İktisada Giriş Teacher's Notes (Chapter 1-3) Class Notes Week 1: Introduction to Economics Definition (Begg): Economics is the study of how a society decides 1- what goods and services to produce , 2- how to produce these goods and services, 3- for whom to produce these goods and services. Goods: st eel, computers, cars, houses, etc. Services: insurance, hotels, transportation, education, retail and wholesale trade, etc. 1.1 Scarcity : Human beings have unlimited wants. We want the best cars, cell phones, houses, education, vacations, etc. But we can not obtain all of our wants because our resources are limited. We need money and time to buy and enjoy these goods and services. So our resources are scarce . Economics considers how prices and markets allocate scarce resources to unlimited wants of the soc iety. Example: Turkish society wants to put a computer in every classroom in primary schools. But the government does not have enough money to do this. Government has to choose between: putting a computer in every classroom 1- building a nuclear power plant. This will reduce Turkey ’ s energy bill of 25 2- billion USD every year for natural gas and oil to other countries. The fact that government has to choose where to spend its money is called a tradeoff . Like government, firms and individuals always face tradeoff s. They have to allocate their scarce resources to their most efficient use. Example: every consumer has a certain income and has to do a budget . As a consumer, y ou cannot buy everything you want. For example, if your monthly income is 1000 liras, and you have to pay 700 liras for rent and other bills, then you have 300 liras to decide what to buy. Let us say a nice cell phone is 300 liras and a textbook is 50 liras. Then you have to choose between the textbook and the cell phone. This is the tradeoff. Her e, the opportunity cost of one cell phone is 6 textbooks. 1.2 Opportunity Cost Definition: (Parkin) The opportunity cost of an action is the value of the next-best alternative action. When there are only two goods as in the example of cell phone and textbo ok, Opp. Cost is easy to calculate. To illustrate Opp. Cost concept, let us introduce the Production possibilities frontier . 1.3 Production Possibilities Frontier Like a consumer cannot consume everything she wants, an economy cannot produce an infinite am ount of goods and services. Because the resources of an economy like Labor, Land and Capital are limited (scarce). Economists like to use models to illustrate ideas, so we use PPF to illustrate scarcity and tradeoff. FIGURE 1 (Parkin): Production Possibili ties Frontier shows the boundary between what an economy can produce and what it cannot.10 15 55 5 5 1 3 2 4 5 A B D E F C Z attainable unattainable pizzas (millions) G CDs (millions) Possibility: Pizzas (millions) CDs(millions) A 0 15 B 1 14 C 2 12 D 3 9 E 4 5 F 5 0 TABLE 1 Idea: As we want to produce more piz zas, we must produce less CDs, because our resources are limited. Attainable points are the points inside and on the curve. They show points that this economy can produce. Unattainable points are points beyond the PPF curve and these points cannot be produ ced. Points on the curve are called efficient . This means all of the resources are spent on production. At a point such as Z, some of the resources are not used efficiently, so we call such points inefficient . At point Z, we can produce both more pizzas an d more CDs. İ f we are on point D and we want to increase CD production, the only way is to decrease pizza production. So point D is efficient and Z is not. O pportunity cost : At point C, we have 2 pizzas and 12 CDs. İ f we want to increase CD production from 2 to 3, w e cannot do this without decreasing pizza production from 12 to 9. Because a point such as G is impossible to produce. Then the opportunity cost of 1 pizza is 3 CDs. One pizza costs us 3 CDs. We come to point D. We can also calculate the opportunity cost o f one CD in terms of pizzas. At point D, increasing CDs by 3 costs us 1 pizza. So opportunity cost of 1 CD is 1/3 pizza (3CD=1pizza, 1CD=1/3pizza). I ncreasing opportunity cost: From point D, if we want to increase pizzas again by 1, then we have to give u p 4 CDs and come to point E. Then the opportunity cost of 1 pizza becomes 4 CDs. Notice that opportunity cost of 1 pizza increases as we produce more and more pizzas. Opportunity costs increase because as we want to produce more pizzas, we force the resour ces that are more suited for CD production to pizza production . For example, workers at SONY can produce many CDs easily because they are experienced in CD production. If we move them to pizza production, they do not know how to make pizza so they will mak e a small amount of pizza. We will get a small increase in pizza production but a large decrease in CD production. 