Micro Ch05 Presentation

CHAPTER
Elasticity and its Application
Microeonomics
PRINCIPLES OF
N. Gregory Mankiw
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by Ron Cronovich
© 2009 South-Western, a part of Cengage Learning, 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?
 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?
1
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?
2
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.
 Elasticity:
A measure of the responsiveness of quantity
demanded or quantity supplied to one of its
determinants.
ELASTICITY AND ITS APPLICATION 3

Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
 Price elasticity of demand measures how

much Quantity demanded of a good responds
to a change in Price of that good.
 It measures the price-sensitivity of buyers’

demand.

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

A. Elastic Demand:
 Demand for a good is said to be elastic if the
quantity demanded responds substantially to
changes in the price.
B. Inelastic Demand:
 Demand is said to be inelastic if the quantity
demanded responds only slightly to changes in
the price.

Determinants of Price Elasticity of
Demand
1. Availability of Close Substitutes
Goods with close substitutes tend to have more
elastic demand because it is easier for consumers
to switch from that good to others.
Example:
 Demand of butter and margarine is elastic.
 Demand for eggs are inelastic.

Demand
2. Necessities versus Luxuries:

Necessities tend to have inelastic demands,
whereas luxuries have elastic demands.
 Whether a good is a necessity or a luxury
depends not on the intrinsic properties of the
good but on the preferences of the buyer.

Demand
 3. Definition of the Market

 The elasticity of demand in any market depends
on how we draw the boundaries of the market.
 Narrowly defined markets tend to have more
elastic demand than broadly defined markets
because it is easier to find close substitutes for
narrowly defined goods.

Demand
 4. Time Horizon:
 Goods tend to have more elastic demand over longer
time horizons.
 When the price of gasoline rises, the quantity of gasoline
demanded falls only slightly in the first few months.
 Over time, however, people buy more fuel efficient cars,
switch to public transportation, and move closer to where
they work.
 Within several years, the quantity of gasoline demanded
falls more substantially.

Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
start value
B
$250 Going from A to B,
A the % change in P equals
$200
($250–$200)/$200 * 100= 25%
D
Q The % Change in Q equals:
8 12
(8 – 12) / 12 * 100 = 33%

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

 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, 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!

 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

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
16
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%
17
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?

What determines price elasticity?
1. Breakfast cereals vs Sunscreen.

2. Blue jeans vs Clothing.
3. Insulin vs Caribbean Cruise.
4. Gasoline in the short run vs Gasoline in the long
run.

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., pancakes, Eggo waffles, leftover pizza),
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.
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).
 There are fewer substitutes available for
broadly defined goods. There aren’t too many
substitutes for clothing.
 Lesson: Price elasticity is higher for
narrowly defined goods than broadly
defined ones.
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.

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 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:
 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

The Variety of Demand Curves
 Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
 Demand is considered elastic when the elasticity
is greater than 1.
 Demand is considered inelastic when the
elasticity is less than 1.
 Five different classifications of D curves.…

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

“Elastic Demand”
Price elasticity % change in Q > 10%
= = >1
D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
>1
Q rises more
than 10%
“Perfectly Elastic Demand” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
infinity
Q changes
by any %
Price Elasticity and Total Revenue
Total revenue:
 The amount paid by
buyers and received
by sellers of a good,
computed as the
price of the good
times the quantity
sold.
 Revenue = P x Q
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?
32
 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.

Elastic demand and Total Revenue
Price elasticity Percentage change in Q
=
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.
Elastic demand and Total Revenue
Elastic demand increased
(elasticity = 1.8) P revenue due
lost
to higher P
If P = $200, revenue
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
causes revenue to fall.
Inelastic demand and Total Revenue
Price elasticity = Percentage change in Q
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.
Inelastic demand and Total Revenue
Now, demand is
increased
inelastic:
revenue due
elasticity = 0.82 P to higher P lost
If P = $200, revenue
Q = 12 and due to
$250 lower Q
revenue = $2400.
If P = $250, $200
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
a price increase 10 12
causes revenue to rise.
General Rules:
 When demand is inelastic (a price elasticity less
than 1), price and total revenue move in the
same direction.
 When demand is elastic (a price elasticity greater
than 1), price and total revenue move in opposite
directions.
 If demand is unit elastic (a price elasticity exactly
equal to 1), total revenue remains constant when
the price changes.
Elasticity & total revenue along a linear demand curve

ACTIVE LEARNING 2
Elasticity and expenditure/revenue
A. Pharmacies raise the price of insulin by 10%.
Does total revenue 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?
40
ACTIVE LEARNING 2
Answers
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?
Revenue = P x Q
Since demand is inelastic, Q will fall less
than 10%, so revenue rises.
41
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.
42
Other Elasticities
 Income elasticity of demand: A measure of how
much quantity demanded of the good responds to
a change in consumers income.
Percent change in Qd
Income elasticity =
of demand Percent change in income
 For normal goods, income elasticity > 0.

