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N. Gregory Mankiw

Economics Principles of Sixth Edition

5

Elasticity and its Application

Premium PowerPoint

Slides by Ron Cronovich

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?

1

A scenario…

You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per 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 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?

2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Elasticity

§ Basic idea:

§ One type of elasticity measures how much demand for your websites will fall if you raise your price.

§ Definition: Elasticity is

3

Price Elasticity of Demand

Price elasticity of demand =

§ Price elasticity of demand measures

§ Loosely speaking, it measures

4

Price Elasticity of Demand

Example:

P

Price elasticity

of demand

equals

D

Q

5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Price Elasticity of Demand

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.

6

Calculating Percentage Changes

P

$250 $200

Standard method

Demand for your websites

B

of computing the percentage (%) change:

end value – start value x 100% start value

A D Q

8 12

Going from A to B, the % change in P equals

($250–$200)/$200 = 25%

7

Calculating Percentage Changes

Problem:

P

$250 $200

Demand for your websites

B A D Q

8 12

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

8

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Calculating Percentage Changes

§ So, we instead use the midpoint method:

§ The midpoint is

§ It doesn’t matter which value you use as the

start and which as the end—you get the same answer either way!

9

Calculating Percentage Changes

§ Using the midpoint method, the % change in P equals

§ The % change in Q equals

§ The price elasticity of demand equals

10

1 A C T I V E L E A R N I N G

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

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What determines price elasticity?

To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. In each example:

§ 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?

13

EXAMPLE 1:

Breakfast Cereal vs. Sunscreen

§ The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why?

§ Lesson:

14

EXAMPLE 2:

“Blue Jeans” vs. “Clothing”

§ The prices of both goods rise by 20%. For which good does Qd drop the most? Why?

§ Lesson: 15

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

EXAMPLE 3:

Insulin vs. Caribbean Cruises

§ The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why?

§ Lesson:

16

EXAMPLE 4:

Gasoline in the Short Run vs. Gasoline in the Long Run

§ The price of gasoline rises 20%. Does Qd drop more in the short run or the long run? Why?

§ Lesson:

17

The Determinants of Price Elasticity: A Summary The price elasticity of demand depends on:

18

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Variety of Demand Curves

§ The price elasticity of demand is closely related to the slope of the demand curve.

§ Rule of thumb:

§ Five different classifications of D curves.…

19

“Perfectly inelastic demand” (one extreme case)

Price elasticity % change in Q

of demand

=

=

% change in P

D curve:

P

D

Consumers’

P1

price sensitivity:

Elasticity:

Q Q1

20

“Inelastic demand”

Price elasticity % change in Q

of demand

=

=

% change in P

D curve:

P

Consumers’ price sensitivity:

Elasticity:

P1

D Q

Q1

21

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

“Unit elastic demand”

Price elasticity % change in Q

of demand

=

=

% change in P

D curve:

P

Consumers’

P1

price sensitivity:

Elasticity:

Q1

D Q

22

“Elastic demand”

Price elasticity % change in Q

of demand

=

=

% change in P

D curve:

P

Consumers’

P1

price sensitivity:

Elasticity:

Q1

D Q

23

“Perfectly elastic demand” (the other extreme)

Price elasticity % change in Q

of demand

=

=

% change in P

D curve:

P

Consumers’

P2 = P1

D

price sensitivity:

Elasticity:

Q Q1

24

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A few elasticities from the real world

Eggs

0.1

Healthcare

0.2

Rice

0.5

Housing

0.7

Beef

1.6

Restaurant meals

2.3

Mountain Dew

4.4

25

Elasticity of a Linear Demand Curve

P $30

20

10

$0

Q

0 20 40 60

The slope of a linear demand curve is constant, but its elasticity is not.

26

Price Elasticity and Total Revenue

§ Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall? Revenue = P x Q

§ A price increase has two effects on revenue:

§ Which of these two effects is bigger? It depends on the price elasticity of demand.

27

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Price Elasticity and Total Revenue

Price elasticity = of demand

Percentage change in Q Percentage change in P

Revenue = P x Q § If demand is elastic, then

28

Price Elasticity and Total Revenue

Elastic demand (elasticity = 1.8)

If P = $200, Q = 12 and revenue = ______

If P = $250, Q = 8 and revenue = ______

P

$250 $200

Demand for your websites

D

When D is elastic,

8

a price increase

causes revenue to __________.

Q 12

29

Price Elasticity and Total Revenue

Price elasticity = of demand

Percentage change in Q Percentage change in P

§ If demand is inelastic, then Revenue = P x Q

§ In our example, suppose that Q only falls to 10 (instead of 8) when you raise your price to $250. 30

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Economics Principles of Sixth Edition

5

Elasticity and its Application

Premium PowerPoint

Slides by Ron Cronovich

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?