1.4 Role of markets and prices in resource allocation : Markets are very useful in allocating resources efficiently in an economy. Prices gove rn the behavior of sellers and buyers in a market. İ f prices are higher, sellers want to sell more and buyers want to buy less. They behave this way, because both sellers and buyers are trying to maximize their profit from trade. In a Free- Market Economy , buyers and sellers follow their self interest. Su rprisingly, the resulting economy is efficient. By following their own self-interest, buyers and sellers help the economy to become efficient. For example, if people start to like pizzas more instead of lahmacun, then price of pizzas would increase, a lot of lahmacun houses will switch to pizza production. Pizza production would increase because both consumers want to buy more and producers want to sell more pizza. Prices are a very important signal in this process. This is how the economy works efficiently with free markets. To see how free markets are good for the economy; we can look at the Centrally Planned Economies in the former Soviet Union, North Korea or Cuba. In a centrally planned (command) economy, everything (land, factories, restaurants) is own ed by the government and government has to decide what to produce and how much to produce each good and who will be able to buy the goods produced. This planning is very complicated when you think of millions of goods and services to be produced. If peopl e start to like pizzas more in a command economy, then they have to write letters to the government and ask for more pizza houses. It would be a very inefficient system. Prices do not signal buyer and seller behavior in a command economy. In a free market economy, prices are very important signals that determine behavior of buyers and sellers. 1.5 Mi croeconomics and macroeconomics Economics has two broad branches: micro and macroeconomics. Microeconomics studies the economic decisions of an individual or a firm. Also, microeconomic problems are specific to an industry or a commodity. For example, microeconomic questions include: Why are people buying more DVDs and less movie tickets? 1- How would a tax on internet shopping affect e-Bay? 2- What are the effects o f the strike in Turkish Airlines on tourism industry? 3- What is the effect of the strong lira on textile industry? 4-Macroeconomics studies the economy as a whole. Macro does not consider an individual or firm or industry (sekt ö r). Macroeconomics studies the T urkish Economy or another country ’ s economy, or the global economy. Macro questions include: Gross Domestic Product: This is the total value of goods and services 1- produced in a year. GDP per capita shows the average income of a person in Turkey. Consumer P rice Index: Average price of goods and services that a 2- consumer buys. Inflation is the rate of increase of CPI. Can the Central Bank of Turkey make everyone richer by printing money 3- and dropping from helicopters? Week 2: Basics of Supply and Demand 2.1 Market A market is an arrangement where buyers and sellers of a good or service meet. Sometimes this is a place, like a vegetable-fruit Bazaar or the supermarket. Sometimes buyers meet sellers on the telephone or the internet. We categorize markets accordi ng to the good, for example “ market for milk ” or “ market for tobacco ” or “ market for stock exchange IMKB ” . 2.2 Demand Demand is the total quantity of a good that buyers want to buy at every price during a given time period. Demand explains behavior of buy ers in a market. On this TABLE 2, the demand for a chocolate bar is given. TABLE 2 Point Price (liras per bar) Quantity Demanded (millions of bars per week) A 0.5 22 B 1.0 15 C 1.5 10 D 2.0 7 E 2.5 5 The law of demand: From Table 1, we can see th at as the price goes up, buyers want to buy less. This is the law of demand: Other things constant, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded. “ Demand ” vers us “ quantity demanded ” : The term demand refers to the entire relationship between the price of a good and the quantity demanded at every price. Demand can be represented as a demand curve. The quantity demanded of a good is the quantity that consumers want to buy at a particular price. Demand curve : the graphical representation of a demand relationship between price and quantity demanded. Quantity demanded is a point on the demand curve. 