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PROFESSOR: So today what we're
going to do is continue our
discussion of supply
and demand.
This is sort of introduction
week, if you will.
We've kind of talked about
supply and demand, and you
guys, rightly, immediately
were on to where do those
curves come from.
And that's what we'll
start next week.
But what I want to do today is
talk some more about what
determines the shapes of supply
and demand curves and
just think about an overview of
how we think about supply
and demand interacting in a
market and what determines how
responsive individuals and
firms are to prices.
And, once again, remember
everyone should have a handout
that you should have picked up
in the back on your way in.
So everyone should
have a handout.
What we talked about last time
was the sort of qualitative
effects, the qualitative version
of the supply and
demand model.
We talked about what happens
when a supply curve shifts,
what happens when a demand
curve shifts.
We talked about how either a
supply shock or a demand shock
could lead to the price
being increased.
But they could have very
different effects on
quantity, et cetera.
What we didn't talk about is
how big these effects are.
I made up some numbers.
I threw them on the graphs.
But I didn't talk about where
the size of those
effects come from.
And where they come from is the
shapes of the supply and
demand curve.
And that's what we'll talk about
today is what determines
the shapes of supply
and demand curves.
And that will be the focus
of today's lecture.
I'll talk both theoretically
about what determines these
shapes and empirically about
how economists go about
figuring out the shapes of
supply and demand curves.
So, to think about this, let's
start with Figure 3-1, which
is a standard market diagram
we had last time.
With an initial equilibrium at
point E1, with an initial
price P1 and a quantity Q1.
That's the equilibrium
that's stable.
Because at that price P1,
consumers demand Q1 units, and
suppliers are willing
to provide Q1 units.
So that's a stable
equilibrium.
Now we have some supply shift.
Last time we talked
about somehow a
pork-specific drought.
That leads the supply
to shift inward.
So the supply curve
rises to S2.
At that new price, initially,
you would have excess demand.
But quickly the price increases
to shut off that
excess demand.
And you end up with a new
equilibrium with a higher
price, P2, and a lower
quantity Q2, and new
equilibrium point E2.
OK?
And we talked that through
last time.
What I want to talk about this
time is well, what determines
the size of that shift from Q1
to Q2 and that price increase
from P1 to P2?
What's going to determine it
is the elasticity of supply
and demand.
The elasticity of supply and
demand is how much do supply
and demand respond?
Do the quantities supplied and
the quantities demanded
respond when the
price changes?
When we say, how elastic is
demand, what we mean is how
sensitive to price is the
quantity demanded.
Or, alternatively, what is the
slope of that demand curve?
So the slope of the demand curve
will be the sensitivity
of quantity demanded to the
price consumers face.
And that will determine the
market responsiveness.
In economics, it's always true
that the best way to think
about things is to
go to extremes.
You have to remember that
extremes don't exist in the
real world.
But it's a useful
teaching device
to think about extremes.
So let's think about one extreme
case in Figure 3-2.
Let's think about the case of
perfectly inelastic demand.
Perfectly inelastic demand,
that's where there's no
elasticity of demand.
What that means is that demand
for a good is unchanged
regardless of the price.
So perfectly inelastic demand is
a case where demand for the
good is unchanged regardless
of the price.
That would lead you to have a
vertical demand curve at a
given quantity.
What this says is regardless
of the price, people always
demand Q.
Can anyone tell me what
would cause demand to
be perfectly inelastic?
In what types of situations
would demand be--
it's never perfectly
inelastic--
would demand be relatively
inelastic?
Yeah?
AUDIENCE: [INAUDIBLE PHRASE].
PROFESSOR: It's all
about substitutes.
When there's no substitutes,
when there's nowhere to go, it
doesn't matter what
the price is.
When there's no substitutes,
demand will be perfectly
inelastic, because you have to
have Q. It doesn't matter what
the price is.
Because there's no substitute
for that good.
So if you wanted amount Q of
that good for any reason,
you're always going to
want that amount Q
no matter the price.
So a perfectly inelastic good
would have no substitutes.
So you'd always want
Q no matter what.
Can anyone think
of an example?
There's no perfectly inelastic
good in the world.
But what sorts of goods?
Yeah?
AUDIENCE: Medicines.
PROFESSOR: Medicines.
Now, not necessarily
all medicines.
So give me an example of a
medicine which would be more
or less inelastic.
So I don't even need
a medical name.
What sort of treatments?
AUDIENCE: Like heart
attack maybe?
PROFESSOR: Yeah, something which
is sort of lifesaving.
The best thing that we often use
is insulin for diabetics.
Diabetics without getting that
insulin to manage their
diabetes will die.
That seems like that's something
where there's not a
whole lot of substitutes.
The substitute is dying.
So basically that's
where demand
is relatively inelastic.
