Economics. PowerPoint Lecture Notes for Chapter 5:

oweroint Lecture Notes for Chapter 5: Elasticity and its Application rinciples of Economics 5 th edition, by N. Gregory Mankiw remium oweroint lides by Ron Cronovich C H A T E R 5 Elasticity and its Application R I N C I L E O F Economics N. Gregory Mankiw remium oweroint lides by Ron Cronovich 2009 outh-western, a part of CengageLearning, all rights reserved The elasticity chapter in most principles textbooks is fairly technical, and is not always students favorite. This oweroint chapter contains several special features designed to engage and motivate students to learn this important material. First, we consider a scenario in which students face a business decision whether to raise the price of a service they sell. This scenario is used to illustrate the effects of raising price on number of units sold and on revenue, which students immediately recognize as critical to the business decision. econd, instead of merely listing the determinants of elasticity, students are asked to think about some concrete 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 oweroint includes one of them immediately after the section on price elasticity of demand. This helps break up what would otherwise be a long stretch of theory. lease be assured that this oweroint presentation is, nonetheless, very consistent with the textbook s approach. 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? 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? 4

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), so you consider raising the price to $250. The law says that you won t sell as many websites if if you raise your price. How many fewer websites? How much will your revenue fall, or might it it increase? We will follow this scenario throughout the first section of this chapter (the section on price elasticity ) to illustrate and motivate several important concepts, such as the impact of price changes on sales and revenue. 5 Elasticity Basic idea: Elasticity measures how much one variable responds to changes in another variable. One type of elasticity measures how much demand for your websites will fall if you raise your price. efinition: Elasticity is a numerical measure of the responsiveness of d or s to one of its determinants. Here, d and s are short for quantity demanded and quantity supplied, as in the oweroint for Chapter 4. ELATICITY AN IT ALICATION 6 rice Elasticity of emand rice elasticity ercentage change in d ercentage change in rice elasticity measures how much d responds to a change in. Loosely speaking, it measures the pricesensitivity of buyers demand. ELATICITY AN IT ALICATION 7 rice Elasticity of emand rice elasticity ercentage change in d ercentage change in Example: rice elasticity equals 15% 10% 1.5 rises by 10% 2 1 falls by 15% 2 1 ELATICITY AN IT ALICATION 8

rice Elasticity of emand rice elasticity Along a curve, and move in in opposite directions, which would make price elasticity negative. We will drop the minus sign and report all all price elasticitiesas as positive numbers. ercentage change in d ercentage change in ELATICITY AN IT ALICATION 9 2 1 2 1 It might be worth explaining to your students that and move in opposite directions means that the percentage change in and the percentage change in will have opposite signs, thus implying a negative price elasticity. To be consistent with the text, the last statement in the green box says that we will report all price elasticities as positive numbers. It might be slightly more accurate to say that we will report all elasticities as non-negative numbers: we want to allow for the (admittedly rare) case of zero elasticity. Calculating ercentage Changes $250 $200 emand for your websites 8 B 12 A tandard method of computing the percentage (%) change: end value start value start value x 100% Going from A to B, the % change in equals ($250 $200)/$200 25% ELATICITY AN IT ALICATION 10 $250 $200 Calculating ercentage Changes emand for your websites 8 B 12 A roblem: The standard method gives different answers depending on where you start. From A to B, rises 25%, falls 33%, elasticity 33/25 1.33 From B to A, falls 20%, rises 50%, elasticity 50/20 2.50 ELATICITY AN IT ALICATION 11 Calculating ercentage Changes o, we instead use the midpoint method: end value start value x 100% midpoint 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! ELATICITY AN IT ALICATION 12

Calculating ercentage Changes Using the midpoint method, the % change in equals $250 $200 $225 x 100% 22.2% These calculations are based on the example shown a few slides back: points A and B on the website demand curve. The % change in equals 12 8 10 x 100% 40.0% The price elasticity equals 40/22.2 1.8 ELATICITY AN IT ALICATION 13 A C T I V E L E A R N I N G 1 Calculate an elasticity Use the following information to calculate the price elasticity for hotel rooms: if $70, d 5000 if $90, d 3000 14 A C T I V E L E A R N I N G 1 Answers Use midpoint method to calculate % change in d (5000 3000)/4000 50% % change in ($90 $70)/$80 25% The price elasticity equals 50% 25% 2.0 15 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: uppose the prices of both goods rise by 20%. The good for which d falls the most (in percent) has the highest price elasticity. Which good is it? Why? What lesson does the example teach us about the determinants of the price elasticity? ELATICITY AN IT ALICATION 16 In essence, the textbook says Here are the determinants of elasticity. The first one is availability of close substitutes. Here s an example. That s great for a textbook. For teaching, I ve found a different approach to be far more effective: having students deduce the general lessons from specific examples they can figure out using common sense. This is the approach on the next few slides. Also, see notes on the next slide for a good suggestion.

