CHAPTER

5 In this chapter, Elasticity Price Elasticity of Demand

look for the answers to these questions:
Elasticity and its Application ▪ What is elasticity? What kinds of issues can
elasticity help us understand?
PRINCIPLES OF ▪ What is the price elasticity of demand?
Macroeconomics How is it related to the demand curve?
N. Gregory Mankiw How is it related to revenue & expenditure?
▪ What is the price elasticity of supply?
How is it related to the supply curve?
Premium PowerPoint Slides
by Ron Cronovich ▪ What are the income and cross-price elasticities of
demand?
© 2009 South-Western, a part of Cengage Learning, all rights reserved
▪ Basic idea: Percentage change in Qd
Price elasticity
=
Elasticity measures how much one variable of demand Percentage change in P
responds to changes in another variable.
▪ One type of elasticity measures how much ▪ Price elasticity of demand measures how
demand for your websites will fall if you raise much Qd responds to a change in P.
your price.
▪ Loosely speaking, it measures the
▪ Definition: price-sensitivity of buyers’ demand.
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.
1 ELASTICITY AND ITS APPLICATION 2 ELASTICITY AND ITS APPLICATION 3

Price Elasticity of Demand Price Elasticity of Demand Calculating Percentage Changes Calculating Percentage Changes
Price elasticity Percentage change in Q d
Price elasticity Percentage change in Q d
Standard method ▪ So, we instead use the midpoint method:
= = of computing the
of demand Percentage change in P of demand Percentage change in P end value – start value
Demand for percentage (%) change: x 100%
P P your websites midpoint
Example: Along a D curve, P and Q end value – start value
P rises move in opposite directions,
P
start value
x 100% ▪ The midpoint is the number halfway between
Price elasticity P2 P2
by 10% which would make price B the start & end values, the average of those
of demand P1 P1 $250
elasticity negative. A Going from A to B, values.
equals D D $200
the % change in P equals
15%
We will drop the minus sign
and report all price D ▪ It doesn’t matter which value you use as the
Q Q ($250–$200)/$200 = 25%
= 1.5 Q2 Q1 Q2 Q1 “start” and which as the “end” – you get the
10% elasticities as Q
Q falls positive numbers. 8 12 same answer either way!
by 15%
ELASTICITY AND ITS APPLICATION 4 ELASTICITY AND ITS APPLICATION 5 ELASTICITY AND ITS APPLICATION 6 ELASTICITY AND ITS APPLICATION 7

Calculating Percentage Changes ACTIVE LEARNING 1 What determines price elasticity? EXAMPLE 1:
Calculate an elasticity Breakfast cereal vs. Sunscreen
▪ Using the midpoint method, the % change To learn the determinants of price elasticity,
in P equals Use the following we look at a series of examples. ▪ The prices of both of these goods rise by 20%.
$250 – $200 information to Each compares two common goods. For which good does Qd drop the most? Why?
x 100% = 22.2%
$225 calculate the In each example: ▪ Breakfast cereal has close substitutes
price elasticity
▪ The % change in Q equals of demand ▪ Suppose the prices of both goods rise by 20%. (e.g., pancakes, Eggo waffles, leftover pizza),
so buyers can easily switch if the price rises.
12 – 8 for hotel rooms: ▪ The good for which Qd falls the most (in percent)
x 100% = 40.0%
has the highest price elasticity of demand.
▪ Sunscreen has no close substitutes,
10 if P = $70, Qd = 5000
Which good is it? Why? so consumers would probably not
▪ The price elasticity of demand equals if P = $90, Qd = 3000 buy much less if its price rises.
▪ What lesson does the example teach us about the
40/22.2 = 1.8 determinants of the price elasticity of demand? ▪ Lesson: Price elasticity is higher when close
substitutes are available.
ELASTICITY AND ITS APPLICATION 8 9 ELASTICITY AND ITS APPLICATION 10 ELASTICITY AND ITS APPLICATION 11

EXAMPLE 2: EXAMPLE 3: EXAMPLE 4: The Determinants of Price Elasticity:

“Blue Jeans” vs. “Clothing” Insulin vs. Caribbean Cruises Gasoline in the Short Run vs. Gasoline in A Summary
▪ The prices of both goods rise by 20%. ▪ The prices of both of these goods rise by 20%. the Long Run
The price elasticity of demand depends on:
For which good does Qd drop the most? Why? For which good does Qd drop the most? Why? ▪ The price of gasoline rises 20%. Does Qd drop
▪ For a narrowly defined good such as ▪ the extent to which close substitutes are
▪ To millions of diabetics, insulin is a necessity. more in the short run or the long run? Why?
available
blue jeans, there are many substitutes A rise in its price would cause little or no ▪ There’s not much people can do in the
(khakis, shorts, Speedos). decrease in demand. short run, other than ride the bus or carpool. ▪ whether the good is a necessity or a luxury
▪ There are fewer substitutes available for ▪ A cruise is a luxury. If the price rises, ▪ In the long run, people can buy smaller cars ▪ how broadly or narrowly the good is defined
broadly defined goods.
some people will forego it.
(There aren’t too many substitutes for clothing,
or live closer to where they work.
▪ the time horizon – elasticity is higher in the
other than living in a nudist colony.) ▪ Lesson: Price elasticity is higher for luxuries ▪ Lesson: Price elasticity is higher in the long run than the short run
▪ Lesson: Price elasticity is higher for narrowly than for necessities. long run than the short run.
defined goods than broadly defined ones.
ELASTICITY AND ITS APPLICATION 12 ELASTICITY AND ITS APPLICATION 13 ELASTICITY AND ITS APPLICATION 14 ELASTICITY AND ITS APPLICATION 15
 The Variety of Demand Curves “Perfectly inelastic demand” (one extreme case) “Inelastic demand” “Unit elastic demand”
% change in Q 0% % change in Q < 10% % change in Q 10%
▪ The price elasticity of demand is closely related Price elasticity
of demand
= = =0
Price elasticity
of demand
= = <1
Price elasticity
of demand
= = =1
% change in P 10% % change in P 10% % change in P 10%
to the slope of the demand curve.

