A scenario. Elasticity. Price Elasticity of Demand. Price Elasticity of Demand. In this chapter, look for the answers to these questions:

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1 5 Elasticity and its Application R I N C I L E O F MICROECONOMIC FOURTH EITION N. GREGORY MANKIW remium oweroint lides by Ron Cronovich 2007 update 2008 Thomson outh-western, all rights reserved In this chapter, look for the answers to these questions: What is? What kinds of issues can help us understand? What is the price? How is it related to the demand curve? How is it related to revenue & expenditure? What is the price? How is it related to the supply curve? What are the income and cross-price elasticities of demand? CHATER 5 ELATICITY AN IT ALICATION 1 A scenario You design websites for local businesses. You charge $200 per website, and currently sell websites per month. Your costs are rising (including the opp. cost of your time), so you consider raising the price to $250. The law says that you won t sell as many websites if if you raise your price. How many fewer websites? How much will your revenue fall, or might it it increase? CHATER 5 ELATICITY AN IT ALICATION 2 Elasticity Basic idea: Elasticity measures how much one variable responds to changes in another variable. One type of measures how much demand for your websites will fall if you raise your price. efinition: Elasticity is a numerical measure of the responsiveness of d or s to one of its determinants. CHATER 5 ELATICITY AN IT ALICATION 3 rice Elasticity of emand rice Elasticity of emand rice ercentage change in d ercentage change in rice ercentage change in d ercentage change in rice measures how much d responds to a change in. Loosely speaking, it measures the pricesensitivity of buyers demand. CHATER 5 ELATICITY AN IT ALICATION 4 Example: rice equals 15% 10% 1.5 rises 2 1 CHATER 5 ELATICITY AN IT ALICATION 5 falls by 15% 2 1 1

2 rice Elasticity of emand Calculating ercentage Changes rice Along a curve, and move in in opposite directions, which would make price negative. We will drop the minus sign and report all all price elasticities as positive numbers. ercentage change in d ercentage change in $250 $200 emand for your websites 8 B A tandard method of computing the percentage (%) change: end value start value start value x 100% Going from A to B, the % change in equals ($250 $200)/$200 25% CHATER 5 ELATICITY AN IT ALICATION 6 CHATER 5 ELATICITY AN IT ALICATION 7 $250 $200 Calculating ercentage Changes emand for your websites 8 B A roblem: The standard method gives different answers depending on where you start. From A to B, rises 25%, falls 33%, 33/ From B to A, falls 20%, rises 50%, 50/ Calculating ercentage Changes o, we instead use the midpoint 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! CHATER 5 ELATICITY AN IT ALICATION 8 CHATER 5 ELATICITY AN IT ALICATION 9 Calculating ercentage Changes Using the midpoint method, the % change in equals $250 $200 $225 The % change in equals 8 10 x 100% 22.2% x 100% 40.0% The price equals 40/ A C T I V E L E A R N I N G 1: Calculate an Use the following information to calculate the price for hotel rooms: if $70, d 5000 if $90, d 3000 CHATER 5 ELATICITY AN IT ALICATION

3 What determines price? To learn the determinants of price, we look at a series of examples. Each compares two common goods. In each example: uppose the prices of both goods rise by 20%. The good for which d falls the most (in percent) has the highest price. Which good is it? Why? What lesson does the example teach us about the determinants of the price? CHATER 5 ELATICITY AN IT ALICATION EXAMLE 1: Rice Krispies vs. unscreen The prices of both of these goods rise by 20%. For which good does d drop the most? Why? Rice Krispies has lots of close substitutes (e.g., Cap n Crunch, Count Chocula), so buyers can easily switch if the price rises. unscreen has no close substitutes, so consumers would probably not buy much less if its price rises. Lesson: rice is higher when close substitutes are available. CHATER 5 ELATICITY AN IT ALICATION 13 EXAMLE 2: Blue Jeans vs. Clothing The prices of both goods rise by 20%. For which good does d drop the most? Why? For a narrowly defined good such as blue jeans, there are many substitutes (khakis, shorts, peedos). There are fewer substitutes available for broadly defined goods. (Can you think of a substitute for clothing, other than living in a nudist colony?) Lesson: rice is higher for narrowly defined goods than broadly defined ones. CHATER 5 ELATICITY AN IT ALICATION 14 EXAMLE 3: Insulin vs. Caribbean Cruises The prices of both of these goods rise by 20%. For which good does d 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: rice is higher for luxuries than for necessities. CHATER 5 ELATICITY AN IT ALICATION 15 EXAMLE 4: Gasoline in the hort Run vs. Gasoline in the Long Run The price of gasoline rises 20%. oes d 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: rice is higher in the long run than the short run. The eterminants of rice A ummary The price depends on: the extent to which close substitutes are available whether the good is a necessity or a luxury how broadly or narrowly the good is defined the time horizon: is higher in the long run than the short run. CHATER 5 ELATICITY AN IT ALICATION 16 CHATER 5 ELATICITY AN IT ALICATION 17 3

