Book: Priciples of Macroeconomics Writer: G. Mankew Chapter: 5 Elasticity and its Applications

1. Chapter 5Chapter 5
Elasticity and its
Applications
© 2002 by Nelson, a division of Thomson Canada Limited© 2002 by Nelson, a division of Thomson Canada Limited

2. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 2
• Learn the meaning of the elasticity of
demand.
• Examine what determines the elasticity of
demand.
• Learn the meaning of the elasticity of
supply.
• Examine what determines the elasticity of
supply.
• Apply the concept of elasticity in three
different markets.
• Learn the meaning of the elasticity of
demand.
• Examine what determines the elasticity of
demand.
• Learn the meaning of the elasticity of
supply.
• Examine what determines the elasticity of
supply.
• Apply the concept of elasticity in three
different markets.
In this chapter you will…In this chapter you will…

3. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 3
• … allows us to analyze supply and
demand with greater precision.
• … is a measure of how much buyers and
sellers respond to changes in market
conditions
• … allows us to analyze supply and
demand with greater precision.
• … is a measure of how much buyers and
sellers respond to changes in market
conditions
THE ELASTICITY OF DEMANDTHE ELASTICITY OF DEMAND

4. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 4
• Price elasticity of demand is a measure of
how much the quantity demanded of a
good responds to a change in the price of
that good.
• Price elasticity of demand is the
percentage change in quantity demanded
given a percent change in the price.
• Price elasticity of demand is a measure of
how much the quantity demanded of a
good responds to a change in the price of
that good.
• Price elasticity of demand is the
percentage change in quantity demanded
given a percent change in the price.
Price Elasticity of DemandPrice Elasticity of Demand

5. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 5
• Availability of Close Substitutes
• Necessities versus Luxuries
• Definition of the Market
• Time Horizon
• Availability of Close Substitutes
• Necessities versus Luxuries
• Definition of the Market
• Time Horizon
The Price Elasticity of Demand and ItsThe Price Elasticity of Demand and Its
DeterminantsDeterminants

6. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 6
• Demand tends to be more elastic:
– the larger the number of close
substitutes.
– if the good is a luxury.
– the more narrowly defined the market.
– the longer the time period.
• Demand tends to be more elastic:
– the larger the number of close
substitutes.
– if the good is a luxury.
– the more narrowly defined the market.
– the longer the time period.
The Price Elasticity of Demand and ItsThe Price Elasticity of Demand and Its
DeterminantsDeterminants

7. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 7
• The price elasticity of demand is
computed as the percentage change in the
quantity demanded divided by the
percentage change in price.
• The price elasticity of demand is
computed as the percentage change in the
quantity demanded divided by the
percentage change in price.
Computing the Price Elasticity of DemandComputing the Price Elasticity of Demand
Priceelasticity of demand=
Percentagechangeinquantity demanded
Percentagechangeinprice

8. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 8
• The midpoint formula is preferable when
calculating the price elasticity of demand
because it gives the same answer
regardless of the direction of the change.
• point Method: A Better Way to Calculate Percentage
Changes and Elasticities
• The midpoint formula is preferable when
calculating the price elasticity of demand
because it gives the same answer
regardless of the direction of the change.
• point Method: A Better Way to Calculate Percentage
Changes and Elasticities
The Midpoint Method: A Better Way toThe Midpoint Method: A Better Way to
Calculate Percentage Changes and ElasticitiesCalculate Percentage Changes and Elasticities
(Q2 - Q1) / [(Q2 + Q1) / 2]
(P2 - P1) / [(P2 + P1) / 2]
Price elasticity of demand =

9. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 9
• From Point A to Point B: Price rise = 50% and Quantity fall = 33%
• From Point B to Point A: Price fall = 33% and Quantity rise = 50%
• From Point A to Point B: Price rise = 50% and Quantity fall = 33%
• From Point B to Point A: Price fall = 33% and Quantity rise = 50%
The Midpoint Method: A Better Way toThe Midpoint Method: A Better Way to
Calculate Percentage Changes and ElasticitiesCalculate Percentage Changes and Elasticities
(80 - 120) /[(80 + 120)/ 2]
(6 - 4) / [(6 + 4)/ 2]
Price elasticity of demand =
• Point A: Price = $4 Quantity = 120
• Point B: Price = $6 Quantity = 80
• Point A: Price = $4 Quantity = 120
• Point B: Price = $6 Quantity = 80
= 1
Mid point method

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

11. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 11
• Perfectly Inelastic
– Quantity demanded does not respond to
price changes.
• Perfectly Elastic
– Quantity demanded changes infinitely
with any change in price.
• Unit Elastic
– Quantity demanded changes by the
same percentage as the price.
• Perfectly Inelastic
– Quantity demanded does not respond to
price changes.
• Perfectly Elastic
– Quantity demanded changes infinitely
with any change in price.
• Unit Elastic
– Quantity demanded changes by the
same percentage as the price.
A Variety of Demand CurvesA Variety of Demand Curves

12. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 12
• Because the price elasticity of demand
measures how much quantity demanded
responds to the price, it is closely related
to the slope of the demand curve.
• Because the price elasticity of demand
measures how much quantity demanded
responds to the price, it is closely related
to the slope of the demand curve.
A Variety of Demand CurvesA Variety of Demand Curves

13. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 13
E = 0
0 Quantity
Price
Demand
100
1. An increase
in price…
$4.00
$5.00
2. …leaves the quantity demanded unchanged.
Figure 5-1 a): Perfectly Inelastic DemandFigure 5-1 a): Perfectly Inelastic Demand

14. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 14
E < 1
0 Quantity
Price
100
1. A 22%
increase in
price…
$5.00
2. … Leads to a 11% decrease in quantity demanded.
Demand
$4.00
90
Figure 5-1 b): Inelastic DemandFigure 5-1 b): Inelastic Demand

15. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 15
E = 1
0 Quantity
Price
100
1. A 22%
increase in
price…
$5.00
2. … Leads to a 22% decrease in quantity demanded.
Demand
$4.00
80
Figure 5-1 c): Unit Elastic DemandFigure 5-1 c): Unit Elastic Demand

16. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 16
E > 1
0 Quantity
Price
100
1. A 22%
increase in
price…
$5.00
2. … Leads to a 67% decrease in quantity demanded.
Demand
$4.00
50
Figure 5-1 d): Elastic DemandFigure 5-1 d): Elastic Demand

17. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 17
E = ∞
0
Quantity
Price
2. At exactly $4, consumers will buy any quantity.
$4.00 Demand
1. At any price above $4, quantity
demanded is zero.
3. At any price below $4, quantity demanded is
infinite.
Figure 5-1 e): Perfectly Elastic DemandFigure 5-1 e): Perfectly Elastic Demand

18. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 18
• Total revenue is the amount paid by
buyers and received by sellers of a good.
• Computed as the price of the good times
the quantity sold.
TR = P x Q
• Total revenue is the amount paid by
buyers and received by sellers of a good.
• Computed as the price of the good times
the quantity sold.
TR = P x Q
Total Revenue and the Price Elasticity ofTotal Revenue and the Price Elasticity of
DemandDemand

19. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 19
Price
Quantity0 100
Demand
P x Q = $400
(revenue)
$4.00
Figure 5-2: Total RevenueFigure 5-2: Total Revenue

20. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 20
Price
Quantity0 80
Demand
$3.00
P x Q = $400
(revenue)
P x Q = $100
(revenue)
$1.00
100
Figure 5-3: How Total Revenue ChangesFigure 5-3: How Total Revenue Changes
When Prices Changes: Inelastic DemandWhen Prices Changes: Inelastic Demand

21. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 21
Price
Quantity
Change in Total Revenue when Price Changes
0 50
Demand
$4.00
$5.00
20
Revenue = $100
Revenue = $200
Figure 5-4: How Total Revenue ChangesFigure 5-4: How Total Revenue Changes
When Prices Changes: Elastic DemandWhen Prices Changes: Elastic Demand

22. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 22
• With an elastic demand curve, an increase
in the price leads to a decrease in quantity
demanded that is proportionately larger.
Thus, total revenue decreases.
• With an elastic demand curve, an increase
in the price leads to a decrease in quantity
demanded that is proportionately larger.
Thus, total revenue decreases.
Elasticity and Total Revenue along a LinearElasticity and Total Revenue along a Linear
Demand CurveDemand Curve

23. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 23
Table 5-1. Elasticity and Total RevenueTable 5-1. Elasticity and Total Revenue
along a Linear Demand Curvealong a Linear Demand Curve

24. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 24
Price
Quantity
2 4 6 8 10 120
6
5
4
3
2
1
7
14
Elasticity
is larger
than 1.
Elasticity
is smaller
than 1.
Figure 5-5: A Linear Demand CurveFigure 5-5: A Linear Demand Curve

25. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 25
• Income elasticity of demand measures
how much the quantity demanded of a
good responds to a change in consumers’
income.
• It is computed as the percentage change
in the quantity demanded divided by the
percentage change in income.
• Income elasticity of demand measures
how much the quantity demanded of a
good responds to a change in consumers’
income.
• It is computed as the percentage change
in the quantity demanded divided by the
percentage change in income.
Other Demand ElasticitiesOther Demand Elasticities
I n c o m e e l a s t i c i t y o f d e m a n d =
P e r c e n t a g e c h a n g e
i n q u a n t i t y d e m a n d e d
P e r c e n t a g e c h a n g e
i n i n c o m e

26. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 26
• Types of Goods
– Normal Goods
– Inferior Goods
• Higher income raises the quantity
demanded for normal goods but lowers
the quantity demanded for inferior goods.
• Types of Goods
– Normal Goods
– Inferior Goods
• Higher income raises the quantity
demanded for normal goods but lowers
the quantity demanded for inferior goods.
Other Demand ElasticitiesOther Demand Elasticities

27. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 27
• Goods consumers regard as necessities
tend to be income inelastic
– Examples include food, fuel, clothing,
utilities, and medical services.
• Goods consumers regard as luxuries tend
to be income elastic.
– Examples include sports cars, furs, and
expensive foods.
• Goods consumers regard as necessities
tend to be income inelastic
– Examples include food, fuel, clothing,
utilities, and medical services.
• Goods consumers regard as luxuries tend
to be income elastic.
– Examples include sports cars, furs, and
expensive foods.
Other Demand ElasticitiesOther Demand Elasticities

28. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 28
• Cross-Price elasticity of demand
measures how much the quantity
demanded of a good responds to a change
in the price of another good.
• It is computed as the percentage change
in the quantity demanded divided by the
percentage change in the price of the
second good.
• Cross-Price elasticity of demand
measures how much the quantity
demanded of a good responds to a change
in the price of another good.
• It is computed as the percentage change
in the quantity demanded divided by the
percentage change in the price of the
second good.
Other Demand ElasticitiesOther Demand Elasticities
Income elasticity of demand =
Percentage change
in quantity demanded
Percentage change
inthe price of
good 2.

29. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 29
• Price elasticity of supply is a measure of
how much the quantity supplied of a good
responds to a change in the price of that
good.
• Price elasticity of supply is the percentage
change in quantity supplied given a
percent change in the price.
• Price elasticity of supply is a measure of
how much the quantity supplied of a good
responds to a change in the price of that
good.
• Price elasticity of supply is the percentage
change in quantity supplied given a
percent change in the price.
PRICE ELASTICITY OF SUPPLYPRICE ELASTICITY OF SUPPLY

30. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 30
• Ability of sellers to change the amount of
the good they produce.
– Beach-front land is inelastic.
– Books, cars, or manufactured goods are
elastic.
• Time period.
– Supply is more elastic in the long run.
• Ability of sellers to change the amount of
the good they produce.
– Beach-front land is inelastic.
– Books, cars, or manufactured goods are
elastic.
• Time period.
– Supply is more elastic in the long run.
The Price Elasticity of Supply and ItsThe Price Elasticity of Supply and Its
DeterminantsDeterminants

31. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 31
• The price elasticity of supply is computed
as the percentage change in the quantity
supplied divided by the percentage
change in price.
• The price elasticity of supply is computed
as the percentage change in the quantity
supplied divided by the percentage
change in price.
Computing the Price Elasticity of SupplyComputing the Price Elasticity of Supply
P r i c e e l a s t i c i t y o f s u p p l y =
P e r c e n t a g e c h a n g e
i n q u a n t i t y s u p p l i e d
P e r c e n t a g e c h a n g e i n p r i c e

32. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 32
• … using the midpoint method, we calculate the percent change in
the price as (2.10 - 1.90) / 2.00 x 100 = 10%
• Similarly, we calculate the percent change in the quantity supplied
as (11 000 - 9000) / 10 000 x 100 = 20%
• … using the midpoint method, we calculate the percent change in
the price as (2.10 - 1.90) / 2.00 x 100 = 10%
• Similarly, we calculate the percent change in the quantity supplied
as (11 000 - 9000) / 10 000 x 100 = 20%
20%
Price elasticity of supply =
• Suppose an increase in the price of milk from $1.90 to $2.10 a litre
raises the amount that dairy farmers produce from 9000 to 11 000
L per month…
• Suppose an increase in the price of milk from $1.90 to $2.10 a litre
raises the amount that dairy farmers produce from 9000 to 11 000
L per month…
= 2.0
Computing the Price Elasticity of SupplyComputing the Price Elasticity of Supply
10%

33. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 33
E = 0
0 Quantity
Price
Supply
1. An increase
in price…
$5.00
2. …leaves the quantity supplied unchanged.
100
$4.00
Figure 5-6 a): Perfectly Inelastic SupplyFigure 5-6 a): Perfectly Inelastic Supply

34. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 34
E < 0
0 Quantity
Price
Supply
100
1. A 22%
increase in
price…
$5.00
2. …leads to a 10% increase in quantity
supplied.
$4.00
110
Figure 5-6 b): Inelastic SupplyFigure 5-6 b): Inelastic Supply

35. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 35
E = 1
0 Quantity
Price
Supply
100
1. A 22%
increase in
price…
$5.00
2. …leads to a 22% increase in quantity
supplied.
$4.00
125
Figure 5-6 c): Unit Elastic SupplyFigure 5-6 c): Unit Elastic Supply

36. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 36
E > 1
0 Quantity
Price
Supply
100
1. A 22%
increase in
price…
$5.00
2. …leads to a 67% increase in quantity
supplied.
$4.00
200
Figure 5-6 d): Elastic SupplyFigure 5-6 d): Elastic Supply

37. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 37
E = ∞
0
Quantity
Price
2. At exactly $4, producers will supply any quantity.
$4.00 Supply
1. At any price above $4, quantity
supplied is infinite.
3. At any price below $4, quantity supplied is zero.
Figure 5-6 e): Perfectly Elastic SupplyFigure 5-6 e): Perfectly Elastic Supply

38. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 38
0
Quantity
Price
$3
100
$4
200
$12
500
$15
525
Elasticity is
greater than 1
Elasticity is less
than 1
Figure 5-7:Figure 5-7: How the price elasticity of supplyHow the price elasticity of supply
can varycan vary

39. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 39
• Good news bad news for farmers
• OPEC
• Drugs and crime
• Good news bad news for farmers
• OPEC
• Drugs and crime
THREE APPLICATIONS OF SUPPLY,THREE APPLICATIONS OF SUPPLY,
DEMAND, AND ELASTICITYDEMAND, AND ELASTICITY

40. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 40
Increase in Supply
Demand
S1
$3
Quantity of Wheat
Price of
Wheat
S2
2. … leads
to a fall in
price…
3. …and a proportionately smaller increase in quantity sold. As a result revenue
falls from $300 to $220.
1. When demand is inelastic, an
increase in supply…
110100
$2
Figure 5-8:Figure 5-8: An Increase in Supply in theAn Increase in Supply in the
Market for WheatMarket for Wheat

41. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 41
Demand
S1
Quantity of Oil
Price
of Oil
S2
1. In the short run, when supply
and demand are inelastic, a shift
in supply…
2. … leads
to a large
increase in
price…
P1
P2
Demand
S1
Quantity of Oil
S2
1. In the long run, when supply
and demand are elastic, a shift in
supply…
2. … leads
to a small
increase in
price…
P1
P2
Price
of Oil
(a) Oil Market in the Short Run (b) Oil Market in the Long Run
Figure 5-9:Figure 5-9: A Reduction in Supply in theA Reduction in Supply in the
World Market for OilWorld Market for Oil

42. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 42
Demand
S1
Quantity of Drugs
Price of
Drugs
S2
1. Drug interdiction reduces the
supply of drugs…
2. … which
raises the
price…
P1
P2
D1
Supply
1. Drug education reduces the
demand for drugs…
2. … which
reduces the
price…
(a) Drug Interdiction (b) Drug Education
Q1Q2
3. … and reduces the
quantity sold.
Q2
3. … and reduces the quantity
sold.
Quantity of Drugs
Price of
Drugs
D2
P1
Q1
P2
Figure 5-10:Figure 5-10: Policies to Reduce the of IllegalPolicies to Reduce the of Illegal
DrugsDrugs

43. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 43
• Price elasticity of demand measures how much
the quantity demanded responds to changes in
the price.
• Price elasticity of demand is calculated as the
percentage change in quantity demanded divided
by the percentage change in price.
• If a demand curve is elastic, total revenue falls
when the price rises.
• If it is inelastic, total revenue rises as the price
rises.
• Price elasticity of demand measures how much
the quantity demanded responds to changes in
the price.
• Price elasticity of demand is calculated as the
percentage change in quantity demanded divided
by the percentage change in price.
• If a demand curve is elastic, total revenue falls
when the price rises.
• If it is inelastic, total revenue rises as the price
rises.
SummarySummary

44. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 44
• The income elasticity of demand measures how
much the quantity demanded responds to
changes in consumers’ income.
• The cross-price elasticity of demand measures
how much the quantity demanded of one good
responds to the price of another good.
• The price elasticity of supply measures how
much the quantity supplied responds to changes
in the price.
• The income elasticity of demand measures how
much the quantity demanded responds to
changes in consumers’ income.
• The cross-price elasticity of demand measures
how much the quantity demanded of one good
responds to the price of another good.
• The price elasticity of supply measures how
much the quantity supplied responds to changes
in the price.
SummarySummary

45. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 45
• In most markets, supply is more elastic in the
long run than in the short run.
• The price elasticity of supply is calculated as the
percentage change in quantity supplied divided
by the percentage change in price.
• The tools of supply and demand can be applied in
many different types of markets.
• In most markets, supply is more elastic in the
long run than in the short run.
• The price elasticity of supply is calculated as the
percentage change in quantity supplied divided
by the percentage change in price.
• The tools of supply and demand can be applied in
many different types of markets.
SummarySummary

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