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Summary of Comments on Slide 1
Page: 1Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:05:25 PMThe elasticity chapter in most principles textbooks is fairly technical, and is not always students favorite.This PowerPoint chapter contains several special features designed to engage and motivate students tolearn this important material.
First, we consider a scenario in which students face a business decision whether to raise the price of aservice they sell. This scenario is used to illustrate the effects of raising price on number of units soldand on revenue, which students immediately recognize as critical to the business decision.
Second, instead of merely listing the determinants of elasticity, students are asked to think about someconcrete examples and deduce from each one a lesson about the determinants of elasticity.
Third, instead of putting the applications at the end of the chapter ( as in the textbook), this PowerPointincludes one of them immediately after the section on price elasticity of demand. This helps break upwhat would otherwise be a long stretch of theory.
Please be assured that this PowerPoint presentation is, nonetheless, very consistent with the textbooksapproach.
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1CHAPTER 5 ELASTICITY AND ITS APPLICATION
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?
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Page: 3
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:05:54 PMWe will follow this scenario throughout the first section of this chapter (the section on price elasticity ofdemand) to illustrate and motivate several important concepts, such as the impact of price changes onsales and revenue.
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3CHAPTER 5 ELASTICITY AND ITS APPLICATION
Elasticity
Basic idea: Elasticity measures how much
one variable responds to changes in another
variable.
One type of elasticity measures how muchdemand for your websites will fall if you raise
your price.
Definition:
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.
Page: 4Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:05:54 PMHere, Qd and Qs are short for quantity demanded and quantity supplied, as in the PowerPoint forChapter 4.
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4CHAPTER 5 ELASTICITY AND ITS APPLICATION
Price Elasticity of Demand
Price elasticity of demand measures how
much Qd
responds to a change in P.
Price elasticityof demand
=Percentage change in Qd
Percentage change in P
Loosely speaking, it measures the price-
sensitivity of buyers demand.
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Page: 7
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:01 PMIt might be worth explaining to your students that P and Q move in opposite directions means that thepercentage change in Q and the percentage change in P will have opposite signs, thus implying anegative price elasticity.
To be consistent with the text, the last statement in the green box says that we will report all priceelasticities as positive numbers. It might be slightly more accurate to say that we will report allelasticities as non-negative numbers: we want to allow for the (admittedly rare) case of zero elasticity.
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8CHAPTER 5 ELASTICITY AND ITS APPLICATION
Calculating Percentage Changes
P
Q
D
$250
8
B
$200
12
A
Demand foryour 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 = 1.33
From B to A,
P falls 20%, Q rises 50%,
elasticity = 50/20 = 2.50
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10CHAPTER 5 ELASTICITY AND ITS APPLICATION
Calculating Percentage Changes
Using the midpoint method, the % change
in Pequals
$250 $200
$225x 100% = 22.2%
The % change in Qequals
12 8
10x 100% = 40.0%
The price elasticity of demand equals
40/22.2 = 1.8
Page: 11
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:02 PMThese calculations are based on the example shown a few slides back: points A and B on the websitedemand curve.
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13CHAPTER 5 ELASTICITY AND ITS APPLICATION
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 Qd 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 thedeterminants of the price elasticity of demand?
Page: 14Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:08 PMIn essence, the textbook says Here are the determinants of elasticity. The first one is availability of closesubstitutes. Heres an example.
Thats great for a textbook. For teaching, Ive found a different approach to be far more effective theapproach on the following four slides, which essentially has students deduce the general lessons fromspecific examples that students can probably figure out with a little common sense.
See notes on the next slide for a good suggestion.
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14CHAPTER 5 ELASTICITY AND ITS APPLICATION
EXAMPLE 1:
Rice Krispies vs. Sunscreen
The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
Rice Krispies has lots of close substitutes(e.g., Capn Crunch, Count Chocula),
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.
Page: 15
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:08 PMSuggestion: For each of these examples, display the slide title (which lists the two goods) and the firsttwo lines of text (which ask which good experiences the biggest drop in demand in response to a 20%price increase). Give your students a quiet minute to formulate their answers. Then, ask for volunteers.