4 The Variety of emand Curves The price is closely related to the slope of the demand curve. Rule of thumb: The flatter the curve, the bigger the. The steeper the curve, the smaller the. Five different classifications of curves. CHATER 5 ELATICITY AN IT ALICATION 18 erfectly inelastic demand (one extreme case) rice curve: vertical 0 0 % change in % change in falls CHATER 5 ELATICITY AN IT ALICATION % 10% 0 changes by 0% Inelastic demand rice % change in % change in < 10% 10% < 1 Unit elastic demand rice % change in % change in 10% 10% 1 curve: relatively steep relatively low < 1 falls CHATER 5 ELATICITY AN IT ALICATION rises less than 10% curve: intermediate slope intermediate 1 falls CHATER 5 ELATICITY AN IT ALICATION rises Elastic demand rice curve: relatively flat relatively high > 1 % change in % change in falls CHATER 5 ELATICITY AN IT ALICATION > 10% 10% > rises more than 10% erfectly elastic demand (the other extreme) rice curve: horizontal extreme infinity % change in % change in 2 changes by 0% CHATER 5 ELATICITY AN IT ALICATION 23 1 any % 0% infinity 1 2 changes by any % 4

5 Elasticity of a Linear emand Curve $ E 200% 40% 5.0 E $ % 67% 1.0 E 40% 200% 0.2 The slope of a linear demand curve is constant, but its is not. rice Elasticity and Total Revenue Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall? Revenue x A price increase has two effects on revenue: Higher means more revenue on each unit you sell. But you sell fewer units (lower ), due to Law of emand. Which of these two effects is bigger? It depends on the price. CHATER 5 ELATICITY AN IT ALICATION 24 CHATER 5 ELATICITY AN IT ALICATION 25 rice Elasticity and Total Revenue rice ercentage change in ercentage change in Revenue x If demand is elastic, then price elast. > 1 % change in > % change in The fall in revenue from lower is greater than the increase in revenue from higher, so revenue falls. CHATER 5 ELATICITY AN IT ALICATION 26 rice Elasticity and Total Revenue Elastic demand ( 1.8) If $200, and revenue $2400. If $250, 8 and revenue $2000. When is elastic, a price increase causes revenue to fall. $250 $200 increased emand for revenue due your websiteslost to higher revenue due to lower CHATER 5 ELATICITY AN IT ALICATION 27 8 rice Elasticity and Total Revenue rice ercentage change in ercentage change in Revenue x If demand is inelastic, then price elast. < 1 % change in < % change in The fall in revenue from lower is smaller than the increase in revenue from higher, so revenue rises. In our example, suppose that only falls to 10 (instead of 8) when you raise your price to $250. CHATER 5 ELATICITY AN IT ALICATION 28 rice Elasticity and Total Revenue Now, demand is inelastic: 0.82 If $200, and revenue $2400. If $250, 10 and revenue $2500. $250 $200 When is inelastic, a price increase causes revenue to rise. emand for your websites increased revenue due to higher CHATER 5 ELATICITY AN IT ALICATION lost revenue due to lower 5

