Chapter 4

ELASTICITY AND ITS APPLICATIONS

For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017
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?
2
 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 (incl.
(incl. the
the opportunity
opportunity cost
cost of
of
your
your time),
time), so
so you’re
you’re thinking
thinking ofof raising
raising the
the price
price
to
to $250.
$250.
The
The law
law of
of demand
demand says
says that
that 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?
3
 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.

4
 Price Elasticity of Demand

 Price elasticity of demand measures how much Qd ,

quantity demanded, responds to a change in P, price.

 It measures the price-sensitivity of buyers’

demand.

Price elasticity Percentage change in Qd

=
of demand Percentage change in P

5
 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Example:
Price elasticity P rises
P2
of demand: by 10% P1
-15% D
= |-1.5 |
10% Q
Q2 Q1
Q falls
by 15%

6
 Price Elasticity of Demand
Price elasticity of Percentage change in Qd
demand =
Percentage change in P

P
Along
AlongaaDDcurve,
curve, PPand
andQ Q
move
movein inopposite
oppositedirections,
directions,
which P2
whichwould
wouldmake
makeprice
price
elasticity
elasticitynegative.
negative. P1
We
Wewill
willdrop
dropthe
theminus
minussign
sign D
and
andreport
report all
allprice
priceelasticities
elasticities
Q
Q2 Q1
as
aspositive
positivenumbers.
numbers.

7
 Calculating Percentage Changes
Demand for your websites Standard method of
computing the
percentage (%) change:

P
B
$250
A Going from A to B,
$200
the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12

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

9
Calculating Percentage Changes
 So, we instead use the midpoint method:

 The midpoint is the number halfway between

the start & end values, also 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!

10
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

11
 What Determines
Price Elasticity of Demand?

1.
1. Availability
Availability of
of Close
Close Substitutes
Substitutes
2.
2. Necessities
Necessities vs.vs. Luxuries:
Luxuries:
3.
3. Definition
Definition of
of Market:
Market: Broad
Broad oror narrow
narrow
4.
4. Time
Time horizon:
horizon: demand
demand inin the
the long
long run
run
versus
versus the
the short
short run.
run.
5.
5. Proportion
Proportion of
of Income
Income Devoted
Devoted to
to Product
Product

12
 What determines price elasticity?
For the determinants of price elasticity, we look at a
series of examples, comparing 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?

13
 Availability of Substitutes
Example : Eggs vs. Olive oil :
• Olive oil has many of close substitutes (e.g.,
sunflower oil, butter, margarine), so buyers can
easily switch if the price rises.
• Eggs has no close substitutes, so consumers
would probably not buy much less if its price
rises.
Price elasticity of demand is higher
when close substitutes are available.

14
 Necessities vs. Luxuries
Example: Bread vs. Cake
• If price of bread goes up, there is little
consumers can do, they keep buying it.
• When cake prices increase, quantity demanded
may fall substantially.
• Note: Do not think of necessities as biological
only, but social as well.

Price elasticity of demand is higher for

luxuries than for necessities.

15
Definition of Market: Narrow vs. Broad
Example: “Blue Jeans” vs. “Clothing”
• For a narrowly defined good such as blue
jeans, there are many substitutes (Chinos,
shorts, etc. ).
• There are fewer substitutes available for
broadly defined goods.
(Can you think of a substitute for clothing?)

Price elasticity is higher for narrowly defined

goods than broadly defined ones.

16
 Time Horizon: Short Run vs. Long Run

Example: Gasoline in the Short Run vs.

Gasoline in the Long Run
• Short-run: There’s not much people can do.
Options are limited: public transport or walking.
• Long-run: Options increase; people can buy
smaller cars or live closer to where they work.
Price elasticity is higher in the long run
than the short run.

17
Estimates of Price Elast. of Demand

Product Elasticity
Bread 0.25
Milk 0.3
Tobacco 0.4
Fuel 0.4
Wine 0.6
Shoes 0.7
Movies 0.9
Entertainment 1.4
Cars 1.9
Furniture 3.0
Particular Car Brand 4.0

18
 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.