Or a heart transplant, when you
get a heart transplant or
any kind of transplant, you have
medicine you take so you
don't reject the transplanted
organ.
That sort of medicine demand
should be very inelastic.
Elastic drug, well,
our favorite
example is always Viagra.
It's something where you'd think
that you can probably
survive without it.
And people would want less
Viagra if you charged a lot
more for it than if you
charged less for it.
So elasticity is going to be
about substitutability.
And that's going to determine
inelastic demand.
Now, what happens with inelastic
demand when there's
a supply shock?
When supply increases,
what happens?
Well, in that case, there can
never be excess demand,
because demand doesn't change.
So all that happens is
price just increases.
If there's inelastic demand,
and there's a supply shock,
then all that happens is an
increase in price and no
change in quantity.
So with inelastic demand,
quantity doesn't change for a
price increase.
Price just goes up.
From a supply shock, prices
just goes up.
Now, let's consider
the opposite.
Let's look at Figure
3-3 and think about
perfectly elastic demand.
Perfectly elastic demand is
demand where consumers,
essentially, don't care
about the quantity.
They just care about
the price.
That is, there are infinitely
good substitutes.
A perfectly elastically demanded
good would be one
where there are, essentially,
perfect substitutes.
An inelastic good is where
there's no substitute.
A perfectly elastic good would
be where there's perfect
substitutes.
Technically, if a good is
perfectly elastically
demanded, then you are
completely indifferent between
that good and a substitute.
Well, if you're completely
indifferent, then if the price
changed at all, you would
immediately switch.
And so the price can't change.
What's an example?
Once again, there's no
good example of a
perfectly elastic good.
Yeah?
AUDIENCE: Candy.
PROFESSOR: What?
AUDIENCE: Candy.
PROFESSOR: Candy.
OK.
So you've got your
Wrigley's gum.
I like the sugar-free,
minty gum.
You've got Orbit and Eclipse.
And I go to the store, and
they're all pretty much the
same price.
If Orbit was more than Eclipse,
I just buy Eclipse.
They're the same.
They're minty gum.
It doesn't make a difference.
So basically the price
is the same.
If there's a supply shock, I
don't know, they're made with
the same shit.
But let's say that Eclipse has
some magic ingredient.
And let's say the Eclipse magic
ingredient got more
expensive, so the supply
curve shifted up.
Well, Eclipse could not respond
by raising its price.
Because I just switched
to Orbit.
Or we often think of McDonald's
and Burger King.
Now, they're less perfect
substitutes, but pretty perfect.
If McDonald's started charging
$10 for a hamburger, you
wouldn't go there anymore.
You'd go to Burger King.
So if there's a supply shock to
a provider that's facing a
perfectly elastic demand curve,
they cannot raise their
price, because people
will just switch.
So quantity will fall a lot.
Because if I'm supplying Eclipse
gum, and it suddenly
costs a lot more to produce
Eclipse gum, but I can't raise
my price, because I will lose
all my business to Orbit, I'm
just going to produce
a lot less Eclipse.
Because I'm losing money now.
So with perfectly inelastic
demand, the
quantity didn't change.
With perfectly elastic demand,
we saw a big quantity change.
So, more generally, what
determines the quantity change
in response to a price change
is the elasticity.
More generally, we're between
these two cases of perfectly
elastic and perfectly
inelastic.
And what's going to determine
the price change is going to
be the price elasticity of
demand epsilon which is going
to be the percentage change in
quantity for each percentage
change in price or, in calculus
terms, dQ/dP.
So it's, basically, the
percentage change in quantity
for the percentage
change in price.
So, for example, if for every 1%
increase in price quantity
falls 2%, that is a price
elasticity of
demand of minus 2.
The price elasticity of demand
is the percentage change in
quantity for the percentage
change in price.
So inelastic demand is
an epsilon of 0.
There is no change in quantity
when price changes.
Perfectly elastic demand is an
epsilon of negative infinity.
Any epsilon change in price
leads to a negative infinite
change in quantity.
Immediately, the quantity
goes to 0 if you try
to raise your price.
So the price elasticity of
demand will typically be
between 0 and negative
infinity.
And the larger it is the more
quantity will change when
prices change.
Questions about that?
Yeah?
AUDIENCE: So that formula,
shouldn't it be dQ/dP times
P/Q because dQ/dP just refers to
the change of the quantity
with respect to price, not
necessarily the percent change.
PROFESSOR: Yeah, you're right.
I was trying to get too fancy
with my calculus.
You're right.
Let's just stick with the
non-calculus formula.
I never should deviate
from my notes.
So let's just stick with the
non-calculus formula.
OK, other questions
about this?
OK.
So, basically, that's
the elasticity.
That's going to be
the elasticity.
