Elasticity and its Application

Credit
N. Gregory Mankiw
Contents

What is elasticity? What kinds of issues can elasticity help us understand?

What is the Price Elasticity of Demand (PED)?

How is it related to the demand curve?
How is it related to revenue & expenditure?

What is the Price Elasticity of Supply?

How is it related to the supply curve?

What are the income and Cross-price Elasticities of Demand?

 A scenario…

▪ You design websites for local businesses.

▪ You charge $200 per website, and currently sell 12 websites per month.
▪ Your costs are rising (including the opportunity cost of your time), so you consider
raising the price to $250.
▪ The law of demand says that you won’t sell as many websites if you raise your
price.
▪ How many fewer websites? How much will your revenue fall, or might it increase?
Elasticity

Basic idea:
▪ Elasticity measures how much one variable responds to changes in another
variable.
▪ One type of elasticity measures how much demand for your websites will fall if
you raise your price.
Definition:
▪ Elasticity is a numerical measure of the responsiveness of quantity demanded
(Qd) or quantity supplied (Qs) to one of its determinants.
Price Elasticity of Demand

Price Elasticity Percentage change in Qd

=
of Demand Percentage change in P

• Price elasticity of demand measures how much Qd responds to

a change in P.

▪ Loosely speaking, it measures the price-sensitivity of

buyers’ demand.
Price Elasticity of Demand
Price Elasticity Percentage change in Qd
=
of Demand Percentage change in P

Example: P rises by 10% P2

P1
D
Price elasticity 15% Q
of demand equals = 1.5 Q2 Q1
10%
Q falls by 15%
Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P

P
▪ Along a D curve, P and Q move in
opposite directions, which would make P2
price elasticity negative.
P1
▪ We will drop the minus sign and report D
all price elasticities as positive
Q
numbers. Q2 Q1
Calculating Percentage Changes
Standard method of computing
the percentage (%) change:
Demand for your websites
P end value – start value
x 100%
start value
B
$250
A the % change in P equals
$200
($250–$200)/$200 = 25%
D
the % change in Q equals
Q
8 12 (8-12)/12 = 33%

Elasticity = 33/25 = 1.33

Calculating Percentage Changes
Problem:
The standard method gives different answers
Demand for your websites depending on where you start.
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200
D From B to A,
P falls 20%, Q rises 50%, elasticity
Q
8 12 = 50/20 = 2.50
Calculating Percentage Changes
• So, we instead use the midpoint method:

end value – start value

x 100%
midpoint

▪ The midpoint is the number halfway between the start and

end values, the average of those values.

▪ It doesn’t matter which value you use as the start and which
as the end—you get the same answer either way!
Calculating Percentage Changes
▪ Using the midpoint method, the % change
in P equals

$250 – $200
x 100% = 22.2%
$225
▪ The % change in Q equals
12 – 8
x 100% = 40.0%
10
▪ The price elasticity of demand equals
40/22.2 = 1.8
Class Exercise: Calculate an elasticity
▪ Use the following information Answers
to calculate the price elasticity
% change in Qd
of demand for hotel rooms:
if P = $70, Qd = 5000 (5000 – 3000)/4000 = 50%

if P = $90, Qd = 3000 % change in P

Use midpoint method to calculate. ($90 – $70)/$80 = 25%

The price elasticity of demand equals
50%
= 2.0
25%
What Determines Price Elasticity?
To learn the determinants of price elasticity, we look at a series of examples.
Each compares two common goods.

In each example:
• Suppose the prices of both goods rise by 20%.

• The good for which Qd falls the most (in percent) has the highest price elasticity of
demand.
Which good is it? Why?

• What lesson does the example teach us about the determinants of the price elasticity
of demand?
EXAMPLE 1: Dosa vs. Nihari
▪ The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?

• Dosa has close substitutes (e.g., Vada Pav, Paratha, Idli, Upma, Samosa etc.), so
buyers can easily switch if the price rises.

• Nihari has no close substitutes, so consumers would probably not buy much
less if its price rises.

▪ Lesson: Price elasticity is higher when close substitutes are available.

EXAMPLE 2: “Tata Indica” vs. “Motorbike”

▪ The prices of both goods rise by 20%.

For which good does Qd drop the most? Why?

