Chapter 5

Elasticity and its

Applications

© 2002 by Nelson, a division of Thomson Canada Limited

In
In this
this chapter
chapter you
you will…
will…
•• Learn
Learn the
the meaning
meaning of
of the
the elasticity
elasticity ofof
demand.
demand.
•• Examine
Examine what
what determines
determines thethe elasticity
elasticity of
of
demand.
demand.
•• Learn
Learn the
the meaning
meaning of
of the
the elasticity
elasticity ofof
supply.
supply.
•• Examine
Examine what
what determines
determines thethe elasticity
elasticity of
of
supply.
supply.
•• Apply
Apply the
the concept
concept of
of elasticity
elasticity in
in three
three
different
different markets.
markets.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 2

 THE
THE ELASTICITY
ELASTICITY OF
OF DEMAND
DEMAND
•• …
… allows
allows us
us to
to analyze
analyze supply
supply and
and
demand
demand with
with greater
greater precision.
precision.

•• …
… is
is aa measure
measure of
of how
how much
much buyers
buyers and
and
sellers
sellers respond
respond to
to changes
changes in
in market
market
conditions
conditions

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 3

 Price
Price Elasticity
Elasticity of
of Demand
Demand
•• Price
Price elasticity
elasticity of
of demand
demand isis aa measure
measure of of
how
how much
much the
the quantity
quantity demanded
demanded of of aa
good
good responds
responds to to aa change
change in
in the
the price
price of
of
that
that good.
good.

•• Price
Price elasticity
elasticity of
of demand
demand is is the
the
percentage
percentage change
change inin quantity
quantity demanded
demanded
given
given aa percent
percent change
change inin the
the price.
price.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 4

 The
The Price
Price Elasticity
Elasticity of
of Demand
Demand and
and Its
Its
Determinants
Determinants
•• Availability
Availability of
of Close
Close Substitutes
Substitutes
•• Necessities
Necessities versus
versus Luxuries
Luxuries
•• Definition
Definition of
of the
the Market
Market
•• Time
Time Horizon
Horizon

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 5

 The
The Price
Price Elasticity
Elasticity of
of Demand
Demand and
and Its
Its
Determinants
Determinants
•• Demand
Demand tends tends to to bebe more
more elastic:
elastic:
–– the
the larger
larger the
the number
number of of close
close
substitutes.
substitutes.
–– ifif the
the good
good is is aa luxury.
luxury.
–– the
the more
more narrowly
narrowly defined
defined the
the market.
market.
–– the
the longer
longer the
the time
time period.
period.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 6

 Computing
Computing the
the Price
Price Elasticity
Elasticity of
of Demand
Demand

•• The
The price
price elasticity
elasticity of
of demand
demand is is
computed
computed asas the
the percentage
percentage change
change in
in the
the
quantity
quantity demanded
demanded divided
divided byby the
the
percentage
percentage change
change in in price.
price.

Percentage change in quantity demanded

Price elasticity of demand =
Percentage change in price

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 7

 The
The Midpoint
Midpoint Method:
Method: A
A Better
Better Way
Way to
to
Calculate
Calculate Percentage
Percentage Changes
Changes and
and Elasticities
Elasticities
•• The
The midpoint
midpoint formula
formula isis preferable
preferable when
when
calculating
calculating the
the price
price elasticity
elasticity ofof demand
demand
because
because itit gives
gives the
the same
same answer
answer
regardless
regardless of of the
the direction
direction ofof the
the change.
change.
•• point
pointMethod:
Method:AABetter
BetterWay
Wayto
toCalculate
CalculatePercentage
Percentage
Changes
Changesand
andElasticities
Elasticities

(Q2 - Q1) / [(Q2 + Q1) / 2]

Price elasticity of demand =
(P2 - P1) / [(P2 + P1) / 2]

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 8

 The
The Midpoint
Midpoint Method:
Method: A
A Better
Better Way
Way to
to
Calculate
Calculate Percentage
Percentage Changes
Changes and
and Elasticities
Elasticities
•• Point
PointA:
A: Price
Price==$4
$4 Quantity
Quantity==120
120
•• Point
PointB:
B: Price
Price==$6
$6 Quantity
Quantity==80
80