19
“Perfectly inelastic demand” ( extreme case)

Price elasticity % change in Q 0%

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

Demand curve: vertical P

D
Consumers’ price
P1
sensitivity: 0
P2
Elasticity: 0
P falls
by 10%
Q
Q1
Q does not change

20
“Inelastic demand”

Price elasticity % change in Q < 10%

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

D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls
by 10% Q
Elasticity: < 1 Q1 Q2
Q rises less
than 10%
21
“Unit elastic demand”
Price elasticity % change in Q 10%
of demand = = =1
% change in P 10%

D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
D
intermediate P falls
by 10% Q
Elasticity: 1 Q1 Q2

Q rises by 10%

22
“Elastic demand”

Price elasticity % change in Q > 10%

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

D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high P falls
by 10%
Q
Elasticity: > 1 Q1 Q2
Q rises more
than 10%
23
“Perfectly elastic demand” (the other extreme)

Price elasticity % change in Q any %

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

D curve: horizontal P

Consumers’ price
sensitivity: extreme P2 = P1 D

P does
Elasticity: infinity not
change
Q
Q1 Q2
Q changes
by any %
24
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 constant,
67%
but its
40%
10 E = = 0.2 elasticity
200%
is not.
$0 Q
0 20 40 60

25
 Total Revenue
Price Total revenue is the amount paid by
buyers and received by sellers of a
good.
Computed as the price of the good
times the quantity sold.

TR = Price x Quantity
$ 200

P × Q = $ 2,500
P
(revenue) Demand

0 12 Quantity

Q 26
 Price Elasticity and Total Revenue

 Continuing our scenario, if you raise your price

from $200 to $250, would your revenue rise or fall?
 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.

27
 Price Elasticity and Total Revenue

Revenue = P x Q

 If demand is elastic, 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.

28
 Price Elasticity and Total Revenue
Elastic demand increased
revenue due to
(elasticity = 1.8) P higher P lost
revenue
If P = $200, due to
Q = 12 and lower Q
$250
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.

When D is elastic, Q
8 12
a price increase
Demand for your websites
causes revenue to fall.
29
 Price Elasticity and Total Revenue

Revenue = P x Q
 If demand is inelastic, 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 total revenue rises.

30
 Price Elasticity and Total Revenue
Now, demand is increased
inelastic: revenue due to
elasticity = 0.82 P higher P lost
revenue
If P = $200, due to
Q = 12 and lower Q
revenue = $2400. $250

If P = $250, $200
Q = 10 and D
revenue = $2500.

When D is inelastic, Q
10 12
a price increase
causes revenue to rise.
Demand for your websites 31
Application (Question 4)

Business Travellers and holidaymakers have the following

demand for airline tickets from Munich to Naples:
Quantity Demanded (units)
Price (€) Business Travellers Holidaymakers
150 2,100 1,000
200 2,000 800
250 1,900 600
300 1,800 400

a. As the price of tickets rises from €200 to €250, what is

the price elasticity of demand for both groups?
% change in P = 50/200= 25 % for both
% change in Q : 100 / 2,000 = 5 % for business trav.
200 / 800 = 25 % for holiday trav.

Price Elasticity : 5% / 25% = 0.20 for business travellers

25 % / 25% = 1.0 for holiday makers
32
Application (Question 4)

b. Why might holidaymakers have a different price elasticity to business

travellers?
• Business travel is a «necessity» while travel for holiday is a «luxury»
• Holidaymakers have other options, i.e. travel by car, fly to a different
city (Antalya ?) while business travellers must fly to Naples and they
do not have much time.
c. What happens to the revenue of airline companies on the Naples-
Munich route in the :
• Business market?
• Holiday market?

33
 Application ( Question 7):
Public Policy aimed at Smoking
a. Studies Show that the price elasticity of demand for
cigarettes is about 0.4. If a pack of cigarettes is
currently priced at € 6 and the government wants
to reduce smoking by 20%, by how much should it
increase the price through a tax?

Applying the data provided to this formula:

Then the price of cigarettes must increase by 0.5 or 50%.

34
 Application ( Question 7):
Public Policy aimed at Smoking
b. If the government permanently increases the price
of cigarettes, will the policy have a larger effect on
smoking in one year or in five years ?
In the long run, smokers can change their behaviour.
They may reduce or give up smoking.

c. Studies find that teenagers have a high price

elasticity of demand for cigarettes than do adults. Why
might this be true?
Teenagers have a larger «proportion of income
devoted to the product».

35
 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 the price-
sensitivity of sellers’ supply.
 Again, use the midpoint method to compute the
percentage changes.