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15CHAPTER 5 ELASTICITY AND ITS APPLICATION
EXAMPLE 2:
Blue Jeans vs. Clothing
The prices of both goods rise by 20%.
For which good does Qd drop the most? Why?
For a narrowly defined good such asblue jeans, there are many substitutes
(khakis, shorts, Speedos). There are fewer substitutes available for
broadly defined goods.
(Can you think of a substitute for clothing,
other than living in a nudist colony?)
Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.
Page: 16
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:08 PMYou might need to clarify the nature of this thought experiment.
Here, we look at two alternate scenarios. In the first, the price of blue jeans (and no other clothing) risesby 20%, and we observe the percentage decrease in quantity of blue jeans demanded.
In the second scenario, the price of all clothing rises by 20%, and we observe the percentage decrease in
demand for all clothing.
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16CHAPTER 5 ELASTICITY AND ITS APPLICATION
EXAMPLE 3:
Insul in vs. Caribbean Cruises
The prices of both of these goods rise by 20%.
For which good does Qd 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.
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17CHAPTER 5 ELASTICITY AND ITS APPLICATION
EXAMPLE 4:
Gasoline in the Short Run vs. Gasoline in
the Long Run
The price of gasoline rises 20%. Does Qd drop
more in the short run or the long run? Why?
Theres not much people can do in the
short run, other than ride the bus or carpool.
In the long run, people can buy smaller carsor live closer to where they work.
Lesson: Price elasticity is higher in the
long run than the short run.
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Page: 19
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:21 PMThis slide is a convenience for your students, and replicates a similar table from the text.
If youre pressed for time, it is probably safe to omit this slide from your presentation.
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19CHAPTER 5 ELASTICITY AND ITS APPLICATION
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 Dcurves.
Page: 20
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:21 PMEconomists classify demand curves according to their elasticity.The next 5 slides present the five different classifications, from least to most elastic.
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Page: 21
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:21 PMIf Q doesnt change, then the percentage change in Q equals zero, and thus elasticity equals zero.
It is hard to think of a good for which the price elasticity of demand is literally zero. Take insulin, forexample. A sufficiently large price increase would probably reduce demand for insulin a little,particularly among people with very low incomes and no health insurance.
However, if elasticity is very close to zero, then the demand curve is almost vertical. In such cases, theconvenience of modeling demand as perfectly inelastic probably outweighs the cost of being slightlyinaccurate.
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Page: 22
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:22 PMAn example: student demand for textbooks that their professors have required for their courses.
Here, its a little more clear that elasticity would be small, but not zero. At a high enough price, somestudents will not buy their books, but instead will share with a friend, or try to find them in the library, orjust take copious notes in class.
Another example: gasoline in the short run.
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Page: 23
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:22 PMThis is the intermediate case: the demand curve is neither relatively steep nor relatively flat. Buyers areneither relatively price-sensitive nor relatively insensitive to price.
This is also the case where price changes have no effect on revenue.
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Page: 24
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:23 PMA good example here would be Rice Krispies, or nearly anything with readily available substitutes.
An elastic demand curve is flatter than a unit elastic demand curve (which itself is flatter than an inelasticdemand curve).
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Page: 25
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:24 PMExtreme price sensitivity means the tiniest price increase causes demand to fall to zero.
Q changes by any % when the D curve is horizontal, quantity cannot be determined from price.Consumers might demand Q1 units one month, Q2 units another month, and some other quantity later.Q can change by any amount, but P always changes by 0% (i.e. doesnt change).
If perfectly inelastic is one extreme, this (perfectly elastic) is the other.
Heres a good real-world example of a perfectly elastic demand curve, which foreshadows an upcomingchapter on firms in competitive markets. Suppose you run a small family farm in Iowa. Your main cropis wheat. The demand curve in this market is downward-sloping, and the market demand and supplycurves determine the price of wheat. Suppose that price is $5/bushel.
