and 5
Elasticity its Elasticity Application Application
PRINCIPLES OF
MICROECONOMICS
FOURTH CANADIAN EDITION
N. G R E G O R Y M A N K I W R O N A L D D. K N E E B O N E K E N N E T H J. M c K ENZIE NICHOLAS ROWE
2008 Nelson Education Ltd.
In this chapter, look for the answers to these questions: What is elasticity? What kinds of issues can elasticity
help us understand?
What is the price elasticity of demand?
How is it related to the demand curve? How is it related to revenue & expenditure?
What is the price elasticity of supply?
How is it related to the supply curve?
What are the income and cross-price elasticities of
demand?
2008 Nelson Education Ltd.
2
Ascenario
You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month.
0
Your costs are rising (including the opportunity cost of your time), so youre thinking of raising your price to $250. The law of demand says that you wont sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it even increase?
2008 Nelson Education Ltd.
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.
0
Definition:
Elasticity is a numerical measure of the responsiveness of Qd or Qs to one of its determinants.
2008 Nelson Education Ltd.
4
PriceElasticityofDemand
Price elasticity of demand = Percentage change in Qd Percentage change in P
0
Price elasticity of demand measures how much Qd
responds to a change in P.
Loosely speaking, it measures the price-sensitivity of
buyers demand.
2008 Nelson Education Ltd.
5
PriceElasticityofDemand
Price elasticity of demand Example: Price elasticity of demand equals 15% 10% = 1.5 = Percentage change in Qd Percentage change in P P P rises P2 by 10% P1
0
D Q2 Q falls by 15%
6
Q1
Q
2008 Nelson Education Ltd.
PriceElasticityofDemand
Price elasticity of demand = Percentage change in Qd Percentage change in P P P2 P1
0
Along a D curve, P and Q move in opposite directions, which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers.
D Q2 Q1 Q
2008 Nelson Education Ltd.
7
CalculatingPercentageChanges
CALCULATE ON MIDTERM
0
Demand for your websites P $250 $200 B A D 8 12 Q
Standard method of computing the percentage (%) change: end value start value start value x 100%
Going from A to B, the % change in P equals ($250$200)/$200 = 25%
2008 Nelson Education Ltd.
8
CalculatingPercentageChanges
0
Demand for your websites P $250 $200 B A D 8 12 Q
Problem: The standard method gives different answers depending on where you start. From A to B, P rises 25%, Q falls 33%, elasticity = 33/25 = 1.33 From B to A, P falls 20%, Q rises 50%, elasticity = 50/20 = 2.50
2008 Nelson Education Ltd.
9
CalculatingPercentageChanges
So, we instead use the midpoint method:
end value start value midpoint
0
x 100%
The midpoint is the number halfway between the
start & end values, also the average of those values.
It doesnt matter which value you use as the start
and which as the end you get the same answer either way!
2008 Nelson Education Ltd.
10
CalculatingPercentageChanges
Using the midpoint method, the % change
in P equals $250 $200 $225 x 100% = 22.2%
0
The % change in Q equals
12 8 10 x 100% = 40.0%
The price elasticity of demand equals
40/22.2 = 1.8
2008 Nelson Education Ltd.
11
ACTIVELEARNING1:
Calculateanelasticity
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
ACTIVELEARNING1:
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% 25% = 2.0
13
Whatdeterminespriceelasticity?
To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. In each example:
0
Suppose the prices of both goods rise by 20%. The good for which Qd falls the most (in percent) 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?
2008 Nelson Education Ltd.
14
EXAMPLE1:RiceKrispiesvs.Sunscreen
The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
0
Rice Krispies has lots of close substitutes (e.g., Capn Crunch, Count Chocula), so buyers can easily switch if the price rises. Sunscreen has no close substitutes, so consumers would probably not buy much less if its price rises.
Lesson: Price elasticity is higher when close
substitutes are available.
2008 Nelson Education Ltd.
15
EXAMPLE2:BlueJeansvs.Clothing
The prices of both goods rise by 20%.
For which good does Qd drop the most? Why?
0
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. (Can you think of a substitute for clothing, other than living in a nudist colony?)
Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.
2008 Nelson Education Ltd.
16
EXAMPLE3:Insulinvs.CaribbeanCruises
The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
0
To millions of diabetics, insulin is a necessity. 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.
Lesson: Price elasticity is higher for luxuries than for
necessities.
2008 Nelson Education Ltd.
17
EXAMPLE4:GasolineintheShortRun vs.GasolineintheLongRun
The price of gasoline rises 20%. Does Qd drop more in
the short run or the long run? Why?
0
Theres not much people can do in the short run, other than ride the bus or carpool. In the long run, people can buy smaller cars or live closer to where they work.
Lesson: Price elasticity is higher in the
long run than the short run.
2008 Nelson Education Ltd.
18
TheDeterminantsofPriceElasticity: ASummary
The price elasticity of demand depends on:
0
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.
2008 Nelson Education Ltd.
19
TheVarietyofDemandCurves
Economists classify demand curves according to their
elasticity.