• For a narrowly defined good such as Tata Indica, there are many substitutes
(Maruti Suzuki, Hyundai, Chevrolet, Renault etc.).

• There are fewer substitutes available for broadly defined goods.

(There aren’t too many substitutes for Motorbike.)

▪ Lesson: Price elasticity is higher for narrowly defined goods than for
broadly defined ones.
EXAMPLE 3: Insulin vs. Andaman Cruise

▪ The prices of both of these goods rise by 20%.

For which good does Qd drop the most? Why?

• To millions of diabetics, insulin is a necessity. A rise in its price would cause

little or no decrease in demand.

• A cruise is a luxury. If the price rises, some people will forego it.

▪ Lesson: Price elasticity is higher for luxuries than for necessities.

EXAMPLE 4: Petrol price in the Short Run vs. Petrol price
in the Long Run

▪ The price of petrol rises 20%.

▪ Does Qd drop more in the short run or the long run? Why?

• There’s not much people can do in the short run, other than ride the bus or
carpool.

• In the long run, people can buy smaller cars or live closer to where they work.

▪ Lesson: Price elasticity is higher in the long run than the short run.
The Determinants of Price Elasticity: A Summary
The price elasticity of demand depends on:

1. The extent to which close substitutes are available

2. Whether the good is a necessity or a luxury

3. How broadly or narrowly the good is defined

4. The time horizon—elasticity is higher in the long run than the short run
The Variety of Demand Curves

The price elasticity of demand is closely related to the slope of the demand curve.

▪ Rule of thumb:

• The flatter the curve, the bigger the elasticity.

• The steeper the curve, the smaller the elasticity.

▪ Five different classifications of D curves.… Economists classify demand curves

according to their elasticity. The next five slides present the five different
classifications, from least to most elastic.
“Perfectly Inelastic Demand” (one extreme case)

Price elasticity % change in Q 0%

= = =0
of demand % change in P 10%

D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
none
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
“Inelastic Demand”
Price elasticity % change in Q < 10%
= = <1
of demand % change in P 10%

D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls by 10%
Q
Elasticity: Q1 Q2
<1 Q rises less than 10%
“Unit Elastic Demand”

Price elasticity % change in Q 10%

= = =1
of demand % change in P 10%

D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
intermediate D
P falls by 10%
Q
Elasticity: Q1 Q2
1 Q rises by 10%
“Elastic Demand”
Price elasticity % change in Q > 10%
= = >1
of demand % change in P 10%

D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls by 10%
Q
Elasticity: Q1 Q2
>1 Q rises more than 10%
“Perfectly Elastic Demand” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
of demand % change in P 0%

D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes by 0%
Q
Elasticity: Q1 Q2
infinity Q changes by any %
Elasticity of a Linear Demand Curve
▪ Calculations of percentage changes use the midpoint
P method. (This is why the increase from Q=0 to Q=20 is
200% 200% rather than infinity.)
$30 E= = 5.0
40% ▪ As you move down a linear demand curve, the slope (the
ratio of the absolute change in P to that in Q) remains
67% constant:
20 E= = 1.0 ▪ From the point (0, $30) to the point (20, $20), the
67%
“rise” equals -$10, the “run” equals +20, so the
40% slope equals -1/2 or -0.5.
10 E= = 0.2 ▪ From the point (40, $10) to the point (60, $0), the
200% “rise” again equals -$10, the “run” equals +20, and
the slope again equals -0.5.
$0 Q ▪ However, the percentage changes in these variables do
0 20 40 60 not remain constant, as shown by the different colored
elasticity calculations.
The slope of a linear demand curve
is constant, but its elasticity is not. ▪ The lesson here is that elasticity falls as you move
downward & rightward along a linear demand curve.
Price Elasticity and Total Revenue
▪ If you raise your price from $200 to $250, would your revenue rise or fall?

Revenue = P x Q

▪ A price increase has two effects on revenue:

1. Higher P means more revenue on each unit you sell.

2. But you sell fewer units (lower Q), due to law of demand.

▪ Which of these two effects is bigger?

It depends on the price elasticity of demand.

