C H A P T E R Elasticity and its ApplicationElasticity and its Application Ei P R I N C I P L E SO FP R I N C I P L E SO F 5 2009 South-Western, a part of Cengage Learning, all rights reserved Economics P R I N C I P L E S O FP R I N C I P L E S O F N. Gregory MankiwN. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich In this chapter, In this chapter, look for the answers to these questions: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 You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month. Your costs are rising (including the opportunity cost of your time) You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month. Your costs are rising (including the opportunity cost of your time) A scenario (including the opportunity cost of your time), so you consider raising the price to $250. The law of demand says that you wont sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase? (including the opportunity cost of your time), so you consider raising the price to $250. The law of demand says that you wont sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase? 2 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 i ELASTICITY AND ITS APPLICATION3 your price. Definition: Elasticity is a numerical measure of the responsiveness of Qdor Qsto one of its determinants. Price Elasticity of Demand Price elasticity of demand measures how much Qdresponds to a change in P. Price elasticity of demand = Percentage change in Qd Percentage change in P ELASTICITY AND ITS APPLICATION4 Qpg Loosely speaking, it measures the price- sensitivity of buyers demand. Price Elasticity of Demand Price elasticity P P P rises Price elasticity of demand = Percentage change in Qd Percentage change in P Example: ELASTICITY AND ITS APPLICATION5 Price elasticity of demand equals Q D Q2 P2 P1 Q1 by 10% Q falls by 15% 15% 10% = 1.5 Price Elasticity of Demand Along a D curve, P and Q move in opposite directions, Along a D curve, P and Q move in opposite directions, P P Price elasticity of demand = Percentage change in Qd Percentage change in P ELASTICITY AND ITS APPLICATION6 which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers. which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers. Q D Q2 P2 P1 Q1 Calculating Percentage Changes P Demand for your websites Standard method of computing the percentage (%) change: end value start value start value x 100% ELASTICITY AND ITS APPLICATION7 Q D $250 8 B $200 12 A Going from A to B, the % change in P equals ($250$200)/$200 = 25% Calculating Percentage Changes P Demand for your websites Problem: The standard method gives different answers depending on where you start. From A to B, ELASTICITY AND ITS APPLICATION8 Q D $250 8 B $200 12 A P rises 25%, Q falls 33%, elasticity = 33/25 = 1.33 From B to A, P falls 20%, Q rises 50%, elasticity = 50/20 = 2.50 Calculating Percentage Changes So, we instead use the midpoint method: end value start value midpoint x 100% The midpoint is the number halfway between thtt &dlthf th ELASTICITY AND ITS APPLICATION9 the start & end values, the average of those values. It doesnt matter which value you use as the “start” and which as the “end” you get the same answer either way! Calculating Percentage Changes Using the midpoint method, the % change in P equals $250 $200 $225 x 100% = 22.2% The % change in Q equals ELASTICITY AND ITS APPLICATION10 The % change in Q equals 12 8 10 x 100% = 40.0% 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 A C T I V E L E A R N I N G 1 1 Calculate an elasticityCalculate an elasticity Use the following information to calculate the price elasticity of demand 11 of demand for hotel rooms: if P = $70, Qd= 5000 if P = $90, Qd= 3000 A C T I V E L E A R N I N G A C T I V E L E A R N I N G 1 1 AnswersAnswers Use midpoint method to calculate % change in Qd (5000 3000)/4000 = 50% % change in P 12 % change in P ($90 $70)/$80 = 25% The price elasticity of demand equals 50% 25% = 2.0 What determines price elasticity? To learn the determinants of price elasticity, we look at a series of examples. Each compares two