5 Elasticity and its Application PRINCIPLES OF FOURTH EDITION N G R E G O R Y M A N K I W PowerPoint® Slides by Ron Cronovich © 2007 Thomson South-Western, all rights reserved 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? CHAPTER ELASTICITY AND ITS APPLICATION 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 opp opp cost cost of of your your time), time), so so you’re you’re thinking thinking of of 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 ELASTICITY AND ITS APPLICATION 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 CHAPTER ELASTICITY AND ITS APPLICATION Price Elasticity of Demand Price elasticity of demand = Percentage change in Qd Percentage change in P  Price elasticity of demand measures how much Qd responds to a change in P  Loosely speaking, it measures the pricesensitivity of buyers’ demand CHAPTER ELASTICITY AND ITS APPLICATION Price Elasticity of Demand Price elasticity of demand Example: Price elasticity of demand equals 15% = 1.5 10% CHAPTER = 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 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 P P2 P1 ELASTICITY AND ITS APPLICATION D Q2 Q1 Q Calculating Percentage Changes Standard method of computing the percentage (%) change: Demand for your websites end value – start value x 100% start value P $250 B A $200 D CHAPTER 12 Going from A to B, the % change in P equals ($250–$200)/$200 = 25% Q ELASTICITY AND ITS APPLICATION 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 From B to A, P falls 20%, Q rises 50%, Q elasticity = 50/20 = 2.50 D CHAPTER 12 ELASTICITY AND ITS APPLICATION Calculating Percentage Changes  So, we instead use the midpoint method: end value – start value x 100% midpoint  The midpoint is the number halfway between the start & end values, also the average of those values  It doesn’t matter which value you use as the “start” and which as the “end” – you get the same answer either way! CHAPTER ELASTICITY AND ITS APPLICATION 10 “Perfectly inelastic” (one extreme) Price elasticity of supply = % change in Q % change in P CHAPTER 10% =0 S P2 Sellers’ price sensitivity: Elasticity: = P S curve: vertical 0% P1 P rises by 10% Q1 Q Q changes by 0% ELASTICITY AND ITS APPLICATION 41 “Inelastic” Price elasticity of supply = % change in Q % change in P P S curve: relatively steep CHAPTER 10% 1 = > 10% P1 P rises by 10% Q1 Q2 Q Q rises more than 10% ELASTICITY AND ITS APPLICATION 44 “Perfectly elastic” (the other extreme) Price elasticity of supply = % change in Q % change in P Elasticity: infinity CHAPTER 0% = infinity P S curve: horizontal Sellers’ price sensitivity: extreme = any % S P2 = P1 P changes by 0% Q1 Q2 Q Q changes by any % ELASTICITY AND ITS APPLICATION 45 The Determinants of Supply Elasticity  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 CHAPTER ELASTICITY AND ITS APPLICATION 46 3: Elasticity and changes in equilibrium ACTIVE LEARNING  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? 47 ACTIVE LEARNING Answers When supply is inelastic, an increase in demand has a bigger impact on price than on quantity 3: Beachfront property (inelastic supply): P S D1 D2 B P2 P1 A Q1 Q2 Q 48 ACTIVE LEARNING Answers When supply is elastic, an increase in demand has a bigger impact on quantity than on price 3: New cars (elastic supply): P D1 D2 S P2 P1 B A Q1 Q2 Q 49 How the Price Elasticity of Supply Can Vary P elasticity 1 $3 100 200 CHAPTER Q 500 525 ELASTICITY AND ITS APPLICATION 50 Other Elasticities  The 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  Recall from chap.4: An increase in income causes an increase in demand for a normal good  Hence, for normal goods, income elasticity >  For inferior goods, income elasticity < CHAPTER ELASTICITY AND ITS APPLICATION 51 Other Elasticities  The 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 Cross-price elast = of demand % change in price of good  For substitutes, cross-price elasticity > E.g., an increase in price of beef causes an increase in demand for chicken  For complements, cross-price elasticity < E.g., an increase in price of computers causes decrease in demand for software CHAPTER ELASTICITY AND ITS APPLICATION 52 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 it’s 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 CHAPTER ELASTICITY AND ITS APPLICATION 53 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 it’s 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 CHAPTER ELASTICITY AND ITS APPLICATION 54 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 CHAPTER ELASTICITY AND ITS APPLICATION 55 [...]... demand = % change in Q % change in P P D curve: vertical CHAPTER 5 10% =0 D P1 Consumers’ price sensitivity: 0 Elasticity: 0 = 0% P2 P falls by 10% Q1 Q Q changes by 0% ELASTICITY AND ITS APPLICATION 21 “Inelastic demand” Price elasticity of demand = % change in Q % change in P P1 Consumers’ price sensitivity: relatively low CHAPTER 5 10% ... measures how much Qd responds to a change in P  Loosely speaking, it measures the pricesensitivity of buyers’ demand CHAPTER ELASTICITY AND ITS APPLICATION Price Elasticity of Demand Price elasticity... 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... demand = % change in Q % change in P P D curve: vertical CHAPTER 10% =0 D P1 Consumers’ price sensitivity: Elasticity: = 0% P2 P falls by 10% Q1 Q Q changes by 0% ELASTICITY AND ITS APPLICATION 21