Price Elasticity and Total Revenue
Price Elasticity Percentage change in Q
=
of Demand Percentage change in P

Revenue = P x Q

• If demand is elastic, then

price elasticity of demand > 1

% change in Q > % change in P

• The fall in revenue from lower Q is greater than the increase in revenue
from higher P, so revenue falls.
Price Elasticity and Total Revenue
Elastic demand
(elasticity = 1.8) increased revenue
P
due to higher P
If P = $200,
Q = 12 and revenue = Demand for
$250 your websites
$2400.
$200
If P = $250, D
Q = 8 and
lost revenue
revenue = $2000. due to lower Q

When D is elastic, a price Q

8 12
increase causes revenue to
fall.
Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
▪ If demand is inelastic, then

price elasticity of demand < 1

% change in Q < % change in P

▪ The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so
revenue rises.

▪ In our example, suppose that Q only falls to 10 (instead of 8) when you raise your price to $250.
Price Elasticity and Total Revenue
Now, demand is inelastic:
elasticity = 0.82
increased revenue
P due to higher P
If P = $200, Demand for your
Q = 12 and revenue = websites
$2400. $250 lost revenue
due to lower Q
If P = $250, $200
Q = 10 and D
revenue = $2500.

When D is inelastic, a price Q

increase causes revenue to 10 12
rise.
Class Exercise: Elasticity and Expenditure/Revenue

Question: Question:
Pharmacies raise the price of insulin by As a result of a fare war, the price of a luxury cruise
10%. falls 20%.
Does luxury cruise companies’ total revenue rise or
Does total expenditure on insulin rise or
fall?
fall?
Answers:
Answers: ▪ Revenue = P x Q
Expenditure = P x Q ▪ The fall in P reduces revenue, but Q increases,
which increases revenue. Which effect is bigger?
Since demand is inelastic, Q will fall less
▪ Since demand is elastic, Q will increase more than
than 10%, so expenditure rises.
20%, so revenue rises.
Does Drug Interdiction Increase or Decrease Drug-Related
Crime?
▪ One side effect of illegal drug use is crime: Users often turn to crime to
finance their habit.
▪ We examine two policies designed to reduce illegal drug use and see
what effects they have on drug-related crime.
▪ For simplicity, we assume the total dollar value of drug-related crime
equals total expenditure on drugs.
▪ Demand for illegal drugs is inelastic, due to addiction issues.
Policy 1: Interdiction
New value of drug-related crime
Price of
Interdiction reduces the Drugs S2
D1
supply of drugs. S1
Since demand for drugs is P2
inelastic, P rises
proportionally more than P1 Initial value of
Q falls. drug-related
crime
Result:
An increase in total
Q2 Q1 Quantity
spending on drugs, and in
of Drugs
drug-related crime.
Policy 2: Education
New value of drug-related
Price of crime
Education reduces the
Drugs
demand for drugs.
D2 D1
S
P and Q fall.

P1 Initial value
Result:
P2 of drug-
A decrease in total spending related crime
on drugs, and in drug-related
crime. Q2 Q1 Quantity
of Drugs
Price Elasticity of Supply
Price elasticity of Percentage change in Qs
=
supply Percentage change in P

• Price Elasticity of Supply measures how much Qs responds to a

change in P.

▪ Loosely speaking, it measures sellers’ price-sensitivity.

▪ Again, use the midpoint method to compute the percentage

changes.
Price Elasticity of Supply
Price elasticity of Percentage change in Qs
=
supply Percentage change in P
P
Example: S
P2
Price elasticity P rises by 8%
P1
of supply equals

Q
16% Q1 Q2
= 2.0
8% Q rises by 16%
The Variety of Supply Curves
The slope of the supply curve is closely related to price elasticity of
supply.

Rule of thumb:

▪ The flatter the curve, the bigger the elasticity.

▪ The steeper the curve, the smaller the elasticity.