•• From
FromPoint
PointAAto
toPoint
PointB:
B:Price
Pricerise
rise==50%
50%and
andQuantity
Quantityfall
fall==33%
33%
•• From
FromPoint
PointBBto
toPoint
PointA:
A:Price
Pricefall
fall==33%
33%and
andQuantity
Quantityrise
rise==50%
50%

(80 - 120) / [(80 + 120)/ 2]

Price elasticity of demand =
(6 - 4) / [(6 + 4)/ 2]

Mid point method

= 1

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 9

 A
A Variety
Variety of
of Demand
Demand Curves
Curves

•• Inelastic
Inelastic Demand
Demand
–– Quantity
Quantity demanded
demanded does does not
not respond
respond
strongly
strongly to
to price
price changes.
changes.
–– Price
Price elasticity
elasticity of
of demand
demand is
is less
less than
than
one.
one.
•• Elastic
Elastic Demand
Demand
–– Quantity
Quantity demanded
demanded responds
responds strongly
strongly
to
to changes
changes in in price.
price.
–– Price
Price elasticity
elasticity of
of demand
demand is
is greater
greater
than
than one.
one.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 10
 A
A Variety
Variety of
of Demand
Demand Curves
Curves

•• Perfectly
Perfectly Inelastic
Inelastic
–– Quantity
Quantity demanded
demanded does
does not
not respond
respond toto
price
price changes.
changes.
•• Perfectly
Perfectly Elastic
Elastic
–– Quantity
Quantity demanded
demanded changes
changes infinitely
infinitely
with
with any
any change
change in
in price.
price.
•• Unit
Unit Elastic
Elastic
–– Quantity
Quantity demanded
demanded changes
changes by by the
the
same
same percentage
percentage as
as the
the price.
price.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 11

 A
A Variety
Variety of
of Demand
Demand Curves
Curves

•• Because
Because thethe price
price elasticity
elasticity of of demand
demand
measures
measures how how much
much quantity
quantity demanded
demanded
responds
responds to to the
the price,
price, itit is
is closely
closely related
related
to
to the
the slope
slope of
of the
the demand
demand curve. curve.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 12

 Figure
Figure 5-1
5-1 a):
a): Perfectly
Perfectly Inelastic
Inelastic Demand
Demand

Price
Demand E=0

$5.00

$4.00
1. An increase
in price…

0 100 Quantity

2. …leaves the quantity demanded unchanged.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 13

 Figure
Figure 5-1
5-1 b):
b): Inelastic
Inelastic Demand
Demand

Price
Demand E<1

$5.00

$4.00
1. A 22%
increase in
price…

0 90 100 Quantity

2. … Leads to a 11% decrease in quantity demanded.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 14

 Figure
Figure 5-1
5-1 c):
c): Unit
Unit Elastic
Elastic Demand
Demand

Price E=1
Demand

$5.00

$4.00
1. A 22%
increase in
price…

0 80 100 Quantity

2. … Leads to a 22% decrease in quantity demanded.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 15

 Figure
Figure 5-1
5-1 d):
d): Elastic
Elastic Demand
Demand

Price E>1
Demand

$5.00

$4.00
1. A 22%
increase in
price…

0 50 100 Quantity

2. … Leads to a 67% decrease in quantity demanded.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 16

 Figure
Figure 5-1
5-1 e):
e): Perfectly
Perfectly Elastic
Elastic Demand
Demand

Price E=

1. At any price above $4, quantity

demanded is zero.

$4.00 Demand
2. At exactly $4, consumers will buy any quantity.

3. At any price below $4, quantity demanded is

infinite.

0
Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 17

 Total
Total Revenue
Revenue and
and the
the Price
Price Elasticity
Elasticity of
of
Demand
Demand
•• Total
Total revenue
revenue isis the
the amount
amount paid
paid by
by
buyers
buyers and
and received
received by by sellers
sellers of
of aa good.
good.
•• Computed
Computed as as the
the price
price of
of the
the good
good times
times
the
the quantity
quantity sold.
sold.

