Elasticity and Its Application

5
Elasticity and its Application

PRINCIPLES OF
FOURTH EDITION
N. G R E G O R Y M A N K I W
PowerPoint Slides
by Ron Cronovich
2007 Thomson South-Western, all rights reserved
In this chapter, look for the answers to

these questions:
What is elasticity? What kinds of issues can
elasticity help us understand?
What is the price elasticity of demand?

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?
CHAPTER 5
ELASTICITY AND ITS APPLICATION
A scenario
You
You design
design websites
websites for
for local
local businesses.
businesses.
You
You charge
charge $200
$200 per
per website,
website, and
and currently
currently sell
sell
12
12 websites
websites per
per month.
month.
Your
Your costs
costs are
are rising
rising (including
(including the
the opp.
opp. cost
cost of
of
your
your time),
time), so
so youre
youre thinking
thinking of
of raising
raising the
the price
price
to
to $250.
$250.
The
The law
law of
of demand
demand says
says that
that you
you wont
wont sell
sell as
as
many
many websites
websites ifif you
you raise
raise your
your price.
price. How
How many
many
fewer
fewer websites?
websites? How
How much
much will
will your
your revenue
revenue fall,
fall,
or
or might
might itit increase?
increase?
CHAPTER 5
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 Qd or Qs to one of its
determinants.
CHAPTER 5
Price Elasticity of Demand

Price elasticity
of demand
Percentage change in Qd
Percentage change in P
Price elasticity of demand measures how

much Qd responds to a change in P.
Loosely speaking, it measures the pricesensitivity of buyers demand.
CHAPTER 5

Price elasticity
of demand
Example:
Price
elasticity
of demand
equals
15%
= 1.5
10%
CHAPTER 5
P
P rises
P2
by 10%
P1
D
Q2
Q1
Q falls
by 15%

Price elasticity
of demand
Along
Along aa DD curve,
curve, PP and
and Q
Q
move
move in
in opposite
opposite directions,
directions,
which
which would
would make
make price
price
elasticity
elasticity negative.
negative.
We
We will
will drop
drop the
the minus
minus sign
sign
and
and report
report
all
all price
price elasticities
elasticities
as
as positive
positive numbers.
numbers.
CHAPTER 5
P
P2
P1
D
Q2
Q1
Calculating Percentage Changes

Standard method
of computing the
percentage (%) change:
Demand for
your websites
end value start value

x 100%
start value
P
$250
Going from A to B,
the % change in P equals
$200
D
8
CHAPTER 5
12
($250$200)/$200 = 25%
Demand for
your websites
P
$250
B
A
$200
8
CHAPTER 5
12
Problem:
The standard method gives
different answers depending
on where you start.
From A to B,
P rises 25%, Q falls 33%,
elasticity = 33/25 = 1.33
From B to A,
D
P falls 20%, Q rises 50%,
Q
elasticity = 50/20 = 2.50

So, we instead use the midpoint method:
end value start value
x 100%
midpoint
The midpoint is the number halfway between

the start & end values, also the average of
those values.
It doesnt matter which value you use as the

start and which as the end you get the
same answer either way!
CHAPTER 5
10

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
CHAPTER 5
11
1:
Calculate an elasticity
ACTIVE LEARNING
Use the following

information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000
12
ACTIVE LEARNING
Answers
1:
Use midpoint method to calculate

% change in Qd
(5000 3000)/4000 = 50%
% change in P
($90 $70)/$80 = 25%
The price elasticity of demand equals
50%
= 2.0
25%
13
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?
CHAPTER 5
14
EXAMPLE 1:
Rice Krispies vs. Sunscreen

The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
Rice Krispies has lots of close substitutes

(e.g., Capn Crunch, Count Chocula),
so buyers can easily switch if the price rises.
Sunscreen 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.
CHAPTER 5
15
EXAMPLE 2:
Blue Jeans vs. Clothing

The prices of both goods rise by 20%.
For a narrowly defined good such as

blue jeans, there are many substitutes
(khakis, shorts, Speedos).
There are fewer substitutes available for

broadly defined goods.
(Can you think of a substitute for clothing,
other than living in a nudist colony?)
Lesson: Price elasticity is higher for narrowly

defined goods than broadly defined ones.
CHAPTER 5
16
EXAMPLE 3:
Insulin vs. Caribbean Cruises

The prices of both of these goods rise by 20%.
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.
CHAPTER 5
17
EXAMPLE 4:
Gasoline in the Short Run vs.

