5
In this chapter, look for the answers to
these questions:
ƒ What is elasticity? What kinds of issues can
Elasticity and its Application
elasticity help us understand?
PRINCIPLES OF
ƒ What is the price elasticity of demand?
MICROECONOMICS
How is it related to the demand curve?
How is it related to revenue & expenditure?
FOURTH EDITION
ƒ What is the price elasticity of supply?
N. G R E G O R Y M A N K I W
How is it related to the supply curve?
ƒ What are the income and cross-price elasticities of
Premium PowerPoint® Slides
by Ron Cronovich
2007 update
demand?
CHAPTER 5
© 2008 Thomson South-Western, all rights reserved
Elasticity
A scenario…
ƒ Basic idea: Elasticity measures how much
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
websites
per
month.
12 websites per month.
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.
Your
Your costs
costs are
are rising
rising (including
(including the
the opp.
opp. 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 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?
CHAPTER 5
ELASTICITY AND ITS APPLICATION
2
Price Elasticity of Demand
Price elasticity
of demand
ƒ Definition:
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.
CHAPTER 5
Price elasticity
of demand
Percentage change in P
ƒ Price elasticity of demand measures how
Example:
much Qd responds to a change in P.
Price
elasticity
of demand
equals
ƒ Loosely speaking, it measures the pricesensitivity of buyers’ demand.
15%
= 1.5
10%
CHAPTER 5
ELASTICITY AND ITS APPLICATION
3
ELASTICITY AND ITS APPLICATION
Price Elasticity of Demand
Percentage change in Qd
=
1
ELASTICITY AND ITS APPLICATION
4
CHAPTER 5
Percentage change in Qd
=
Percentage change in P
P
P rises
P2
by 10%
P1
D
Q2
Q1
Q
Q falls
by 15%
ELASTICITY AND ITS APPLICATION
5
1
Price Elasticity of Demand
Price elasticity
of demand
Percentage change in Qd
=
Percentage change in P
Along
Along aa DD curve,
curve, PP and
and Q
Q
move
move in
in opposite
opposite directions,
directions,
which
which would
would make
make price
price
elasticity
elasticity negative.
negative.
We
We will
will drop
drop the
the minus
minus sign
sign
and
and report
report
all
all price
price elasticities
elasticities
as
as positive
positive numbers.
numbers.
CHAPTER 5
Calculating Percentage Changes
Demand for
your websites
P
Q2
Q1
$250
8
$200
CHAPTER 5
12
7
end value – start value
x 100%
midpoint
ƒ The midpoint is the number halfway between
the start & end values, the average of those
values.
ƒ It doesn’t matter which value you use as the
From B to A,
P falls 20%, Q rises 50%,
Q
elasticity = 50/20 = 2.50
ELASTICITY AND ITS APPLICATION
ELASTICITY AND ITS APPLICATION
ƒ So, we instead use the midpoint method:
D
8
CHAPTER 5
12
($250–$200)/$200 = 25%
Q
Calculating Percentage Changes
From A to B,
P rises 25%, Q falls 33%,
elasticity = 33/25 = 1.33
A
D
Q
6
Going from A to B,
the % change in P equals
A
$200
D
Problem:
The standard method gives
different answers depending
on where you start.
B
B
$250
P1
Calculating Percentage Changes
P
end value – start value
x 100%
start value
P
P2
ELASTICITY AND ITS APPLICATION
Demand for
your websites
Standard method
of computing the
percentage (%) change:
“start” and which as the “end” – you get the
same answer either way!
8
CHAPTER 5
ELASTICITY AND ITS APPLICATION
9
A C T I V E L E A R N I N G 1:
Calculate an elasticity
Calculating Percentage Changes
ƒ Using the midpoint method, the % change
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
in P equals
$250 – $200
x 100% = 22.2%
$225
ƒ The % change in Q equals
12 – 8
x 100% = 40.0%
10
if P = $70, Qd = 5000
ƒ The price elasticity of demand equals
if P = $90, Qd = 3000
40/22.2 = 1.8
CHAPTER 5
ELASTICITY AND ITS APPLICATION
10
11
2
EXAMPLE 1:
What determines price elasticity?
Rice Krispies vs. Sunscreen
To learn the determinants of price elasticity,
we look at a series of examples.
Each compares two common goods.
ƒ The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
• Rice Krispies has lots of close substitutes
In each example:
(e.g., Cap’n Crunch, Count Chocula),
so buyers can easily switch if the price rises.
• Suppose the prices of both goods rise by 20%.
• The good for which Qd falls the most (in percent)
• Sunscreen has no close substitutes,
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?
CHAPTER 5
ELASTICITY AND ITS APPLICATION
so consumers would probably not
buy much less if its price rises.
ƒ Lesson: Price elasticity is higher when close
substitutes are available.
