Demand

For many goods, demand is much more price elastic in the long run than in the short run. One reason is that people take time to change their consumption habits. For example, even if the price of coffee rises sharply, the quantity demanded will fall only gradually as consumers slowly begin to drink less of it. Another reason is that the demand for a good might be linked to the stock of another good, which changes only slowly. For example, the demand for gasoline is much more elastic in the long run than in the short run. A sharply higher price of gasoline reduces the quantity demanded in the short run by causing motorists to drive less,but it has its greatest impact on demand by inducing consumers to buy smaller and more fuel-efficient cars. But the stock of cars changes only slowly, so that the quantity of gasoline demanded falls only slowly. Figure 2.12a shows short-run and long-run demand curves for goods such as these.

On the other hand, for some goods just the opposite is true-demand is more elastic in the short run than in the long run. These goods (automobiles, refrigerators, televisions, or the capital equipment purchased by industry) are durable, so that the total stock of each good owned by consumers is large relative to the annual production. As a result, a small change in the total stock that consumers want to hold can result in a large percentage change in the level of purchases. Suppose, for example, that price goes up 10 percent, causing the total stock of the good consumers want to hold to drop 5 percent. Initially, this will cause purchases to drop much more than 5 percent. But eventually, as the stock depreciates (and units must be replaced), demand will increase again, so that in the long run the total stock of the good owned by consumers will be about 5 percent less than before the price increase.

Automobiles are an example. (Annual U.S. demand-new car purchases-is about 7 to 10 million, but the stock of cars is around 70 million.) If automo-

Quantity

FIGURE 2.12a Gasoline: Short-Run and Long-Run Demand Curves. In the short run, an increase in price has only a small effect on the demand for gasoline. Motorists may drive less, but they will not change the kind of car they are driving overnight. In the longer run, however, they will shift to smaller and more fuel-efficient cars, so the effect of the price increase will be larger. Demand is therefore more elastic in the long run than in the short run.

FIGURE 2.12b Automobiles: Short-Run and Long-Run Demand Curves. The opposite is true for automobile demand. If price increases, consumers initially defer buying a new car, so that annual demand falls sharply. In the longer run, however, old cars wear out and must be replaced, so that annual demand picks up. Demand is therefore less elastic in the long run than in the short run.

Quantity

Quantity

FIGURE 2.12a Gasoline: Short-Run and Long-Run Demand Curves. In the short run, an increase in price has only a small effect on the demand for gasoline. Motorists may drive less, but they will not change the kind of car they are driving overnight. In the longer run, however, they will shift to smaller and more fuel-efficient cars, so the effect of the price increase will be larger. Demand is therefore more elastic in the long run than in the short run.

FIGURE 2.12b Automobiles: Short-Run and Long-Run Demand Curves. The opposite is true for automobile demand. If price increases, consumers initially defer buying a new car, so that annual demand falls sharply. In the longer run, however, old cars wear out and must be replaced, so that annual demand picks up. Demand is therefore less elastic in the long run than in the short run.

bile prices rise, many people will delay buying new cars, and the quantity demanded will fall sharply (even though the total stock of cars that consumers want to hold falls only a small amount). But eventually, old cars wear out and have to be replaced, so demand picks up again. As a result, the long-run change in the quantity demanded is much smaller than the short-run change. Figure 2.12b shows demand curves for a durable good like automobiles.

Income elasticities also differ from the short run to the long run. For most goods and services-foods, beverages, fuel, entertainment, etc.-the income elasticity of demand is larger in the long run than in the short run. For example, consider the behavior of gasoline consumption during a period of strong economic growth when aggregate income rises by 10 percent. Eventually people will increase their gasoline consumption-they can afford to take more trips and perhaps own a larger car. But this change in consumption takes time, and initially demand increases only a small amount. Thus, the long-run elasticity will be larger than the short-run elasticity.

Year

GNP _ Investment

FIGURE 2.13 GNP and Investment in Durable Equipment. Annual growth rates are compared for GNP and investment in durable equipment. The short-run GNP elasticity of demand is larger than the long-run elasticity for long-lived capital equipment, so changes in investment in equipment magnify changes in GNP Hence, capital goods industries are considered "cyclical."

Year

GNP _ Investment

FIGURE 2.13 GNP and Investment in Durable Equipment. Annual growth rates are compared for GNP and investment in durable equipment. The short-run GNP elasticity of demand is larger than the long-run elasticity for long-lived capital equipment, so changes in investment in equipment magnify changes in GNP Hence, capital goods industries are considered "cyclical."

For a durable good, the opposite is true. Again,consider automobiles. If aggregate income rises by 10 percent, the stock of cars that consumers will want to hold will also rise, say, by 5 percent. But this means a much larger increase in current purchases of cars. (If the stock is 70 million,a 5 percent increase is 3.5 million, which might be about 50 percent of normal demand in a single year.) Eventually consumers succeed in building up the stock of cars, after which new purchases are largely to replace old cars. (These new purchases will still be greater than before because with a larger stock of cars outstanding, more cars need to be replaced each year.) Clearly,the short-run income elasticity of demand will be much larger than the long-run elasticity.