Now, an interesting point about
elasticity is now, we're
not going to get into
producer theory
for a couple of lectures.
But as a little peek ahead about
producer theory, let's
think about how elasticity
determines the money that
producers make from selling
their goods.
Well, if a producer sells Q
goods at a price P, they make
revenues R. Revenues are the
price times the quantity.
The amount of money a producer
makes when it sells goods, its
revenues, this isn't
its profits.
We're not having profits.
It's just the amount of money
it makes, not the amount of
money it takes home at
the end of the day.
I'm ignoring the cost
of making the goods.
The amount of total
revenues it makes
is price times quantity.
Well, we can then say that the
change in revenues with
respect to price is what?
It's Q plus dQ, plus delta Q--
let me put it this way to make
my math clearer--
plus P times delta Q over delta
P. That's how revenues
change with respect to price.
Or, in other words, plugging
in from the elasticity
formula, delta R over delta P
equals Q times 1 plus epsilon.
So, in other words, what this
says is that if you're a
producer, and you're trying to
decide whether to raise your
price, whether that will
increase revenues, it all
depends on the elasticity.
If the elasticity is between
0 and minus 1, then raising
prices will raise revenues.
If the elasticity is greater
than minus 1, then raising
prices will lower revenues.
We're often faced with the issue
of why did they charge
this much for this good, or
should they raise their prices
or not raise their price.
Well, that's all about the
elasticity of demand.
The elasticity of demand will
determine whether they're
going to make more money by
raising their price or lose
money by raising their price.
For Eclipse gum, their
elasticity of demand is well
above minus 1 in absolute value,
so they're going to
lose money by raising
their price.
If they take the current level
of Eclipse, for every penny
they raise, they'll
lose money.
For insulin, for every
penny they raise,
they'll make money.
And then you might say well,
then how come the price of
insulin isn't infinity
and the price of
Eclipse gum isn't zero?
Well, that's what we'll talk
about in a few weeks.
Because it also depends on the
costs of producing it.
But at the end of the day,
that's what's going to
determine the money that's made
by producers when they
change their prices.
Questions about that?
OK.
So now, that's how we think
about the shape
of supply and demand.
The shape of supply and demand
is determined by these
elasticities.
So now we have to get into OK,
well, where do we get these
elasticities from?
And that is the main topic of
empirical economics which is
estimating these kinds of
elasticities, estimating these
types of elasticities.
So one of the first distinctions
I drew in the
lectures is between theoretical
economics and
empirical economics.
Theoretical economics can tell
us this is what a graph looks
like and supply and demand.
Theoretical economics can't
really tell us how big, for
example, an elasticity
is going to be.
It can tell us, there's more
substitutes or less
substitutes so we
can rank them.
We know the elasticity for
Eclipse gum has got to be
higher than the elasticity
for insulin.
But from the theoretical model,
we can't say what the
elasticity actually is.
To say what an elasticity
actually is, we need to go to
an empirical model.
We actually need to bring data
to bear on the question.
And this is very difficult.
Because here we face the
fundamental conundrum facing
the empirical economist which
is distinguishing causation
from correlation.
And the whole guts of empirical
economics is all
about this question,
distinguishing causation from
correlation.
The classic story that
illustrates this, it's due to
my colleague, Frank Fisher,
from a textbook many years
ago, was the story of in ancient
Russia there was a
cholera outbreak, and many
people were dying.
So the government decided to
send doctors out to try to
solve the problem.
And where there were
more people sick,
they sent more doctors.
Well, the peasants said,
wait a second.
We observe that where there's
more doctors, more people are
dying from cholera.
So the doctors must be
causing the cholera.
So they rose up and killed
the doctors.
The peasants confused causation
with correlation.
They thought that the fact that
you saw more people dying
where there's more doctors
meant that doctors were
causing the disease.
Clearly that's wrong.
That's why they were peasants.
But it's not just peasants
that make this mistake.
For example, in 1988, Harvard
University, our illustrious
neighbor to the south,
I guess, west,
east, I don't know.
Which way is Harvard?
I don't know directions,
down the street.
A Harvard University dean
conducted an interview with a
set of freshmen.
And they found that those
that had taken
SAT preparation courses--
now, you all took SAT
preparation courses.
But in 1988, not everyone did.
Those who'd taken SAT
preparation courses scored an
average of 63 points lower--
this was back when the
SAT was 1600 points--
63 points lower on their SATs
then those that had not taken
preparation courses.
The dean concluded that
preparation courses were
unhelpful, and that the testing
industry was preying
on the insecurities
of students to
provide a useless service.
Why was the dean confusing
causation with correlation?
What did the dean get wrong in
drawing that conclusion?
Yeah?