12
CHAPTER 5
ELASTICITY AND ITS APPLICATION
EXAMPLE 2:
EXAMPLE 3:
“Blue Jeans” vs. “Clothing”
ƒ The prices of both goods rise by 20%.
Insulin vs. Caribbean Cruises
ƒ The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
For which good does Qd drop the most? Why?
• For a narrowly defined good such as
•
13
• To millions of diabetics, insulin is a necessity.
blue jeans, there are many substitutes
(khakis, shorts, Speedos).
There are fewer substitutes available for
broadly defined goods.
(Can you think of a substitute for clothing,
other than living in a nudist colony?)
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.
ƒ Lesson: Price elasticity is higher for luxuries
than for necessities.
ƒ Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.
CHAPTER 5
ELASTICITY AND ITS APPLICATION
14
CHAPTER 5
ELASTICITY AND ITS APPLICATION
15
The Determinants of Price Elasticity:
A Summary
EXAMPLE 4:
Gasoline in the Short Run vs. Gasoline in
the Long Run
The
The price
price elasticity
elasticity of
of demand
demand depends
depends on:
on:
ƒƒ the
the extent
extent to
to which
which close
close substitutes
substitutes are
are
available
available
ƒƒ whether
whether the
the good
good is
is aa necessity
necessity or
or aa luxury
luxury
ƒ 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.
ƒƒ how
how broadly
broadly or
or narrowly
narrowly the
the good
good is
is defined
defined
ƒƒ the
time
horizon:
elasticity
is
higher
in
the time horizon: elasticity is higher in the
the
long
long run
run than
than the
the short
short run.
run.
• In the long run, people can buy smaller cars
or live closer to where they work.
ƒ Lesson: Price elasticity is higher in the
long run than the short run.
CHAPTER 5
ELASTICITY AND ITS APPLICATION
16
CHAPTER 5
ELASTICITY AND ITS APPLICATION
17
3
The Variety of Demand Curves
“Perfectly inelastic demand” (one extreme case)
% change in Q
Price elasticity
=
=
of demand
% change in P
ƒ The price elasticity of demand is closely related
to the slope of the demand curve.
ƒ Rule of thumb:
P
D curve:
vertical
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
18
ELASTICITY AND ITS APPLICATION
“Inelastic demand”
P falls
by 10%
Price elasticity
=
=
of demand
% change in P
CHAPTER 5
< 10%
10%
P1
P2
D
P falls
by 10%
Q
Q1 Q2
Q rises less
than 10%
20
ELASTICITY AND ITS APPLICATION
CHAPTER 5
10%
=1
P1
P2
P falls
by 10%
Elasticity:
1
10%
P
Consumers’
price sensitivity:
intermediate
D
Q1
Q
Q2
Q rises by 10%
21
ELASTICITY AND ITS APPLICATION
“Perfectly elastic demand” (the other extreme)
> 10%
% change in Q
Price elasticity
>1
=
=
of demand
10%
% change in P
any %
% change in Q
Price elasticity
= infinity
=
=
of demand
0%
% change in P
P
D curve:
relatively flat
P2
P falls
by 10%
Consumers’
price sensitivity:
extreme
D
Q1
Q2
Q
Elasticity:
infinity
Q rises more
than 10%
ELASTICITY AND ITS APPLICATION
P
D curve:
horizontal
P1
Consumers’
price sensitivity:
relatively high
CHAPTER 5
19
ELASTICITY AND ITS APPLICATION
D curve:
intermediate slope
“Elastic demand”
Elasticity:
>1
Q changes
by 0%
% change in Q
Price elasticity
=
=
of demand
% change in P
<1
P
D curve:
relatively steep
Elasticity:
<1
Q
Q1
“Unit elastic demand”
% change in Q
Consumers’
price sensitivity:
relatively low
CHAPTER 5
D
P2
Elasticity:
0
CHAPTER 5
=0
P1
Consumers’
price sensitivity:
0
ƒ Five different classifications of D curves.…
0%
10%
22
CHAPTER 5
D
P2 = P1
P changes
by 0%
Q1
Q2
Q
Q changes
by any %
ELASTICITY AND ITS APPLICATION
23
4
Elasticity of a Linear Demand Curve
Price Elasticity and Total Revenue
ƒ Continuing our scenario, if you raise your price
P
200%
E =
= 5.0
40%
$30
20
E =
10
$0
67%
= 1.0
67%
E =
0
CHAPTER 5
20
40
60
40%
= 0.2
200%
from $200 to $250, would your revenue rise or fall?
The slope
of a linear
demand
curve is
constant,
but its
elasticity
is not.
Revenue = P x Q
ƒ 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.
ƒ Which of these two effects is bigger?
Q
It depends on the price elasticity of demand.