Because the demands for durable goods fluctuate so sharply in response to short-run changes in income,the industries that produce these goods are very vulnerable to changing macroeconomic conditions, and in particular to the business cycle-recessions and booms. Hence, these industries are often called

FIGURE 2.14 Consumption of Durables Versus Nondurables. Annual growth rates are compared for GNP, consumer expenditures on durable goods (automobiles, appliances, furniture, etc.), and consumer expenditures on nondurable goods (food, clothing, services, etc.). The stock of durables is large compared with annual demand, so short-run demand elasticities are larger than long-run elasticities. Like capital equipment, industries that produce consumer durables are "cyclical" (i.e., changes in GNP are magnified). This is not true for nondurables.

FIGURE 2.14 Consumption of Durables Versus Nondurables. Annual growth rates are compared for GNP, consumer expenditures on durable goods (automobiles, appliances, furniture, etc.), and consumer expenditures on nondurable goods (food, clothing, services, etc.). The stock of durables is large compared with annual demand, so short-run demand elasticities are larger than long-run elasticities. Like capital equipment, industries that produce consumer durables are "cyclical" (i.e., changes in GNP are magnified). This is not true for nondurables.

cyclical Industries-their sales tend to magnify cyclical changes in gross national product (GNP) and national income.

Figures 2.13 and 2.14 illustrate this. Figure 2.13 plots two variables over time the annual real (inflation-adjusted) rate of growth of GNP, and the annual real rate of growth of investment in producers' durable equipment (i.e., machinery and other equipment purchased by firms). Note that the durable equipment series follows the same pattern as the GNP series, but the changes in GNP are magnified. For example, in 1961-1966 GNP grew by at least 4 percent each year. Purchases of durable equipment also grew but by much more (over 10 percent in 1963-1966). On the other hand, during the recessions of 1974-1975,1982, and 1991, equipment purchases fell by much more than GNP.

Figure 2.14 also shows the real rate of growth of GNP, and in addition, the annual real rates of growth of spending by consumers on durable goods (automobiles, appliances, etc.), and on nondurable goods (food, fuel, clothing etc.). Note that both consumption series follow GNP but only the durable goods series tends to magnify the changes in GNP Changes in consumption of nondurables are roughly the same as changes in GNP, but changes in consumption of durables are usually several times larger. It should be clear from this why companies such as General Motors and General Electric are considered "cyclical"-sales of cars and of electrical appliances are strongly affected by changing macroeconomic conditions.

Gasoline and automobiles exemplify some of the different characteristics of demand discussed above. They are complementary goods-an increase in the price of one tends to reduce the demand for the other. And their respective dynamic behaviors (long-run versus short-run elasticities) are just the opposite from each other-for gasoline the long-run price and income elasticities are larger than the short-run elasticities; for automobiles the reverse is true.

There have been a number of statistical studies of the demands for gasoline and automobiles. Here we report estimates of price and income elasticities from two studies that emphasize the dynamic response of demand.6 Table 2.1 shows price and income elasticities of demand for gasoline in the United States for the short run, the long run, and just about everything in between.

Note the large differences between the long-run and the short-run elasticities. Following the sharp increases that occurred in the price of gasoline with the rise of the OPEC cartel in 1974, many people (including executives in the automobile and oil industries) claimed that the demand for gasoline would

6 The study of gasoline demand is in Robert S. Pindyck, The Structure of World Energy Demand (Cam bridge. Mass.: MIT Press, 1979). The estimates of automobile demand elasticities are based on the ar tide by Saul H. Hymans, "Consumer Durable Spending: Explanation and Prediction," Brookings Pa person Economic Activity 1 (1971): 173-199.

table 2.1 Demand For Gasoline

Years Following Price or Income Change

Elasticity 1 2 3 5 10 20

not change much-that demand was not very elastic. Indeed, for the first year after the price rise, they were right-the quantity demanded did not change much. But demand did eventually change. It just took time for people to alter their driving habits and to replace large cars with smaller and more fuel-efficient ones. This response continued after the second sharp increase in oil prices that occurred in 1979-1980. It is partly because of this that OPEC could not maintain oil prices above $30 per barrel, and prices fell.

Table 2.2 shows price and income elasticities of demand for automobiles. Note that the short-run elasticities are much larger than the long-run elasticities. It should be clear from the income elasticities why the automobile industry is so highly cyclical. For example, GNP fell by nearly 3 percent in real (inflation-adjusted) terms during the 1982 recession, but automobile sales fell by about 8 percent in real terms.7 Auto sales recovered, however, during 1983-1985. Auto sales also fell by about 8 percent during the 1991 recession (when GNP fell 2 percent), but began to recover in 1993.

table 2.2 Demand For Automobiles

Years Following Price or Income Change table 2.2 Demand For Automobiles

Years Following Price or Income Change

Elasticity

1

2

3

5

10

20

Price Income

-1.20 3.00

-0.93 2.33

-0.75 1.88

-0.55 1.38

-0.42 1.02

-0.40 1.00

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