Gasoline in the Long Run
The price of gasoline rises 20%. Does Qd drop
more in the short run or the long run? Why?
Theres 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.
CHAPTER 5
18
The Determinants of Price Elasticity:

A Summary
The
The price
price elasticity
elasticity of
of demand
demand depends
depends on:
on:
the
the extent
extent to
to which
which close
close substitutes
substitutes are
are
available
available
whether
whether the
the good
good is
is aa necessity
necessity or
or aa luxury
luxury
how
how broadly
broadly or
or narrowly
narrowly the
the good
good is
is defined
defined
the
the time
time horizon:
horizon: elasticity
elasticity is
is higher
higher in
in the
the
long
long run
run than
than the
the short
short run.
run.
CHAPTER 5
19
The Variety of Demand Curves

Economists classify demand curves according to
their elasticity.
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.
The next 5 slides present the different

classifications, from least to most elastic.
CHAPTER 5
20
Perfectly inelastic demand (one extreme

case)
Price elasticity
of demand
% change in Q
% change in P
P
D curve:
vertical
CHAPTER 5
10%
=0
P1
Consumers
price sensitivity:
0
Elasticity:
0
0%
P2
P falls
by 10%
Q1
Q changes
by 0%
21
Inelastic demand
Price elasticity
of demand
% change in Q
% change in P
P1
Consumers
price sensitivity:
relatively low
CHAPTER 5
10%
<1
D curve:
relatively steep
Elasticity:
<1
< 10%
P2
D
P falls
by 10%
Q1 Q2
Q rises less
than 10%
22
Unit elastic demand

Price elasticity
of demand
% change in Q
% change in P
P1
Consumers
price sensitivity:
intermediate
CHAPTER 5
10%
=1
D curve:
intermediate slope
Elasticity:
1
10%
P2
P falls
by 10%
D
Q1
Q2
Q rises by 10%
23
Elastic demand
Price elasticity
of demand
% change in Q
% change in P
P1
Consumers
price sensitivity:
relatively high
CHAPTER 5
10%
>1
D curve:
relatively flat
Elasticity:
>1
> 10%
P2
P falls
by 10%
Q1
Q2
Q rises more
than 10%
24
Perfectly elastic demand (the other

extreme)
Price elasticity
of demand
% change in Q
% change in P
Elasticity:
infinity
CHAPTER 5
0%
= infinity
D curve:
horizontal
Consumers
price sensitivity:
extreme
any %
P2 = P1
P changes
by 0%
Q1
Q2
Q changes
by any %
25
Elasticity of a Linear Demand

Curve
P
200%
E =
= 5.0
40%
$30
67%
E =
= 1.0
67%
20
40%
E =
= 0.2
200%
10
$0
CHAPTER 5
20
40
60
The slope
of a linear
demand
curve is
constant,
but its
elasticity
is not.
26
Price Elasticity and Total

Revenue
Continuing our scenario, 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:
Higher P means more revenue on each unit
you sell.
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.
CHAPTER 5
27

Revenue
Price elasticity
=
of demand
Percentage change in Q
Revenue = P x Q
If demand is elastic, then

price elast. 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.
CHAPTER 5
28

Revenue
Elastic demand
(elasticity = 1.8)
If P = $200,
Q = 12 and
revenue = $2400.
If P = $250,
Q = 8 and
revenue = $2000.
$250
$200
When D is elastic,
a price increase
causes revenue to fall.
CHAPTER 5
increased
Demand for
revenue due
your websiteslost
to higher P
revenue
due to
lower Q
D
12
29

Revenue
Price elasticity
=
of demand
Percentage change in Q
If demand is inelastic, then
Revenue = P x Q
price elast. 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.
CHAPTER 5
30

Revenue
Now, demand is
inelastic:
elasticity = 0.82
If P = $200,
Q = 12 and
revenue = $2400.
If P = $250,
Q = 10 and
revenue = $2500.
$250
increased
Demand for
revenue
due
your websites
lost
to higher P
revenue
due to
lower Q
$200
When D is inelastic,
a price increase
causes revenue to rise.
CHAPTER 5
10 12
31
2:
Elasticity and expenditure/revenue
ACTIVE LEARNING
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?