36
 Price Elasticity of Supply

Price elasticity Percentage change in Qs

of supply
=
Percentage change in P
P
Example: S
P rises
Price by 8%
P2
elasticity P1
of supply
equals
Q
16% Q1 Q2
= 2.0
8% Q rises
by 16%
37
 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.
38
“Perfectly inelastic” (one extreme)
0%
10% =0

Supply curve: vertical P

S

P2
Sellers’ price
sensitivity: 0 P1
P rises
by 10%
Elasticity: 0 Q
Q1 Q changes
by 0%

39
“Inelastic”
< 10%
<1
10%

S curve: relatively steep P

S
Sellers’ price P2
sensitivity:
relatively low P1
P rises
Elasticity: < 1 by 10%
Q
Q1 Q2
Q rises less than
10%
40
“Unit elastic”
10%
=1
10%

S curve: P
intermediate slope S
P2
Sellers’
price sensitivity: P1
intermediate P rises
by 10%
Q
Elasticity: =1 Q1 Q2
Q rises
by 10%

41
“Elastic”
> 10%
>1
10%

S curve: relatively flat P

S
Sellers’ price P2
sensitivity:
relatively high P1
P rises
Elasticity: > 1 by 10%
Q
Q1 Q2
Q rises more
than 10%

42
“Perfectly elastic” (the other extreme)
any %
= infinity
0%

S curve: horizontal P

Sellers’ price P2 = P1 S
sensitivity: extreme
P does not
change
Elasticity: infinity
Q
Q1 Q2
Q changes
by any %

43
 The Determinants of Supply Elasticity
 Depends on the flexibility of sellers to change
the production of the good in response to
changes in price.
 Example:
• Supply of beachfront property is price inelastic,
as it is almost impossible to produce more.
• Supply of manufactured goods is relatively price
elastic, firms that produce them can increase
production when prices rise, by adding another
shift.

44
 Time Period
For many goods, price elasticity of supply is
greater in the long run than in the short run.
• In the short run, firms can only hire more labour
and buy more raw materials if they want to
produce more, but that cannot increase the size
of the factory.
• In the long run, supply is more price elastic
because firms can build new factories or close
old ones, buy more equipment.
• In thel long-run, new firms may be able to enter
the market or some firms may exit the market

45
 Productive Capacity

• Most businesses have a finite capacity in the

short run.
• If firms are operating at or near full capacity,
they may find it difficult incerase output in
response to rising prices; resulting in price
inelastic supply.
• If firms are operating below full capacity, it iwll
be easier firms to expand output quickly, so
supply would be more elastic.

46
 Size of Firm/ Industry

• Supply may be more price elastic in smaller

firms and industries than for large one.
• A small firm faces increasing prices and wants
to increase production. It can easily buy raw
materials without increasing unit costs and hire
labour without offering higher wages.
• Large firms buy in large quantities and this may
lead to higher unit prices. Sometimes they
cannot buy as much as they want in the short
run.

47
 Mobility of Factors of Production

 How easily firms can change the inputs of

factors of production required to change output:
• Land: Mobility of land to switch between
different uses (grow apples vs. wheat or build a
hotel)
• Labour: Mobility of Labour to switch between
uses
- Training and Expertise
- Availability of Labour: Immigration
• Capital: Access to capital for investment

48
 Ease of Storing Stock/Inventory

• Stor,ng fresh fruit is not always easy because it

is perishable, so price elasticity of supply may
be more elastic.
• In industries where inventory build up id easy
and cheap, supply is more price elastic.

49
Application (Question 1)
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?

50
Application (Question 1)
Answers
Beachfront property
When supply (inelastic supply):
is inelastic, P
an increase in
demand has a D 1 D2 S
bigger impact
on price than P2 B
on quantity.
P1 A

Q
Q1 Q2

51
A C T I V E L E A R N I N G 3:
Answers
New cars
When supply (elastic supply):
is elastic, P
an increase in
demand has a D 1 D2
bigger impact S
on quantity
than on price. B
P2
A
P1

Q
Q1 Q2

52
How the Price Elasticity of Supply Can Vary

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

53
 Other Elasticities
 The 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 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.
54
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 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.

55
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 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.

56
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.

57
Application (Fig. 4.11)
Price Sensitivity in Passenger Train Market

Panel (a): Panel (b):

Market between 6:00 a.m. Market after 9:00 a.m.
And 9:00 a.m.

P D S P S

80 D

40

Q Q
1,000 800

58
Application (Fig. 4.1)
Farmers’ Income and Productivity

 Use of more machinery

and advances in science
and technology led to S1
S2
increases in productivity. P
 However farmers’
income has decreased. 200

 This can be explained by

the elasticity of demand 100
and supply curves.
D1 D2
Q
2,000 3,000

59