TR
TR == PP xx Q
Q

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 18

 Figure
Figure 5-2:
5-2: Total
Total Revenue
Revenue
Price

$4.00

P x Q = $400
(revenue)
Demand

0 100 Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 19

 Figure
Figure 5-3:
5-3: How
How Total
Total Revenue
Revenue Changes
Changes
When
When Prices
Prices Changes:
Changes: Inelastic
Inelastic Demand
Demand
Price

$3.00

P x Q = $400
(revenue)
$1.00
P x Q = $100
(revenue) Demand

0 80 100 Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 20

 Figure
Figure 5-4:
5-4: How
How Total
Total Revenue
Revenue Changes
Changes
When
When Prices
Prices Changes:
Changes: Elastic
Elastic Demand
Demand
Price
Change in Total Revenue when Price Changes

$5.00

$4.00

Demand

Revenue = $200

Revenue = $100

0 20 50 Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 21

 Elasticity
Elasticity and
and Total
Total Revenue
Revenue along
along aa Linear
Linear
Demand
Demand Curve
Curve
•• With
With anan elastic
elastic demand
demand curve,
curve, an
an increase
increase
in
in the
the price
price leads
leads to
to aa decrease
decrease in
in quantity
quantity
demanded
demanded that that is
is proportionately
proportionately larger.
larger.
Thus,
Thus, total
total revenue
revenue decreases.
decreases.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 22

Table
Table 5-1.
5-1. Elasticity
Elasticity and
and Total
Total Revenue
Revenue
along
along aa Linear
Linear Demand
Demand Curve
Curve

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 23

Figure
Figure 5-5:
5-5: A
A Linear
Linear Demand
Demand Curve
Curve
Price

7 Elasticity
is larger
than 1.
6

4
Elasticity
is smaller
3 than 1.

0 4 14 Quantity
2 6 8 10 12

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 24

 Other
Other Demand
Demand Elasticities
Elasticities

•• Income
Income elasticity
elasticity of
of demand
demand measures
measures
how
how much much the
the quantity
quantity demanded
demanded ofof aa
good
good responds
responds toto aa change
change inin consumers’
consumers’
income.
income.
•• ItIt is
is computed
computed as as the
the percentage
percentage change
change
in
in thethe quantity
quantity demanded
demanded divided
divided by
by the
the
percentage
percentage change
change in in income.
income.

P e rc e n ta g e c h a n g e
in q u a n tity d e m a n d e d
In c o m e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e
in in c o m e
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 25
 Other
Other Demand
Demand Elasticities
Elasticities

•• Types
Types of of Goods
Goods
–– Normal
Normal Goods
Goods
–– Inferior
Inferior Goods
Goods
•• Higher
Higher income
income raises
raises the
the quantity
quantity
demanded
demanded for for normal
normal goods
goods butbut lowers
lowers
the
the quantity
quantity demanded
demanded for for inferior
inferior goods.
goods.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 26

 Other
Other Demand
Demand Elasticities
Elasticities

•• Goods
Goods consumers
consumers regard
regard asas necessities
necessities
tend
tend toto be
be income
income inelastic
inelastic
–– Examples
Examples include
include food,
food, fuel,
fuel, clothing,
clothing,
utilities,
utilities, and
and medical
medical services.
services.
•• Goods
Goods consumers
consumers regard
regard asas luxuries
luxuries tend
tend
to
to be
be income
income elastic.
elastic.
–– Examples
Examples include
include sports
sports cars,
cars, furs,
furs, and
and
expensive
expensive foods.
foods.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 27

 Other
Other Demand
Demand Elasticities
Elasticities
•• Cross-Price
Cross-Price elasticity
elasticity of
of demand
demand
measures
measures how how much
much the
the quantity
quantity
demanded
demanded of of aa good
good responds
responds to to aa change
change
in
in thethe price
price of
of another
another good.
good.
•• ItIt is
is computed
computed as as the
the percentage
percentage changechange
in
in thethe quantity
quantity demanded
demanded divided
divided by by the
the
percentage
percentage changechange in in the
the price
price ofof the
the
second
second good.good.
Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in the price of
good 2.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 28
 PRICE
PRICE ELASTICITY
ELASTICITY OF
OF SUPPLY
SUPPLY
•• Price
Price elasticity
elasticity of
of supply
supply is is aa measure
measure of of
how
how much
much the
the quantity
quantity supplied
supplied of of aa good
good
responds
responds toto aa change
change inin the
the price
price of
of that
that
good.
good.