 For inferior goods, income elasticity < 0

Example
 Let’s take an example of a shop that sells watches. They
estimate that when the average real income of its
customers falls from $60,000 to $40,000, the demand for
its watches falls from 5,000 to 4,000 units sold, with all
other things remaining the same.
 Using the income elasticity of demand formula
 % change in income= 60,000-40,000/ 50,000 *100= 40%
 % change in Q demanded= 5000-4000/4500*100=22.2%
 Income Elasticity of demand= 22.2/ 40 = 0.57

Income elasticity of demand
Normal Goods:
 Higher income raises their quantity demanded.
 Because quantity demanded and income move in the
same direction, normal goods have positive income
elasticities.
 Even among normal goods, income elasticities vary
substantially in size.
 Necessities have small income elasticities
 Luxuries have large income elasticities.
45
Income elasticity of demand
Inferior Goods:
 Higher income lowers their quantity demanded.
 Because quantity demanded and income move
in opposite directions, inferior goods have
negative income elasticities.

Cross-price elasticity of demand
 Measures the response of demand for one good to
changes in the price of another good.
 It is computed as the percentage change in
quantity demanded of the first good divided by the
percentage change in the price of the second
good.
Cross-price elast. % change in Qd for good 1

=
of demand % change in price of good 2

Cross-price elasticity of demand
 For substitutes, cross-price elasticity is positive

(e.g., an increase in price of beef causes an
increase in demand for chicken)
 For complements, cross-price elasticity is

negative (e.g., an increase in price of computers
causes decrease in demand for software)

Example 1: cross elasticity and substitutes
 The quantity demanded of product A has increased by
12% in response to a 15% increase in price of product B.
Calculate the cross elasticity of demand and tell whether
the product pair is (a) apples and oranges, or (b) cars
and gas.
 Cross elasticity of demand = % change in quantity
demanded of A ÷ % change in price of B
 = 12% ÷ 15%
 = 0.67
 Since the cross elasticity of demand is positive, product A
and B are substitute goods. They are apples and oranges

Price Elasticity of Supply
 Price elasticity of supply: A measure of how
much the quantity supplied of a good respond
to a change in the price of that good.
Percentage change in Qs
Price elasticity =
of supply Percentage change in P
 It measures sellers’ price-sensitivity.

 Again, use the midpoint method to compute the
percentage changes.

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%
The Determinants of Price
Elasticity of Supply
 Supply of a good is said to be elastic if the

quantity supplied responds substantially to
changes in the price.
 Supply is said to be inelastic if the quantity
supplied responds only slightly to changes in the
price.

The Determinants of Supply Elasticity
 A key determinant of the price elasticity of supply
is the time period being considered.
 Supply is usually more elastic in the long run
than in the short run.
 In the short run, the quantity supplied is not very
responsive to the price.
 In the long run, the quantity supplied can
respond substantially to price changes.
53
Using Mid Point Method to calculate Price
Elasticity of Supply
 For example, suppose that an increase in the price of
milk from $2.85 to $3.15 a gallon raises the amount that
dairy farmers produce from 9,000 to 11,000 gallons per
month. Using the midpoint method, we calculate the
percentage change in price as
 Percentage change in price = (3.15 – 2.85) / 3.00 × 100 =
10 percent.
 Percentage change in quantity supplied = (11,000 –
9,000) / 10,000 × 100 = 20 percent.
 In this case, the price elasticity of supply is
 Price elasticity of supply = 20 percent / 10 percent = 2.0
54
The Variety of Supply Curves
 Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
 Five different classifications.…