1

A scenario…

You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per 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 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?

2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Elasticity

§ Basic idea:

§ One type of elasticity measures how much demand for your websites will fall if you raise your price.

§ Definition: Elasticity is

3

Price Elasticity of Demand

Price elasticity of demand =

§ Price elasticity of demand measures

§ Loosely speaking, it measures

4

Price Elasticity of Demand

Example:

P

Price elasticity

of demand

equals

D

Q

5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Price Elasticity of Demand

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.

6

Calculating Percentage Changes

P

$250 $200

Standard method

Demand for your websites

B

of computing the percentage (%) change:

end value – start value x 100% start value

A D Q

8 12

Going from A to B, the % change in P equals

($250–$200)/$200 = 25%

7

Calculating Percentage Changes

Problem:

P

$250 $200

Demand for your websites

B A D Q

8 12

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

8

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Calculating Percentage Changes

§ So, we instead use the midpoint method:

§ The midpoint is

§ It doesn’t matter which value you use as the

start and which as the end—you get the same answer either way!

9

Calculating Percentage Changes

§ Using the midpoint method, the % change in P equals

§ The % change in Q equals

§ The price elasticity of demand equals

10

1 A C T I V E L E A R N I N G

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

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What determines price elasticity?

To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. In each example:

§ 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?

13

EXAMPLE 1:

Breakfast Cereal vs. Sunscreen

§ The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why?

§ Lesson:

14

EXAMPLE 2:

“Blue Jeans” vs. “Clothing”

§ The prices of both goods rise by 20%. For which good does Qd drop the most? Why?

§ Lesson: 15

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

EXAMPLE 3:

Insulin vs. Caribbean Cruises

§ The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why?

§ Lesson:

16

EXAMPLE 4:

Gasoline in the Short Run vs. Gasoline in the Long Run

§ The price of gasoline rises 20%. Does Qd drop more in the short run or the long run? Why?

§ Lesson:

17

The Determinants of Price Elasticity: A Summary The price elasticity of demand depends on:

18

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Variety of Demand Curves

§ The price elasticity of demand is closely related to the slope of the demand curve.

§ Rule of thumb:

§ Five different classifications of D curves.…

19

“Perfectly inelastic demand” (one extreme case)

Price elasticity % change in Q

of demand

=

=

% change in P

D curve:

P

D

Consumers’

P1

price sensitivity:

Elasticity:

Q Q1

20

“Inelastic demand”

Price elasticity % change in Q

of demand

=

=

% change in P

D curve:

P

Consumers’ price sensitivity:

Elasticity:

P1

D Q

Q1

21

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

“Unit elastic demand”

Price elasticity % change in Q

of demand

=

=

% change in P

D curve:

P

Consumers’

P1

price sensitivity:

Elasticity:

Q1

D Q

22

“Elastic demand”

Price elasticity % change in Q

of demand

=

=

% change in P

D curve:

P

Consumers’

P1

price sensitivity:

Elasticity:

Q1

D Q

23

“Perfectly elastic demand” (the other extreme)

Price elasticity % change in Q

of demand

=

=

% change in P

D curve:

P

Consumers’

P2 = P1

D

price sensitivity:

Elasticity:

Q Q1

24

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A few elasticities from the real world

Eggs

0.1

Healthcare

0.2

Rice

0.5

Housing

0.7

Beef

1.6

Restaurant meals

2.3

Mountain Dew

4.4

25

Elasticity of a Linear Demand Curve

P $30

20

10

$0

Q

0 20 40 60

The slope of a linear demand curve is constant, but its elasticity is not.

26

Price Elasticity and Total Revenue

§ Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall? Revenue = P x Q

§ A price increase has two effects on revenue:

§ Which of these two effects is bigger? It depends on the price elasticity of demand.

27

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Price Elasticity and Total Revenue

Price elasticity = of demand

Percentage change in Q Percentage change in P

Revenue = P x Q § If demand is elastic, then

28

Price Elasticity and Total Revenue

Elastic demand (elasticity = 1.8)

If P = $200, Q = 12 and revenue = ______

If P = $250, Q = 8 and revenue = ______

P

$250 $200

Demand for your websites

D

When D is elastic,

8

a price increase

causes revenue to __________.

Q 12

29

Price Elasticity and Total Revenue

Price elasticity = of demand

Percentage change in Q Percentage change in P

§ If demand is inelastic, then Revenue = P x Q

§ In our example, suppose that Q only falls to 10 (instead of 8) when you raise your price to $250. 30

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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