Topic 3

Elasticity and its

Applications

©
© 2002
2002 by
by Nelson,
Nelson, aa division
division of
of Thomson
Thomson Canada
Canada Limited
Limited
In
In this
this chapter
chapter you
you will…
will…
•• Learn
Learn the
the meaning
meaning of
of the
the elasticity
elasticity ofof
demand.
demand.
•• Examine
Examine what
what determines
determines thethe elasticity
elasticity of
of
demand.
demand.
•• Learn
Learn the
the meaning
meaning of
of the
the elasticity
elasticity ofof
supply.
supply.
•• Examine
Examine what
what determines
determines thethe elasticity
elasticity of
of
supply.
supply.
•• Apply
Apply the
the concept
concept of
of elasticity
elasticity in
in three
three
different
different markets.
markets.

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

 THE
THE ELASTICITY
ELASTICITY OF
OF DEMAND
DEMAND
•• …
… allows
allows us
us to
to analyze
analyze demand
demand with
with
greater
greater precision.
precision.

•• …… is
is aa measure
measure of
of how
how much
much buyers
buyers
respond
respond to to changes
changes in
in market
market conditions
conditions

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 3

 Price
Price Elasticity
Elasticity of
of Demand
Demand
•• Price
Price elasticity
elasticity of
of demand
demand isis aa measure
measure of of
how
how much
much the
the quantity
quantity demanded
demanded of of aa
good
good responds
responds to to aa change
change in
in the
the price
price of
of
that
that good.
good.

•• Price
Price elasticity
elasticity of
of demand
demand is is the
the
percentage
percentage change
change inin quantity
quantity demanded
demanded
given
given aa percent
percent change
change inin the
the price.
price.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 4

 The
The Price
Price Elasticity
Elasticity of
of Demand
Demand and
and Its
Its
Determinants
Determinants
•• Availability
Availability of
of Close
Close Substitutes
Substitutes
•• Necessities
Necessities versus
versus Luxuries
Luxuries
•• Definition
Definition of
of the
the Market
Market
•• Time
Time Horizon
Horizon

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

 The
The Price
Price Elasticity
Elasticity of
of Demand
Demand and
and Its
Its
Determinants
Determinants
•• Demand
Demand tends tends to to bebe more
more elastic:
elastic:
–– the
the larger
larger the
the number
number of of close
close
substitutes.
substitutes.
–– ifif the
the good
good is is aa luxury.
luxury.
–– the
the more
more narrowly
narrowly defined
defined the
the market.
market.
–– the
the longer
longer the
the time
time period.
period.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 6

 Computing
Computing the
the Price
Price Elasticity
Elasticity of
of Demand
Demand

•• The
The price
price elasticity
elasticity of
of demand
demand is is
computed
computed asas the
the percentage
percentage change
change in
in the
the
quantity
quantity demanded
demanded divided
divided byby the
the
percentage
percentage change
change in in price.
price.

Percentage change in quantity demanded

Price elasticity of demand =
Percentage change in price

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 7

 The
The Midpoint
Midpoint Method:
Method:AABetter
Better Way
Way to
to
Calculate
Calculate Percentage
Percentage Changes
Changes and
and Elasticities
Elasticities
•• The
The midpoint
midpoint formula
formula isis preferable
preferable when
when
calculating
calculating the
the price
price elasticity
elasticity ofof demand
demand
because
because itit gives
gives the
the same
same answer
answer
regardless
regardless of of the
the direction
direction ofof the
the change.
change.
•• point
pointMethod:
Method:AABetter
BetterWay
Wayto
toCalculate
CalculatePercentage
Percentage
Changes
Changesand
andElasticities
Elasticities

(Q2 - Q1) / [(Q2 + Q1) / 2]

Price elasticity of demand =
(P2 - P1) / [(P2 + P1) / 2]

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 8

 The
The Midpoint
Midpoint Method:
Method:AABetter
Better Way
Way to
to
Calculate
Calculate Percentage
Percentage Changes
Changes and
and Elasticities
Elasticities
•• Point
PointA:
A: Price
Price==$4
$4 Quantity
Quantity==120
120
•• Point
PointB:
B: Price
Price==$6
$6 Quantity
Quantity==80
80

•• From
FromPoint
PointAAto
toPoint
PointB:
B:Price
Pricerise
rise==50%
50%and
andQuantity
Quantityfall
fall==33%
33%
•• From
FromPoint
PointBBto
toPoint
PointA:
A:Price
Pricefall
fall==33%
33%and
andQuantity
Quantityrise
rise==50%
50%

(80 - 120) / [(80 + 120)/ 2]

Price elasticity of demand =
(6 - 4) / [(6 + 4)/ 2]

