Professional Documents
Culture Documents
Economics
N. Gregory
PRINCIPLES OF
Mankiw
In this chapter,
look for the answers to these
questions:
What is elasticity? What kinds of issues can
elasticity help us understand?
A scenario
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
12 websites
websites per
per month.
month.
Your
Your costs
costs are
are rising
rising
(including
(including the
the opportunity
opportunity 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 wont
wont 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?
3
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.
Definition:
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.
ELASTICITY AND ITS APPLICATION
Percentage change in Qd
Percentage change in P
Percentage change in Qd
Percentage change in P
P
Example:
Price elasticity
of demand
equals
P rises
P2
by 10%
P1
15%
= 1.5
10%
ELASTICITY AND ITS APPLICATION
D
Q2
Q1
Q falls
by 15%
6
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.
ELASTICITY AND ITS APPLICATION
P
P2
P1
D
Q2
Q1
Calculating Percentage
Changes
Standard method
of computing the
percentage (%) change:
Demand for
your websites
P
$250
Going from A to B,
the % change in P equals
$200
D
8
12
($250$200)/$200 = 25%
Calculating Percentage
Changes
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
12
From B to A,
D
P falls 20%, Q rises 50%,
Q
elasticity = 50/20 = 2.50
Calculating Percentage
Changes
10
Calculating Percentage
Changes
$250 $200
x 100% = 22.2%
$225
11
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
12
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%
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14
EXAMPLE 1:
15
EXAMPLE 2:
16
EXAMPLE 3:
17
EXAMPLE 4:
18
how
how broadly
broadly or
or narrowly
narrowly the
the good
good is
is defined
defined
the
the time
time horizon
horizon elasticity
elasticity is
is higher
higher in
in the
the
long
long run
run than
than the
the short
short run
run
19
Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
20
% change in Q
% 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%
21
Inelastic demand
Price elasticity
of demand
% change in Q
% change in P
10%
<1
D curve:
relatively steep
P1
Consumers
price sensitivity:
relatively low
Elasticity:
<1
< 10%
P2
D
P falls
by 10%
Q1 Q2
Q rises less
than 10%
22
Unit elastic
demand
% 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%
23
Elastic demand
Price elasticity
of demand
% change in Q
% change in P
10%
>1
D curve:
relatively flat
P1
Consumers
price sensitivity:
relatively high
Elasticity:
>1
> 10%
P2
P falls
by 10%
Q1
Q2
Q rises more
than 10%
24
Price elasticity
of demand
% change in Q
% change in P
Elasticity:
infinity
0%
= infinity
D curve:
horizontal
Consumers
price sensitivity:
extreme
any %
P2 = P1
P changes
by 0%
Q1
Q2
Q changes
by any %
25
200%
E =
= 5.0
40%
$30
67%
E =
= 1.0
67%
20
40%
E =
= 0.2
200%
10
$0
20
40
60
The slope
of a linear
demand
curve is
constant,
but its
elasticity
is not.
26
27
Percentage change in Q
Percentage change in P
Revenue = P x Q
28
Elastic demand
(elasticity = 1.8)
If P = $200,
Q = 12 and
revenue = $2400.
If P = $250,
Q = 8 and
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
29
Percentage change in Q
Percentage change in P
Revenue = P x Q
30
$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
31
ACTIVE LEARNING 2
Elasticity and
expenditure/revenue
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?
B. As a result of a fare war, the price of a luxury
32
ACTIVE LEARNING 2
Answers
A. Pharmacies raise the price of insulin by 10%.
33
ACTIVE LEARNING 2
Answers
B. As a result of a fare war, the price of a luxury
34
35
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.
Result: an increase in
total spending on drugs,
and in drug-related crime
ELASTICITY AND ITS APPLICATION
S1
initial value
of drugrelated
crime
Q2 Q1
Quantity
of Drugs
36
Policy 2: Education
Education
reduces the
demand for
drugs.
Price of
Drugs
D1
S
P and Q fall.
Result:
A decrease in
total spending
on drugs, and
in drug-related
crime.
initial value
of drugrelated
crime
P1
P2
Q2 Q1
Quantity
of Drugs
37
Percentage change in Qs
Percentage change in P
38
Percentage change in Qs
Percentage change in P
P
Example:
Price
elasticity
of supply
equals
P rises
P2
by 8%
P1
16%
= 2.0
8%
ELASTICITY AND ITS APPLICATION
Q1
Q2
Q rises
by 16%
39
Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
40
% change in Q
% change in P
P
S curve:
vertical
10%
=0
P2
Sellers
price sensitivity:
none
Elasticity:
0
0%
P1
P rises
by 10%
Q1
Q changes
by 0%
41
Inelastic
Price elasticity
of supply
% change in Q
% change in P
P
S curve:
relatively steep
10%
<1
P2
Sellers
price sensitivity:
relatively low
Elasticity:
<1
< 10%
P1
P rises
by 10%
Q1 Q2
Q rises less
than 10%
42
Unit elastic
Price elasticity
of supply
% change in Q
% 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%
43
Elastic
Price elasticity
of supply
% change in Q
% change in P
10%
>1
S curve:
relatively flat
S
P2
Sellers
price sensitivity:
relatively high
Elasticity:
>1
> 10%
P1
P rises
by 10%
Q1
Q2
Q rises more
than 10%
44
% change in Q
% change in P
Elasticity:
infinity
0%
= infinity
S curve:
horizontal
Sellers
price sensitivity:
extreme
any %
P2 = P1
P changes
by 0%
Q1
Q2
Q changes
by any %
45
46
ACTIVE LEARNING 3
47
ACTIVE LEARNING 3
Answers
When supply
is inelastic,
an increase in
demand has a
bigger impact
on price than
on quantity.
Beachfront property
(inelastic supply):
P
D1 D2
P2
P1
A
Q1 Q2
Q
48
ACTIVE LEARNING 3
Answers
When supply
is elastic,
an increase in
demand has a
bigger impact
on quantity
than on price.
New cars
(elastic supply):
P
D1 D2
S
P2
P1
B
A
Q1
Q2
Q
49
$15
Supply
Supply often
often
becomes
becomes
less
less elastic
elastic
as
as Q
Q rises,
rises,
due
due to
to
capacity
capacity
limits.
limits.
12
elasticity
>1
$3
100 200
Q
500 525
50
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
51
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
Cross-price elast.
=
of demand
% change in price of good 2
52
53
CHAPTER SUMMARY
Elasticity measures the responsiveness of
Qd or Qs to one of its determinants.
CHAPTER SUMMARY
Demand is less elastic in the short run,
for necessities, for broadly defined goods,
or for goods with few close substitutes.
CHAPTER SUMMARY
56