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An elasticity is a unit-free measure. By comparing markets using elasticities it does not matter how we measure the price or the quantity in the two markets. Elasticities allow economists to quantify the differences among markets without standardizing the units of measurement.
What is an Elasticity?
Measurement of the percentage change in one variable that results from a 1% change in another variable. Can come up with many elasticities. We will introduce four.
three from the demand function one from the supply function
2 VIP Elasticities
Price elasticity of demand: how sensitive is the quantity demanded to a change in the price of the good. Price elasticity of supply: how sensitive is the quantity supplied to a change in the price of the good. Often referred to as own price elasticities.
When the price of gasoline rises by 1% the quantity demanded falls by 0.2%, so gasoline demand is not very price sensitive. Price elasticity of demand is -0.2 . When the price of gold jewelry rises by 1% the quantity demanded falls by 2.6%, so jewelry demand is very price sensitive. Price elasticity of demand is -2.6 .
Elasticity
A measure of the responsiveness of one variable (usually quantity demanded or supplied) to a change in another variable Most commonly used elasticity: price elasticity of demand, defined as:
elastic when Ed > 1, unit elastic when Ed = 1, and inelastic when Ed < 1.
a price increase from $1 to $2 represents a 100% increase in price, a price increase from $2 to $3 represents a 50% increase in price, a price increase from $3 to $4 represents a 33% increase in price, and a price increase from $10 to $11 represents a 10% increase in price. Notice that, even though the price increases by $1 in each case, the percentage change in price becomes smaller when the starting value is larger.
Price
7
6 5 4 3
2
1 0 10 20 30 40 50 60 70 80 90 100 120
Quantity/Time
where:
Example
Suppose that quantity demanded falls from 60 to 40 when the price rises from $3 to $5. The arc elasticity measure is given by:
Total revenue = price x quantity What happens to total revenue if the price rises?
an increase in TR when demand is elastic. a decrease in TR when demand is inelastic. an unchanged level of total revenue when demand is unit elastic.
a decrease in TR when demand is elastic. an increase in TR when demand is inelastic. an unchanged level of total revenue when demand is unit elastic.
Price discrimination
different customers are charged different prices for the same product, due to differences in price elasticity of demand higher prices for those customers who have the most inelastic demand lower prices for those customers who have a more elastic demand.
customers who are willing to pay the highest prices are charged a high price, and customers who are more sensitive to price differentials are charged a low price.
The cross-price elasticity of demand between two goods j and k is defined as:
cross-price elasticity is positive if and only if the goods are substitutes cross-price elasticity is negative if and only if the goods are complements.
A good is a normal good if income elasticity > 0. A good is an inferior good if income elasticity < 0.
A good is a luxury good if income elasticity > 1. A good is a necessity good if income elasticity < 1.
short run - period of time in which capital is fixed all inputs are variable in the long run supply will be more elastic in the long run than in the short run since firms can expand or contract their capital in the long run.
Tax incidence
distribution of the burden of a tax depends on the elasticities of demand and supply. When supply is more elastic than demand, consumers bear a larger share of the tax burden. Producers bear a larger share of the burden of a tax when demand is more elastic than supply.
Quantity demanded = f( )
out-of-pocket price real income time costs prices of substitutes and complements tastes and preferences profile state of health quality of care
Elasticity
Cross Elasticity: The responsiveness of demand of one good to changes in the price of a related good either a substitute or a complement
% Qd of good t __________________ Xed = % Price of good y
Elasticity
Cross Elasticity will have negative sign (inverse relationship between the two) Cross Elasticity will have a positive sign (positive relationship between the two)
Elasticity
The responsiveness of supply to changes in price If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price If Pes is elastic supply can react quickly to changes in price
Pes =
Determinants of Elasticity
Time period the longer the time under consideration the more elastic a good is likely to be Number and closeness of substitutes the greater the number of substitutes, the more elastic The proportion of income taken up by the product the smaller the proportion the more inelastic Luxury or Necessity - for example, addictive drugs
Importance of Elasticity
Relationship between changes in price and total revenue Importance in determining what goods to tax (tax revenue) Importance in analysing time lags in production Influences the behaviour of a firm
Information asymmetry Healthcare is difficult and expensive to commodify Excess capacity is needed for market choice to work (waiting list) Exit from the market is very difficult-interdendent Market entry is prohibitively expensive Problems with private insurance systems (poor get lowest and rich get the best) Price signals don't work (risk pooling is needed) Medical professionalism is anti-market
Patients want local services Markets provide for wants rather than needs Need for specialty clusters, high volume workload and regional and national planning First duty of investor owned firms is to their shareholders, not patients
Summary
Health care characterized by info. asymmetry suppliers better informed than consumers
Suppliers (professionals) therefore act as patients agent, making decisions for them Creates potential for supplier-induced demand (demand in excess of what patient would chose)