B. As a result of a fare war, the price of a luxury
cruise falls 20%.

Does luxury cruise companies total revenue
rise or fall?
32
ACTIVE LEARNING
Answers
2:
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?

Expenditure = P x Q
Since demand is inelastic, Q will fall less
than 10%, so expenditure rises.
33
ACTIVE LEARNING
Answers
2:
B. As a result of a fare war, the price of a luxury
cruise falls 20%.

Does luxury cruise companies total revenue
rise or fall?
Revenue = P x Q
The fall in P reduces revenue,
but Q increases, which increases revenue.
Which effect is bigger?
Since demand is elastic, Q will increase more
than 20%, so revenue rises.
34
APPLICATION: Does Drug Interdiction
Increase or Decrease Drug-Related

One side effect of illegal drug use is crime:
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.
CHAPTER 5
35
Policy 1: Interdiction
Interdiction
reduces
Price of
Drugs
the supply
of drugs.
P2
Since demand
for drugs is
inelastic,
P1
P rises proportionally more
than Q falls.
Result: an increase in
total spending on drugs,
and in drug-related crime
CHAPTER 5
new value of drugrelated crime

S2
D1
S1
initial value
of drugrelated
crime
Q2 Q1
Quantity
of Drugs
36
Policy 2: Education
Education
reduces the
demand for
drugs.
Price of
Drugs
new value of drugrelated crime

D2
D1
S
P and Q fall.
Result:
A decrease in
total spending
on drugs, and
in drug-related
crime.
CHAPTER 5
initial value
of drugrelated
crime
P1
P2
Q2 Q1
Quantity
of Drugs
37
Price Elasticity of Supply

Price elasticity
of supply
Percentage change in Qs
Price elasticity of supply measures how much

Qs responds to a change in P.
Loosely speaking, it measures the pricesensitivity of sellers supply.
Again, use the midpoint method to compute the

percentage changes.
CHAPTER 5
38
Price Elasticity of Supply

Price elasticity
of supply
Example:
Price
elasticity
of supply
equals
16%
= 2.0
8%
CHAPTER 5
Percentage change in Qs
P
P rises
P2
by 8%
P1
Q1
Q2
Q rises
by 16%
39
The Variety of Supply Curves

Economists classify supply curves according to
their elasticity.
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.
The next 5 slides present the different

classifications, from least to most elastic.
CHAPTER 5
40
Perfectly inelastic (one extreme)

Price elasticity
of supply
% change in Q
% change in P
CHAPTER 5
10%
=0
P2
Sellers
price sensitivity:
0
Elasticity:
0
S curve:
vertical
0%
P1
P rises
by 10%
Q1
Q changes
by 0%
41
Inelastic
Price elasticity
of supply
% change in Q
% change in P
P
S curve:
relatively steep
CHAPTER 5
10%
<1
P2
Sellers
price sensitivity:
relatively low
Elasticity:
<1
< 10%
P1
P rises
by 10%
Q1 Q2
Q rises less
than 10%
42
Unit elastic
Price elasticity
of supply
% change in Q
% change in P
S
P2
Sellers
price sensitivity:
intermediate
CHAPTER 5
10%
=1
S curve:
intermediate slope
Elasticity:
=1
10%
P1
P rises
by 10%
Q1
Q2
Q rises
by 10%
43
Elastic
Price elasticity
of supply
% change in Q
% change in P
S
P2
Sellers
price sensitivity:
relatively high
CHAPTER 5
10%
>1
S curve:
relatively flat
Elasticity:
>1
> 10%
P1
P rises
by 10%
Q1
Q2
Q rises more
than 10%
44
Perfectly elastic (the other

extreme)
Price elasticity
of supply
% change in Q
% change in P
Elasticity:
infinity
CHAPTER 5
0%
= infinity
S curve:
horizontal
Sellers
price sensitivity:
extreme
any %
P2 = P1
P changes
by 0%
Q1
Q2
Q changes
by any %
45
The Determinants of Supply

Elasticity
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.
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.
CHAPTER 5
46
3:
Elasticity and changes in equilibrium
ACTIVE LEARNING
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).
For which product will P change the most?