6 A C T I V E L E A R N I N G 2: Elasticity and expenditure/revenue A. harmacies raise the price of insulin. oes total expenditure on insulin rise or fall? B. As a result of a fare war, the price of a luxury cruise falls 20%. oes luxury cruise companies total revenue rise or fall? 30 A C T I V E L E A R N I N G 2: Answers B. As a result of a fare war, the price of a luxury cruise falls 20%. oes luxury cruise companies total revenue rise or fall? Revenue x The fall in reduces revenue, but increases, which increases revenue. Which effect is bigger? ince demand is elastic, will increase more than 20%, so revenue rises. 31 ALICATION: oes rug Interdiction Increase or ecrease rug-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. emand for illegal drugs is inelastic, due to addiction issues. CHATER 5 ELATICITY AN IT ALICATION 32 Interdiction reduces the supply of drugs. olicy 1: Interdiction new value of drugrelated crime rice of rugs 2 2 ince demand for drugs is inelastic, rises proportionally more 1 than falls. Result: an increase in total spending on drugs, and in drug-related crime CHATER 5 ELATICITY AN IT ALICATION initial value of drugrelated crime uantity of rugs Education reduces the demand for drugs. and fall. Result: A decrease in total spending on drugs, and in drug-related crime. olicy 2: Education rice of rugs 1 2 new value of drugrelated crime uantity of rugs CHATER 5 ELATICITY AN IT ALICATION initial value of drugrelated crime rice Elasticity of upply rice ercentage change in s ercentage change in rice measures how much s responds to a change in. Loosely speaking, it measures the pricesensitivity of sellers supply. Again, use the midpoint method to compute the percentage changes. CHATER 5 ELATICITY AN IT ALICATION 35 6

7 rice Elasticity of upply rice Example: rice equals 16% 8% 2.0 ercentage change in s ercentage change in rises by 8% 2 1 CHATER 5 ELATICITY AN IT ALICATION 36 rises by 16% 1 2 The Variety of upply Curves The slope of the supply curve is closely related to price. Rule of thumb: The flatter the curve, the bigger the. The steeper the curve, the smaller the. Five different classifications. CHATER 5 ELATICITY AN IT ALICATION 37 erfectly inelastic (one extreme) rice % change in % change in 0% 10% 0 Inelastic rice % change in % change in < 10% 10% < 1 curve: vertical ellers 0 0 rises CHATER 5 ELATICITY AN IT ALICATION changes by 0% curve: relatively steep ellers relatively low < 1 rises CHATER 5 ELATICITY AN IT ALICATION rises less than 10% Unit elastic rice % change in % change in 10% 10% 1 Elastic rice % change in % change in > 10% 10% > 1 curve: intermediate slope ellers intermediate 1 rises CHATER 5 ELATICITY AN IT ALICATION rises curve: relatively flat ellers relatively high > 1 rises CHATER 5 ELATICITY AN IT ALICATION rises more than 10% 7

8 erfectly elastic (the other extreme) rice curve: horizontal ellers extreme infinity % change in % change in 2 changes by 0% CHATER 5 ELATICITY AN IT ALICATION any % 0% infinity 2 changes by any % The eterminants of upply Elasticity The more easily sellers can change the quantity they produce, the greater the price of supply. Example: upply of beachfront property is harder to vary and thus less elastic than supply of new cars. For many goods, price 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. CHATER 5 ELATICITY AN IT ALICATION 43 A C T I V E L E A R N I N G 3: Elasticity and changes in equilibrium The supply of beachfront property is inelastic. The supply of new cars is elastic. uppose population growth causes demand for both goods to double (at each price, d doubles). For which product will change the most? For which product will change the most? How the rice Elasticity of upply Can Vary $15 4 $3 > < upply often becomes less elastic as rises, due to capacity limits. 44 CHATER 5 ELATICITY AN IT ALICATION 45 Other Elasticities The income measures the response of d to a change in consumer income. Income ercent change in d ercent 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 > 0. For inferior goods, income < 0. CHATER 5 ELATICITY AN IT ALICATION 46 Other Elasticities The cross-price measures the response for one good to changes in the price of another good. Cross-price elast. % change in d for good 1 % change in price of good 2 For substitutes, cross-price > 0 E.g., an increase in price of beef causes an increase in demand for chicken. For complements, cross-price < 0 E.g., an increase in price of computers causes decrease in demand for software. CHATER 5 ELATICITY AN IT ALICATION 47 8

9 CHATER UMMARY Elasticity measures the responsiveness of d or s to one of its determinants. rice equals percentage change d in divided by percentage change in. 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. CHATER UMMARY emand is less elastic in the short run, for necessities, for broadly defined goods, or for goods with few close substitutes. rice equals percentage change in s divided by percentage change in. When it s less than one, supply is inelastic. When greater than one, supply is elastic. rice is greater in the long run than in the short run. CHATER 5 ELATICITY AN IT ALICATION 48 CHATER 5 ELATICITY AN IT ALICATION 49 CHATER UMMARY The income measures how much quantity demanded responds to changes in buyers incomes. The cross-price measures how much demand for one good responds to changes in the price of another good. CHATER 5 ELATICITY AN IT ALICATION 50 9