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Chapter 5 Notes

Reading (Chapters 5) Mankiw Text

Topics: Elasticity and Applications (First topic

i Micro

in

Mi

that

th t is

i nott in

i Macro)

M

) Focus

F

on

Elasticities of Demand & Supply, know only

the definition of Elasticity of Income & CrossPrice Elasticity

For HW, please do Chapter 5 Problems &

Applications, #2 (same in 5e), #3 (same in 5e), #4

(same as in 5e) & 10 (same as in 5e )

A scenario

You design websites for local businesses.

You charge $200 per website,

and currently sell 12 websites per month

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 wont

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?

1

9/17/2012

Elasticity

Basic idea:

Elasticity measures how much one variable

responds

p

to changes

g 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.

2

Price elasticity

of demand

Percentage change in Qd

=

Percentage change in P

much Qd responds to a change in P.

buyers demand.

9/17/2012

Price elasticity

of demand

Percentage change in Qd

=

Percentage change in P

P

Example:

P rises

P2

by 10%

P1

Price elasticity

of demand

equals

15%

= 1.5

10%

Q2

Q1

Q falls

by 15%

4

Price elasticity

of demand

Percentage change in Qd

=

Percentage change in P

move in opposite directions,

which would make price

elasticity negative.

We will drop the minus sign

and report all price

elasticities as

positive numbers.

ELASTICITY AND ITS APPLICATION

P

P2

P1

D

Q2

Q1

9/17/2012

Standard method

of computing the

percentage

p

g ((%)) change:

g

Demand for

your websites

x 100%

start value

P

B

$250

Going from A to B,

g in P equals

q

the % change

$200

D

8

12

($250$200)/$200 = 25%

Problem:

The standard method gives

different answers depending

on where you start.

Demand for

your websites

P

$250

From A to B,

P rises 25%, Q falls 33%,

elasticity = 33/25 = 1.33

B

A

$200

From B to A,

A

P falls 20%, Q rises 50%,

Q

elasticity = 50/20 = 2.50

D

8

12

9/17/2012

So, we instead use the midpoint method:

end value start value

x 100%

midpoint

id i t

the start & end values, the average of those

values.

It doesnt

doesn t matter which value you use as the

start and which as the end you get the

same answer either way!

ELASTICITY AND ITS APPLICATION

Using the midpoint method, the % change

in P equals

$250 $200

x 100% = 22.2%

$225

12 8

x 100% = 40.0%

10

40/22.2 = 1.8

ELASTICITY AND ITS APPLICATION

9/17/2012

ACTIVE LEARNING

Calculate an elasticity

Use the following

information to

calculate the

price elasticity

of demand

for hotel rooms:

if P = $70

$70, Qd = 5000

if P = $90, Qd = 3000

10

ACTIVE LEARNING

Answers

Use midpoint method to calculate

% change

g in Qd

(5000 3000)/4000 = 50%

% change in P

($90 $70)/$80 = 25%

The price elasticity of demand equals

50%

= 2.0

25%

11

9/17/2012

To learn the determinants of price elasticity,

we look at a series of examples.

Each compares

p

two common g

goods.

In each example:

The good for which Qd falls the most (in percent)

has the highest price elasticity of demand.

Whi h good

Which

d is

i it? Wh

Why?

?

determinants of the price elasticity of demand?

ELASTICITY AND ITS APPLICATION

12

EXAMPLE 1:

The prices of both of these goods rise by 20%.

For which good does Qd drop the most? Why?

(e.g., pancakes, Eggo waffles, leftover pizza),

so buyers can easily switch if the price rises.

probably

y not

so consumers would p

buy much less if its price rises.

substitutes are available.

ELASTICITY AND ITS APPLICATION

13

9/17/2012

EXAMPLE 2:

For which good does Qd drop the most? Why?

For a narrowly defined good such as

blue jeans, there are many substitutes

(khakis, shorts, Speedos).

There are fewer substitutes available for

broadly defined goods.

(Th

(There

arentt too

t many substitutes

b tit t for

f clothing,

l thi

other than living in a nudist colony.)

defined goods than broadly defined ones.

ELASTICITY AND ITS APPLICATION

14

EXAMPLE 3:

The prices of both of these goods rise by 20%.

For which good does Qd drop the most? Why?

A rise in its price would cause little or no

decrease in demand.

people

p will forego

g it.

some p

than for necessities.

ELASTICITY AND ITS APPLICATION

15

9/17/2012

EXAMPLE 4:

in the Long Run

The price of gasoline rises 20%. Does Qd drop

more in the short run or the long run? Why?

short run, other than ride the bus or carpool.

or live closer to where they work.

long run than the short run.

ELASTICITY AND ITS APPLICATION

16

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

17

9/17/2012

The price elasticity of demand is closely related

to the slope of the demand curve.

The flatter the curve, the bigger the elasticity.

The steeper the curve, the smaller the elasticity.