Mid point method

= 1

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 9

 A
AVariety
Variety of
of Demand
Demand Curves
Curves

•• Inelastic
Inelastic Demand
Demand
–– Quantity
Quantity demanded
demanded does does not
not respond
respond
strongly
strongly to
to price
price changes.
changes.
–– Price
Price elasticity
elasticity of
of demand
demand is
is less
less than
than
one.
one.
•• Elastic
Elastic Demand
Demand
–– Quantity
Quantity demanded
demanded responds
responds strongly
strongly
to
to changes
changes in in price.
price.
–– Price
Price elasticity
elasticity of
of demand
demand is
is greater
greater
than
than one.
one.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 10

 A
AVariety
Variety of
of Demand
Demand Curves
Curves

•• Perfectly
Perfectly Inelastic
Inelastic
–– Quantity
Quantity demanded
demanded does
does not
not respond
respond toto
price
price changes.
changes.
•• Perfectly
Perfectly Elastic
Elastic
–– Quantity
Quantity demanded
demanded changes
changes infinitely
infinitely
with
with any
any change
change in
in price.
price.
•• Unit
Unit Elastic
Elastic
–– Quantity
Quantity demanded
demanded changes
changes by by the
the
same
same percentage
percentage as
as the
the price.
price.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 11

 A
AVariety
Variety of
of Demand
Demand Curves
Curves

•• Because
Because thethe price
price elasticity
elasticity of of demand
demand
measures
measures how how much
much quantity
quantity demanded
demanded
responds
responds to to the
the price,
price, itit is
is closely
closely related
related
to
to the
the slope
slope of
of the
the demand
demand curve. curve.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 12

 Figure
Figure 5-1
5-1 a):
a): Perfectly
Perfectly Inelastic
Inelastic Demand
Demand

Price
Demand E=0

$5.00

$4.00
1. An increase
in price…

0 100 Quantity

2. …leaves the quantity demanded unchanged.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 13

 Figure
Figure 5-1
5-1 b):
b): Inelastic
Inelastic Demand
Demand

Price
Demand E<1

$5.00

$4.00
1. A 22%
increase in
price…

0 90 100 Quantity

2. … Leads to a 11% decrease in quantity demanded.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 14

 Figure
Figure 5-1
5-1 c):
c): Unit
Unit Elastic
Elastic Demand
Demand

Price E=1
Demand

$5.00

$4.00
1. A 22%
increase in
price…

0 80 100 Quantity

2. … Leads to a 22% decrease in quantity demanded.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 15

 Figure
Figure 5-1
5-1 d):
d): Elastic
Elastic Demand
Demand

Price E>1
Demand

$5.00

$4.00
1. A 22%
increase in
price…

0 50 100 Quantity

2. … Leads to a 67% decrease in quantity demanded.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 16

 Figure
Figure 5-1
5-1 e):
e): Perfectly
Perfectly Elastic
Elastic Demand
Demand

Price E=

1. At any price above $4, quantity

demanded is zero.

$4.00 Demand
2. At exactly $4, consumers will buy any quantity.

3. At any price below $4, quantity demanded is infinite.

0
Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 17

 Total
Total Revenue
Revenue and
and the
the Price
Price Elasticity
Elasticity of
of
Demand
Demand
•• Total
Total revenue
revenue is
is the
the amount
amount paid
paid by
by
buyers
buyers and
and received
received byby sellers
sellers of
of aa good.
good.
•• Computed
Computed as as the
the price
price of
of the
the good
good times
times
the
the quantity
quantity sold.
sold.

TR
TR == PP xx Q
Q

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 18

 Figure
Figure 5-2:
5-2: Total
Total Revenue
Revenue
Price

$4.00

P x Q = $400
(revenue)
Demand

0 100 Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 19

 Figure
Figure 5-3:
5-3: How
How Total
Total Revenue
Revenue Changes
Changes
When
When Prices
Prices Changes:
Changes: Inelastic
Inelastic Demand
Demand
Price

$3.00

P x Q = $240
(revenue)
$1.00
P x Q = $100
(revenue) Demand

0 80 100 Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 20

 Figure
Figure 5-4:
5-4: How
How Total
Total Revenue
Revenue Changes
Changes
When
When Prices
Prices Changes:
Changes: Elastic
Elastic Demand
Demand
Price
Change in Total Revenue when Price Changes

$5.00

$4.00

Demand

Revenue = $200

Revenue = $100

0 20 50 Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 21

 Elasticity
Elasticity and
and Total
Total Revenue
Revenue along
along aa Linear
Linear
Demand
Demand Curve
Curve
•• With
With anan elastic
elastic demand
demand curve,
curve, an
an increase
increase
in
in the
the price
price leads
leads to
to aa decrease
decrease in
in quantity
quantity
demanded
demanded that that is
is proportionately
proportionately larger.
larger.
Thus,
Thus, total
total revenue
revenue decreases.
decreases.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 22

