N.

GREGORY MANKIW
PRINCIPLES OF

ECONOMICS
Eighth Edition

CHAPTE Elasticity and Its

R
Application
5 Premium PowerPoint Slides by:
V. Andreea CHIRITESCU
Eastern Illinois University
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1
 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 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)
– You consider raising the price to $250.
• The law of demand: 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?
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 The Elasticity of Demand
• Elasticity
– Measure of the responsiveness ofQ d orQ s
• To a change in one of its determinants
• Price elasticity of demand
– How much the quantity demanded of a
good responds to a change in the price of
that good
• Loosely speaking, it measures the price-
sensitivity of buyers’ demand

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 Price Elasticity of Demand
Price elasticity of demand =
d
P p er cen ta g e ch a n g e in Q

p er cen ta g e ch a n g e in P

P rises P 2 
15%
 1 .5
by 10% P 10%
1
Along a D curve, P andDQ move in opposite
directions, which would makeprice elasticity
negative . Q
Q2 Q1
Q falls
by 15%
We will drop the minus sign and report all price elasticities as
positive numbers.

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 Calculating Percentage Changes
Standard method of computing the
Demand for your
percentage (%) change:
websites
P
end va l ue  sta r t va l ue
B   100%
$250 sta r t va l ue
A Going from A to B:
$200 • the % change in P = ($250–
D $200)/$200 = 25%
• the % change in Q = - 33%
Q • Price elasticity = 33/25 = 1.33
8 12
Going from B to A:
• the % change in P = - 20%
• the % change in Q = 50%
We get different values!
• Price elasticity = 50/20 = 2.5
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 The Price Elasticity of Demand
• Midpoint method
– The midpoint is the number halfway
between the start and end values
• The average of those values

en d v al u e - start v al u e
p ercen tag e ch an g e  100%
m i d p oi n t
 Q1
(Q 2 ) / [ (Q 2  Q1 ) / 2 ]
P ri ce el asti ci ty of d em an d 
(P2  P1 ) / [ (P2  P1 ) / 2 ]

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 Calculating Percentage Changes
Demand for your websites
P
B
$250 Using the midpoint method of
A computing % changes:
$200
D
Q
8 12
$250  $200
% ch an g e i n P =  1 0 0 %  2 2 .2 %
$225
12 8
% ch an g e i n Q = 100%  40%
10
40%
P ri ce el asti ci ty =  1 .8
2 2 .2 %
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 Active Learning 1 Calculate an elasticity
Use the following information to calculate the
price elasticity of demand for iPhones:
• if P = $400, Qd = 10,600
• if P = $600, Qd = 8,400
• Use the midpoint method to calculate
percentage changes.

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 Active Learning 1 Answers
Using the midpoint method to calculate
percentage changes:
• % change in P =
[($600 - $400)/$500] ×100 = 40%
• % change in Qd =
[(10,600 – 8,400)/9,500] ×100 = 23.16%
• Price elasticity of demand =
= % change in Qd / % change in P
= 23.16/40 = 0.58
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 The Price Elasticity of Demand
• Determinants of price elasticity of demand
– We look at a series of examples comparing
two common goods
• In each example:
– Suppose prices of both goods rise by 20%
– Which good has the highest price elasticity
of demand? Why?
– What lesson we learn about the
determinants of price elasticity of demand?
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 The Price Elasticity of Demand
Example 1: Physical book vs. Mobile phone
– Prices of both of these goods rise by 20%.
For which good does Qd drop the most?
Why?
• Physical book has close substitutes (e-book, pdf), so buyers can easily switch if the
price rises
• Mobile phone has no close substitutes, so a price increase would not affect demand
very much