For which product will Q change the most?
47
ACTIVE LEARNING
Answers
When supply
is inelastic,
an increase in
demand has a
bigger impact
on price than
on quantity.
3:
Beachfront property
(inelastic supply):
P
D1 D2
P2
P1
A
Q1 Q2
Q
48
ACTIVE LEARNING
Answers
When supply
is elastic,
an increase in
demand has a
bigger impact
on quantity
than on price.
3:
New cars
(elastic supply):
P
D1 D2
S
P2
P1
B
A
Q1
Q2
Q
49
How the Price Elasticity of Supply Can

Vary
P
elasticity
<1
$15
Supply
Supply often
often
becomes
becomes
less
less elastic
elastic
as
as Q
Q rises,
rises,
due
due to
to
capacity
capacity
limits.
limits.
12
elasticity
>1
$3
100 200
CHAPTER 5
Q
500 525
50
Other Elasticities
The income elasticity of demand measures the
response of Qd to a change in consumer income.
Percent change in Qd
Income elasticity
=
of demand
Percent change in income
Recall from chap.4: 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.
CHAPTER 5
51
Other Elasticities
The cross-price elasticity of demand measures
the response of demand for one good to changes
in the price of another good.
% change in Qd for good 1
Cross-price elast.
=
of demand
% change in price of good 2
For substitutes, cross-price elasticity > 0

E.g., an increase in price of beef 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.
CHAPTER 5
52
CHAPTER SUMMARY
Elasticity measures the responsiveness of
Qd or Qs to one of its determinants.
Price elasticity of demand equals percentage

change Qd in divided by percentage change in P.
When its 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.
CHAPTER 5
53
CHAPTER SUMMARY
Demand is less elastic in the short run,
for necessities, for broadly defined goods,
or for goods with few close substitutes.
Price elasticity of supply equals percentage

change in Qs divided by percentage change in P.
When its 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.
CHAPTER 5
54
CHAPTER SUMMARY
The income elasticity of demand measures how
much quantity demanded responds to changes in
buyers incomes.
The cross-price elasticity of demand measures

how much demand for one good responds to
changes in the price of another good.
CHAPTER 5
55

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5

Elasticity and its Application

In this chapter, look for the answers to

What is the price elasticity of demand?

What is the price elasticity of supply?

What are the income and cross-price elasticities of

ELASTICITY AND ITS APPLICATION

ELASTICITY AND ITS APPLICATION

ELASTICITY AND ITS APPLICATION

Price Elasticity of Demand

Price elasticity of demand measures how

Loosely speaking, it measures the pricesensitivity of buyers demand.

ELASTICITY AND ITS APPLICATION

Price Elasticity of Demand

ELASTICITY AND ITS APPLICATION

Price Elasticity of Demand

ELASTICITY AND ITS APPLICATION

Calculating Percentage Changes

end value start value

ELASTICITY AND ITS APPLICATION

Calculating Percentage Changes

ELASTICITY AND ITS APPLICATION

Calculating Percentage Changes

The midpoint is the number halfway between

It doesnt matter which value you use as the

ELASTICITY AND ITS APPLICATION

Calculating Percentage Changes

The % change in Q equals

The price elasticity of demand equals

ELASTICITY AND ITS APPLICATION

Use the following

Use midpoint method to calculate

What determines price

To learn the determinants of price elasticity,

Suppose the prices of both goods rise by 20%.

What lesson does the example teach us about the

ELASTICITY AND ITS APPLICATION

Rice Krispies vs. Sunscreen

Rice Krispies has lots of close substitutes

Sunscreen has no close substitutes,

Lesson: Price elasticity is higher when close

ELASTICITY AND ITS APPLICATION

Blue Jeans vs. Clothing

For a narrowly defined good such as

There are fewer substitutes available for

Lesson: Price elasticity is higher for narrowly

ELASTICITY AND ITS APPLICATION

Insulin vs. Caribbean Cruises

To millions of diabetics, insulin is a necessity.

If the price rises,

Lesson: Price elasticity is higher for luxuries

ELASTICITY AND ITS APPLICATION

Gasoline in the Short Run vs.

Theres not much people can do in the

In the long run, people can buy smaller cars

Lesson: Price elasticity is higher in the

ELASTICITY AND ITS APPLICATION

The Determinants of Price Elasticity: