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5 Elasticity and its Application
PRINCIPLES OF
ECONOMICS
FOURTH EDITION
N. G R E G O R Y M A N K I W
PowerPoint® Slides
by Ron Cronovich
© 2007 Thomson South-Western, 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?
CHAPTER 5 ELASTICITY AND ITS APPLICATION 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 opp.
opp. cost
cost of
of
your
your time),
time), so
so you’re
you’re thinking
thinking of
of 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?
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.

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.

=
P
Example:
P rises
Price P2
by 10%
elasticity P1
of demand D
equals
Q
15% Q2 Q1
= 1.5 Q falls
10%
by 15%
=
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 Q
all Q2 Q1
all price
price elasticities
elasticities
as
as positive
positive numbers.
numbers.

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

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

 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, also 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!

 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

A C T I V E L E A R N I N G 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
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?

EXAMPLE 1:
Rice Krispies vs. Sunscreen
 The prices of both of these goods rise by 20%.
For which good does Qd 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.
• 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.
EXAMPLE 2:
“Blue Jeans” vs. “Clothing”
 The prices of both goods rise by 20%.
• 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.
(Can you think of a substitute for clothing,
other than living in a nudist colony?)
 Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.
EXAMPLE 3:
Insulin vs. Caribbean Cruises
 The prices of both of these goods rise by 20%.
• 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.

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.

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.

The Variety of Demand Curves
 Economists classify demand curves according to
their elasticity.
 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.
 The next 5 slides present the different
classifications, from least to most elastic.

“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
0
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of demand
D curve: P
relatively steep
P1
Consumers’
relatively low D
P falls Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
“Unit elastic demand”
= = =1
% change in P 10%
of demand
D curve: P
intermediate slope
P1
Consumers’
D
intermediate
P falls Q
1
Q rises by 10%

“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
>1
Q rises more
than 10%
“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
infinity
Q changes
by any %
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

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.

Revenue
Price elasticity Percentage change in Q
=
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.
Revenue Demand for
Elastic demand increased your websites
(elasticity = 1.8) P revenue due lost
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.
Revenue
Price elasticity Percentage change in Q
=
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.
Revenue Demand for
Now, demand is
increased your websites
inelastic:
revenue due
elasticity = 0.82 P to higher P lost
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 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
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
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.
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
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

Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P
 Price elasticity of supply measures how much

Qs responds to a change in P.
 Loosely speaking, it measures the price-
sensitivity of sellers’ supply.
 Again, use the midpoint method to compute the
percentage changes.

Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P
P
Example: S
P rises
Price by 8%
P2
elasticity P1
of supply
equals
Q
16% Q1 Q2
= 2.0
8% Q rises
by 16%
The Variety of Supply Curves
 Economists classify supply curves according to
their elasticity.
 The slope of the supply curve is closely related
to price elasticity of supply.
 Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
 The next 5 slides present the different
classifications, from least to most elastic.

“Perfectly inelastic” (one extreme)
= = =0
% change in P 10%
of supply
S curve: P
S
vertical
P2
Sellers’
0
P rises Q
Elasticity: by 10% Q1
0
Q changes
by 0%
“Inelastic”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of supply
S curve: P
S
relatively steep
P2
Sellers’
relatively low
P rises Q
<1
Q rises less
than 10%
“Unit elastic”
= = =1
% change in P 10%
of supply
S curve: P
intermediate slope S
P2
Sellers’
intermediate
P rises Q
=1
Q rises
by 10%
“Elastic”
Price elasticity % change in Q > 10%
= = >1
% change in P 10%
of supply
S curve: P
relatively flat S
P2
Sellers’
relatively high
P rises Q
>1
Q rises more
than 10%
“Perfectly elastic” (the other
extreme)
Price elasticity % change in Q any %
= = = infinity
% change in P 0%
of supply
S curve: P
horizontal
P2 = P1 S
Sellers’
price sensitivity:
extreme
P changes Q
infinity
Q changes
by any %
The Determinants of Supply
Elasticity
 The more easily sellers can change the quantity
they produce, the greater the price elasticity of
supply.
 Example: Supply of beachfront property is
harder to vary and thus less elastic than
supply of new cars.
 For many goods, price elasticity of supply 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.

Elasticity and changes in equilibrium
 The supply of beachfront property is inelastic.
The supply of new cars is elastic.
 Suppose population growth causes
demand for both goods to double
(at each price, Qd doubles).
 For which product will P change the most?
 For which product will Q change the most?
47
Answers
Beachfront property
When supply (inelastic supply):
is inelastic, P
an increase in
demand has a D1 D2 S
bigger impact
on price than P2 B
on quantity.
P1 A
Q
Q1 Q2
48
Answers
New cars
When supply (elastic supply):
is elastic, P
an increase in
demand has a D1 D2
bigger impact S
on quantity
than on price. B
P2
A
P1
Q
Q1 Q2
49
How the Price Elasticity of Supply Can
Vary
P Supply
Supply often
often
S
elasticity becomes
becomes
$15 <1 less
less elastic
elastic
as
as Q
Q rises,
rises,
12
due
due to
to
elasticity capacity
capacity
>1 limits.
limits.
4
$3
Q
100 200
500 525

Other Elasticities
 The income elasticity of demand measures the
response of Qd to a change in consumer income.
Income elasticity Percent change in Qd

=
of demand Percent 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 elasticity > 0.
 For inferior goods, income elasticity < 0.

Other Elasticities
 The cross-price elasticity of demand measures
the response of demand for one good to changes
in the price of another good.
Cross-price elast. % change in Qd for good 1

=
of demand % change in price of good 2
 For substitutes, cross-price elasticity > 0
E.g., an increase in price of beef causes an
increase in demand for chicken.
 For complements, cross-price elasticity < 0
E.g., an increase in price of computers causes
decrease in demand for software.
CHAPTER SUMMARY
 Elasticity measures the responsiveness of
Qd or Qs to one of its determinants.
 Price elasticity of demand equals percentage
change Qd in divided by percentage change in P.
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.

CHAPTER SUMMARY
 Demand is less elastic in the short run,
for necessities, for broadly defined goods,
or for goods with few close substitutes.
 Price elasticity of supply equals percentage
change in Qs divided by percentage change in P.
When it’s less than one, supply is “inelastic.”
When greater than one, supply is “elastic.”
 Price elasticity of supply is greater in the long run
than in the short run.

CHAPTER SUMMARY
 The income elasticity of demand measures how
much quantity demanded responds to changes in
buyers’ incomes.
 The cross-price elasticity of demand measures
how much demand for one good responds to
changes in the price of another good.

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5 Elasticity and its Application

© 2007 Thomson South-Western, all rights reserved

CHAPTER 5 ELASTICITY AND ITS APPLICATION 4

 Price elasticity of demand measures how

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The price elasticity of demand equals

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Result: an increase in Q2 Q1 Quantity

CHAPTER 5 ELASTICITY AND ITS APPLICATION 37

 Price elasticity of supply measures how much

CHAPTER 5 ELASTICITY AND ITS APPLICATION 38

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CHAPTER 5 ELASTICITY AND ITS APPLICATION 46

CHAPTER 5 ELASTICITY AND ITS APPLICATION 50

Income elasticity Percent change in Qd

 Recall from chap.4: An increase in income causes

CHAPTER 5 ELASTICITY AND ITS APPLICATION 51

Cross-price elast. % change in Qd for good 1

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