0.5 1.5 2.0 1.0 25 10 5 15 20 2.5 3.0 E quantity demanded (million bars) D C B A price (liras/bar) demand for energy bars FIGURE 2Change in demand: If some oth er factor other than price changes the demand behavior of consumers for a good, then the demand curve shifts. When demand curve shifts, this means that quantity demanded changes at every price. Figure 3 and Table 3 illustrate an increase in demand for choc olate. Point Price (liras per bar) Quantity Demanded (millions of bars per week) Point Price Quantity demanded A 0.5 22 A ’ 0.5 32 B 1.0 15 B ’ 1.0 25 C 1.5 10 C ’ 1.5 20 D 2.0 7 D ’ 2.0 17 E 2.5 5 E ’ 2.5 15 Table 3 FIGURE3 0.5 1.5 2.0 1.0 25 10 5 15 20 2.5 3.0 E quantity demanded (million bars) D C B A price (liras/bar) 32 E ’ D ’ C ’ B ’ A ’ M ovement along the demand curve: If all other factors are constant and only price of the good changes, then we move along the original demand curve. For example, starting with the original demand, if the price of chocolate increases from 1 lira to 2 liras, then quantity demanded decreases from 15 to 7. In this case demand curve does not shift because the change is a price change.Factor s that change demand (and shift the demand curve) : The following nonprice factors cause the demand curve to shift. If price itself changes, demand curve does not shift, we move along the curve. Prices of related goods : Consider the market for (gas) benzene. If the price 1- of LPG decreases, what happens to demand for benzene? Demand for benzene decreases because people will buy c ars that operate with LPG instead of benzene. LPG and benzene are thus substitute goods . A substitute is a good that can be used in place of another good (Ex: lahmacun and durum). If the prices of cars decrease, what happens to demand for benzene? Demand f or benzene increases because benzene and cars are complement goods . A complement is a good that is used in conjunction with another good (Ex: tea and sugar). Income: Usually when income increases, demand for most goods increases. 2- These are called Normal go ods like cars, washing machines, etc. If the demand for a good increases when incomes rise, this good is called a normal good . Sometimes, when their income increases, people buy less bread, or less intercity bus tickets (they fly instead). Here bread and i ntercity bus tickets are called inferior goods. If the demand for a good decreases when incomes rise, this good is an inferior good. Expected future prices. If everybody starts to expect the price of benzene to 3- increase next week on Monday, what would they do? They would go and fill their tanks today. Demand for benzene today increases. Similarly, if everyone starts to expect the price of laptops to decrease next month, then your demand for laptops today decreases. People wait to buy laptops at a cheaper pr ice. So a change in price expectations influence today ’ s demand. Tastes, fashion . People demand more vegetables today because of health 4- concerns. Similarly more spring water is sold today because people do not drink tap water. 20 years ago many people dra nk tap water and demand for spring water was very small. Population growth causes demand for many goods to rise . Think of demand 5- for cars in Bilecik and in İ stanbul. Demand is larger in Istanbul of course. Season. Food demand increases during Ramadan, demand for airline travel 6- increases during summer. 2.3 Supply Supply is the total quantity of a good that sellers want to sell at every price during a given time period. Supply explains the behavior of sellers in a market. Quantity supplied of a good or service is the amount that sellers want to sell at a particular price during a given time period. Table 4 shows the supply of chocolate. Point Price Quantity supplied A 0.5 0 B 1.0 6 C 1.5 10 D 2.0 13 E 2.5 15 TABLE 4 Law of supply: Other things constant, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied.0.5 1.5 2.0 1.0 25 10 5 15 20 2.5 3.0 E quantity supplied(million bars) D C B A price (liras/bar) supply of energy bars FIGURE 4 Change in supply: If one of the factors of supply other than price changes, then supply curve shifts. “ Supply increases ” means quantity supplied increases at every price. Point Price Quantity supplied Point Price Quantity supplied A 0.5 0 A ’ 0.5 7 B 1.0 6 B ’ 1.0 15 C 1.5 10 C ’ 1.5 20 D 2.0 13 D ’ 2.0 25 E 2.5 15 E ’ 2.5 30 TABLE 50.5 1.5 2.0 1.0 25 10 5 15 20 2.5 3.0 E quantity supplied(million bars) D C B A price (liras/bar) supply of energy bars new supply 30 FIGURE 5 Determinants of supply: Factors other than price that influen ces supply of a good. Technological improvements , It becomes easier to produce goods. 