Perfectly Inelastic Supply: Elasticity Equals 0
= = =0
of supply % change in P 10%
S curve: P
S
vertical
P2
Sellers’
none
P rises Q
Elasticity: by 10% Q1
0
Q changes
by 0%
Inelastic Supply: Elasticity is less than 1
Price elasticity % change in Q < 10%
= = <1
S curve: P
S
relatively steep
P2
Sellers’
relatively low
P rises Q
<1
Q rises less
than 10%
Unit Elastic Supply : Elasticity Equals 1
= = =1
S curve: P
intermediate slope S
P2
Sellers’
intermediate
P rises Q
=1
Q rises
by 10%
Elastic Supply: Elasticity Greater Than 1
Price elasticity % change in Q > 10%
= = >1
S curve: P
relatively flat S
P2
Sellers’
relatively high
P rises Q
>1
Q rises more
than 10%
Perfectly Elastic Supply: Elasticity Equals Infinity
Price elasticity % change in Q any %
= = = infinity
S curve: P
horizontal
P2 = P1 S
Sellers’
price sensitivity:
extreme
P changes Q
infinity
Q changes
by any %
How the Price Elasticity of Supply Can Vary
 Here an increase in P from $3 to

$4 increases the quantity from
100 to 200.
 The 67 % increase in Qs is
larger than the 29 % increase in
P, supply curve is elastic in this
range.
 By contrast, when the P rises
from $12 to $15, the Qs rises
only from 500 to 525.
 The 5 % increase in Qs is
smaller than the 22 % increase
in P, the supply curve is inelastic
in this range.

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?
62
ACTIVE LEARNING 3
Answers
Beachfront property
When supply (inelastic supply):
is inelastic, P
an increase in
demand has a D1 D S
2
bigger impact
on price than P2 B
on quantity.
P1 A
Q
Q 1 Q2
63
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
64
Policy 1: Interdiction
Interdiction new value of drug-
reduces Price of related crime
the supply Drugs S2
D1
of drugs. S1
Since demand P2
for drugs is
inelastic, initial value
P1
P rises propor- of drug-
tionally more related
than Q falls. crime
Result: an increase in Q2 Q1 Quantity

total spending on drugs, of Drugs
and in drug-related crime
Policy 2: Education
new value of drug-
Education Price of related crime
reduces the Drugs
demand for D2 D1
drugs. S
P and Q fall.
P1 initial value
Result: of drug-
A decrease in P2 related
total spending crime
on drugs, and
in drug-related Q 2 Q1 Quantity
crime. of Drugs

CHAPTER 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.
73
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.
74
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.
75

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CHAPTER

Elasticity and its Application

Premium PowerPoint Slides

ELASTICITY AND ITS APPLICATION 3

 Price elasticity of demand measures how

 It measures the price-sensitivity of buyers’

ELASTICITY AND ITS APPLICATION 4

We will drop the minus sign D

ELASTICITY AND ITS APPLICATION 6

ELASTICITY AND ITS APPLICATION 7

ELASTICITY AND ITS APPLICATION 8

2. Necessities versus Luxuries:

ELASTICITY AND ITS APPLICATION 9

 3. Definition of the Market

ELASTICITY AND ITS APPLICATION 10

ELASTICITY AND ITS APPLICATION 11

ELASTICITY AND ITS APPLICATION 12

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ELASTICITY AND ITS APPLICATION 15

The price elasticity of demand equals

ELASTICITY AND ITS APPLICATION 18

1. Breakfast cereals vs Sunscreen.

ELASTICITY AND ITS APPLICATION 19

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ELASTICITY AND ITS APPLICATION 24

ELASTICITY AND ITS APPLICATION 25

ELASTICITY AND ITS APPLICATION 28

ELASTICITY AND ITS APPLICATION 33

ELASTICITY AND ITS APPLICATION 39

 For normal goods, income elasticity > 0.

ELASTICITY AND ITS APPLICATION 43

ELASTICITY AND ITS APPLICATION 44

ELASTICITY AND ITS APPLICATION 46

Cross-price elast. % change in Qd for good 1

ELASTICITY AND ITS APPLICATION 47

 For substitutes, cross-price elasticity is positive

 For complements, cross-price elasticity is

ELASTICITY AND ITS APPLICATION 48

ELASTICITY AND ITS APPLICATION 49

 It measures sellers’ price-sensitivity.

ELASTICITY AND ITS APPLICATION 50

 Supply of a good is said to be elastic if the

ELASTICITY AND ITS APPLICATION 52

ELASTICITY AND ITS APPLICATION 55

 Here an increase in P from $3 to

ELASTICITY AND ITS APPLICATION 61

Result: an increase in Q2 Q1 Quantity

ELASTICITY AND ITS APPLICATION 72

 Elasticity measures the responsiveness of

 Demand is less elastic in the short run,

 The income elasticity of demand measures how

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