N. Gregory Mankiw & Mohamed H.

Rashwan

Principles of
Economics
Middle East Edition

Chapter 5
Elasticity and its
Application
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 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?

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 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 opportunity
opportunity cost
cost of
of your
your time),
time),
so
so you
you consider
consider raising
raising the
the price
price to
to $250.
$250.
The
The law
law of
of demand
demand sayssays thatthat you
you won’t
won’t 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?

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 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.

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 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.

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 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Example:
P rises
Price elasticity P2
by 10%
P1
of demand D
equals
15% Q
= 1.5 Q2 Q1
10%
Q falls
by 15%
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 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, P2
which would make price
elasticity negative. P1

We will drop the minus sign D

and report all price Q
elasticities as Q2 Q1
positive numbers.

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 Calculating Percentage Changes
Midpoint method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
midpoint
B
$250
A
$200
D
Q
8 12

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 Calculating Percentage Changes
 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!

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 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

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 ACTIVE LEARNING 1
Calculate an elasticity

Use the following information to calculate the price

elasticity of demand for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000

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 ACTIVE LEARNING 1
Answers

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%
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 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?

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 EXAMPLE 1:
Breakfast Cereal vs. Sunscreen
 The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
 Breakfast cereal has close substitutes
(e.g., bread, eggs, cheeses),
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.
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 EXAMPLE 2:
“Coffee ” vs. “Drink”
 The prices of both goods rise by 20%.
For which good does Qd drop the most? Why?
 For a narrowly defined good such as
Coffee, there are many substitutes
(tea, water, juice).
 There are fewer substitutes available for
broadly defined goods.
(There aren’t too many substitutes for drink!)
 Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.

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 EXAMPLE 3:
Insulin vs. Caribbean Cruises
 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.

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 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?
 There’s not much people can do in the
short run, other than ride the bus or train.
 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.

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 The Determinants of Price Elasticity:
A Summary

The price elasticity of demand depends on:

 the extent to which close substitutes are
available
 whether the good is a necessity or a luxury
 how broadly or narrowly the good is defined
 the time horizon—elasticity is higher in the
long run than the short run

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 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.…

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 “Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
% change in P 10%
of demand
D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
none
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
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 “Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of demand
D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls Q
Elasticity: by 10% Q 1 Q2
<1
Q rises less
than 10%
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 “Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
% change in P 10%
of demand
D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
D
intermediate
P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%

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

Eggs 0.1
Healthcare 0.2
Rice 0.5
Housing 0.7
Beef 1.6
Restaurant meals 2.3
Mountain Dew (a fizzy drink made
4.4
by PepsiCo)

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 Elasticity of a Linear Demand Curve

P The slope
200% of a linear
$30 E = = 5.0
40% demand
67% curve is
20 E = = 1.0
67% constant,
but its
40%
10 E = = 0.2 elasticity
200%
is not.
$0 Q
0 20 40 60

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 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 Pice 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.
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 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 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.
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 Price Elasticity and Total Revenue
Elastic demand increased
Demand for
(elasticity = 1.8) P revenue due
your websiteslost
to higher P
revenue
If P = $200,
due to
Q = 12 and $250 lower Q
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
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 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 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.
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 Price Elasticity and Total Revenue
Now, demand is
increased
Demand for
inelastic:
revenue due
your websites
elasticity = 0.82 P to higher P lost
If P = $200, revenue
due to
Q = 12 and
$250 lower Q
revenue = $2400.
$200
If P = $250,
Q = 10 and D
revenue = $2500.
When D is inelastic,
Q
a price increase 10 12
causes revenue to rise.
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 ACTIVE LEARNING 2
Elasticity and expenditure/revenue

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?

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 ACTIVE LEARNING 2
Answers

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.

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 ACTIVE LEARNING 2
Answers

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.
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 Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of 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.

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 Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P
P
Example: S
P rises
Price P2
by 8%
elasticity P1
of supply
equals
Q
16% Q1 Q2
= 2.0
8% Q rises
by 16%
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 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…

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 “Perfectly inelastic” (one extreme)
Price elasticity % change in Q 0%
= = =0
% change in P 10%
of supply
S curve: P
S
vertical
P2
Sellers’
price sensitivity: P1
none
P rises Q
Elasticity: by 10% Q1
0
Q changes
by 0%
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 “Inelastic”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of supply
S curve: P
S
relatively steep
P2
Sellers’
price sensitivity: P1
relatively low
P rises Q
Elasticity: by 10% Q 1 Q2
<1
Q rises less
than 10%
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 “Unit elastic”
Price elasticity % change in Q 10%
= = =1
% change in P 10%
of supply
S curve: P
intermediate slope S
P2
Sellers’
price sensitivity: P1
intermediate
P rises Q
Elasticity: by 10% Q1 Q2
=1
Q rises
by 10%
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 “Elastic”
Price elasticity % change in Q > 10%
= = >1
% change in P 10%
of supply
S curve: P
relatively flat S
P2
Sellers’
price sensitivity: P1
relatively high
P rises Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
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 “Perfectly elastic” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
% change in P 0%
of supply
S curve: P
horizontal
P2 = P1 S
Sellers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
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 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.

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 ACTIVE LEARNING 3
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).
 For which product will P change the most?
 For which product will Q change the most?

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 ACTIVE LEARNING 3
Answers

Beachfront property
When supply (inelastic supply):
is inelastic, P
an increase in
demand has a D1 D 2 S
bigger impact
on price than P2 B
on quantity.
P1 A

Q
Q 1 Q2
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 ACTIVE LEARNING 3
Answers

New cars
When supply (elastic supply):
is elastic, P
an increase in
demand has a D1 D 2
bigger impact S
on quantity
than on price. B
P2
A
P1

Q
Q1 Q2
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 How the Price Elasticity of Supply Can Vary

P Supply often
S
elasticity becomes
$15 <1 less elastic
as Q rises,
12
due to
elasticity capacity
>1 limits.
4
$3
Q
100 200
500 525
If the elasticity grater than 1  47
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 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 from Chapter 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.

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48
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 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 elast. % 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 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)
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49
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 Cross-Price Elasticities in the News
“As Gas Costs Soar, Buyers Flock to Small Cars”
-New York Times, 5/2/2008
“Gas Prices Drive Students to Online Courses”
-Chronicle of Higher Education, 7/8/2008
“Gas prices knock bicycle sales, repairs into higher gear”

-Associated Press, 5/11/2008

“Camel demand soars in India”
(as a substitute for “gas-guzzling tractors”)
-Financial Times, 5/2/2008
“High gas prices drive farmer to switch to mules”
-Associated Press, 5/21/2008
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 S U M MA RY

• 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.
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 S U M MA RY

• 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.

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 S U M MA RY

• 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.

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