AUDIENCE: What had probably
happened is the students who
got worse scores realized that
they wanted to try and improve
their scores by taking
an SAT prep class.
So that's why there is a lower
average score for the people
who had taken the class.
PROFESSOR: Generally, the people
who needed the help the
most took the most courses.
And so they had an underlying
lower score.
So, in fact, you can't tell
anything from the fact that
the people who took the prep
course scored worse.
It's just another excellent
example of confusing causation
with correlation.
And that's another example.
Another example I like quite
a lot is studies of
breastfeeding.
There are numbers of studies of
breastfeeding, especially
in developing countries, where
they found that the longer
children were breastfed
the sicker they were.
So they concluded that
breastfeeding was bad for kids.
Well, that's not the truth.
The truth is the sicker kids
need to be breastfed more,
because breastfeeding is
actually good for kids.
And they just confused the
causation with the
correlation.
Now, these are all
fun examples.
But the truth is this is a
common mistake made by
citizens, policy makers,
everyone in the real world.
It's taking two things that move
together and assuming one
causes the other.
And this is the fundamental
conundrum facing empirical
economics in trying to address
these kinds of things like
measuring elasticities.
So to understand that, let's
think about the issue of
trying to estimate the
elasticity of demand for pork.
Let's say you have the exciting
job of estimating the
elasticity of demand for pork.
That's your assignment.
Well, you say, wait a second.
What we learned in class, as
shown in Figure 3-4, is that
the price of pork can rise for
very different reasons.
Figure 3-4, we start at an
initial equilibrium like E1
with a quantity like
Q1 and a price P1.
Now, imagine that there was a
shift in demand, because the
price of beef rose, remember?
The price of beef rose.
That shifted demand
from D1 to D2.
What did that lead to?
A higher price and a
higher quantity.
So if you took that diagram--
forget the supply shift for a
minute, just imagine that's
the change--
and you said, aha.
I can measure the elasticity.
I see here there's a
change in price.
I can then look at how
quantity changed.
And I'll get the elasticity
right after all.
It's delta Q over Q
or delta P over P.
So I just look, and I take Q2
prime minus Q1 over Q1.
That's the percentage change
in Q. I take P2
over P1 over P1.
That's the percentage
change in price.
And what do I get?
A wrong signed elasticity
is what I get.
I get a positive elasticity,
because Q is going up
and P is going up.
Why?
Because I'm confusing causation
with correlation.
It's not the price change that
caused quantity to change.
In fact, it's the opposite.
It's a taste shift, which caused
quantity to increase
which drove up the price.
It was a demand increase which
caused the quantity demanded
to increase which drove
up the price.
So it's the quantity driving
the price, not the price
driving the quantity.
So if you looked at that simple
example, as many people
in the real world do, they'd
say, hey, look.
Higher prices cause
higher quantities.
You're getting the
wrong answer.
Because you're confusing
correlation which is the
higher price is correlated
with the higher quantity.
Because there was a common
factor causing both of them
which is the demand shift
and not causation.
The higher price did not cause
the higher quantity.
What do we need to do?
We need to distinguish why
the price increased.
We need to distinguish
why the price
increased to measure this.
If, instead, we looked at a
shift in supply such as the
case that's shifting from
S1 to S2 and moving the
equilibrium from E1 to
E2, then you would
get the right answer.
Because then you'd say, look.
Something independent
to consumers
shifted up the price.
Some shock to the supply of
pork shifted up the price.
And we saw that their quantity
fell as a result.
What's the key?
The key is that to measure an
elasticity of demand, you're
measuring the slope of
the demand curve.
So you need to shift along a
demand curve, not shift the
demand curve itself.
So if you look at this figure,
what's the concept we want?
We want the slope of
the demand curve.
Well, you get that by shifting
from E1 to E2, because you
shift along the demand curve.
So by looking at what happens
to quantity as price rises
from E1 to E2, you get the slope
of the demand curve.
You get that delta Q over
delta P you want.
But from E1 to E2 prime, you're
not shifting along the
demand curve.
You're actually measuring the
elasticity of supply.
You're measuring the elasticity
of supply.
You're shifting along
a supply curve.
So you're actually answering a
different question, a relevant
question, but a different one.
That question is, what's the
elasticity of supply?
How willing are pork producers
to supply pork as
the price goes up?
So it's the same delta Q over
delta P. But here we did the
elasticity of demand.
There's a corresponding
elasticity of supply which is
measured the same way.
It's delta Q over delta
P, but it's for a
different kind of shock.
It's what you get from moving
along the supply curve.
So if we went from E1 to E2
prime, we can use that to
measure the elasticity of supply
or the slope of the
supply curve.
And we do that if something
shifts demand to move us along
the supply curve.
From E1 to E2, we measure the
elasticity of demand as
something shifts supply
and moves us
along the demand curve.
So what we need to measure the
elasticity of demand is
something which shifts
supply but does not,
itself, affect demand.
And the best example of this
that we use in economics, a
great example, is government
policy which comes along and
changes the supply conditions
for a good.
So, for example, let's think
about a tax on pork.
So if you go to Figure 3-5,
imagine the government came
along and taxed pork.
The government comes along
and taxes pork.
Let's think about what
a tax on pork does.
The government comes along, and
let's say the pork market
is initially in equilibrium
at $3.30 with 220 million
kilograms of pork sold.
Now the government comes along
and says that it's going to
charge $1.05 in tax for every
kilogram of pork.
So it's going to impose
a tax of $1.05
per kilogram on producers.
So it's saying to producers of
pork, for every kilogram of
pork you sell, you have
to send a check to the
government for $1.05.
For every kilogram of pork you
sell, you have to send a check
to the government for $1.05.
Now, somebody talk me through
how a supplier
thinks through that.
How does a supplier
react to that?
What do they think?
They're initially happy at
E1 selling 220 million
kilograms at $3.30.
What happens when the government
comes in and says
you have to pay $1.05 for every
kilogram of pork you sell?
What happens?
Yeah.
AUDIENCE: The producer decides
that the current amount of
money they have will not be able
to buy as much inputs to
create their products.
So they can produce less.
PROFESSOR: Exactly.
So, in other words, the cost
of producing just rose.
So what do they do?
So, in other words, what they
say is look, effectively, if I
was happy before selling 220
million kilograms at $3.30, to
keep me equally happy selling
220 million kilograms, I'm
going to have to raise
the price.
We should add this to
graph, actually.
If you draw a vertical line up
for me, one to the S2 curve.
Draw a little dashed line up
from the E1 to the S2 curve
and then over.
That price intersection
will be $4.35.
So in other words, if you want
me to keep producing 220
million kilograms of pork,
I'm going to have
to get $4.35 a kilogram.
And you might say, what gives
you the right to get that?
And it's not about rights.
It's about what producers
are willing to do.
That same mathematics, that same
supply curve that tells
us they're willing to sell 220
million kilograms at $3.30
says, if you want them to keep
selling 220 million kilograms
but also pay $1.05 to the
government, they're going to
have to get $4.35 a kilogram.
So what happens is that's
a supply shift.
And with the same reaction
we saw last time with the
drought, the price goes up,
consumers demand less, and you
reach a new equilibrium
at the price E2.
You reach a new equilibrium
where you sell 206 million
kilograms for a price
of $4.00.
So someone tell me how I use
this example to find
elasticity of demand.
Yeah.
AUDIENCE: I guess you need to
know that the change in price
traveled along the
demand curve.
So you know that it's not
[INAUDIBLE PHRASE].
PROFESSOR: OK, so tell me.
You don't have to do the
math in your head.
But how would I compute it?
AUDIENCE: You would take E1 and
E2, and then you would do
the price over the
quantity change.
PROFESSOR: Right, exactly.
So the quantity change delta
Q over Q, is what?
It's minus 14 over 220.
It fell by 14 million
kilograms over 220.
The price change, delta P
over P, the price rose
from $3.30 to $4.00.
So the price change is
$0.70 over $3.30.
And using those, you
end up with a price
elasticity of minus 0.3.
Or, in other words, there's
a 6.4% change in quantity.
This is minus 6.4% for a
21% change in price.
So quantity falls by 6.4% when
price goes up by 21%.
That's a price elasticity
of minus 0.3.
Or that's a relatively
inelastic demand.
It's not perfectly inelastic,
but it's relatively inelastic.
In other words, at that point,
pork producers could make
money by raising the price.
Now, you might say well,
why didn't they?
That's something we'll discuss
in a couple weeks.
But at that point, demand
is relatively inelastic.
And you've got a convincing
estimate, because you moved
along that demand curve.
You used the supply shift.
Now, we're going to talk about
taxation much, much later in
the semester.
Let me just talk for one minute
about what we learned
from this graph.
What happens?
Well, the shaded area is the
money the government raises
from its tax.
The government has a tax
of $1.05 at 206 million
kilograms. So it raises $1.05
times 206 million kilograms
which is that shaded area.
There are two points to note the
we'll come back to later
in the semester.
The first point to note is the
amount of money the government
raises will depend directly on
the elasticity of demand.
Can anyone tell me how much
money the government would
raise if you had a perfectly
inelastic demand?
Yeah.
AUDIENCE: [INAUDIBLE PHRASE].
PROFESSOR: Right.
If we think about this demand
curve being perfectly flat, if
we think about this demand curve
being perfectly flat,
then basically the producer
can't charge any more for
their good.
So it's going to depend on
whether the producer is
willing to sell at $1.05 less
and how much less they're
willing to sell.
If they're willing to sell a
lot less, they're going to
make a lot less money.
It's going to be where that
second supply curve intersects
a flat demand curve.
So that quantity is going
to be a lot smaller.
We don't have it
on the diagram.
But you see where that dashed
line at $3.30 intersects S2,
that's way to the left.
Quantity is going to fall
a ton in this market.
When quantity falls, the
government is going to raise a
lot less money.
Because the government
raises $1.05 on every
unit sold at the end.
So if the government taxes
very elastically demanded
goods, it's going to
raise less money.
If it taxes inelastically
demanded goods like insulin,
it's going to raise more money,
because the quantity
doesn't change.
Yeah.
AUDIENCE: So cigarettes are
relatively inelastic.
PROFESSOR: Yes, exactly.
Cigarettes are relatively
inelastic.
The elasticity is around
minus 0.5.
So the government will actually
raise money by
raising the cigarette tax.
Those of us, as good liberals,
think we should tax yachts.
Let's tax yachts.
Only rich guy have yachts.
The problem is yachts are
incredibly elastically demanded.
So you raise a lot less money
taxing yachts than you think.
Because guys buy fewer yachts,
and you don't raise as much
money as you think you would.
You still raise some, and it
still may be worth it.
But you raise less
than you think.
So that's one sort of
observation about this.
It's basically how much money
you'll raise will be a
function of how elastic
the demand is.
The other important observation
to make is why
it's actually hard for
governments to figure out how
much money they're going
to raise for a tax.
Because, to figure it out,
they need to know these
elasticities.
That is, the naive thing to do
would have been to say what?
Well, we're selling 220 million
kilograms of pork.
That's $1.05.
We're going to tax
each kilogram.
So that's 220 million
times $1.05.
And that's how much
money we raise.
Well, that's wrong, we
know, because that
assumes inelastic demand.
If demand's elastic, they'll
raise less than that.
Well, if we want to figure out
how much a government is going
to raise from a tax, they've
got to know what these
elasticities are.
And those are actually pretty
hard things to know.
So that's why there's
uncertainty.
That's why when politicians will
say, this tax will raise
x and you'll hear the New York
Times report, the tax will
raise x, that is a guess.
Those are guesses, because
they depend on our best
estimate of the key elasticities
that determine
how people respond.
Yeah.
AUDIENCE: But in Washington
you have tax
cuts that raise money.
PROFESSOR: Well, some
claim you do.
You don't actually.
But some claim you have tax
cuts that raise money.
That's because they think the
elasticity is very large.
If the elasticity is
large enough, a tax
cut can raise money.
So, basically, that's all about
that some people think
that elasticities are large
enough that tax
cuts can raise money.
Those people are wrong.
But that's what they claim.
Yeah.
AUDIENCE: [INAUDIBLE PHRASE].
PROFESSOR: Yes.
Excellent point.
You'll go through that
in section on Friday.
So what I've done is I've done
an example of a constant
elasticity curve.
Actually, I've done something
here which is logically
inconsistent.
This curve is linear which means
it can't be constant
elasticity.
If it's constant elasticity,
it would have to curve.
So what I've estimated here
is a local elasticity.
I have estimated the elasticity
around that price change.
But the elasticity, if this
curve is true, would be
different at different
points on this curve.
If the elasticity is going to
be constant all over the
curve, and you're going to do
a constant elasticity of
demand, that's going to
be a curve that bends,
not a linear curve.
So a linear demand curve
is not constant
elasticity of demand.
We will typically ignore that
issue and focus on local
elasticities.
But that is an important
issue.
We'll discuss that in section
on Friday, the difference
between constant elasticity of
demand curves and linear
demand curves.
But, typically, we're think
about local changes.
So if it's local enough, it
doesn't really matter.
But, for a broad change, it will
matter what the shape of
the curve is.
Good point.
Other questions?
OK.
Let me then turn to another
problem we face
in empirical economics.
So this is an example of a
problem we're facing in
empirical economics.
Let me turn to an example of
another problem we face in
empirical economics estimating
elasticities.
It is that individuals often
choose the price they face.
Individuals, typically, often
don't just face a price that's
given to them.
And then you can say, OK,
they're given a price, and we
see how they respond.
They often choose the
price they face.
Let me explain what
I mean by that.
A classic example of an
elasticity that matters a lot
for policies is the elasticity
of demand for medical care,
the elasticity of demand
for medical care.
That is how much less medical
care will you use if you have
to pay for it?
So, for example, most of us have
insurance through MIT or
maybe through our parents.
And the way health insurance
works is you pay a certain
amount per month or your parents
do, and, in return,
that health insurance covers the
cost of your medical care,
most of it.
But, typically, you have
to pay some of it.