▪ Rule of thumb: D curve: P D curve: P D curve: P

D
vertical relatively steep intermediate slope
The flatter the curve, the bigger the elasticity.
P1 P1 P1
The steeper the curve, the smaller the elasticity. Consumers’ Consumers’ Consumers’
price sensitivity: P2 price sensitivity: P2 price sensitivity: P2
▪ Five different classifications of D curves.… none relatively low D intermediate D

P falls Q P falls Q P falls Q

Elasticity: by 10% Q1 Elasticity: by 10% Q1 Q2 Elasticity: by 10% Q1 Q2
0 Q changes <1 1
Q rises less Q rises by 10%
by 0% than 10%
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“Elastic demand” “Perfectly elastic demand” (the other extreme) Elasticity of a Linear Demand Curve Price Elasticity and Total Revenue
Price elasticity
=
% change in Q
=
> 10%
>1
Price elasticity
=
% change in Q
=
any %
= infinity
▪ Continuing our scenario, if you raise your price
of demand % change in P 10% of demand % change in P 0% P The slope from $200 to $250, would your revenue rise or fall?
200% of a linear
D curve: P D curve: P $30 E = = 5.0 Revenue = P x Q
40% demand
relatively flat horizontal
67% curve is ▪ A price increase has two effects on revenue:
Consumers’
P1
Consumers’
P2 = P1 D 20 E =
67%
= 1.0 constant, ▪ Higher P means more revenue on each unit
price sensitivity: P2 D price sensitivity: but its you sell.
40%
relatively high extreme 10 E =
200%
= 0.2 elasticity ▪ But you sell fewer units (lower Q),
P falls P changes
is not. due to Law of Demand.
Q Q
Elasticity: by 10% Q1 Q2 Elasticity: by 0% Q1 Q2
>1 infinity
$0
0 20 40 60
Q
▪ Which of these two effects is bigger?
Q rises more Q changes It depends on the price elasticity of demand.
than 10% by any %
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Price Elasticity of Supply Price Elasticity of Supply The Variety of Supply Curves “Perfectly inelastic” (one extreme)
% change in Q 0%
Price elasticity Percentage change in Qs Price elasticity Percentage change in Qs ▪ The slope of the supply curve is closely related to Price elasticity
of supply
= = =0
= = % change in P 10%
of supply Percentage change in P of supply Percentage change in P price elasticity of supply.
▪ Rule of thumb: S curve: P
▪ Price elasticity of supply measures how much Example:
P
S vertical
S
The flatter the curve, the bigger the elasticity.
Qs responds to a change in P. P rises P2
Price P2 The steeper the curve, the smaller the elasticity. Sellers’
by 8%
▪ Loosely speaking, it measures sellers’ elasticity
price-sensitivity. of supply
P1
▪ Five different classifications.… price sensitivity: P1
none
equals
▪ Again, use the midpoint method to compute the Q Elasticity:
P rises
Q1
Q
16% Q1 Q2 by 10%
percentage changes. = 2.0 0
8% Q rises Q changes
by 16% by 0%
ELASTICITY AND ITS APPLICATION 24 ELASTICITY AND ITS APPLICATION 25 ELASTICITY AND ITS APPLICATION 26 ELASTICITY AND ITS APPLICATION 27

“Inelastic” “Unit elastic” “Elastic” “Perfectly elastic” (the other extreme)

Price elasticity % change in Q < 10% Price elasticity % change in Q 10% Price elasticity % change in Q > 10% Price elasticity % change in Q any %
= = <1 = = =1 = = >1 = = = infinity
of supply % change in P 10% of supply % change in P 10% of supply % change in P 10% of supply % change in P 0%

S curve: P S curve: P S curve: P S curve: P

S S S
relatively steep intermediate slope relatively flat horizontal
P2 P2 P2 P2 = P1 S
Sellers’ Sellers’ Sellers’ Sellers’
price sensitivity: P1 price sensitivity: P1 price sensitivity: P1 price sensitivity:
relatively low intermediate relatively high extreme
P rises Q P rises Q P rises Q P changes Q
Elasticity: by 10% Q1 Q2 Elasticity: by 10% Q1 Q2 Elasticity: by 10% Q1 Q2 Elasticity: by 0% Q1 Q2
<1 =1 >1 infinity
Q rises less Q rises Q rises more Q changes
than 10% by 10% than 10% by any %
ELASTICITY AND ITS APPLICATION 28 ELASTICITY AND ITS APPLICATION 29 ELASTICITY AND ITS APPLICATION 30 ELASTICITY AND ITS APPLICATION 31
 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.
ELASTICITY AND ITS APPLICATION
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.
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
= Cross-price elast.
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.
32 ELASTICITY AND ITS APPLICATION
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.
36
Other Elasticities
▪ 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
=
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)
33 ELASTICITY AND ITS APPLICATION
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.
37
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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