Elasticity and Its Application, High school final essays of Microeconomics

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Elasticity and its Application

Microeonomics

P R I N C I P L E S O F

N. Gregory Mankiw

This lecture is brought to you by Dr. Doan Le

CHAPTER

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 Q

d

or Q

s

to one of its

determinants.

Price Elasticity of Demand  Price elasticity of demand measures how

much Q

d

responds to a change in P.

Price elasticity of demand = Percentage change in Q d Percentage change in P  Loosely speaking, it measures the price-

sensitivity of buyers’ demand.

Calculating Percentage Changes P Q D $ 8 B $ 12 A Demand for your websites Standard method of computing the percentage (%) change: end value – start value start value x 100% Going from A to B, the % change in P equals ($250–$200)/$200 = 25%

Calculating Percentage Changes P Q D $ 8 B $ 12 A Demand for your websites Problem: The standard method gives different answers depending on where you start. From A to B, P rises 25%, Q falls 33%, elasticity = 33/25 = 1. From B to A, P falls 20%, Q rises 50%, elasticity = 50/20 = 2.

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 Q d 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: Pho vs. Sunscreen  The prices of both of these goods rise by 20%.

For which good does Q

d 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.

EXAMPLE 3: Insulin vs. Caribbean Cruises  The prices of both of these goods rise by 20%.

For which good does Q

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: 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 Q 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: Price elasticity is higher in the long run than the short run.

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.…

Q 1 P 1 D “Perfectly inelastic demand” (one extreme case) P Q P 2 P falls by 10% Q changes by 0% 0% 10% = 0 Price elasticity of demand = % change in Q % change in P = Consumers’ price sensitivity: D curve: Elasticity: vertical none 0

D “Unit elastic demand” P Q Q 1 P 1 Q 2 P 2 Q rises by 10% 10% 10% = 1 Price elasticity of demand = % change in Q % change in P = P falls by 10% Consumers’ price sensitivity: Elasticity: intermediate 1 D curve: intermediate slope

D “Elastic demand” P Q Q 1 P 1 Q 2 P 2 Q rises more than 10%

10% 10% 1 Price elasticity of demand = % change in Q % change in P = P falls by 10% Consumers’ price sensitivity: D curve: Elasticity: relatively flat relatively high 1