1- Increases supply. Prices of inputs , If price of electricity is larger, what happens to the supply of 2- bathrobes? If price of jet fuel increases, what happens to supply of airline tickets? Decreases supply. Expected future prices: If the price of a good is expected to rise in the future, 3- then supply decreases today and increases in the future. For example, if the food traders expect the price of olive oil to increase next mo nth, then they store more olive oil and sell a small amount now. Because they can make much more profit next month. The number of suppliers: Think of 10 years ago. Price of an air conditioner 4- was more than 1000 USD. Today you can buy the same AC for 500 US D. This is because ten years ago only imported ACs were sold in Turkey. Today, many companies including Vestel and Ar ç elik are producing and selling ACs. So supply of ACs is much greater than 10 years ago. 2.4 Market Equilibrium: Equilibrium is a situation where opposing forces balance each other. In a free market, price balances demand and supply and brings the market to an equilibrium. Equilibrium price is the price at which quantity supplied equals the quantity demanded. Equilibrium quantity is the quan tity bought and sold at the equilibrium price. Surplus Case For example , if the current price of potatoes is 0.5 lira/kg, and if the quantity supplied is 100 tons this week, and quantity demanded is 80 tons, then is this market at equilibrium? What do you expect to happen to the price? This market is not at equilibrium because there is a surplus of potatoes . Only 80 tons of potatoes will be sold. When potato sellers cannot sell the remaining 20 tons, they start to cut price. Also potato farmers decrease po tato production. When sellers cut prices below 0.5 lira, quantity demanded increases and surplus amount decreases below 20 tons. This process goes on until surplus amount becomes zero. So in case of a surplus, price decreases so that quantity demanded bala nces quantity supplied. Now, let us go back to the chocolates example. Table 6 and Figure 6 combines the demand and supply curves we have seen before. Price Quantity demanded Quantity supplied Shortage (-) or Surplus (+) 0.5 22 0 -22 1.0 15 6 -9 1.5 10 10 0 2.0 7 13 +6 2.5 5 15 +10 TABLE 60.5 1.5 2.0 1.0 25 10 5 15 20 2.5 3.0 quantity supplied(million bars) price (liras/bar) supply of energy bars demand for energy bars Equilibrium FIGURE 6 Shortage Case Now let us assume that price of chocolate is 1 lira. At 1 lira, quantity demanded is 15 and quantity supplied is 6. This price is not an equilibrium price. So onl y 6 bars of chocolate is actually sold. There is a shortage of 9 bars of chocolate in the market. This means some buyers are willing to pay more than 1 lira for chocolate but there is no chocolate to buy. Some chocolate sellers see this opportunity and sta rt to increase price and they can still sell it. So in case of a shortage, price increases to bring the market into equilibrium. Summary We have seen that when the market is not at equilibrium, price adjusts (decreases or increases) to bring the market int o equilibrium. When there is surplus, sellers will cut prices to eliminate unsold stocks. When there is a shortage, then sellers will increase prices and some buyers are still willing to pay the higher price for chocolate. These processes show that price c oordinates the plans of buyers and sellers so that market moves toward equilibrium. Predicting Changes in Price and Quantity 2.5 An increase in demand: See Figure 7 and Table 7. Starting from equilibrium position, let us assume that demand for chocolate incre ases for some reason. Maybe because it is the Valentine ’ s Day. At the current price of 1.5 lira, there is a shortage of 10 m chocolate in the market. This causes price to increase. When price increases, quantity demanded decreases and quantity supplied in creases. Price increases until the shortage