Gov and MArket
Elasticity and Its Application
CHAPTER
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PowerPoint Slides prepared by:
V. Andreea CHIRITESCU
Eastern Illinois University
N. GREGORY MANKIW PRINCIPLES OF ECONOMICS Eight Edition
N. Gregory Mankiw Principles Of Economics Eight Edition
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The Elasticity of Demand
Elasticity
Measure of the responsiveness of quantity demanded or quantity supplied
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
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The Elasticity of Demand
Price elasticity of demand
Percentage change in quantity demanded divided by the percentage change in price
Elastic demand
Quantity demanded responds substantially to changes in price
Inelastic demand
Quantity demanded responds only slightly to changes in price
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The Elasticity of Demand
Determinants of price elasticity of demand
Availability of close substitutes
Goods with close substitutes: more elastic demand
Necessities versus luxuries
Necessities: inelastic demand
Luxuries: elastic demand
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The Elasticity of Demand
Determinants of price elasticity of demand
Definition of the market
Narrowly defined markets: more elastic demand
Time horizon
Demand is more elastic over longer time horizons
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The Elasticity of Demand
Computing the price elasticity of demand
Percentage change in quantity demanded divided by percentage change in price
Use absolute value (drop the minus sign)
Midpoint method
Two points: (Q1, P1) and (Q2, P2)
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The Elasticity of Demand
Variety of demand curves
Demand is elastic
Price elasticity of demand > 1
Demand is inelastic
Price elasticity of demand < 1
Demand has unit elasticity
Price elasticity of demand = 1
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The Elasticity of Demand
Variety of demand curves
Demand is perfectly inelastic
Price elasticity of demand = 0
Demand curve is vertical
Demand is perfectly elastic
Price elasticity of demand = infinity
Demand curve is horizontal
The flatter the demand curve
The greater the price elasticity of demand
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Figure 1 The Price Elasticity of Demand (a, b)
The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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Perfectly Inelastic Demand:
Elasticity Equals 0
Price
Quantity
0
Demand
100
$5
4
1. An increase in price…
2. …leaves
the quantity
demanded
unchanged
(b) Inelastic Demand: Elasticity Is Less Than 1
Price
Quantity
0
$5
4
1. A 22%
increase
in price…
2. … leads to an 11% decrease in quantity demanded
Demand
100
90
Figure 1 The Price Elasticity of Demand (c)
The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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(c) Unit Elastic Demand: Elasticity Equals 1
Price
Quantity
0
$5
4
1. A 22%
increase
in price…
2. … leads to a 22% decrease in quantity demanded
Demand
100
80
Figure 1 The Price Elasticity of Demand (d, e)
The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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(d) Elastic demand:
Elasticity > 1
Price
Quantity
0
$5
4
A 22%
increase
in price…
2. … leads to a 67% decrease in quantity demanded
Demand
100
50
(e) Perfectly elastic demand:
Elasticity equals infinity
Price
Quantity
0
Demand
$4
1. At any price
above $4, quantity
demanded is zero
2. At exactly $4,
consumers will
buy any quantity
3. At a price
below $4, quantity
demanded is infinite
The Elasticity of Demand
Total revenue, TR
Amount paid by buyers and received by sellers of a good
Price of the good times the quantity sold (P × Q)
For a price increase
If demand is inelastic, TR increases
If demand is elastic, TR decreases
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Figure 2 Total Revenue
The total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, P × Q.
Here, at a price of $4, the quantity demanded is 100, and total revenue is $400.
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P
Q
P × Q=$400
(revenue)
Quantity
0
Demand
Price
100
$4
Figure 3 How Total Revenue Changes When Price Changes (a)
The impact of a price change on total revenue (the product of price and quantity) depends on the elasticity of demand. In panel (a), the demand curve is inelastic.
In this case, an increase in the price leads to a decrease in quantity demanded that is proportionately smaller, so total revenue increases. Here an increase in the price from $4 to $5 causes the quantity demanded to fall from 100 to 90. Total revenue rises from $400 to $450.
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(a) The Case of Inelastic Demand
Price
Demand
100
Quantity
0
90
4
$5
A
B
1. When the demand
curve is inelastic . . .
3. . . . is greater than the lost revenue from selling fewer units.
2. . . . the extra revenue from selling at a higher price . . .
Figure 3 How Total Revenue Changes When Price Changes (b)
The impact of a price change on total revenue (the product of price and quantity) depends on the elasticity of demand. In panel (b), the demand curve is elastic.
In this case, an increase in the price leads to a decrease in quantity demanded that is proportionately larger, so total revenue decreases. Here an increase in the price from $4 to $5 causes the quantity demanded to fall from 100 to 70. Total revenue falls from $400 to $350.