So how many people have
gone to the doctor in
the last six months?
Did you have to pay something?
How much did you pay?
Did you pay a copayment?
No?
None of you?
Yeah.
How much did you pay?
AUDIENCE: I think like $20.
PROFESSOR: $20, $10, $5, that's
what's called the
copayment, or $0.
Most insurance these days has
what's called copayments.
A copayment is what you pay
when you go to the doctor.
Insurance picks up the
rest. You don't know.
You didn't know how much the
whole doctor visit cost. You
just went, you gave
them your card.
They said your copayment
is $20.
You gave them $20.
You don't know.
The visit might have cost $100,
$200, $500, $1,000.
You don't know.
Your insurer picks up the rest.
You pay the copayment.
Copayments are rapidly on the
rise in health insurance.
There's a rapid rise
in copayments.
Increasingly, insurers are
saying, look, health care
costs are out of control.
One way we're going to combat
them is by making people bear
more of the cost
that they use.
I could go on forever about
how I'm a health care
economist. I could go on about
health care forever.
But just to fix ideas on why
this is an issue, in 1950, the
US economy spent 5% of our gross
domestic product, 5% of
our size of the economy
went to health care.
Today it's 17%.
By 2075, it's projected
to be 40%.
That is of every dollar that's
made in America, $0.40 will go
to medical care.
By 100 years later,
it's about 100%.
Literally, if we do nothing,
the entire economy will be
health care.
Obviously, that can't happen.
We've got to deal with this.
And one way that insurers and
some policy makers are saying
we need to deal with this is we
need to make consumers bear
more of the costs of
their medical care.
We need to make consumers pay
more when they go to the
doctor, so that they understand
the consequences of
their decision.
Well, if we're going to do that,
a key question we need
to know is well, does it
affect their behavior?
If we make consumers pay more,
and it doesn't at all affect
their demand for medical care--
it's just a tax on
them, essentially--
then that's different than if
it causes them to use less
medical care.
It may be good, may be bad.
We'll come back to that.
But the key empirical question
is what is the elasticity of
demand for medical care?
If you pay $20 and you pay $0,
how much less like are you to
use the doctor when you pay $20
versus when you pay $0.
Well, we can all introspect
this and think about it.
But, in fact, to answer this we
have to go to the data and
ask, well, what's
the difference?
So people, for many years,
went to the data.
And they said, look, there's all
sorts of differences out
there across people and what
they pay for their copayments.
Some people have insurance where
they pay nothing, some
where they have $20.
Some people have what they call
high-deductible plans.
A deductible plan is where you
pay the full cost of your
visits until you reach
some limit.
So a $2000 deductible plan will
be one where you pay all
of your medical costs until
you've spent $2,000.
It's a big copayment.
So we look across those people,
and people did.
And they found, look, the people
that have plans where
they spend more for health care,
where they have a high
copayment, use a lot less health
care than where they
don't have to spend anything.
The elasticity of demand
looks very, very high.
What is wrong with
those studies?
What is wrong with the
conclusion those people drew?
They drew it by comparing people
who had plans where
they paid a lot to go to the
doctor, and therefore use a
lot less care to people who
didn't pay anything when they
went to the doctor and
used a lot more care.
I pick the $20 person, because
I picked on you already.
AUDIENCE: Probably they chose
to have a high-deductible
plan, because they don't often
go to the doctor already.
PROFESSOR: The rational choice,
if you're young and
healthy, for almost everyone in
this room, is going to be a
very high-deductible,
high copayment plan.
Because it will cost you less
money, because the insurer is
shifting the money to you.
But you don't use the
doctor anyway.
So who cares?
So the healthier people are
going to choose the plans
where they pay more.
So, of course, you're going to
find in the plans where people
pay more they use less
medical care.
But is it because they're paying
more, or is it because
healthy guys choose
those plans?
It's causation versus
correlation.
We don't know.
Well, how can we figure
that out?
Well, if we were doctors, what
we'd do-- real doctors, not a
doctor like me, a real doctor,
a medical doctor--
what we'd do is we'd run
a randomized trial.
So if doctors want to figure
out whether a drug works or
not, they don't just look at
guys who take the drug versus
guys who don't.
They run a randomized trial.
They randomly assign some people
to take the drug and
some people not.
Now, when you run a randomized
trial, by definition, you get
a causal effect.
Well, this room isn't
quite big enough.
We all know the law
of large numbers.
But imagine there were four
times as many people in this
room or five times as many
people in this room.
OK?
And I had you come
up to the front.
I flipped a coin and said half
of you are going to take the
drug, and half of you
are not, randomly by
the flip of a coin.
Then, by definition, any
statistically noticeable
differences I get between the
group the takes the drug and
the group that doesn't is
caused by the drug.