Now consider the demand curve facing you, the individual wheat farmer. If you charge a price of $5,you can sell as much or as little as you want. If you charge a price even just a little higher than $5,demand for YOUR wheat will fall to zero: Buyers would not be willing to pay you more than $5 whenthey could get the same wheat elsewhere for $5. Similarly, if you drop your price below $5, thendemand for YOUR wheat will become enormous (not literally infinite, but almost infinite): if otherwheat farmers are charging $5 and you charge less, then EVERY buyer will want to buy wheat from you.
Why is the demand curve facing an individual producer perfectly elastic? Recall that elasticity is greaterwhen lots of close substitutes are available. In this case, you are selling a product that has many perfectsubstitutes: the wheat sold by every other farmer is a perfect substitute for the wheat you sell.
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25CHAPTER 5 ELASTICITY AND ITS APPLICATION
Elasticity of a Linear Demand Curve
The slope
of a linear
demand
curve is
constant,but its
elasticity
is not.
P
Q
$30
20
10
$00 20 40 60
200%
40%= 5.0E =
67%
67%= 1.0E =
40%
200%= 0.2E =
Page: 26
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:24 PMThe material on this slide is not used anywhere else in the textbook. Therefore, if you are pressed fortime and looking for things to cut, you might consider cutting this slide. (Note that this is my personalrecommendation and is not necessarily the official position of Greg Mankiw or Thomson/South-Western.)
Due to space limitations, this slide uses E as an abbreviation for elasticity, or more specifically, the price
elasticity of demand, and the slide omits the analysis of revenue along the demand curve.
Calculations of percentage changes use the midpoint method. (This is why the increase from Q=0 toQ=20 is 200% rather than infinity.)
As you move down a linear demand curve, the slope (the ratio of the absolute change in P to that in Q)remains constant:
From the point (0, $30) to the point (20, $20), the rise equals -$10, the run equals +20, so the slopeequals -1/2 or -0.5.
From the point (40, $10) to the point (60, $0), the rise again equals -$10, the run equals +20, and theslope again equals -0.5.
However, the percentage changes in these variables do not remain constant, as shown by the differentcolored elasticity calculations that appear on the slide.
The lesson here is that elasticity falls as you move downward & rightward along a linear demand curve.
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26CHAPTER 5 ELASTICITY AND ITS APPLICATION
Price Elasticity and Total Revenue Continuing our scenario, if you raise your price
from $200 to $250, would your revenue rise or fall?
Revenue = Px Q
A price increase has two effects on revenue:
Higher Pmeans more revenue on each unityou sell.
But you sell fewer units (lower Q), due toLaw of Demand.
Which of these two effects is bigger?
It depends on the price elasticity of demand.
Page: 27Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:25 PMWe return to our scenario. Its not hard for students to imagine being in this position running theirown business and trying to decide whether to raise the price.
To most of your students, it should be clear that making the best possible decision would requireinformation about the likely effects of the price increase on revenue. That is why elasticity is so helpful,as we will now see.
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27CHAPTER 5 ELASTICITY AND ITS APPLICATION
Price Elasticity and Total Revenue
If demand is elastic, thenprice elast. of demand > 1
% change in Q > % change in P
The fall in revenue from lower Qis greater
than the increase in revenue from higher P,
so revenue falls.
Revenue = Px Q
Price elasticityof demand
=Percentage change in Q
Percentage change in P
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Page: 29
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:26 PMIn the Normal view (edit mode), the labels over the graph look cluttered, like theyre on top of eachother. This is not a mistake in Slide Show mode (presentation mode), they will be fine try it!
Point out to students that the area (outlined in blue) representing lost revenue due to lower Q is largerthan the area (outlined in yellow) representing increased revenue due to higher P. Hence, the net effectis a fall in revenue.
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29CHAPTER 5 ELASTICITY AND ITS APPLICATION
Price Elasticity and Total Revenue
If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
In our example, suppose that Qonly falls to 10
(instead of 8) when you raise your price to $250.
Revenue = Px Q
Price elasticityof demand
=Percentage change in Q
Percentage change in P
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Page: 31
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:26 PMAgain, the slide appears cluttered in Normal view (edit mode), but everything is fine when displayed inSlide Show mode (presentation mode).