becomes zero. When there is no shortage is zero, the market is at equilibrium. New equilibrium price is 2.5 liras per chocolate and new equilibrium quantity is 15 m bars. Price Old Quantity Demanded New Quantit y Demanded Quantity supplied 0.5 22 32 0 1.0 15 25 6 1.5 10 20 10 2.0 7 17 13 2.5 5 15 15 TABLE 70.5 1.5 2.0 1.0 25 10 5 15 20 2.5 3.0 quantity supplied(million bars) price (liras/bar) supply of energy bars new demand 30 old demand FIGURE 7 Summary: When demand increases in the market, both market price and quantity sold increases. So if demand decreas es in the market, the opposite happens; market price and quantity sold decreases. An increase in supply If food processing technology improves, then the supply of chocolate increases. See Table 8 and Figure 8. Price Quantity Demanded Old Quantity Supplied New Quantity supplied 0.5 22 0 7 1.0 15 6 15 1.5 10 10 20 2.0 7 13 25 2.5 5 15 30 TABLE 80.5 1.5 2.0 1.0 25 10 5 15 20 2.5 3.0 quantity supplied(million bars) price (liras/bar) new supply 30 old supply F İ GURE 8 Since supply has increased, at the initial equilibrium price of 1.5 liras, there is a surplus. This causes the price to f all. As the price falls, qty demanded increases and quantity supplied decreases. This causes the surplus to shrink. This process stops at the new equilibrium price of 1.0 liras. At the new eqbm, 15 m bars are bought and sold. So new equilibrium qty is 15 m bars. Summary: When supply of a good increases, its price decreases and its quantity sold increases. Ex: In Turkey, supply of ACs have increased in the last five years. AC prices have fallen a lot and qty of ACs sold have increased. Conversely, if supply of a good decreases, then price increases and qty sold decreases. There are 6 combinations of supply and demand changes. As an exercise, try to see what happens to equilibrium price and quantity in each case. Change in demand, no change in supply, 1- Change in supply, no change in demand 2-Increase both in demand and supply 3- Decrease both in demand and supply 4- Decrease in demand and increase in supply 5- Increase in demand and decrease in supply 6- Week 3: Applications of Supply and Demand Price controls: 3.1 Gove rnment intervenes into free markets in the form of price ceilings and price floors. Price Floor 3.1.1 A price floor is a minimum price set and en acted by the government for a good or service. It makes the sale of a good or service below a certain price illegal . The Turkish govt. sets price floors for several food products. Some examples are hazelnuts, tobacco, tea and wheat. Why does the govt. have such a policy? In order to support the farmers. Usually, if a group of producers is a member of a union or they ar e a politically important group, they have greater bargaining power and force the government to policies that benefit its members. Figure 9 show s the effect of a price floor in hazelnut market . P liras/kg Q (kgs) D eqbm price 3 S price floor 5 surplus amount FIGURE 9: Price Floor For exampl e, assume that the eqbm price for hazelnuts is 3 liras . For a price floor to have a real effect (be “ binding ” ) , it must be above th e eqbm price. A price floor below 3 liras would have no real effect on the market outcome. Let us assume that after negotiati ons between the govt. and hazelnut producers confederation , the price floor is set to be 5 liras/kg . This policy causes a surplus amount shown on the Figure . What happens to the surplus amount of hazelnuts? How does the govt. keep the price high and preven t the market from moving toward eqbm ? By buying the surplus amount. Sometimes the govt. is able to sell this amount, but most of the time, sells it for a price a lot less than the price it has paid for it . This causes the govt. institutions like Fiskobirli k to have deficits . Who pays for t hese losses ? T he treasury pays, and so the ta xpayers pay . Another price floor in the labor market is the minimum wage . By the same reasoning as above, minimum wage causes a surplus of labor which is also called unemploy ment . Show on the same figure. 