CHAPTER

Elasticity and its Application

PRINCIPLES OF

Macroeconomics
N. Gregory Mankiw

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by Ron Cronovich
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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? 1
 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 2

 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 3

 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%
of demand P1
equals D
15% Q
= 1.5 Q2 Q1
10%
Q falls
by 15%
ELASTICITY AND ITS APPLICATION 4
 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Along a D curve, P and Q
move in opposite directions, P2
which would make price
elasticity negative. P1

We will drop the minus sign D

and report all price Q
elasticities as Q2 Q1
positive numbers.

ELASTICITY AND ITS APPLICATION 5

 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 6

 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 7

 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 8

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

9
 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 10

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 11
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 12
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 13

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 14

 The Determinants of Price Elasticity:
A Summary
The price elasticity of demand 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 – elasticity is higher in the
long run than the short run

ELASTICITY AND ITS APPLICATION 15

 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 16

“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%

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 17
“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
of demand % change in P 10%

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 18
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
of demand % change in P 10%

D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
intermediate D

P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%

ELASTICITY AND ITS APPLICATION 19

“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
of demand % change in P 10%

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 20
“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
of demand % change in P 0%

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 21
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 constant,
67%
but its
40%
10 E = = 0.2 elasticity
200%
is not.
$0 Q
0 20 40 60

ELASTICITY AND ITS APPLICATION 22

 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 23
 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 sellers’
price-sensitivity.
▪ Again, use the midpoint method to compute the
percentage changes.

ELASTICITY AND ITS APPLICATION 24

 Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P
P
Example: S
P rises
Price P2
by 8%
elasticity P1
of supply
equals
Q
16% Q1 Q2
= 2.0
8% Q rises
by 16%
ELASTICITY AND ITS APPLICATION 25
 The Variety of Supply Curves
▪ 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.
▪ Five different classifications.…

ELASTICITY AND ITS APPLICATION 26

“Perfectly inelastic” (one extreme)
Price elasticity % change in Q 0%
= = =0
of supply % change in P 10%

S curve: P
S
vertical
P2
Sellers’
price sensitivity: P1
none
P rises Q
Elasticity: by 10% Q1
0
Q changes
by 0%
ELASTICITY AND ITS APPLICATION 27
“Inelastic”
Price elasticity % change in Q < 10%
= = <1
of supply % change in P 10%

S curve: P
S
relatively steep
P2
Sellers’
price sensitivity: P1
relatively low
P rises Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
ELASTICITY AND ITS APPLICATION 28
“Unit elastic”
Price elasticity % change in Q 10%
= = =1
of supply % change in P 10%

S curve: P
intermediate slope S
P2
Sellers’
price sensitivity: P1
intermediate
P rises Q
Elasticity: by 10% Q1 Q2
=1
Q rises
by 10%
ELASTICITY AND ITS APPLICATION 29
“Elastic”
Price elasticity % change in Q > 10%
= = >1
of supply % change in P 10%

S curve: P
relatively flat S
P2
Sellers’
price sensitivity: P1
relatively high
P rises Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
ELASTICITY AND ITS APPLICATION 30
“Perfectly elastic” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
of supply % change in P 0%

S curve: P
horizontal
P2 = P1 S
Sellers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
ELASTICITY AND ITS APPLICATION 31
 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 ITS APPLICATION 32

 Other Elasticities
▪ 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 Chapter 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.
ELASTICITY AND ITS APPLICATION 33
 Other Elasticities
▪ 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)
ELASTICITY AND ITS APPLICATION 34
 Cross-Price Elasticities in the News
“As Gas Costs Soar, Buyers Flock to Small Cars”
-New York Times, 5/2/2008
“Gas Prices Drive Students to Online Courses”
-Chronicle of Higher Education, 7/8/2008
“Gas prices knock bicycle sales, repairs into higher gear”
-Associated Press, 5/11/2008
“Camel demand soars in India”
(as a substitute for “gas-guzzling tractors”)
-Financial Times, 5/2/2008
“High gas prices drive farmer to switch to mules”
-Associated Press, 5/21/2008

ELASTICITY AND ITS APPLICATION 35

CHAPTER SUMMARY

▪ Elasticity measures the responsiveness of

Qd or Qs to one of its determinants.
▪ Price elasticity of demand equals percentage
change in Qd 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.
36
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.
37
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.

38