Table
Table 5-1.
5-1. Elasticity
Elasticity and
and Total
Total Revenue
Revenue along
along
aa Linear
Linear Demand
Demand Curve
Curve

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 23

Figure
Figure 5-5:
5-5:AALinear
Linear Demand
Demand Curve
Curve
Price

7 Elasticity
is larger
than 1.
6

4
Elasticity
is smaller
3 than 1.

0 2 4 14 Quantity
6 8 10 12

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 24

 Other
Other Demand
Demand Elasticities
Elasticities
•• Income
Income elasticity
elasticity of
of demand
demand measures
measures
how
how much much the
the quantity
quantity demanded
demanded ofof aa
good
good responds
responds toto aa change
change inin consumers’
consumers’
income.
income.
•• ItIt is
is computed
computed as as the
the percentage
percentage change
change
in
in thethe quantity
quantity demanded
demanded divided
divided by
by the
the
percentage
percentage change
change in in income.
income.

P ercen tag e ch an g e
in q u an tity d em an d ed
In co m e elasticity o f d em an d =
P ercen tag e ch an g e
in in co m e
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 25
 Other
Other Demand
Demand Elasticities
Elasticities

•• Types
Types ofof Goods
Goods
–– Normal
Normal Goods
Goods
–– Inferior
Inferior Goods
Goods
•• Higher
Higher income
income raises
raises the
the quantity
quantity
demanded
demanded for for normal
normal goods
goods butbut lowers
lowers
the
the quantity
quantity demanded
demanded for for inferior
inferior goods.
goods.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 26

 Other
Other Demand
Demand Elasticities
Elasticities

•• Goods
Goods consumers
consumers regard
regard asas necessities
necessities
tend
tend toto be
be income
income inelastic
inelastic
–– Examples
Examples include
include food,
food, fuel,
fuel, clothing,
clothing,
utilities,
utilities, and
and medical
medical services.
services.
•• Goods
Goods consumers
consumers regard
regard asas luxuries
luxuries tend
tend
to
to be
be income
income elastic.
elastic.
–– Examples
Examples include
include sports
sports cars,
cars, furs,
furs, and
and
expensive
expensive foods.
foods.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 27

 Other
Other Demand
Demand Elasticities
Elasticities
•• Cross-Price
Cross-Price elasticity
elasticity of
of demand
demand
measures
measures how how much
much the
the quantity
quantity
demanded
demanded of of aa good
good responds
responds to to aa change
change
in
in thethe price
price ofof another
another good.
good.
•• ItIt is
is computed
computed as as the
the percentage
percentage changechange
in
in thethe quantity
quantity demanded
demanded divided
divided by by the
the
percentage
percentage change change in in the
the price
price ofof the
the
second
second good. good.
Percentage change
Cross in quantity demanded
Price
elasticity of demand =
Percentage change
in the price of
good 2.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 28
 PRICE
PRICE ELASTICITY
ELASTICITY OF
OF SUPPLY
SUPPLY
•• Price
Price elasticity
elasticity of
of supply
supply is is aa measure
measure of of
how
how much
much the
the quantity
quantity supplied
supplied of of aa good
good
responds
responds toto aa change
change inin the
the price
price of
of that
that
good.
good.

•• Price
Price elasticity
elasticity of
of supply
supply is is the
the percentage
percentage
change
change inin quantity
quantity supplied
supplied given
given aa
percent
percent change
change inin the
the price.
price.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 29

 The
The Price
Price Elasticity
Elasticity of
of Supply
Supply and
and Its
Its
Determinants
Determinants
•• Ability
Ability of
of sellers
sellers to
to change
change the the amount
amount of of
the
the good
good they
they produce.
produce.
–– Beach-front
Beach-front land
land isis inelastic.
inelastic.
–– Books,
Books, cars,
cars, or
or manufactured
manufactured goods goods are
are
elastic.
elastic.
•• Time
Time period.
period.
–– Supply
Supply is is more
more elastic
elastic inin the
the long
long run.
run.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 30

 Computing
Computing the
the Price
Price Elasticity
Elasticity of
of Supply
Supply

•• The
The price
price elasticity
elasticity of
of supply
supply is is computed
computed
as
as the
the percentage
percentage change
change inin the
the quantity
quantity
supplied
supplied divided
divided by
by the
the percentage
percentage
change
change in in price.
price.