•• Price
Price elasticity
elasticity of
of supply
supply is is the
the percentage
percentage
change
change inin quantity
quantity supplied
supplied given
given aa
percent
percent change
change inin the
the price.
price.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 29

 The
The Price
Price Elasticity
Elasticity of
of Supply
Supply and
and Its
Its
Determinants
Determinants
•• Ability
Ability of
of sellers
sellers to
to change
change the the amount
amount of of
the
the good
good they
they produce.
produce.
–– Beach-front
Beach-front land
land isis inelastic.
inelastic.
–– Books,
Books, cars,
cars, or
or manufactured
manufactured goods goods are
are
elastic.
elastic.
•• Time
Time period.
period.
–– Supply
Supply is is more
more elastic
elastic inin the
the long
long run.
run.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 30

 Computing
Computing the
the Price
Price Elasticity
Elasticity of
of Supply
Supply

•• The
The price
price elasticity
elasticity of
of supply
supply is is computed
computed
as
as the
the percentage
percentage change
change inin the
the quantity
quantity
supplied
supplied divided
divided by
by the
the percentage
percentage
change
change in in price.
price.

P e rc e n ta g e c h a n g e
in q u a n tity s u p p lie d
P ric e e la s tic ity o f s u p p ly =
P e rc e n ta g e c h a n g e in p ric e

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 31

 Computing
Computing the
the Price
Price Elasticity
Elasticity of
of Supply
Supply
•• Suppose
Supposean anincrease
increasein
inthe
theprice
priceof
ofmilk
milkfrom
from$1.90
$1.90to
to$2.10
$2.10aalitre
litre
raises
raisesthe
theamount
amountthat
thatdairy
dairyfarmers
farmersproduce
producefrom
from9000
9000toto11
11000
000
LLper month…
per month…

•• ……using
usingthe
themidpoint
midpointmethod,
method,we wecalculate
calculatethe
thepercent
percentchange
changeinin
the price as (2.10 - 1.90) / 2.00 x 100 = 10%
the price as (2.10 - 1.90) / 2.00 x 100 = 10%
•• Similarly,
Similarly,we
wecalculate
calculatethe
thepercent
percentchange
changeininthe
thequantity
quantitysupplied
supplied
as
as(11
(11000
000--9000)
9000)/ /10
10000
000xx100
100==20%
20%

20%
Price elasticity of supply = = 2.0
10%

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 32

 Figure
Figure 5-6
5-6 a):
a): Perfectly
Perfectly Inelastic
Inelastic Supply
Supply

Price
Supply E=0

$5.00

$4.00
1. An increase
in price…

0 100 Quantity

2. …leaves the quantity supplied unchanged.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 33

 Figure
Figure 5-6
5-6 b):
b): Inelastic
Inelastic Supply
Supply

Price E<0
Supply

$5.00

$4.00
1. A 22%
increase in
price…

0 100 110 Quantity

2. …leads to a 10% increase in quantity

supplied.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 34
 Figure
Figure 5-6
5-6 c):
c): Unit
Unit Elastic
Elastic Supply
Supply

Price E=1

Supply

$5.00

$4.00
1. A 22%
increase in
price…

0 100 125 Quantity

2. …leads to a 22% increase in quantity

supplied.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 35
 Figure
Figure 5-6
5-6 d):
d): Elastic
Elastic Supply
Supply

Price E>1

Supply
$5.00

$4.00
1. A 22%
increase in
price…

0 100 200 Quantity

2. …leads to a 67% increase in quantity

supplied.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 36
 Figure
Figure 5-6
5-6 e):
e): Perfectly
Perfectly Elastic
Elastic Supply
Supply

Price E=

1. At any price above $4, quantity

supplied is infinite.

$4.00 Supply
2. At exactly $4, producers will supply any quantity.