3.1.2 Price Ceiling A price ceiling is a maximum price set and enacted by the government for a good or service. It makes the sale of a good or service above a certain price illegal. Consid er the price ceiling for bread , 40 Yk r per loaf . Why does the government think this is necessary? Govt. wants to support poor consumers through this policy. Figure 10 shows the effect of a price ceiling on bread. P Ykr/loaf Q (loaves) D eqbm price 40 S price ceiling 70 shortage amount FIGURE 10 Assume the eqbm price of bread is 70 Ykr . A binding price ceiling must be below the eqbm price. Otherwise it would have no effect on the market. The result of the price ceiling is that t here is a shortage of bread in the market. When there is a shortage of a good, it must be rationed with some k ind of mechanism. Which buyers will be able to get the limited amount of bread ? During the WWII years, bread was distributed with a “ karne ” , a ration coupon that gives every person a right to one loaf per day. If we assume that bread is distributed accordi ng to “ first-come, first-served ” principle as it is the case today, then people have to wait in line to get bread. Also, you cannot find the regular bread after 7pm in the evening. This is because the bakeries do not want to sell the cheap bread; they bake only a limited quantity. They bake other types like francala that there is no price restriction and so more expensive. So price ceilings have unwanted consequences like this. Rent ceiling: Good for the poor. Show the short term and long term effects by dr awing two supply curves. In the short run, supply curve is steep as it is hard to respond to the policy quickly. In the long run, available housing for rent may decrease as landlords use their houses for other more profitable purposes. P (liras/ month) Q (loaves) D eqbm rent 500 LRS rent ceiling 700 LR shortage SRS SR shortage FIGURE 11 Shortage of houses available for rent increase s in the long run . We will have similar results if the government decides to enact a law that restricts the rate of increase of rents to the CPI inflation. Normally rents increase faster tha n CPI in Turkey. There will be a shortage of houses available for rent, at least in the long run. Elasticity of demand: 3.2 Elasticity m easur es the sensitivity (responsiveness) of quantity demanded to changes in price and income. We are looking at the law of demand in more detail by measuring elasticity. Law of demand says that as price of the good increases, qty demanded decreases. But we did not consider the magnitude of the price change on demand. Here we will quantify this effect formally. 3.2.1 Price E lasticity of Demand Price elasticity of demand (PED) measures the sensitivity of quantity demanded to changes in price. PED is defined as the percentage change in the quantity of a good demanded divided by the corresponding percentage change in its price. price in change % demanded qty in change % ? PED Point Price (lira/ticket) Quantity of tickets demanded (1000) Price Elasticity of Demand A 125 0 ? ? B 100 20 - 4 C 75 40 - 1.5 D 62.5 50 -1 E 50 60 - 0.67 F 25 80 -0.25 G 0 100 0 TABLE 925 75 100 50 100 40 20 60 80 125 quantity demanded (1000 tickets) E C B A price (liras/ticket) F G 0 FIGURE 12 Example: Consider Table 9 . This is the number of football game tickets for, say, Galatasaray. Verify PED numbers in column four . Explain slowly how to calculate percentage changes. Percentage change of x ? y is calculated by ? ? 100 * x x y ? . A ? B Price change of 125 ? 100 is a percentage change of (-25 / 125) * 100 = -20%. Corresponding Qty change of 0 ? 20 is a percentage change of (20 / 0) * 100 = ? ? . Then PED = ? ? . B ? C Price change: 100 ? 75 is (-25 / 100)*100 = -25% Qty change: 20 ? 40 is (20/20)*100 = 100%. Then the PED = 100/-25 = -4. D ? E Price change: 62.5 ? 50 is (-12.5/62.5)*100 = -20%Qty change: 50 ? 60 is (10/50)*100 = 20% . Then PED = -1 . Demand is elastic if |PED| > 1. Demand is inelastic if |PED| < 1. Demand is unit elastic if |PED| = 1 . In our example, demand is elastic through points A, B and C. Demand is inelastic through points E, F and G. Demand is unit elastic at point D. E lastici ty on a linear demand curve . On the upper half of the curve through A ? C , quantity changes are large relative to price changes. So demand is elastic on the upper part. On the lower part of the curve E ? G , price changes are large relative to quantity cha nges. So demand is inelastic on the lower part of the curve. At point D, price changes become equal to qty changes. At that point, PED is equal to -1. Why is elasticity important? Consider yourself as a manager of a football club, say Galatasaray . Table 1 0 shows demand for tickets and total revenue . Your objective is to maximize Total Revenue from ticket sales where Total Revenue (TR) = Price (P) X Number of tickets sold (Q) Price (lira/ticket) Quantity of tickets demanded (1000) Price Elasticity of Deman d Total Revenue 125 0 ? ? 