Point out to students that the area representing lost revenue due to lower Q is smaller than the arearepresenting increased revenue due to higher P. Hence, the net effect is an increase in revenue.
The knife-edge case, not shown here but perhaps worth mentioning in class, is unit-elastic demand. Inthat case, an increase in price leaves revenue unchanged: the increase in revenue from higher P exactlyoffsets the lost revenue due to lower Q.
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Page: 32
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:29 PMThese problems, perhaps similar to those you might ask on an exam, are complex in that they testseveral skills at once: Students must determine whether demand for each good is elastic or inelastic,and they must determine the impact of a price change on revenue/expenditure.
So far, weve been talking about how elasticity determines the effects of an increase in P on revenue.Part (b) asks your students to determine the effects of a decrease in P.
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Page: 34
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:33 PMThe first part of the explanation discusses the opposing effects on revenue; its purpose is to clarify theeffects of a price decrease on revenue, as we have previously only discussed the effects of a priceincrease.
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34CHAPTER 5 ELASTICITY AND ITS APPLICATION
APPLICATION: Does Drug Interdiction
Increase or Decrease Drug-Related Crime?
One side effect of illegal drug use is crime:
Users often turn to crime to finance their habit.
We examine two policies designed to reduce
illegal drug use and see what effects they have
on drug-related crime. For simplicity, we assume the total dollar value
of drug-related crime equals total expenditure
on drugs.
Demand for illegal drugs is inelastic, due to
addiction issues.
Page: 35Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:33 PMIn the textbook, this application appears near the end of the chapter, and you can easily move theseslides to the end if you wish to teach things in the same order as the book.
However, I encourage you to consider teaching this application right here - immediately after thesection on price elasticity of demand. It is safe to do so, as this application only requires knowledge ofprice elasticity of demand. Also, putting the application here breaks up what would otherwise be a very
long section of theory with a real-world example that most students find very interesting. Knowingelasticity helps us understand what might otherwise be a counter-intuitive result (that drug interdictionincreases drug-related crime rather than reducing it).
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Page: 36
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:34 PMBy the time all elements have appeared on the screen, the slide will look kind of busy. I think this isokay, because the elements appear on the screen one by one, so students have time to absorb each onebefore the next one appears.
However, if youd rather strip the slide down a bit, heres a suggestion: in Normal view (which is usedto edit slides), you can delete the boxes that represent the initial and new values of drug-related crime,
and the accompanying captions. Then, when presenting this slide in class, simply point out (with yourmouse cursor, a laser pointer, or even your arms and hands) the areas that represent the initial and newvalues of drug-related crime.
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37CHAPTER 5 ELASTICITY AND ITS APPLICATION
Price Elasticity of Supply
Price elasticity of supply measures how much
Qs responds to a change in P.
Price elasticityof supply
=Percentage change in Qs
Percentage change in P
Loosely speaking, it measures the price-
sensitivity of sellers supply.
Again, use the midpoint method to compute the
percentage changes.
Page: 38Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:35 PMMost everything in the price elasticity of supply section corresponds to analogous concepts from theprice elasticity of demand section. So, it is probably safe to move through this section more quickly.
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39CHAPTER 5 ELASTICITY AND ITS APPLICATION
The Variety of Supply Curves
The slope of the supply curve is closely related
to price elasticity of supply.
Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
Five different classifications.
Page: 40
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:35 PMEconomists classify supply curves according to their elasticity.
The next 5 slides present the different classifications, from least to most elastic.
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45CHAPTER 5 ELASTICITY AND ITS APPLICATION
The Determinants of Supply Elasticity
The more easily sellers can change the quantity
they produce, the greater the price elasticity of
supply.
Example: Supply of beachfront property isharder to vary and thus less elastic than
supply of new cars.
For many goods, price elasticity of supply
is greater in the long run than in the short run,
because firms can build new factories,
or new firms may be able to enter the market.
Page: 46Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:38 PMThis section is not perfectly analogous to the section on the determinants of the price elasticity ofdemand, but its similar enough that you can probably cover it more quickly and with less hand-holding.
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Page: 47
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:41 PMThis is one of the Problems and Applications at the end of the chapter.
