Elasticity With Comments

8/3/2019 Elasticity With Comments

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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?

This page contains no comments


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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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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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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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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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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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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

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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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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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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.

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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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EXAMPLE 2:

Blue Jeans vs. Clothing

The prices of both goods rise by 20%.


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.

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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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EXAMPLE 3:

Insul in vs. Caribbean Cruises

The prices of both of these goods rise by 20%.


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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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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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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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.

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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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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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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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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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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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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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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 =

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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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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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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


=Percentage change in Q




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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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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


=Percentage change in Q




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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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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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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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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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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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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


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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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.

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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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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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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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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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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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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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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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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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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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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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