3. At any price below $4, quantity supplied is zero.

0
Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 37

 Figure
Figure 5-7:
5-7: How
How the
the price
price elasticity
elasticity of
of supply
supply
can
can vary
vary
Price

$15
Elasticity is less
than 1

$12

Elasticity is
greater than 1

$4
$3

0 100 200 500

525 Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 38

 THREE
THREE APPLICATIONS
APPLICATIONS OF
OF SUPPLY,
SUPPLY,
DEMAND,
DEMAND, AND
AND ELASTICITY
ELASTICITY

•• Good
Good news
news bad
bad news
news for
for farmers
farmers
•• OPEC
OPEC
•• Drugs
Drugs and
and crime
crime

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 39

 Figure
Figure 5-8:
5-8: An
An Increase
Increase in
in Supply
Supply in
in the
the
Market
Market for
for Wheat
Wheat
Price of
Wheat Increase in Supply
1. When demand is inelastic, an
increase in supply… S1
S2

$3

$2

2. … leads
to a fall in
price…

Demand

100 110 Quantity of Wheat

3. …and a proportionately smaller increase in quantity sold. As a result revenue

falls from $300 to $220.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 40
 Figure
Figure 5-9:
5-9: A
A Reduction
Reduction in
in Supply
Supply in
in the
the
World
World Market
Market for
for Oil
Oil
(a) Oil Market in the Short Run (b) Oil Market in the Long Run
Price Price
of Oil 1. In the short run, when supply of Oil
and demand are inelastic, a shift
in supply… S 2 1. In the long run, when supply
and demand are elastic, a shift in
supply…
S1
S2

S1
P2 P2
P1

P1
2. … leads
Demand
2. … leads to a small
to a large increase in
increase in price…
price…
Demand

Quantity of Oil Quantity of Oil

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 41
 Figure
Figure 5-10:
5-10: Policies
Policies toto Reduce
Reduce the
the of of Illegal
Illegal
Drugs
Drugs (a) Drug Interdiction (b) Drug Education
Price of Price of
Drugs 1. Drug interdiction reduces the
supply of drugs…
Drugs
1. Drug education reduces the
S2 demand for drugs…

S1
Supply

P2
P1

P2
P1
D1
2. … which
2. … which reduces the
raises the price…
price…
D2
Demand

Q2 Q1 Quantity of Drugs Q2 Q1 Quantity of Drugs

3. … and reduces the 3. … and reduces the quantity
quantity sold. sold.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 42
Summary
Summary
•• Price
Priceelasticity
elasticityofofdemand
demand measures
measures how how much
much
the
thequantity
quantitydemanded
demanded responds
respondsto tochanges
changesin in
the
theprice. price.
•• Price
Priceelasticity
elasticityofofdemand
demand is iscalculated
calculatedas asthe
the
percentage
percentagechange changein inquantity
quantitydemanded
demanded divided
divided
by
by the thepercentage
percentagechange
changein inprice.
price.
•• IfIf aademand
demand curve
curveis iselastic,
elastic, total
total revenue
revenuefalls
falls
when
whenthe theprice
pricerises.
rises.
•• IfIf itit is
isinelastic,
inelastic, total
total revenue
revenue rises
risesasasthe
theprice
price
rises.
rises.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 43

Summary
Summary
•• The
Theincome
incomeelasticity
elasticityof
of demand
demandmeasures
measureshowhow
much
much thethequantity
quantity demanded
demanded responds
responds to
to
changes
changesin in consumers’
consumers’ income.
income.
•• The
Thecross-price
cross-priceelasticity
elasticity of
of demand
demand measures
measures
how
howmuchmuch the
thequantity
quantitydemanded
demanded of of one
onegood
good
responds
respondsto tothe
theprice
priceofof another
anothergood.
good.
•• The
Theprice
priceelasticity
elasticity of
of supply
supplymeasures
measureshow
how
much
much thethequantity
quantity supplied
suppliedresponds
respondstotochanges
changes
in
in the
theprice.
price.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 44

Summary
Summary
•• In
In most
mostmarkets,
markets,supply
supplyisismore
moreelastic
elasticin
inthe
the
long
long run
run than
than in
inthe
the short
short run.
run.
•• The
Theprice
priceelasticity
elasticity of
of supply
supplyis iscalculated
calculated asasthe
the
percentage
percentagechange
changein inquantity
quantitysupplied
supplieddivided
divided
by
by the
thepercentage
percentagechange
changein inprice.
price.
•• The
Thetools
toolsofof supply
supplyandanddemand
demandcan canbe
beapplied
appliedinin
many
manydifferent
different types
types ofofmarkets.
markets.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 45

The
The End
End

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 46