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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
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.
In this chapter you will…In this chapter you will…
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
THE ELASTICITY OF DEMANDTHE ELASTICITY OF DEMAND
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 DemandPrice Elasticity of Demand
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
The Price Elasticity of Demand and Its The Price Elasticity of Demand and Its DeterminantsDeterminants
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.
The Price Elasticity of Demand and Its The Price Elasticity of Demand and Its DeterminantsDeterminants
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.
Computing the Price Elasticity of DemandComputing the Price Elasticity of Demand
Price elasticity of demand= Percentage change in quantity demandedPercentage change in price
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 Method: A Better Way to The 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 =
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%
The Midpoint Method: A Better Way to The 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
= 1Mid point method
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.
A Variety of Demand CurvesA Variety of Demand Curves
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.
A Variety of Demand CurvesA Variety of Demand Curves
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.
A Variety of Demand CurvesA Variety of Demand Curves
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
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
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
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
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 17
E =
0Quantity
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
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 and the Price Elasticity of Total Revenue and the Price Elasticity of DemandDemand
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
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 Changes Figure 5-3: How Total Revenue Changes When Prices Changes: Inelastic DemandWhen Prices Changes: Inelastic Demand
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 Changes Figure 5-4: How Total Revenue Changes When Prices Changes: Elastic DemandWhen Prices Changes: Elastic Demand
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.
Elasticity and Total Revenue along a Linear Elasticity and Total Revenue along a Linear Demand CurveDemand Curve
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 23
Table 5-1. Elasticity and Total Revenue Table 5-1. Elasticity and Total Revenue along a Linear Demand Curvealong a Linear Demand Curve
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 24
Price
Quantity2 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
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.
Other Demand ElasticitiesOther Demand Elasticities
In co m e e la stic ity o f dem an d =
P ercen tag e ch an ge in q u an tity d em an d ed
P ercen tag e ch an ge in in co m e
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.
Other Demand ElasticitiesOther Demand Elasticities
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.
Other Demand ElasticitiesOther Demand Elasticities
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.
Other Demand ElasticitiesOther Demand Elasticities
Income elasticity of demand =
Percentage change in quantity demandedPercentage change
in the price of good 2.
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 SUPPLYPRICE ELASTICITY OF SUPPLY
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.
The Price Elasticity of Supply and Its The Price Elasticity of Supply and Its DeterminantsDeterminants
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.
Computing the Price Elasticity of SupplyComputing the Price Elasticity of Supply
P rice e las tic ity o f sup p ly =
P ercen tag e ch an g e in qu an tity sup p lied
P ercen tag e chang e in p rice
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%
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…
= 2.0
Computing the Price Elasticity of SupplyComputing the Price Elasticity of Supply
10%
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
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 34
E < 0
0 Quantity
PriceSupply
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
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
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
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 37
E =
0Quantity
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
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 38
0Quantity
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 supply How the price elasticity of supply can varycan vary
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 39
• Good news bad news for farmers• OPEC• Drugs and crime
THREE APPLICATIONS OF SUPPLY, THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITYDEMAND, AND ELASTICITY
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 the An Increase in Supply in the Market for WheatMarket for Wheat
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 the A Reduction in Supply in the World Market for OilWorld Market for Oil
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 Illegal Policies to Reduce the of Illegal DrugsDrugs
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.
SummarySummary
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.
SummarySummary
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.
SummarySummary
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 46
The EndThe End
