Transcript

BellringerBellringerWhich of the following goods do you think the Which of the following goods do you think the government would be most likely to be concerned government would be most likely to be concerned its price and why?its price and why?

Mankiw Chapter 5 - Elasticity

Reminder: Article next weekReminder: Article next weekstart of class, topics: ???start of class, topics: ???

ElasticElastic Elastic DemandElastic Demand Very responsive Very responsive

to price changeto price change Most normal Most normal

goodsgoods Rare purchasesRare purchases Big budgetBig budget Many substitutesMany substitutes

Why important to Why important to think about as a think about as a firm?firm?

Price/month

Quantity

D-nice apartments

1000

500

100

1000 5000 10,000

InelasticInelastic

Inelastic DemandInelastic Demand Not responsive to Not responsive to

price changeprice change Few substitutesFew substitutes Small part of budgetSmall part of budget Most goods, close to Most goods, close to

needsneeds Ex: lifesaversEx: lifesavers Why does Why does

government often government often control prices of control prices of inelastic goods?inelastic goods? Illegal drugs?Illegal drugs?

Price/dose

Quantity

D-dialysis100

1 2 3

200

300

400

500

600

700

In RealityIn Reality

A

B

C

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EXAMPLE 1:EXAMPLE 1:Breakfast cereal vs. SunscreenBreakfast cereal vs. Sunscreen The prices of both of these goods rise by 20%. The prices of both of these goods rise by 20%.

For which good does For which good does QQdd drop the most? Why? drop the most? Why? Breakfast cereal has close substitutes Breakfast cereal has close substitutes

((e.ge.g., pancakes, waffles, leftover pizza), ., pancakes, waffles, leftover pizza), so buyers can easily switch if the price rises.so buyers can easily switch if the price rises.

Sunscreen has no close substitutes, Sunscreen has no close substitutes, so consumers would probably not so consumers would probably not buy much less if its price rises. buy much less if its price rises.

Lesson: Lesson: Price elasticity is higher when close substitutes are available.

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EXAMPLE 2:EXAMPLE 2:“Blue Jeans” vs. “Clothing”“Blue Jeans” vs. “Clothing” The prices of both goods rise by 20%. The prices of both goods rise by 20%.

For which good does For which good does QQdd drop the most? Why? drop the most? Why? For a narrowly defined good such as For a narrowly defined good such as

blue jeans, there are many substitutes blue jeans, there are many substitutes (khakis, shorts, Speedos). (khakis, shorts, Speedos).

There are fewer substitutes available for broadly There are fewer substitutes available for broadly defined goods. defined goods. (There aren’t too many substitutes for clothing, (There aren’t too many substitutes for clothing, other than living in a nudist colony.) other than living in a nudist colony.)

Lesson: Lesson: Price elasticity is higher for narrowly defined Price elasticity is higher for narrowly defined goods than broadly defined ones. goods than broadly defined ones.

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

For which good does For which good does QQdd drop the most? Why? drop the most? Why? To millions of diabetics, insulin is a necessity. To millions of diabetics, insulin is a necessity.

A rise in its price would cause little or no A rise in its price would cause little or no decrease in demand. decrease in demand.

A cruise is a luxury. If the price rises, A cruise is a luxury. If the price rises, some people will forego it. some people will forego it.

Lesson: Lesson: Price elasticity is higher for Price elasticity is higher for luxuries than for necessities. luxuries than for necessities.

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How to calculate Price Elasticity of How to calculate Price Elasticity of DemandDemand

Price elasticity of demandPrice elasticity of demand measures how measures how much much QQdd responds to a change in responds to a change in PP..

Price elasticity of demand

=Percentage change in Qd

Percentage change in P

Loosely speaking, it measures the price-sensitivity of buyers’ demand.

Price Elasticity of Price Elasticity of DemandDemand

Price elasticity Price elasticity of demand of demand equalsequals

P

Q

D

Q2

P2

P1

Q1

P rises by 10%

Q falls by 15%

15%

10%= 1.5

Price elasticity of demand

=Percentage change in Qd

Percentage change in P

Example:

Price Elasticity of Price Elasticity of DemandDemand

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.

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.

P

Q

D

Q2

P2

P1

Q1

Price elasticity of demand

=Percentage change in Qd

Percentage change in P

Calculating Percentage Calculating Percentage Changes %Changes %

P

Q

D

$250

8

B

$200

12

A

Demand for iphones

Standard method of computing the percentage (%) change:

end value – start value

start valuex 100%

Going from A to B, the % change in P equals

($250–$200)/$200 = 25%

New – Old

Oldx 100%

Calculating Percentage Calculating Percentage ChangesChanges

D

$250

8

B

$200

12

A

Demand for iphones

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 = 1.33

From B to A, P falls 20%, Q rises 50%, elasticity = 50/20 = 2.50

P

Q

Calculating Percentage Calculating Percentage ChangesChanges So, we instead use the So, we instead use the midpoint methodmidpoint method: :

end value – start valuemidpoint

x 100%

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!

Calculating Percentage Changes Using the midpoint method, the % change Using the midpoint method, the % change

in in PP equals equals$250 – $200

$225x 100% = 22.2%

The % change in Q equals

12 – 810

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 11

Calculate an elasticityCalculate an elasticityUse the following information to calculate the price elasticity 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 11

AnswersAnswersUse midpoint method to calculate % change in Qd

(5000 – 3000)/4000 = 50%

% change in P

($90 – $70)/$80 = 25%

The price elasticity of demand equals

50%25%

= 2.0

SummarySummary

Q1

P1

D

““Perfectly inelastic demand”Perfectly inelastic demand” (one extreme case)(one extreme case)

P

Q

P2

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

““Inelastic demand”Inelastic demand”

P

QQ1

P1

Q2

P2

Q rises less 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 steep

relatively low

< 1

D

““Unit elastic demand”Unit elastic demand”

P

QQ1

P1

Q2

P2

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”Elastic demand”

P

QQ1

P1

Q2

P2

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

D

““Perfectly elastic demand”Perfectly elastic demand”

P

Q

P1

Q1

P changes by 0%

Q changes by any %

any %

0%= infinity

Q2

P2 =Consumers’ price sensitivity:

D curve:

Elasticity:infinity

horizontal

extreme

Price elasticity

of demand

=% change in Q

% change in P=

One Final Test of elasticityOne Final Test of elasticity Revenue TestRevenue Test TR = Price X QdTR = Price X Qd

If in Price causes an Total Revenue then D is inelastic (consumers don’t change Qd)

If in Price causes in Total Revenue then D is elastic (consumers do change Qd)

elastic

inelastic

EX 1

EX 2

Summarize

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