0 100 20 - 4 2000 75 40 - 1.5 3000 62.5 50 -1 3125 50 60 - 0.67 3000 25 80 -0.25 2000 0 100 0 0 TABLE 10 Where should you pick the ticket price in order to maximize revenue? Assume initially tickets are 100 TL. Should you decrease or increase ticket prices? If you increase price to 125 TL, nobody will buy tickets and revenue is zero. If you decrease price to 75, total revenue increases because the number of tickets sold increases faster than the decrease in price. This means buyers are very sensitive to the price cut. |PED| > 1 because: %change in qty demanded > %change in price . Notice that there is a close relationship between elasticity and total revenue: When demand is elastic; |PED| > 1, the manage r should decrease the 1- price to increase TR, When demand is inelastic; |PED| < 1, the manager should increase the 2- price to increase TR, TR is maximized when |PED| = 1. At this point, if you increase or decrease 3- price (a small amount), TR is unchanged. Oth er Examples: Agricultural products , crude oil and hous es have inelastic demand. Tourism expenditures, cars, furniture have elastic demand . Table 11 shows some real world elasticities. Price Elastic Demand Metals 1.52 Electrical Engineering Products 1.39 Mechanical Engineering Products 1.30 Furniture 1.26 Motor Vehicles 1.14 Transportation services 1.03 Price Inelastic Demand Gas, Electricity and Water 0.92 Chemicals 0.89 Drinks 0.78 Clothing 0.64 Tobacco 0.61 Banking and Insurance 0.56 Ho using 0.55 Agricultural and Fish Products 0.42 Books, Magazines, newspapers 0.34 Food 0.12 Oil 0.05 TABLE 11: REAL WORLD PRICE ELAST İ C İ T İ ES OF DEMANDSource s : From M. Parkin’s Economics who compiled from : Ahsan Mansur and John Whalley, “ Numerical Spec ification of Applied General Equilibrium Models: Estimation Calibration and Data ” , in Applied General Equilibrium Analysis, eds. Herbert E. Scarf and John B. Shoven (New York: Cambridge University Press, 1984), 109, and Henri Theil, Ching-Fan Chung and Jam es L. Seale, Jr. Advances in Econometrics, Supplement I, 1989, International Evidence on Consumption patterns (Greenwich, Conn.: JAI Press, Inc., 1989) and Geoffrey Heal, Columbia University, Web site. What Determines Price Elasticity? Ease of substituti on: If the price of cigarettes increases by one percent, does the 1- quantity demanded decrease by 5% or 0.5%? Probably by 0.5% because it is hard for smokers to substitute some other good for cigarettes. Width of the market definition: Now consider a particu lar brand of cigarettes, 2- say Parliament . If the price of Parliament cigarettes increases by one percent, does the quantity demanded decrease by 5% or 0.5%? Probably by 5%. Because it is easier to substitute another cigarette brand for Parliament. As we def ine a narrower category for a commodity, price elasticity increases. Time Elapsed Since Price Change: Short-run response is inelastic, long-run 3- response is much more elastic. Oil price shock of 1973-74 OAPEC (Organization of Arab Petroleum Exporting Count ries) agreed to restrict oil supply to U.S. and Western Europe in response to 1- Western pressures for cheap crude oil, 2- Their support for Israel. Figure 10 s how s the short-run and long-run effects of this. 100 quantity demanded (barrels) A price (dollars/barrel) 0 inelastic demand(a) elastic demand(b) D D S S S ’ S ’ D D S S S ’ S ’ F İ GURE 1 3: Elastic and inelastic demands In the short-run , price of crude oil had quadrupled by 1974. This was because demand for oil was very inelastic, around -0.1 . As shown on part (a) of Figure 10, the decrease in the supply of crude oil led to a large increase in its price but a small decrease in qty of oil sold. This means that the revenue of OPEC countries has increased very sharply after the embargo. But in the long-run , consumers were better able to substitute away from oil by buying smaller cars, use public transportation, use alternative energy sources such as natural gas, nuclear power, wind and water . Use paper bags instead of plastic bags, etc. Demand is much more elastic in the long-run than in the short-run. So in the long- run, the demand c urve is much flatter as in part (b) of Figure 10. As a result, the same fall in the supply of oil produced a small price increase but a large decrease in qty of oil sold in the long-run. Then the OPEC revenues