CHAPTER

5
Elasticity and its Application

Economics
PRINCIPLES OF

N. Gregory Mankiw

© 2009 South-Western, a part of Cengage Learning, 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?
2
 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 opportunity
opportunity cost
cost of
of your
your time),
time),
so
so you
you consider
consider 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?
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.
 Definition:
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.

ELASTICITY AND ITS APPLICATION 4

 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P

 Price elasticity of demand measures how

much Qd responds to a change in P.

 Loosely speaking, it measures the price-

sensitivity of buyers’ demand.

ELASTICITY AND ITS APPLICATION 5

 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Example:
P rises
Price elasticity P2
by 10%
P1
of demand D
equals
15% Q
= 1.5 Q2 Q1
10%
Q falls
by 15%
ELASTICITY AND ITS APPLICATION 6
 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Along
Along aa DD curve,
curve, PP and
and QQ
move
move in in opposite
opposite directions,
directions, P2
which
which would
would make
make price
price
elasticity P1
elasticity negative.
negative.
We D
We will
will drop
drop the
the minus
minus sign
sign
and
and report
report all
all price
price Q
elasticities Q2 Q1
elasticities as
as
positive
positive numbers.
numbers.

ELASTICITY AND ITS APPLICATION 7

 Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B,
$200
the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12

ELASTICITY AND ITS APPLICATION 8

 Calculating Percentage Changes
Problem:
The standard method gives
Demand for different answers depending
your websites on where you start.
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200
D From B to A,
P falls 20%, Q rises 50%,
Q
8 12 elasticity = 50/20 = 2.50

ELASTICITY AND ITS APPLICATION 9

 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, 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!

ELASTICITY AND ITS APPLICATION 10

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

ELASTICITY AND ITS APPLICATION 11

ACTIVE LEARNING 1
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

12
ACTIVE LEARNING 1
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%
= 2.0
25%
13
 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?

ELASTICITY AND ITS APPLICATION 14

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?
 Breakfast cereal has close substitutes
(e.g., pancakes, Eggo waffles, leftover pizza),
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.
ELASTICITY AND ITS APPLICATION 15
EXAMPLE 2:
“Blue Jeans” vs. “Clothing”
 The prices of both goods rise by 20%.
For which good does Qd drop the most? Why?
 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.
(There aren’t too many substitutes for clothing,
other than living in a nudist colony.)
 Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.
ELASTICITY AND ITS APPLICATION 16
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?
 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.

ELASTICITY AND ITS APPLICATION 17

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?
 There’s 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.

ELASTICITY AND ITS APPLICATION 18

 The Determinants of Price Elasticity:
A Summary
The
The price
price elasticity
elasticity of
of demand
demand depends
depends on: on:
 the
the extent
extent to
to which
which close
close substitutes
substitutes are
are
available
available
 whether
whether the
the good
good is is aa necessity
necessity or
or aa luxury
luxury
 how
how broadly
broadly or
or narrowly
narrowly the
the good
good is
is defined
defined
 the
the time
time horizon
horizon –– elasticity
elasticity is
is higher
higher in
in the
the
long
long run
run than
than the
the short
short run
run

ELASTICITY AND ITS APPLICATION 19

 The Variety of Demand Curves
 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.
 Five different classifications of D curves.…

ELASTICITY AND ITS APPLICATION 20

“Perfectly inelastic demand” (one extreme
case)
Price elasticity % change in Q 0%
= = =0
% change in P 10%
of demand
D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
none
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
ELASTICITY AND ITS APPLICATION 21
“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of demand
D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
ELASTICITY AND ITS APPLICATION 22
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
% change in P 10%
of demand
D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
D
intermediate
P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%

ELASTICITY AND ITS APPLICATION 23

“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
% change in P 10%
of demand
D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
ELASTICITY AND ITS APPLICATION 24
“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
% change in P 0%
of demand
D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
ELASTICITY AND ITS APPLICATION 25
Elasticity of a Linear Demand Curve

P The slope
200% of a linear
$30 E = = 5.0
40% demand
67% curve is
20 E = = 1.0
67% constant,
but its
40%
10 E = = 0.2 elasticity
200%
is not.
$0 Q
0 20 40 60

ELASTICITY AND ITS APPLICATION 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:
 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.

ELASTICITY AND ITS APPLICATION 27

 Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

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.
ELASTICITY AND ITS APPLICATION 28
 Price Elasticity and Total Revenue
Elastic demand increased
Demand for
(elasticity = 1.8) P revenue due
your websiteslost
to higher P
revenue
If P = $200,
due to
Q = 12 and $250 lower Q
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
ELASTICITY AND ITS APPLICATION 29
 Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
 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.
ELASTICITY AND ITS APPLICATION 30
 Price Elasticity and Total Revenue
Now, demand is increased Demand for
inelastic: revenue your websites
elasticity = 0.82 due to
P lost
higher P
If P = $200, revenue
due to
Q = 12 and
$250 lower Q
revenue = $2400.
$200
If P = $250,
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
10 12
a price increase
causes revenue to rise.
ELASTICITY AND ITS APPLICATION 31
ACTIVE LEARNING 2
Elasticity and expenditure/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
ACTIVE LEARNING 2
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.

33
ACTIVE LEARNING 2
Answers
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?
Revenue = P x Q
The fall in P reduces revenue,
but Q increases, which increases revenue.
Which effect is bigger?
Since demand is elastic, Q will increase more
than 20%, so revenue rises.
34
APPLICATION: Does Drug Interdiction Increase
or Decrease Drug-Related Crime?
 One side effect of illegal drug use is crime:
Users often turn to crime to finance their habit.
 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 drug-related crime equals total expenditure
on drugs.
 Demand for illegal drugs is inelastic, due to
addiction issues.
ELASTICITY AND ITS APPLICATION 35
 Policy 1: Interdiction
Interdiction new value of drug-
reduces Price of related crime
the supply Drugs S2
D1
of drugs. S1
Since demand P2
for drugs is
inelastic, initial value
P1
P rises propor- of drug-
tionally more related
than Q falls. crime

Result: an increase in Q2 Q1 Quantity

total spending on drugs, of Drugs
and in drug-related crime
ELASTICITY AND ITS APPLICATION 36
 Policy 2: Education
new value of drug-
Education Price of related crime
reduces the Drugs
demand for D2 D1
drugs. S

P and Q fall.
P1 initial value
Result: of drug-
A decrease in P2 related
total spending crime
on drugs, and
in drug-related Q2 Q1 Quantity
crime. of Drugs

ELASTICITY AND ITS APPLICATION 37