0
The price elasticity of demand is closely related to the
slope of the demand curve.
Rule of thumb:
The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity.
The next 5 slides present the different classifications,
from least to most elastic.
2008 Nelson Education Ltd.
20
Perfectlyinelasticdemand(oneextremecase)
% change in Q Price elasticity = = of demand % change in P D curve: vertical Consumers price sensitivity: 0 Elasticity: 0 P falls by 10% Q1 Q changes by 0%
21
0
0% 10% D
=0
P P1 P2
Q
Doesnt obey the Law of Demand
2008 Nelson Education Ltd.
Inelasticdemand
< 10% < 1 % change in Q Price elasticity = = of demand % change in P 10% D curve: relatively steep Consumers price sensitivity: relatively low Elasticity: <1 P falls by 10% Q1 Q2 Q rises less than 10%
2008 Nelson Education Ltd.
0
P P1 P2 D Q
22
Unitelasticdemand
% change in Q Price elasticity = = of demand % change in P D curve: intermediate slope Consumers price sensitivity: intermediate Elasticity: 1 P falls by 10% Q1 Q2 P1 P2 D P 10% 10% =1
0
Q
Q rises by 10%
2008 Nelson Education Ltd.
23
Elasticdemand
> 10% % change in Q Price elasticity = = of demand % change in P 10% D curve: relatively flat Consumers price sensitivity: relatively high Elasticity: >1 P falls by 10% Q1 Q2 P1 P2 D P >1
0
Q
Q rises more than 10%
2008 Nelson Education Ltd.
24
Perfectlyelasticdemand(theotherextreme)
any % % change in Q Price elasticity = infinity = = of demand 0% % change in P D curve: horizontal Consumers price sensitivity: extreme Elasticity: infinity P changes by 0% Q1 Q2 P P2 = P1 D
0
Q
Q changes by any %
2008 Nelson Education Ltd.
25
ElasticityofaLinearDemandCurve
P $30 20 10 $0 200% E= = 5.0 40% 67% E= = 1.0 67% 40% E= = 0.2 200% 0 20 40 60 Q The slope of a linear demand curve is constant, but its elasticity is not.
0
2008 Nelson Education Ltd.
26
PriceElasticityandTotalRevenue
Continuing our scenario, if you raise your price
from $200 to $250, would your revenue rise or fall? Revenue = P x Q
0
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.
Which of these two effects is bigger?
It depends on the price elasticity of demand.
2008 Nelson Education Ltd.
27
PriceElasticityandTotalRevenue
Price elasticity of demand = Percentage in change Q Percentage change in P
0
Revenue = P x Q
If demand is elastic, then
price elast. of demand > 1 % change in Q > % change in P
The fall in revenue from lower Q is greater
than the increase in revenue from higher P, so revenue falls.
2008 Nelson Education Ltd.
28
PriceElasticityandTotalRevenue
Elastic demand (elasticity = 1.8) If P = $200, Q = 12 and revenue = $2400. If P = $250, Q = 8 and revenue = $2000. When D is elastic, a price increase causes revenue to fall.
2008 Nelson Education Ltd.
0
P
increased revenue due to higher P
$250 $200
lost revenue due to lower Q D
8
12
Q
29
PriceElasticityandTotalRevenue
Price elasticity of demand = Percentage change in Q Percentage change in P Revenue = P x Q
0
If demand is inelastic, then
price elast. of demand < 1 % change in Q < % change in P
The fall in revenue from lower Q is smaller
than the increase in revenue from higher P, so revenue rises.
In our example, suppose that Q only falls to 10 (instead
of 8) when you raise your price to $250.
2008 Nelson Education Ltd.
30
PriceElasticityandTotalRevenue
Now, demand is inelastic: elasticity = 0.82 If P = $200, Q = 12 and revenue = $2400. If P = $250, Q = 10 and revenue = $2500. increased revenue due to higher P
0
P
$250 $200
lost revenue due to lower Q
D Q
When D is inelastic, a price increase causes revenue to rise.
2008 Nelson Education Ltd.
10
12
31
ACTIVELEARNING2:
Elasticityandexpenditure/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 cruise falls 20%. Does luxury cruise companies total revenue rise or fall?
32
ACTIVELEARNING2:
Answers
A. Pharmacies raise the price of insulin by 10%. Does total expenditure on insulin rise or fall? Expenditure = P x Q Since demand is inelastic, Q will fall less than 10%, so expenditure rises. B. The fall in P reduces revenue, but Q increases, which increases revenue. Which effect if bigger? Since demand is elastic. Q will increase more than 20%, so revenue rises
33
APPLICATION:DoesDrugInterdiction IncreaseorDecreaseDrugRelatedCrime?
One side effect of illegal drug use is crime: Users often
turn to crime to finance their habit.
0
We examine two policies designed to reduce illegal drug
use and see what effects they have on drug-related crime.
For simplicity, we assume the total dollar value of drugrelated crime equals total expenditure on drugs.
Demand for illegal drugs is inelastic, due to addiction
issues.