• Price elasticity is higher when close

substitutes are available

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 The Price Elasticity of Demand
Example 2: Vanilla ice-cream vs. Food
– Prices of both of these goods rise by 20%.
For which good does Qd drop the most?
Why?
• For a narrowly defined good, vanilla ice-cream,
there are many substitutes
There are fewer substitutes available for
broadly defined goods (food)
Price elasticity is higher for narrowly defined
goods than for broadly defined ones.
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 The Price Elasticity of Demand
Example 3: Insulin vs. Yachts
– Prices of both of these goods rise by 20%.
For which good does Qd drop the most?
Why?
• Insulin is a necessity to diabetics. A rise in price
would cause little or no decrease in demand
• A yacht is a luxury. If the price rises, some people
will forego it.
• Price elasticity is higher for luxuries than
for necessities.
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 The Price Elasticity of Demand
Example 4: Gasoline in the Short Run vs.
Gasoline in the Long Run
– The price of gasoline rises 20%. DoesQ d
drop more in the short run or the long run?
Why?
• There’s not much people can do in the
short run.
• In the long run, people can buy smaller cars
or live closer to work.
• Price elasticity is higher in the long run
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 The Price Elasticity of Demand
• Variety of demand curves
– Demand is elastic
• Price elasticity of demand > 1
– Demand is inelastic
• Price elasticity of demand < 1
– Demand has unit elasticity
• Price elasticity of demand = 1

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 The Price Elasticity of Demand
• Variety of demand curves
– Demand is perfectly inelastic
• Price elasticity of demand = 0
• Demand curve is vertical
– Demand is perfectly elastic
• Price elasticity of demand = infinity
• Demand curve is horizontal
• The flatter the demand curve
– The greater the price elasticity of demand
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 Perfectly inelastic demand

Price elasticity % change inQ 0%

= = =0
of demand % change inP 10%

P
D D curve
Vertical
P1

P2 Consumers’ price
sensitivity:
None
P falls Q
by 10% Q1
Elasticity:
Q changes
by 0% 0
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 Inelastic demand

Price elasticity % change inQ <10%

= = <1
of demand % change inP 10%
P
D curve
P1 relatively steep

P2 Consumers’ price
D sensitivity:
P falls Q relatively low
by 10% Q 1Q 2

Q rises less Elasticity:

than 10% <1
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 Unit elastic demand

Price elasticity % change inQ 10%

= = =1
of demand % change inP 10%

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

Price elasticity % change inQ >10%

= = >1
of demand % change inP 10%
P
D curve
P1 relatively flat

P2 D Consumers’ price
sensitivity:
P falls Q relatively high
by 10% Q1 Q2
Q rises more Elasticity:
than 10% >1
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 Perfectly elastic demand

Price elasticity % change inQ any %

= = = infinity
of demand % change inP 0%
P
D curve
horizontal
P 2 =P 1 D
P changes Consumers’ price
by 0% sensitivity:
extreme
Q
Q1 Q2
Elasticity:
Q changes
by any %
infinity
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 A Few Elasticities from the Real World

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 Elasticity along a Linear Demand Curve

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

$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?
Total Revenue (TR) = P x Q
• A price increase has two effects on revenue:
– Higher revenue: because of the higher P
– Lower revenue: you sell fewer units (lower Q)
• Which of these two effects is bigger?
– It depends on the price elasticity of demand

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 Price Elasticity and Total Revenue
• For a price increase, if demand is elastic
 E > 1: % change in Q > % change in P
 TR decreases: the fall in revenue from lower
Q > the increase in revenue from higher P
• For a price increase, if demand is
inelastic
 E < 1: % change in Q < % change in P
 TR increases: the fall in revenue from lower Q
< the increase in revenue from higher P

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 Price Elasticity and Total Revenue
Demand for your websites
Elastic demand
increased (elasticity = 1.8)
P revenue
due to lost IfP = $200,Q = 12, and
P
higher revenue revenue = $2400
$250 due to
Q
lower
$200 IfP = $250,Q = 8, and
D revenue = $2000

When D is elastic,
Q a price increase
8 12
causes revenue to fall.

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 Price Elasticity and Total Revenue
Demand for your websites
Inelastic demand
increased (elasticity = 0.82)
P revenue
due to lost IfP = $200,Q = 12, and
P
higher revenue revenue = $2400
$250 due to
Q
lower IfP = $250,Q = 10, and
$200
revenue = $2500
D
When D is inelastic,
a price increase
Q
10 12 causes revenue to rise.