ELASTICITY AND ITS APPLICATION
24
Price Elasticity and Total Revenue
Price elasticity
=
of demand
Elastic demand
(elasticity = 1.8)
Percentage change in Q
Percentage change in P
If P = $200,
Q = 12 and
revenue = $2400.
ƒ If demand is elastic, then
If P = $250,
Q = 8 and
revenue = $2000.
price elast. of demand > 1
% change in Q > % change in P
ƒ The fall in revenue from lower Q is greater
26
Price Elasticity and Total Revenue
Price elasticity
=
of demand
Percentage change in P
CHAPTER 5
$200
D
Q
12
8
27
ELASTICITY AND ITS APPLICATION
If P = $200,
Q = 12 and
revenue = $2400.
Revenue = P x Q
If P = $250,
Q = 10 and
revenue = $2500.
ƒ The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
Demand for your websites
P
increased
revenue due
to higher P
$250
(instead of 8) when you raise your price to $250.
28
CHAPTER 5
lost
revenue
due to
lower Q
$200
When D is inelastic,
a price increase
causes revenue to rise.
ƒ In our example, suppose that Q only falls to 10
ELASTICITY AND ITS APPLICATION
increased
Demand for
revenue due
your websiteslost
to higher P
revenue
due to
lower Q
Price Elasticity and Total Revenue
price elast. of demand < 1
% change in Q < % change in P
CHAPTER 5
$250
Now, demand is
inelastic:
elasticity = 0.82
Percentage change in Q
ƒ If demand is inelastic, then
P
When D is elastic,
a price increase
causes revenue to fall.
than the increase in revenue from higher P,
so revenue falls.
ELASTICITY AND ITS APPLICATION
25
ELASTICITY AND ITS APPLICATION
Price Elasticity and Total Revenue
Revenue = P x Q
CHAPTER 5
CHAPTER 5
ELASTICITY AND ITS APPLICATION
D
10
12
Q
29
5
A C T I V E L E A R N I N G 2:
Elasticity and expenditure/revenue
ACTIVE LEARNING
Answers
A. Pharmacies raise the price of insulin by 10%.
2:
B. As a result of a fare war, the price of a luxury
Does total expenditure on insulin rise or fall?
cruise falls 20%.
Does luxury cruise companies’ total revenue
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?
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.
30
APPLICATION: Does Drug Interdiction
Increase or Decrease Drug-Related Crime?
ƒ One side effect of illegal drug use is crime:
Users often turn to crime to finance their habit.
ƒ We examine two policies designed to reduce
illegal drug use and see what effects they have
on drug-related crime.
ƒ For simplicity, we assume the total dollar value
of drug-related crime equals total expenditure
on drugs.
addiction issues.
32
ELASTICITY AND ITS APPLICATION
Policy 1: Interdiction
Interdiction
reduces
Price of
Drugs
the supply
of drugs.
P2
Since demand
for drugs is
inelastic,
P1
P rises proportionally more
than Q falls.
CHAPTER 5
Policy 2: Education
Education
reduces the
demand for
drugs.
Price of
Drugs
CHAPTER 5
initial value
of drugrelated
crime
Q2 Q1
Quantity
of Drugs
ELASTICITY AND ITS APPLICATION
Price elasticity
of supply
D1
S
33
Percentage change in Qs
=
Percentage change in P
ƒ Price elasticity of supply measures how much
Qs responds to a change in P.
P and Q fall.
Result:
A decrease in
total spending
on drugs, and
in drug-related
crime.
S1
Price Elasticity of Supply
new value of drugrelated crime
D2
new value of drugrelated crime
S2
D1
Result: an increase in
total spending on drugs,
and in drug-related crime
ƒ Demand for illegal drugs is inelastic, due to
CHAPTER 5
31
initial value
of drugrelated
crime
P1
P2
Q2 Q1
ELASTICITY AND ITS APPLICATION
Quantity
of Drugs
34
ƒ Loosely speaking, it measures the pricesensitivity of sellers’ supply.
ƒ Again, use the midpoint method to compute the
percentage changes.
CHAPTER 5
ELASTICITY AND ITS APPLICATION
35
6
Price Elasticity of Supply
Price elasticity
of supply
to price elasticity of supply.