2008 Nelson Education Ltd.
34
Policy1:Interdiction
Interdiction reduces the supply of drugs. Since demand for drugs is inelastic, P rises proportionally more than Q falls. Price of Drugs P2 P1 new value of drugrelated crime S2 D1
0
S1
initial value of drugrelated crime Q2 Q 1 Quantity of Drugs
35
Result: an increase in total spending on drugs, and in drug-related crime
2008 Nelson Education Ltd.
Policy2:Education
Education reduces the demand for drugs. P and Q fall. Result: A decrease in total spending on drugs, and in drug-related crime. P1 P2 Q2 Q 1 Price of Drugs new value of drugrelated crime D2 D1 S
0
initial value of drugrelated crime Quantity of Drugs
36
2008 Nelson Education Ltd.
PriceElasticityofSupply
Price elasticity of supply = Percentage change in Qs Percentage change in P
0
Price elasticity of supply measures how much Qs
responds to a change in P.
Loosely speaking, it measures the price-sensitivity of
sellers supply.
Again, use the midpoint method to compute the
percentage changes.
2008 Nelson Education Ltd.
37
PriceElasticityofSupply
Price elasticity of supply Example: Price elasticity of supply equals = Percentage change in Qs Percentage change in P P P rises P2 by 8% P1
0
S
16%
8%
= 2.0
Q1 Q rises by 16%
Q2
Q
2008 Nelson Education Ltd.
38
TheVarietyofSupplyCurves
Economists classify supply curves according to their
elasticity.
0
The slope of the supply curve is closely related to price
elasticity of supply.
Rule of thumb:
The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity.
The next 5 slides present the different classifications,
from least to most elastic.
2008 Nelson Education Ltd.
39
Perfectlyinelastic(oneextreme)
% change in Q Price elasticity = = of supply % change in P S curve: vertical Sellers price sensitivity: 0 Elasticity: 0 P rises by 10% Q1 Q changes by 0%
2008 Nelson Education Ltd.
0
0% 10% S
=0
P P2 P1
Q
40
Inelastic
< 10% % change in Q Price elasticity = = of supply % change in P 10% S curve: relatively steep Sellers price sensitivity: relatively low Elasticity: <1 P rises by 10% Q1 Q2 Q rises less than 10%
2008 Nelson Education Ltd.
0
<1
P P2 P1
S
Q
41
Unitelastic
% change in Q Price elasticity = = of supply % change in P S curve: intermediate slope Sellers price sensitivity: intermediate Elasticity: =1 P rises by 10% Q1 Q2 P1 P S P2 10% 10% =1
0
Q
Q rises by 10%
2008 Nelson Education Ltd.
42
Elastic
> 10% % change in Q Price elasticity >1 = = of supply 10% % change in P S curve: relatively flat Sellers price sensitivity: relatively high Elasticity: >1 P rises by 10% Q1 Q2 P1 P S P2
0
Q
Q rises more than 10%
2008 Nelson Education Ltd.
43
Perfectlyelastic(theotherextreme)
0
any % % change in Q Price elasticity = infinity = = of supply 0% % change in P S curve: horizontal Sellers price sensitivity: extreme Elasticity: infinity P changes by 0% Q1 Q2 Q changes by any %
2008 Nelson Education Ltd.
P P2 = P1 S
Q
44
TheDeterminantsofSupplyElasticity
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.
2008 Nelson Education Ltd.
45
ACTIVELEARNING3:
Elasticityandchangesinequilibrium
The supply of beachfront property is inelastic. The
supply of new cars is elastic.
Suppose population growth causes
demand for both goods to double (at each price, Qd doubles).
For which product will P change the most? For which product will Q change the most?
46
HowthePriceElasticityofSupplyCanVary
0
P
$15 12
elasticity <1
S
Supply often becomes less elastic as Q rises, due to capacity limits.
4 $3
elasticity >1 Q
500 525
2008 Nelson Education Ltd.
100 200
47
OtherElasticities
The income elasticity of demand measures the
response of Qd to a change in consumer income. Income elasticity of = demand Percent change in Qd Percent change in income
Recall from chap.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.
2008 Nelson Education Ltd.
48
OtherElasticities
Note that income elasticity also has 2
components for normal goods
If elasticity is between 0 and 1, then the good is
necessity and although consumption rises when income rises, it does not rise as quickly
If elasticity is greater than 1, we say the good is
a luxury and consumption rises faster than income
2008 Nelson Education Ltd.
49
OtherElasticities
The cross-price elasticity of demand measures the
response of demand for one good to changes in the price of another good. Cross-price elast. of demand = % change in Qd for good 1 % 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.
2008 Nelson Education Ltd.
50
CHAPTER SUMMARY
Elasticity measures the responsiveness of
Qd or Qs to one of its determinants.
Price elasticity of demand equals percentage change Qd
in divided by percentage change in P. When its 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.
2008 Nelson Education Ltd.
51
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 its 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.
2008 Nelson Education Ltd.
52
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.
2008 Nelson Education Ltd.
53
End: Chapter 5
2008 Nelson Education Ltd.
54