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(b) The Case of Elastic Demand
Price
$5
Demand
Quantity
0
100
70
4
A
B
1. When the demand
curve is elastic . . .
3. . . . is less than the lost revenue from selling fewer units.
2. . . . the extra revenue from selling at a higher price . . .
The Elasticity of Demand
When demand is inelastic (elasticity < 1)
P and TR move in the same direction
If P ↑, TR also ↑
When demand is elastic (elasticity > 1)
P and TR move in opposite directions
If P ↑, TR ↓
If demand is unit elastic (elasticity = 1)
Total revenue remains constant when the price changes
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The Elasticity of Demand
Linear demand curve
Constant slope
Rise over run
Different price elasticities
Inelastic demand: points with low price and high quantity
Elastic demand: points with high price and low quantity
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Figure 4 Elasticity along a Linear Demand Curve
The slope of a linear demand curve is constant, but its elasticity is not. The price elasticity of demand is calculated using the demand schedule in the table and the midpoint method.
At points with a low price and high quantity, the demand curve is inelastic.
At points with a high price and low quantity, the demand curve is elastic.
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1. an
Quantity
0
Price
Demand
$7
14
6
5
4
3
2
1
2
4
6
8
10
12
Elasticity is larger than 1
Elasticity is smaller than 1
Figure 4 Elasticity along a Linear Demand Curve
The slope of a linear demand curve is constant, but its elasticity is not. The price elasticity of demand is calculated using the demand schedule in the table and the midpoint method. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic.
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The Elasticity of Demand
Income elasticity of demand
How much the quantity demanded of a good responds to a change in consumers’ income
Percentage change in quantity demanded
Divided by the percentage change in income
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The Elasticity of Demand
Normal goods
Positive income elasticity
Necessities
Smaller income elasticities
Luxuries
Large income elasticities
Inferior goods
Negative income elasticities
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The Elasticity of Demand
Cross-price elasticity of demand
How much the quantity demanded of one good responds to a change in the price of another good
Percentage change in quantity demanded of the first good
Divided by the percentage change in price of the second good
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The Elasticity of Demand
Substitutes
Goods typically used in place of one another
Positive cross-price elasticity
Complements
Goods that are typically used together
Negative cross-price elasticity
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The Elasticity of Supply
Price elasticity of supply
How much the quantity supplied of a good responds to a change in the price of that good
Percentage change in quantity supplied
Divided by the percentage change in price
Depends on the flexibility of sellers to change the amount of the good they produce
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The Elasticity of Supply
Elastic supply
Quantity supplied responds substantially to changes in the price
Inelastic supply
Quantity supplied responds only slightly to changes in the price
Determinant of price elasticity of supply
Time period
Supply is more elastic in the long run
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The Elasticity of Supply
Computing price elasticity of supply
Percentage change in quantity supplied divided by percentage change in price
Always positive
Midpoint method
Two points: (Q1, P1) and (Q2, P2)
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The Elasticity of Supply
Variety of supply curves
Supply is unit elastic
Price elasticity of supply = 1
Supply is elastic
Price elasticity of supply > 1
Supply is inelastic
Price elasticity of supply < 1
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The Elasticity of Supply
Variety of supply curves
Supply is perfectly inelastic
Price elasticity of supply = 0
Supply curve is vertical
Supply is perfectly elastic
Price elasticity of supply = infinity
Supply curve is horizontal
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Figure 5 The Price Elasticity of Supply (a, b)
The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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(a) Perfectly Inelastic Supply: Elasticity Equals 0
Price
Quantity
0
Supply
100
$5
4
1. An
increase
in price…
2. …leaves
the quantity
supplied
unchanged
(b) Inelastic Supply: Elasticity Is Less Than 1
Price
Quantity
0
$5
4
1. A 22%
increase
in price…
2. … leads to
a 10% increase
in quantity
supplied
100
110
Supply
Figure 5 The Price Elasticity of Supply (c)
The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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(c) Unit Elastic Supply: Elasticity Equals 1
Price
Quantity
0
$5
4
1. A 22%
increase
in price…
2. … leads to
a 22% increase
in quantity
supplied
100
125
Supply
Figure 5 The Price Elasticity of Supply (d, e)
The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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(d) Elastic Supply: Elasticity Is Greater Than 1
Price
Quantity
0
$5
4
1. A 22%
increase
in price…
2. … leads to
a 67% increase
in quantity
supplied
100
200
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Price
Quantity
0
Supply
$4
1. At any price above $4, quantity supplied is infinite
2. At exactly $4,
producers will
supply any quantity
3. At any price
below $4, quantity
supplied is zero
Supply
The Elasticity of Supply
Supply curve
Different price elasticities
Points with low price and low quantity
Elastic supply
Capacity for production not being used
Points with high price and high quantity
Inelastic supply
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Figure 6 How the Price Elasticity of Supply Can Vary
Because firms often have a maximum capacity for production, the elasticity of supply may be very high at low levels of quantity supplied and very low at high levels of quantity supplied.