decreased a lot as time passed. The real price of crude oil decreased back to levels close to the pre-crisis levels in 1986. price (dollars/barrel)Another factor that contributed to the revenue decline was that oil production made by non-OPEC countries significantly increased in the long-run. This response by non- OPEC cou ntries made the long-run supply of oil more elastic. OPEC revenues decreased further. It was easier to keep prices high in the SR than in LR. Year: Crude oil price change % 73-74 50 79 14 80 34 81 34 82 -10 83 -10 84 -10 85 -10 86 -45 “ Can good n ews for farming be bad news for farmers? ” Consider market for wheat. Wheat has an inelastic demand. Assume initially the market is at its eqbm. Now, suppose Fatih Uni. professors have found a two times productive wheat seed. Also suppose that all farmers use this new seed and are farming two times the old amount. Supply curve will shift right . The new eqbm will be at some point with a lower price and a higher qty . So far everything sounds good. But t he TOTAL REVENUE earned by all farmers DECREASES because P. Elasticity of D emand for wheat is only 0.24 . When price falls by for example, 20%, qty demanded will increase by only 4.8%. Farmers will make less money as a result of technological improvement. A t this point, you may ask “ why do the farmers adopt the innovation and increase supply ? ” . They do b ecause t he decision facing each farmer is whether to increase her crop taking PRICE of wheat AS GIVEN. The farmer does not take into account the effect of her actions on the market price for wheat. Since all farm ers face a similar choice of action, they all decide to increase production . As a result they earn less money . The inelastic demand for agricultural products explains two developments: every year, the percentage of labor force working in agriculture falls in (i) many countries including Turkey: in US, it fell from 17% in 1950 to 2% in 2000, EU subsidies on agriculture : EU pays farmers to leave part of their lands (ii) unplanted in order to keep supply low and prices high . Of course, this policy hurts consumers and t he society. It only benefits the farmers. 3.2.2 Income elasticity of demand Income elasticity of demand is defined as the percentage change in the quantity of a good demanded divided by the percent age change in consumers ’ income: income in change % demanded qty in change % IED ? Consider demand for tomatoes, laptop computers and bus tickets. Which one do you think has a larger income elasticity of demand? Consider the case when your income rises from 1000 liras a month to 5 00 0 liras a month. How much does your demand for tomatoes increase? How much does your demand for a trip to Paris increase? How about bus tickets ? Luxury goods have an IED larger than one. Airline travel is a luxury good. Necessity goods have an IED less than one. Tomatoes, tobacco, clothing are necessity goods. Normal goods have a positive income elasticity of demand. Most goods are normal. Inferior goods have a negative income elasticity of demand (IED). Bus tickets are examples of inferior goods. Table 12 shows some real world income elasticities of demand. Income Elastic Demand Airline travel 5.82 Movies 3.41 Foreign travel 3.08 Electricity 1.94 Restaurant meals 1.61 Haircuts 1.36 Automobiles 1.07 Income Inelastic Demand Tobacco 0.86 Alcoholic Drinks 0.62 Furniture 0.53 Clothing 0.51 Newspa pers and Magazines 0.38 Telephone 0.32 Food 0.14 TABLE 12: REAL WORLD INCOME ELASTICITIES OF DEMAND Source: From M. Parkin ’ s Economics who compiled from H.S. Houthakker and Lester T. Taylor, Consumer Demand in the United States (Cambridge, Mass.: Harvar d University Press, 1970) and Henri Theil, Ching-Fan Chung and James L. Seale, Jr. Advances in Econometrics, Supplement I, 1989, International Evidence on Consumption patterns (Greenwich, Conn.: JAI Press, Inc., 1989) 3.2.3 Cross-price elasticity of deman d The Cross-price elasticity of demand for good i with respect to changes in the price of good j is : j good of price in change % demanded i good of qty in change % j) (i, CPED ? Substitute goods have positive cross-price elasticity of demand. LPG and benzene are substitute goods. When price of benzene go es up, quantity of LPG demanded increases. Complement goods have a negative cross-price elasticity of demand. Cars and benzene are complement goods. When price of benzene goes up, all other things kept constant, demand for cars decreases.