Percentage change in P
P
ƒ Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
S
P rises
P2
by 8%
P1
ƒ Five different classifications.…
Q1
16%
= 2.0
8%
CHAPTER 5
ƒ The slope of the supply curve is closely related
Percentage change in Qs
=
Example:
Price
elasticity
of supply
equals
The Variety of Supply Curves
Q2
Q
Q rises
by 16%
36
ELASTICITY AND ITS APPLICATION
“Perfectly inelastic” (one extreme)
P
S curve:
vertical
CHAPTER 5
< 10%
% change in Q
Price elasticity
<1
=
=
of supply
10%
% change in P
=0
Q
Q1
P2
38
ELASTICITY AND ITS APPLICATION
CHAPTER 5
P1
P rises
by 10%
Elasticity:
<1
Q changes
by 0%
Q
Q1 Q2
Q rises less
than 10%
39
ELASTICITY AND ITS APPLICATION
“Elastic”
% change in Q
Price elasticity
=
=
of supply
% change in P
10%
10%
> 10%
% change in Q
Price elasticity
>1
=
=
of supply
10%
% change in P
=1
P
S curve:
intermediate slope
P2
Q1
Q2
Q
Elasticity:
>1
Q rises
by 10%
ELASTICITY AND ITS APPLICATION
S
P2
Sellers’
price sensitivity:
relatively high
P1
P rises
by 10%
P
S curve:
relatively flat
S
Sellers’
price sensitivity:
intermediate
CHAPTER 5
S
Sellers’
price sensitivity:
relatively low
“Unit elastic”
Elasticity:
=1
P
S curve:
relatively steep
S
P1
P rises
by 10%
Elasticity:
0
10%
P2
Sellers’
price sensitivity:
0
37
ELASTICITY AND ITS APPLICATION
“Inelastic”
0%
% change in Q
Price elasticity
=
=
of supply
% change in P
CHAPTER 5
40
CHAPTER 5
P1
P rises
by 10%
Q1
Q2
Q
Q rises more
than 10%
ELASTICITY AND ITS APPLICATION
41
7
“Perfectly elastic” (the other extreme)
Price elasticity
=
=
of supply
% change in P
Sellers’
price sensitivity:
extreme
CHAPTER 5
ƒ The more easily sellers can change the quantity
= infinity
0%
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.
P
S curve:
horizontal
Elasticity:
infinity
The Determinants of Supply Elasticity
any %
% change in Q
S
P2 = P1
ƒ For many goods, price elasticity of supply
P changes
by 0%
Q2
Q1
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.
Q
Q changes
by any %
ELASTICITY AND ITS APPLICATION
42
3:
Elasticity and changes in equilibrium
ACTIVE LEARNING
CHAPTER 5
How the Price Elasticity of Supply Can Vary
ƒ The supply of beachfront property is inelastic.
P
ƒ Suppose population growth causes
$15
demand for both goods to double
(at each price, Qd doubles).
12
elasticity
<1
elasticity
>1
ƒ For which product will P change the most?
ƒ For which product will Q change the most?
4
$3
100 200
44
CHAPTER 5
Other Elasticities
Q
500 525
ELASTICITY AND ITS APPLICATION
45
Other Elasticities
ƒ The cross-price elasticity of demand measures
ƒ The income elasticity of demand measures the
the response of demand for one good to changes
in the price of another good.
response of Qd to a change in consumer income.
Percent change in Qd
Income elasticity
=
of demand
Percent change in income
% change in Qd for good 1
Cross-price elast.
=
of demand
% change in price of good 2
ƒ Recall from chap.4: An increase in income causes
ƒ For substitutes, cross-price elasticity > 0
E.g., an increase in price of beef causes an
increase in demand for chicken.
an increase in demand for a normal good.
ƒ Hence, for normal goods, income elasticity > 0.
ƒ For complements, cross-price elasticity < 0
ƒ For inferior goods, income elasticity < 0.
ELASTICITY AND ITS APPLICATION
Supply
Supply often
often
becomes
becomes
less
less elastic
elastic
as
as Q
Q rises,
rises,
due
due to
to
capacity
capacity
limits.
limits.
S
The supply of new cars is elastic.
CHAPTER 5
43
ELASTICITY AND ITS APPLICATION
E.g., an increase in price of computers causes
decrease in demand for software.
46
CHAPTER 5
ELASTICITY AND ITS APPLICATION
47
8
CHAPTER SUMMARY
ƒ Elasticity measures the responsiveness of
CHAPTER SUMMARY
ƒ Demand is less elastic in the short run,
Qd or Qs to one of its determinants.
for necessities, for broadly defined goods,
or for goods with few close substitutes.
ƒ Price elasticity of demand equals percentage
ƒ Price elasticity of supply 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.”
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.”
ƒ When demand is inelastic, total revenue rises
ƒ Price elasticity of supply is greater in the long run
when price rises. When demand is elastic, total
revenue falls when price rises.
CHAPTER 5
ELASTICITY AND ITS APPLICATION
than in the short run.
48
CHAPTER 5
ELASTICITY AND ITS APPLICATION
49
CHAPTER SUMMARY
ƒ The income elasticity of demand measures how
much quantity demanded responds to changes in
buyers’ incomes.
ƒ The cross-price elasticity of demand measures
how much demand for one good responds to
changes in the price of another good.
CHAPTER 5
ELASTICITY AND ITS APPLICATION
50
9