18

% change in Q

Price elasticity

=

=

of demand

% change in P

P

D curve:

vertical

10%

=0

P1

Consumers

price sensitivity:

none

Elasticity:

0

0%

P2

P falls

by 10%

Q1

Q changes

by 0%

19

10

9/17/2012

Inelastic demand

< 10%

% change in Q

Price elasticity

<1

=

=

of demand

10%

% change in P

P

D curve:

relatively steep

P1

Consumers

price sensitivity:

relatively low

Elasticity:

<1

P2

D

P falls

by 10%

Q1 Q2

Q rises less

than 10%

20

% change in Q

Price elasticity

=

=

of demand

% change in P

10%

=1

D curve:

intermediate slope

P1

Consumers

price sensitivity:

intermediate

Elasticity:

1

10%

P2

P falls

by 10%

D

Q1

Q2

Q rises by 10%

21

11

9/17/2012

Elastic demand

> 10%

% change in Q

Price elasticity

>1

=

=

of demand

10%

% change in P

P

D curve:

relatively flat

P1

Consumers

price sensitivity:

relatively high

Elasticity:

>1

P2

P falls

by 10%

Q1

Q2

Q rises more

than 10%

22

any %

% change in Q

Price elasticity

= infinity

=

=

of demand

0%

% change in P

P

D curve:

horizontal

Consumers

price sensitivity:

extreme

Elasticity:

infinity

P2 = P1

P changes

by 0%

Q1

Q2

Q changes

by any %

23

12

9/17/2012

P

$30

E =

20

200%

= 5.0

50

40%

E =

10

$0

67%

= 1.0

67%

E =

20

40

60

40%

= 0.2

200%

The slope

of a linear

demand

curve is

constant,

but its

elasticity

i not.

is

t

24

Continuing our scenario, if you raise your price

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

Revenue = P x Q

Higher P means more revenue on each unit

you sell.

But you sell fewer units (lower Q),

due to Law of Demand

Demand.

It depends on the price elasticity of demand.

ELASTICITY AND ITS APPLICATION

25

13

9/17/2012

Price elasticity

=

of demand

Percentage change in Q

Percentage change in P

Revenue = P x Q

price elast. of demand > 1

% change in Q > % change in P

than the increase in revenue from higher P,

so revenue falls.

26

Elastic demand

(elasticity = 1.8)

If P = $200,

$200

Q = 12 and

revenue = $2400.

If P = $250,

Q = 8 and

re en e = $2000.

revenue

$2000

$250

increased

Demand for

revenue due

your websiteslost

to higher P

revenue

due to

lower Q

$200

When D is elastic,

a price increase

causes revenue to fall.

ELASTICITY AND ITS APPLICATION

12

27

14

9/17/2012

Price elasticity

=

of demand

Percentage change in Q

Percentage change in P

Revenue = P x Q

% change in Q < % change in P

than the

th

th increase

i

iin revenue ffrom hi

higher

h P,

P

so revenue rises.

(instead of 8) when you raise your price to $250.

28

Now, demand is

inelastic:

elasticity = 0.82

If P = $200,

Q = 12 and

revenue = $2400.

If P = $250,

Q = 10 and

revenue = $2500.

$250

increased

Demand for

revenue

due

your websites

lost

to higher P

revenue

due to

lower Q

$200

When D is inelastic,

a price increase

causes revenue to rise.

ELASTICITY AND ITS APPLICATION

10 12

29

15

9/17/2012

ACTIVE LEARNING

A. Pharmacies raise the price of insulin by 10%.

B. As a result of a fare war, the price of a luxury

Does luxury cruise companies total revenue

rise or fall?

30

ACTIVE LEARNING

Answers

A. Pharmacies raise the price of insulin by 10%.

p

on insulin rise or fall?

Expenditure = P x Q

Since demand is inelastic, Q will fall less

than 10%, so expenditure rises.

31

16

9/17/2012

ACTIVE LEARNING

Answers

B. As a result of a fare war, the price of a luxury

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.

32

Users often turn to crime to finance their habit.

illegal drug use and see what effects they have

on drug-related crime.

of drug-related

drug related crime equals total expenditure

on drugs.

addiction issues.

ELASTICITY AND ITS APPLICATION

33

17

9/17/2012

Policy 1: Interdiction

Interdiction

reduces

Price of

Drugs

the supply

g

of drugs.

P2

Since demand

for drugs is

inelastic,

P1

P rises proportionally more

than Q falls.

falls

S2

D1

S1

initial value

of drugrelated

crime

Result: an increase in

total spending on drugs,

and in drug-related crime

Q2 Q1

Quantity

of Drugs

34

Policy 2: Education

Education

reduces the

demand for

drugs.

Price of

Drugs

D2

D1

S

P and Q fall.

Result:

A decrease in

t t l spending

total

di

on drugs, and

in drug-related

crime.

initial value

of drugrelated

crime

P1

P2

Q2 Q1

Quantity

of Drugs

35

18

9/17/2012

Price elasticity

of supply

Percentage change in Qs

=

Percentage change in P

Qs responds to a change in P.

price-sensitivity.

percentage changes.

36

Price elasticity

of supply

Percentage change in Qs

=

Percentage change in P

P

Example:

Price

elasticity

of supply

equals

l

P rises

P2

by 8%

P1

16%

= 2.0

8%

ELASTICITY AND ITS APPLICATION

Q1

Q2

Q rises

by 16%

37

19

9/17/2012

The slope of the supply curve is closely related to

price elasticity of supply.

