03 elasticity

BellringerBellringer
Which of the following goods do you think theWhich of the following goods do you think the
government would be most likely to be concernedgovernment would be most likely to be concerned
its price and why?its price and why?
Mankiw Chapter 5 - Elasticity

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weekweek
start of class, topics: ???start of class, topics: ???

ElasticElastic
 Elastic DemandElastic Demand
 Very responsiveVery responsive
to price changeto price change
 Most normalMost normal
goodsgoods
 Rare purchasesRare purchases
 Big budgetBig budget
 Many substitutesMany substitutes
 Why important toWhy important to
think about as athink about as a
firm?firm?
Price/month
Quantity
D-nice apartments
1000
500
100
1000 5000 10,000

InelasticInelastic
 Inelastic DemandInelastic Demand
 Not responsive toNot responsive to
price changeprice change
 Few substitutesFew substitutes
 Small part of budgetSmall part of budget
 Most goods, close toMost goods, close to
needsneeds
 Ex: lifesaversEx: lifesavers
 Why doesWhy does
government oftengovernment often
control prices ofcontrol prices of
inelastic goods?inelastic goods?
 Illegal drugs?Illegal drugs?
Price/dose
Quantity
D-dialysis100
1 2 3
200
300
400
500
600
700

7
EXAMPLE 1:EXAMPLE 1:
Breakfast cereal vs. SunscreenBreakfast cereal vs. Sunscreen
 The prices of both of these goods rise by 20%.The prices of both of these goods rise by 20%.
For which good doesFor which good does QQdd
drop the most? Why?drop the most? Why?
 Breakfast cereal has close substitutesBreakfast cereal has close substitutes
((e.ge.g., pancakes, waffles, leftover pizza),., pancakes, waffles, leftover pizza),
so buyers can easily switch if the price rises.so buyers can easily switch if the price rises.
 Sunscreen has no close substitutes,Sunscreen has no close substitutes,
so consumers would probably notso consumers would probably not
buy much less if its price rises.buy much less if its price rises.
 Lesson:Lesson: Price elasticity is higher when
close substitutes are available.

8
“Blue Jeans” vs.“Blue Jeans” vs.
“Clothing”“Clothing” The prices of both goods rise by 20%.The prices of both goods rise by 20%.
 For a narrowly defined good such asFor a narrowly defined good such as
blue jeans, there are many substitutesblue jeans, there are many substitutes
(khakis, shorts, Speedos).(khakis, shorts, Speedos).
 There are fewer substitutes available forThere are fewer substitutes available for
broadly defined goods.broadly defined goods.
(There aren’t too many substitutes for clothing,(There aren’t too many substitutes for clothing,
other than living in a nudist colony.)other than living in a nudist colony.)
 Lesson:Lesson: Price elasticity is higher for narrowlyPrice elasticity is higher for narrowly
defined goods than broadly defined ones.defined goods than broadly defined ones.

9
Insulin vs. CaribbeanInsulin vs. Caribbean
CruisesCruises The prices of both of these goods rise by 20%.The prices of both of these goods rise by 20%.
 To millions of diabetics, insulin is a necessity.To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or noA rise in its price would cause little or no
decrease in demand.decrease in demand.
 A cruise is a luxury. If the price rises,A cruise is a luxury. If the price rises,
some people will forego it.some people will forego it.
 Lesson:Lesson: Price elasticity is higher forPrice elasticity is higher for
luxuries than for necessities.luxuries than for necessities.

10
How to calculate Price Elasticity ofHow to calculate Price Elasticity of
DemandDemand
 Price elasticity of demandPrice elasticity of demand measuresmeasures
how muchhow much QQdd
responds to a change inresponds to a change in PP..
Price elasticity
of demand
=
Percentage change in Qd
Percentage change in P
 Loosely speaking, it measures the price-
sensitivity of buyers’ demand.

Price Elasticity ofPrice Elasticity of
DemandDemand
Price elasticityPrice elasticity
of demandof demand
equalsequals
P
Q
D
Q2
P2
P1
Q1
P rises
by 10%
Q falls
by 15%
15%
10%
= 1.5
Price elasticity
of demand
=
Example:

Price Elasticity ofPrice Elasticity of
DemandDemand
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.
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.
P
Q
D
Q2
P2
P1
Q1
Price elasticity
of demand
=

Calculating PercentageCalculating Percentage
Changes %Changes %
P
Q
D
$250
8
B
$200
12
A
Demand for
iphones
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%
New – Old
Old
x 100%

ChangesChanges
D
$250
8
B
$200
12
A
Demand for
iphones
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
P
Q

ChangesChanges So, we instead use theSo, we instead use the midpoint methodmidpoint method::
end value – start value
midpoint
x 100%
 The midpoint is the number halfway between
the start & end values, 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!

Calculating Percentage
Changes
 Using the midpoint method, the % changeUsing the midpoint method, the % change
inin PP equalsequals
$250 – $200
$225
x 100% = 22.2%
 The % change in Q equals
12 – 8
10
x 100% = 40.0%
 The price elasticity of demand equals
40/22.2 = 1.8

A C T I V E L E A R N I N GA C T I V E L E A R N I N G 11
Calculate an elasticityCalculate 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

A C T I V E L E A R N I N GA C T I V E L E A R N I N G 11
AnswersAnswers
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

Q1
P1
D
““Perfectly inelastic demand”Perfectly inelastic demand”
(one extreme case)(one extreme case)
P
Q
P2
P falls
by 10%
Q changes
by 0%
0%
10%
= 0
Price elasticity
of demand
=
% change in Q
% change in P
=
Consumers’
price sensitivity:
D curve:
Elasticity:
vertical
none
0

D
““Inelastic demand”Inelastic demand”
P
Q
Q1
P1
Q2
P2
Q rises less
than 10%
< 10%
10%
< 1
Price elasticity
of demand
=
% change in Q
% change in P
=
P falls
by 10%
Consumers’
price sensitivity:
D curve:
Elasticity:
relatively steep
relatively low
< 1

D
““Unit elastic demand”Unit elastic demand”
P
Q
Q1
P1
Q2
P2
Q rises by 10%
10%
10%
= 1
Price elasticity
of demand
=
% change in Q
% change in P
=
P falls
by 10%
Consumers’
price sensitivity:
Elasticity:
intermediate
1
D curve:
intermediate slope

D
““Elastic demand”Elastic demand”
P
Q
Q1
P1
Q2
P2
Q rises more
than 10%
> 10%
10%
> 1
Price elasticity
of demand
=
% change in Q
% change in P
=
P falls
by 10%
Consumers’
price sensitivity:
D curve:
Elasticity:
relatively flat
relatively high
> 1

D
““Perfectly elastic demand”Perfectly elastic demand”
P
Q
P1
Q1
P changes
by 0%
Q changes
by any %
any %
0%
= infinity
Q2
P2 =
Consumers’
price sensitivity:
D curve:
Elasticity:
infinity
horizontal
extreme
Price elasticity
of demand
=
% change in Q
% change in P
=

One Final Test ofOne Final Test of
elasticityelasticity
 Revenue TestRevenue Test
 TR = Price X QdTR = Price X Qd
 If in Price causes an
Total Revenue then D is
inelastic (consumers don’t
change Qd)
 If in Price causes in
Total Revenue then D is
elastic (consumers do
change Qd)

03 elasticity

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