Here an increase in price from $3 to $4 increases the quantity supplied from 100 to 200. Because the 67 percent increase in quantity supplied (computed using the midpoint method) is larger than the 29 percent increase in price, the supply curve is elastic in this range.
By contrast, when the price rises from $12 to $15, the quantity supplied rises only from 500 to 525. Because the 5 percent increase in quantity supplied is smaller than the 22 percent increase in price, the supply curve is inelastic in this range.
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Price
Quantity
0
$15
12
Supply
100
525
500
200
4
3
Elasticity is small
(less than 1).
Elasticity is large
(greater than 1).
Three Applications
Can Good News for Farming Be Bad News for Farmers?
New hybrid of wheat – increase production per acre by 20%
Supply curve shifts to the right
Higher quantity and lower price
Demand is inelastic: total revenue falls
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Figure 7 An Increase in Supply in the Market for Wheat
When an advance in farm technology increases the supply of wheat from S1 to S2, the price of wheat falls. Because the demand for wheat is inelastic, the increase in the quantity sold from 100 to 110 is proportionately smaller than the decrease in the price from $3 to $2. As a result, farmers’ total revenue falls from $300 ($3 × 100) to $220 ($2 × 110).
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S1
S2
Price of
Wheat
Quantity of Wheat
0
110
$3
2
100
Demand
1. When demand is inelastic,
an increase in supply . . .
2. … leads
to a large fall
in price. . .
3. … and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220.
Three Applications
Can Good News for Farming Be Bad News for Farmers?
Paradox of public policy
Induce farmers not to plant crops
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Three Applications
Why Did OPEC Fail to Keep the Price of Oil High?
Increase in prices: 1973 – 1974, 1971 – 1981
Short-run: supply and demand are inelastic
Decrease in supply: large increase in price
Long-run: supply and demand are elastic
Decrease in supply: small increase in price
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Figure 8 A Reduction in Supply in the World Market for Oil
When the supply of oil falls, the response depends on the time horizon. In the short run, supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve shifts from S1 to S2, the price rises substantially.
In the long run, however, supply and demand are relatively elastic, as in panel (b). In this case, the same size shift in the supply curve (S1 to S2) causes a smaller increase in the price.
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Price
Price
Demand
P2
(a) The Oil Market in the Short Run
Demand
(b) The Oil Market in the Long Run
S1
S2
P1
1. In the short run, when supply and demand are inelastic, a shift in supply. . .
2. … leads to a large increase in price
P2
S1
S2
P1
1. In the long run, when supply and demand are elastic, a shift in supply. . .
2. … leads to a small increase in price
Quantity
0
Quantity
0
Three Applications
Does Drug Interdiction Increase or Decrease Drug-related Crime?
Increase the number of federal agents devoted to the war on drugs
Illegal drugs: supply curve shifts left
Higher price and lower quantity
Amount of drug-related crimes
Inelastic demand for drugs
Higher drugs price: higher total revenue
Increase drug-related crime
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Three Applications
Does Drug Interdiction Increase or Decrease Drug-related Crime?
Policy of drug education
Reduce demand for illegal drugs
Left shift of demand curve
Lower quantity
Lower price
Reduce drug-related crime
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Figure 9 Policies to Reduce the Use of Illegal Drugs
Drug interdiction reduces the supply of drugs from S1 to S2, as in panel (a). If the demand for drugs is inelastic, then the total amount paid by drug users rises, even as the amount of drug use falls.
By contrast, drug education reduces the demand for drugs from D1 to D2, as in panel (b). Because both price and quantity fall, the amount paid by drug users falls.
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Price
Price
Demand
P2
(a) Drug Interdiction
D1
(b) Drug Education
S1
S2
P1
1. Drug interdiction reduces the supply of drugs. . .
2. … which
raises the
price . . .
P2
Supply
P1
1. Drug education reduces the demand for drugs . . .
2. . . . which
reduces the
price . . .
Quantity
0
Quantity
0
Q1
Q2
3. … and reduces the quantity sold
D2
Q1
Q2
3. … and reduces the quantity sold
]
)/
P
)/[(P
P
(P
]
)/
Q
)/[(Q
Q
(Q
2
2
1
2
1
2
1
2
1
2
+
-
+
-
=
demand
of
elasticity
Price
2121
2121
2
2
Price elasticity of supply
(QQ)/[(QQ)/]
(PP)/[(PP)/]
-+
=
-+