▪ Five different classifications…

“Perfectly Inelastic” (one extreme)
Price elasticity % change in Q 0%
= = =0
of supply % change in P 10%

S curve: P
S
vertical
P2
Sellers’
price sensitivity: P1
none
P rises by 10%
Q
Elasticity: Q1
0 Q changes by 0%
“Inelastic”
Price elasticity % change in Q < 10%
= = <1
of supply % change in P 10%

S curve: P
S
relatively steep
P2
Sellers’
price sensitivity: P1
relatively low
P rises by 10%
Q
Elasticity: Q1 Q2
<1
Q rises less than 10%
“Unit Elastic”
Price elasticity % change in Q 10%
= = =1
of supply % change in P 10%

S curve: P
intermediate slope S
P2
Sellers’
price sensitivity: P1
intermediate
P rises by 10%
Q
Elasticity: Q1 Q2
=1 Q rises by 10%
“Elastic”
Price elasticity % change in Q > 10%
= = >1
of supply % change in P 10%

S curve: P
relatively flat S
P2
Sellers’
price sensitivity: P1
relatively high
P rises by 10%
Q
Elasticity: Q1 Q2
>1 Q rises more than 10%
“Perfectly Elastic” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
of supply % change in P 0%

S curve: P
horizontal
P2 = P1 S
Sellers’ price sensitivity:
extreme

P changes by 0%
Q
Elasticity: Q1 Q2
infinity Q changes by any %
The Determinants of Supply Elasticity
1. The more easily sellers can change the quantity they produce, the
greater the price elasticity of supply.

• Example: Supply of beachfront property is harder to vary and thus less elastic than
supply of new cars.

2. For many goods, price elasticity of supply is greater in the long run than
in the short run, because firms can build new factories, or new firms may
be able to enter the market.
Elasticity and Changes in Equilibrium
▪ The supply of beachfront property is inelastic. The supply of new cars
is elastic.
▪ Suppose population growth causes demand for both goods to double
(at each price, Qd doubles).
1. For which product will P change the most?

2. For which product will Q change the most?

Answers

D1 D2 S
When supply is inelastic, Beachfront property
an increase in demand has (inelastic supply)
a bigger impact on price P2 B
than on quantity.
P1 A

Q
Q1 Q2
Answers
P

D1 D2
S
When supply is elastic,
an increase in demand B New cars
P2
has a bigger impact on A (elastic supply):
P1
quantity than on price.

Q
Q1 Q2
How the Price Elasticity of Supply Can Vary

P
S
elasticity
$15 <1

12 Supply often becomes

elasticity less elastic as Q rises,
>1
4 due to capacity limits.
$3
Q
100 200
500 525
Other Elasticities
Income Elasticity of Demand measures the response of Qd to a change in
consumer income

Income elasticity Percent change in Qd

=
of demand Percent change in income

▪ Recall: An increase in income causes an increase in demand for a normal

good.
▪ Hence, for normal goods, income elasticity > 0.
▪ For inferior goods, income elasticity < 0.
Other Elasticities
Cross-price Elasticity of Demand:
measures the response of demand for one good to changes in the price of
another good.

Cross-price Elasticity % change in Qd for good 1

=
of Demand % change in price of good 2

▪ For substitutes, cross-price elasticity > 0

▪ (e.g., an increase in price of mutton causes an increase in demand for
chicken)
▪ For complements, cross-price elasticity < 0
▪ (e.g., an increase in price of computers causes decrease in demand for
software)
Summary
▪ Elasticity measures the responsiveness of Qd or Qs to one of its determinants.
▪ Price elasticity of demand equals percentage change in Qd divided by percentage change in P. When it’s
less than one, demand is “inelastic.” When greater than one, demand is “elastic.”
▪ When demand is inelastic, total revenue rises when price rises. When demand is elastic, total revenue
falls when price rises.
▪ Demand is less elastic: in the short run; for necessities; for broadly defined goods; and for goods with few
close substitutes.
▪ Price elasticity of supply equals percentage change in Qs divided by percentage change in P. When it’s less
than one, supply is “inelastic.” When greater than one, supply is “elastic.”
▪ Price elasticity of supply is greater in the long run than in the short run.
▪ The income elasticity of demand (YED) measures how much quantity demanded responds to changes in
buyers’ incomes.
▪ The cross-price elasticity of demand (XED) measures how much demand for one good responds to
changes in the price of another good.
Calculating PED

Good 𝑷𝟎 𝑸𝟎 𝑷𝟏 𝑸𝟏 ∆ in P ∆ in Qd %∆ in Qd %∆ in P PED Elasticity

X 10 100 12 98 2 2 -2 20 0.1 <1

Y 10 100 12 80 2 20 -20 20 1 =1

Z 10 100 12 56 2 44 -44 20 2.2 >1