P ercen tag e ch an g e
in q u an tity su p p lied
P rice elasticity o f su p p ly =
P ercen tag e ch an g e in p rice

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 31

 Computing
Computing the
the Price
Price Elasticity
Elasticity of
of Supply
Supply
•• Suppose
Supposean anincrease
increasein
inthe
theprice
priceof
ofmilk
milkfrom
from$1.90
$1.90to
to$2.10
$2.10aalitre
litre
raises
raisesthe
theamount
amountthat
thatdairy
dairyfarmers
farmersproduce
producefrom
from9000
9000toto11
11000
000
LLper month…
per month…

•• ……using
usingthe
themidpoint
midpointmethod,
method,we wecalculate
calculatethe
thepercent
percentchange
changeinin
the price as (2.10 - 1.90) / 2.00 x 100 = 10%
the price as (2.10 - 1.90) / 2.00 x 100 = 10%
•• Similarly,
Similarly,we
wecalculate
calculatethe
thepercent
percentchange
changein inthe
thequantity
quantitysupplied
supplied
as
as(11
(11000
000--9000)
9000)/ /10
10000
000xx100
100==20%
20%

20%
Price elasticity of supply = = 2.0
10%

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 32

 Figure
Figure 5-6
5-6 a):
a): Perfectly
Perfectly Inelastic
Inelastic Supply
Supply

Price
Supply E=0

$5.00

$4.00
1. An increase
in price…

0 100 Quantity

2. …leaves the quantity supplied unchanged.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 33

 Figure
Figure 5-6
5-6 b):
b): Inelastic
Inelastic Supply
Supply

Price E<0
Supply

$5.00

$4.00
1. A 22%
increase in
price…

0 100 110 Quantity

2. …leads to a 10% increase in quantity

supplied.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 34
 Figure
Figure 5-6
5-6 c):
c): Unit
Unit Elastic
Elastic Supply
Supply

Price E=1

Supply

$5.00

$4.00
1. A 22%
increase in
price…

0 100 125 Quantity

2. …leads to a 22% increase in quantity

supplied.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 35
 Figure
Figure 5-6
5-6 d):
d): Elastic
Elastic Supply
Supply

Price E>1

Supply
$5.00

$4.00
1. A 22%
increase in
price…

0 100 200 Quantity

2. …leads to a 67% increase in quantity

supplied.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 36
 Figure
Figure 5-6
5-6 e):
e): Perfectly
Perfectly Elastic
Elastic Supply
Supply

Price E=

1. At any price above $4, quantity

supplied is infinite.

$4.00 Supply
2. At exactly $4, producers will supply any quantity.

3. At any price below $4, quantity supplied is zero.

0
Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 37

Summary
Summary
•• Price
Priceelasticity
elasticityofofdemand
demandmeasures
measureshow how much
much
the
thequantity
quantitydemanded
demandedresponds
respondsto tochanges
changesin in
the
theprice. price.
•• Price
Priceelasticity
elasticityofofdemand
demandis iscalculated
calculatedas asthe
the
percentage
percentagechange changein inquantity
quantitydemanded
demandeddivided
divided
by
bythe thepercentage
percentagechange
changein inprice.
price.
•• IfIf aademand
demandcurve
curveis iselastic,
elastic, total
total revenue
revenuefalls
falls
when
whenthe theprice
pricerises.
rises.
•• IfIf itit is
isinelastic,
inelastic, total
total revenue
revenuerises
risesasasthe
theprice
price
rises.
rises.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 38

Summary
Summary
•• The
Theincome
incomeelasticity
elasticityof
of demand
demandmeasures
measureshowhow
much
muchthethequantity
quantitydemanded
demandedresponds
respondstoto
changes
changesin inconsumers’
consumers’income.
income.
•• The
Thecross-price
cross-priceelasticity
elasticityofof demand
demandmeasures
measures
how
how much
muchthe
thequantity
quantitydemanded
demandedof of one
onegood
good
responds
respondsto tothe
theprice
priceofof another
anothergood.
good.
•• The
Theprice
priceelasticity
elasticityof
of supply
supplymeasures
measureshow
how
much
muchthethequantity
quantitysupplied
suppliedresponds
respondstotochanges
changes
in
inthe
theprice.
price.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 39

Summary
Summary
•• In
Inmost
mostmarkets,
markets, supply
supplyis ismore
moreelastic
elasticin
inthe
the
long
longrun
runthan
thanin
inthe
theshort
short run.
run.
•• The
Theprice
priceelasticity
elasticityof
of supply
supplyis iscalculated
calculatedas asthe
the
percentage
percentagechange
changein inquantity
quantitysupplied
supplieddivided
divided
by
bythe
thepercentage
percentagechange
changein inprice.
price.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 40

The End

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 5: Page 41