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Page: 48
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:43 PMIn this slide and the next, the initial price and quantity and the two demand curves are the same. Theonly difference is the elasticity of supply and slope of the supply curve.
[The D curve shifts to the right, but not in a parallel fashion: at each price, quantity demanded is twiceas high, so the new D curve will be flatter than the initial one.]
In the text box containing the verbal explanation, bigger impact is shorthand for bigger percentageimpact or bigger proportional impact.
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Page: 50
Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:49 PMThis graph replicates the one in Figure 6. Note: The graph here is not quite drawn to scale.
When the price rises from $3 to $4 (a 29% increase, using the midpoint method), quantity rises from 100to 120 (or 67%). Because 67% > 29%, price elasticity of supply is greater than one. When the pricerises from $12 to $15 (22%), quantity rises from 500 to 525 (about 5%), so price elasticity of supply isless than one.
The way I like to explain this is as follows:
When output is very low, it is relatively easy for firms to increase output. They may have excess capacity,or they are not requiring full effort from their workers. Increasing output is not difficult, so it doesnttake much of an increase in price to induce an increase in production.
When output is very high, it is relatively expensive for firms to increase output further: theres little or noexcess capacity, they are already running their factories and machines at a high level of intensity. Toincrease output further, they might have to pay their workers overtime, and their machines experiencemore wear and tear and therefore require more repairs. So, at high levels of output, it takes a muchlarger price increase to make firms willing to increase output further.
Eventually, firms bump up against their capacity constraints, and simply cannot increase output inresponse to further price increases.
Of course, all of this applies to the short run. In the long run, firms can build more factories, and(depending on the market structure) new firms can enter the market.
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50CHAPTER 5 ELASTICITY AND ITS APPLICATION
Other Elasticit ies
The income elasticity of demand measures the
response of Qd to a change in consumer income.
Income elasticityof demand
=Percent change in Qd
Percent change in income
Recall from chap.4: An increase in income causes
an increase in demand for a normalgood.
Hence, for normal goods, income elasticity > 0.
For inferiorgoods, income elasticity < 0.
Page: 51Author: Presenter Subject: Presentation Notes Date: 12/23/2011 12:06:49 PMThis topic and the next one (cross-price elasticity) do not appear anywhere else in the book. Instructorswho are pressed for time may consider cutting these topics.
(This is merely my suggestion, not the official position of Greg Mankiw or Thomson/South-Western.)
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51CHAPTER 5 ELASTICITY AND ITS APPLICATION
Other Elasticit ies
The cross-price elasticity of demand measures
the response of demand for one good to changes
in the price of another good.
Cross-price elast.of demand
=% change in Qd for good 1
% change in price of good 2
For substitutes, cross-price elasticity > 0
E.g., an increase in price of beef causes an
increase in demand for chicken.
For complements, cross-price elasticity < 0
E.g., an increase in price of computers causes
decrease in demand for software.
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52CHAPTER 5 ELASTICITY AND ITS APPLICATION
CHAPTER SUMMARY
Elasticity measures the responsiveness of
Qd or Qs to one of its determinants.
Price elasticity of demand equals percentage
change Qd in divided by percentage change in P.
When its less than one, demand is inelastic.
When greater than one, demand is elastic.
When demand is inelastic, total revenue rises
when price rises. When demand is elastic, total
revenue falls when price rises.
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53CHAPTER 5 ELASTICITY AND ITS APPLICATION
CHAPTER SUMMARY
Demand is less elastic in the short run,
for necessities, for broadly defined goods,
or for goods with few close substitutes.
Price elasticity of supply equals percentage
change in Qs divided by percentage change in P.
When its less than one, supply is inelastic.
When greater than one, supply is elastic.
Price elasticity of supply is greater in the long run
than in the short run.
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54CHAPTER 5 ELASTICITY AND ITS APPLICATION
CHAPTER SUMMARY
The income elasticity of demand measures how
much quantity demanded responds to changes in
buyers incomes.
The cross-price elasticity of demand measures
how much demand for one good responds to
changes in the price of another good.
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