GREGORY MANKIW PRINCIPLES OF ECONOMICS Chap 5

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V. Andreea CHIRITESCU

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N. GREGORY MANKIW

PRINCIPLES OF

ECONOMICS

Eight Edition

Elasticity and Its

Application

CHAPTER

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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?

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A scenario:

•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 consider raising the price to $250.

• The law of demand: you won’t sell as many

websites if you raise your price.

–How many fewer websites?

–How much will your revenue fall, or might it

increase?

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The Elasticity of Demand

•Elasticity

–Measure of the responsiveness of Qdor Qs

•To a change in one of its determinants

•Price elasticity of demand

–How much the quantity demanded of a

good responds to a change in the price of

that good

•Loosely speaking, it measures the price–

sensitivity of buyers’ demand

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Price Elasticity of Demand

Price elasticity of demand =

Along a D curve, P and Q

move in opposite directions,

which would make price

elasticity negative.

We will drop the minus sign and report all price elasticities as positive

numbers.

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P

Q

D

Q2

P2

P1

Q1

Prises

by 10%

Qfalls

by 15%

15% 1.5

10%

d

percentage change in Q

percentage change in P

=

==

Calculating Percentage Changes

Going from B to A:

•the % change in P = – 20%

•the % change in Q = 50%

•Price elasticity = 50/20 = 2.5

6

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P

Q

D

$250

8

B

$200

12

A

Demand for your

websites

100%

end value start value

start value

−

=

Standard method of computing the

percentage (%) change:

Going from A to B:

•the % change in P = ($250–

$200)/$200 = 25%

•the % change in Q = – 33%

•Price elasticity = 33/25 = 1.33

We get different values!

The Price Elasticity of Demand

•Midpoint method

–The midpoint is the number halfway

between the start and end values

•The average of those values

7

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2 1 2 1

end value – start value

percentage change 100%

midpoint

2

Price elasticity of demand 2

(Q Q ) / [(Q Q ) / ]

(P P ) / [(P P ) / ]

=

−+

=−+

Calculating Percentage Changes

8

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management system for classroom use.

P

Q

D

$250

8

B

$200

12

A

Demand for your websites

Using the midpoint method of

computing % changes:

$250 $200

% change in P = 100% 22.2%

$225

12 8

% change in Q = 100% 40%

10

40%

Price elasticity = 1.8

22.2%

−=

=

Active Learning 1 Calculate an elasticity

Use the following information to calculate the

price elasticity of demand for iPhones:

•if P = $400, Qd= 10,600

•if P = $600, Qd= 8,400

•Use the midpoint method to calculate

percentage changes.

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Active Learning 1 Answers

Using the midpoint method to calculate

percentage changes:

•% change in P =

[($600 – $400)/$500] ×100 = 40%

•% change in Qd=

[(10,600 –8,400)/9,500] ×100 = 23.16%

•Price elasticity of demand =

= % change in Qd/ % change in P

= 23.16/40 = 0.58

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The Price Elasticity of Demand

•Determinants of price elasticity of demand

–We look at a series of examples comparing

two common goods

•In each example:

–Suppose prices of both goods rise by 20%

–Which good has the highest price elasticity

of demand? Why?

–What lesson we learn about the

determinants of price elasticity of demand?

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The Price Elasticity of Demand

Example 1: Breakfast cereal vs. Sunscreen

–Prices of both of these goods rise by 20%.

For which good does Qddrop the most?

Why?

•Breakfast cereal has close substitutes, so

buyers can easily switch if the price rises

management system for classroom use.