And how do I know that?
Because I know the groups are
otherwise identical by the law
of large numbers.
By the law of large numbers, I
know that as long as I have
enough people, they're
identical.
So if the only difference
between them is that one's
taking the drug and one's not,
that's a randomized trial.
That would be how I could solve
the causation versus
correlation problem.
In medicine, thousands of
randomized trials every day
are being run.
In fact, the FDA, before it
will approve a drug, will
typically require a
randomized trial.
Well, in the social sciences,
it's harder to
run randomized trials.
Because we're actually trying
to understand things like
people's demand for medical
care, not whether a
drug works or not.
But, in fact, one of the most
famous social randomized
trials in history was called
the RAND Health Insurance
Experiment run in the 1970s.
This is where some innovative
health economists who
understood this problem that
we laid out about the fact
that you can't just compare more
or less generous health
insurance policies, actually
randomized health insurance
policies across people.
They recruited volunteers, and
they literally said, we're
going to randomize.
Some people are going to have
policies where the health care
is free, and some people are
going to have policies where
they have to pay, essentially,
all the costs of health care.
So they, essentially, randomized
across these
different groups.
And, therefore, they can
assess what the price
elasticity was.
Because they knew the price
difference between groups.
For one, the price was zero.
For one, the price was one.
They actually had a range of
prices they varied it across.
They could look at the quantity
response, and they
knew that was a quantity
response to the price, because
people weren't choosing
their prices.
The prices were being
assigned to them.
What did they find?
Well, they found that medical
demand is elastic, although
not as elastic as the
previous study.
It's somewhat elastic.
It's not as elastic as the
previous studies found.
They found that the elasticity
of demand for medical care is
around minus 0.2.
So when the price goes up,
people use less medical care
but not that much less.
Now, let's be clear.
Remember what elasticity is.
That delta Q over Q. The same
study showed that if you take
someone who paid nothing and
make them pay almost
everything, their utilization of
medical care falls by 45%.
That's consistent with that
small elasticity.
Because that's a huge delta
P, percent delta P. So,
basically, that's comes to the
question about local versus
global elasticities.
So it's not saying that
prices don't matter.
But it's not a very, very
elastically demanded good.
So that's how they measure
that price of
elasticity of demand.
That experiment, which was run
over 35 years ago now, that
result drives much of what
we do in health policy.
So a lot of the estimates that
we saw for the recently passed
health reform bill
derived from how
do we get that estimate.
We'll have to figure out how
people are going to respond
with their medical care when we
give them health insurance.
The recently passed health care
bill just gave 32 million
people health insurance.
Well, how are they going
to respond to
having health insurance?
We go back to the RAND estimates
and say, well, we
have this elasticity
of demand.
We know what we're doing
to the price.
We figure out how much medical
care is going to go up.
But here's the other thing.
Here's the question in
the lecture that
that we'll close with.
Is that a good thing or a bad
thing that medical care fell
when the price went up?
And how would we tell
whether it's a good
thing or a bad thing?
So we know when we raise
the price, people use
less medical care.
How can we tell if that's a
good thing or a bad thing?
In the same experiment,
how could we tell?
What could we do?
Yeah.
AUDIENCE: Maybe you'll get
death rates or like--
PROFESSOR: You look
at their health.
You say, look, the
same trial can
answer a different question.
We know that when you charge
someone for health
care, they use less.
Well, are they sicker?
The answer, not at all.
People use less health
and were no sicker.
Why?
Because we waste a huge amount
of health care in the US.
A huge amount of health
care is wasted.
So, in fact, we could cut back
quite a lot on health care,
and we'd be no sicker.
And that's what the RAND
experiment showed, that we can
charge people to use
medical providers.
And they'll use less medical
care, and they won't be sicker
as a result.
Which suggests that, actually,
as we try to think about
getting our health care costs
under control in America,
making people pay something to
go to the doctor is not a
crazy thing to be
thinking about.
How much?
Well that depends on efficiency
versus equity.
We can't make someone who has no
income pay $1,000 to go to
the doctor.
That, clearly, is a mistake.
But we can take a rich guy like
me and make me pay $50 to
go to the doctor.
There's no reason
not to do that.
So, basically, that's a lesson
of how you can use elasticity
of demand to help inform
the kind of
policies we need to make.
OK, let me stop there.
By the way, if you at all find
this stuff interesting, and
you haven't yet read
Freakonomics--
how many of you have
read Freakonomics?
That's amazing.
OK.
If you haven't read
Freakonomics, you should.
It's a great book.
If you're lazy, the movie
is coming out.
And Freakonomics the movie
is premiering on
Friday the 30th at LSC.
So if you're interested in
learning more about empirical
tools in economics, you can
watch Freakonomics the movie
on Friday the 30th.