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 The Price Elasticity of Supply
• Price elasticity of supply
– How much the quantity supplied of a good
responds to a change in the price of that
good
– Percentage change in quantity supplied
• Divided by the percentage change in price
– Loosely speaking, it measures sellers’
price-sensitivity

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 Price Elasticity of Supply
Price elasticity p ercen tag e ch an g e i n Q
s
16%
of supply   2
p ercen tag e ch an g e i n P 8%

P
S
P rises P 2
by 8% P
1
Again, we use the
midpoint method to
Q
compute the Q1 Q2
percentage changes. Q rises
by 16%
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 The Price Elasticity of Supply
• Variety of supply curves
– Supply is unit elastic
• Price elasticity of supply = 1
– Supply is elastic
• Price elasticity of supply > 1
– Supply is inelastic
• Price elasticity of supply < 1

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 The Price Elasticity of Supply
• Variety of supply curves
– Supply is perfectly inelastic
• Price elasticity of supply = 0
• Supply curve is vertical
– Supply is perfectly elastic
• Price elasticity of supply = infinity
• Supply curve is horizontal
• The flatter the supply curve
– The greater the price elasticity of supply
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 Perfectly inelastic supply

Price elasticity % change inQ 0%

= = =0
of supply % change inP 10%
S curve:
P
vertical S

Sellers’ price P2
P rises
sensitivity: by 10% P
1
none

Elasticity: Q
Q1
0 Q changes
by 0%
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 Inelastic supply

Price elasticity % change inQ < 10%

= = <1
of supply % change inP 10%
S curve:
P
relatively steep S

Sellers’ price P2
P rises
sensitivity: by 10% P
1
relatively low

Elasticity: Q
Q1 Q2
<1
Q rises less
than 10%
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 Unit elastic supply

Price elasticity % change inQ 10%

= = =1
of supply % change inP 10%
S curve:
intermediate slope P
S
Sellers’ price sensitivity: P2
intermediate P1

Elasticity: P rises
=1 by 10% Q
Q1 Q2
Q rises
by 10%
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 Elastic supply

Price elasticity % change inQ > 10%

= = >1
of supply % change inP 10%
S curve:
P
relatively flat
S

Sellers’ price P rises P 2

sensitivity: by 10%
P1
relatively high

Elasticity: Q
Q1 Q2
>1 Q rises more
than 10%
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 Perfectly elastic supply

Price elasticity % change inQ any %

= = = infinity
of supply % change inP 0%
S curve:
horizontal P

Sellers’ price P 2 =P 1 S
sensitivity: P changes
extreme by 0%

Elasticity: Q
Q1 Q2
infinity Q changes
by any %
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 The Determinants of Supply Elasticity
• Greater price elasticity of supply
– The more easily sellers can change the
quantity they produce
• Supply of beachfront property - harder to vary
and thus less elastic than supply of new cars
• Price elasticity of supply is greater in the
long run than in the short run
– In the long run: firms can build new factories,
or new firms may be able to enter the market

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 How the Price Elasticity of Supply Can Vary

Price Elasticity is small Supply

(less than 1). Supply often
$15
becomes less
12 elastic as Q
Elasticity is large rises, due to
(greater than 1).
capacity limits.
4
3

0 100 200 500 525 Quantity

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 Other Elasticities of Demand
• Income elasticity of demand
– How much the quantity demanded of a
good responds to a change in consumers’
income
– Percentage change in quantity demanded
• Divided by the percentage change in income
– Normal goods: income elasticity > 0
– Inferior goods: income elasticity < 0

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 Other Elasticities of Demand
• Cross-price elasticity of demand
– How much theQ d of one good responds
to a change in the price of another good
– Percentage change inQ d of the first good
• Divided by the percentage change in price of
the second good
– Substitutes: cross-price elasticity > 0
– Complements: cross-price elasticity < 0

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 Applications
• Can Good News for Farming Be Bad News
for Farmers?
– New hybrid of wheat – increase
production per acre 20%
• Supply curve shifts to the right
• Higher quantity and lower price
• Demand is inelastic: total revenue falls
– Paradox of public policy: induce farmers
not to plant crops

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 An Increase in Supply in the Market for Wheat

Price of 1. When demand is inelastic,

Wheat an increase in supply . . .
S1

S2
2. … leads
to a large fall $3
3. … and a proportionately
in price. . .
2 smaller increase in quantity
sold. As a result, revenue falls
from $300 to $220.

Demand
0 100 110 Quantity of Wheat

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 Summary
• Elasticity measures the responsiveness of
Q d orQ s to one of its determinants.
• Price elasticity of demand equals percentage
change inQ d divided by percentage change inP .
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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 Summary
• 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 inQ s divided by percentage change inP .
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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 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.
• The tools of supply and demand can be applied
in many different kinds of markets.

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