Rule

R l off th

thumb:

b

The flatter the curve, the bigger the elasticity.

The steeper the curve, the smaller the elasticity.

38

0%

% change in Q

Price elasticity

=

=

of supply

% change in P

P

S curve:

vertical

=0

P2

Sellers

price sensitivity:

none

Elasticity:

0

10%

P1

P rises

by 10%

Q1

Q changes

by 0%

39

20

9/17/2012

Inelastic

< 10%

% change in Q

Price elasticity

<1

=

=

of supply

10%

% change in P

P

S curve:

relatively steep

S

P2

Sellers

price sensitivity:

relatively low

Elasticity:

<1

P1

P rises

by 10%

Q1 Q2

Q rises less

than 10%

40

Unit elastic

% change in Q

Price elasticity

=

=

of supply

% change in P

10%

=1

S curve:

intermediate slope

S

P2

Sellers

price sensitivity:

intermediate

Elasticity:

=1

10%

P1

P rises

by 10%

Q1

Q2

Q rises

by 10%

41

21

9/17/2012

Elastic

> 10%

% change in Q

Price elasticity

>1

=

=

of supply

10%

% change in P

P

S curve:

relatively flat

S

P2

Sellers

price sensitivity:

relatively high

Elasticity:

>1

P1

P rises

by 10%

Q1

Q2

Q rises more

than 10%

42

any %

% change in Q

Price elasticity

= infinity

=

=

of supply

0%

% change in P

P

S curve:

horizontal

Sellers

price sensitivity:

extreme

Elasticity:

infinity

P2 = P1

P changes

by 0%

Q1

Q2

Q changes

by any %

43

22

9/17/2012

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.

is greater in the long run than in the short run

run,

because firms can build new factories,

or new firms may be able to enter the market.

44

ACTIVE LEARNING

The supply of beachfront property is inelastic.

The supply of new cars is elastic.

demand for both goods to double

(at each price, Qd doubles).

For which product will Q change the most?

45

23

9/17/2012

ACTIVE LEARNING

Answers

When supply

is inelastic,

an increase in

demand has a

bigger impact

on price than

on quantity

quantity.

Beachfront property

((inelastic supply):

pp y)

P

D1 D2

S

B

P2

P1

A

Q

Q1 Q2

46

ACTIVE LEARNING

Answers

When supply

is elastic,

an increase in

demand has a

bigger impact

on quantity

than on price

price.

New cars

(elastic

(e

as c supp

supply):

y)

P

D1 D2

S

P2

P1

B

A

Q1

Q2

Q

47

24

9/17/2012

P

Supply often

becomes

less elastic

as Q rises,

due to

capacity

limits.

S

elasticity

<1

$15

12

elasticity

>1

4

$3

100 200

Q

500 525

48

Other Elasticities

Income elasticity of demand: measures the

response of Qd to a change in consumer income

Percent change in Qd

Income elasticity

=

of demand

Percent change in income

causes an increase in demand for a normal good.

For inferior goods, income elasticity < 0.

ELASTICITY AND ITS APPLICATION

49

25

9/17/2012

Other Elasticities

changes in the price of another good

% change in Qd for good 1

Cross-price elast.

=

of demand

% change in price of good 2

(e.g., an increase in price of beef causes an

increase in demand for chicken)

(e.g., an increase in price of computers causes

decrease in demand for software)

ELASTICITY AND ITS APPLICATION

50

As Gas Costs Soar, Buyers Flock to Small Cars

-New York Times, 5/2/2008

Gas

Gas Prices Drive Students to Online Courses

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

gas-guzzling

guzzling tractors)

tractors )

-Financial Times, 5/2/2008

High gas prices drive farmer to switch to mules

-Associated Press, 5/21/2008

ELASTICITY AND ITS APPLICATION

51

26

9/17/2012

INTERPRETATION OF

ELASTICITIESNot In Your Text

How do we interpret elasticities more precisely? Saying that 1.0

or greater means demand is more elastic still does not help us

understand the magnitude of price sensitivity.

If Elasticity of Demand = 3

INTERPRETATION: A 1% change in price will result in a 3%

change in quantity demanded.

Example: If the Elasticity of Demand for gasoline is -3.0

What does this mean? If the price of gasoline goes up by 1%,

quantity demanded will fall by 3%.

What if?? What if the price of gasoline goes up by 4%? How

much will the quantity demanded be expected to drop?

4 x 3 = 12, so if the price of gasoline goes up by 4%, Qty

demanded should fall by 12%.

ELASTICITY AND ITS APPLICATION

52

had major implications for both American farmers and

U.S. agricultural

policy.

g

p

y

To understand what happened, lets examine the behavior of supply

and demand beginning in 1981.

can determine the market-clearing price of wheat for 1981:

27

9/17/2012

We can likewise calculate the price elasticity of supply:

EPS

P QS 3.46

3 46

(240) 0.32

Q P 2630

Because these supply and demand curves are linear, the price

elasticities will vary as we move along the curves.

28

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