!!

Exercise: When reading the text

1. Look up any new vocabulary words.

2. Some of the concepts you should apply include:

a. Supply and Demand

b. Elasticity

Page 31 of 31

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