EXAMLE 1: Breakfast cereal vs. unscreen The prices of both of these goods rise by 20%. For which good does d drop the most? Why? Breakfast cereal has close substitutes (e.g., pancakes, Eggo waffles, leftover pizza), so buyers can easily switch if the price rises. unscreen has no close substitutes, so consumers would probably not buy much less if its price rises. Lesson: rice elasticity is higher when close substitutes are available. uggestion: For each of these examples, display the slide title (which lists the two goods) and the first two 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. ELATICITY AN IT ALICATION 17 EXAMLE 2: Blue Jeans vs. Clothing The prices of both goods rise by 20%. For which good does d drop the most? Why? For a narrowly defined good such as blue jeans, there are many substitutes (khakis, shorts, peedos). There are fewer substitutes available for broadly defined goods. (There aren t too many substitutes for clothing, other than living in a nudist colony.) Lesson: rice elasticity is higher for narrowly defined goods than broadly defined ones. ELATICITY AN IT ALICATION 18 You 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) rises by 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. EXAMLE 3: Insulin vs. Caribbean Cruises The prices of both of these goods rise by 20%. For which good does d 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: rice elasticity is higher for luxuries than for necessities. ELATICITY AN IT ALICATION 19 EXAMLE 4: Gasoline in the hort Run vs. Gasoline in the Long Run The price of gasoline rises 20%. oes d drop more in the short run or the long run? Why? There s not much people can do in the short run, other than ride the bus or carpool. In the long run, people can buy smaller cars or live closer to where they work. Lesson: rice elasticity is higher in the long run than the short run. ELATICITY AN IT ALICATION 20

The eterminants of rice A ummary The price elasticity depends on: the extent to which close substitutes are available whether the good is a necessity or a luxury how broadly or narrowly the good is defined the time horizon elasticity is higher in the long run than the short run This slide is a convenience for your students, and replicates a similar table from the text. If you re pressed for time, it is probably safe to omit this slide from your presentation. ELATICITY AN IT ALICATION 21 The Variety of emand Curves The price elasticity 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 curves. Economists classify demand curves according to their elasticity. The next 5 slides present the five different classifications, from least to most elastic. ELATICITY AN IT ALICATION 22 erfectly inelastic demand (one extreme case) rice elasticity curve: vertical Consumers none 0 % change in % change in falls by 10% ELATICITY AN IT ALICATION 23 1 2 0% 10% 0 1 changes by 0% If doesn t change, then the percentage change in 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, for example. 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, the convenience of modeling demand as perfectly inelastic probably outweighs the cost of being slightly inaccurate.

Inelastic demand rice elasticity curve: relatively steep Consumers relatively low % change in % change in falls by 10% 1 2 < 1 rises less than 10% ELATICITY AN IT ALICATION 24 1 2 < 10% 10% < 1 An example: tudent demand for textbooks that their professors have required for their courses. Here, it s a little more clear that elasticity would be small, but not zero. At a high enough price, some students will not buy their books, but instead will share with a friend, or try to find them in the library, or just take copious notes in class. Another example: Gasoline in the short run. Unit elastic demand rice elasticity curve: intermediate slope Consumers intermediate 1 % change in % change in falls by 10% 1 2 10% 10% 1 1 2 rises by 10% This is the intermediate case: the demand curve is neither relatively steep nor relatively flat. Buyers are neither relatively price-sensitive nor relatively insensitive to price. (This is also the case where price changes have no effect on revenue.) ELATICITY AN IT ALICATION 25 Elastic demand rice elasticity curve: relatively flat Consumers relatively high > 1 % change in % change in falls by 10% ELATICITY AN IT ALICATION 26 1 2 > 10% 10% > 1 1 2 rises more than 10% A good example here would be breakfast cereal, 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 inelastic demand curve).

erfectly elastic demand (the other extreme) Extreme price sensitivity means the tiniest price increase rice elasticity % change in any % causes demand to fall to zero. % change in 0% infinity curve: horizontal Consumers extreme infinity 2 1 changes by 0% ELATICITY AN IT ALICATION 27 1 2 changes by any % changes by any % when the curve is horizontal, quantity cannot be determined from price. Consumers might demand 1 units one month, 2 units another month, and some other quantity later. can change by any amount, but always changes by 0% (i.e., doesn t change). If perfectly inelastic is one extreme, this case (perfectly elastic) is the other. Here s a good real-world example of a perfectly elastic demand curve, which foreshadows an upcoming chapter on firms in competitive markets. uppose you run a small family farm in Iowa. Your main crop is wheat. The demand curve in this market is downward-sloping, and the market demand and supply curves determine the price of wheat. uppose 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 when they could get the same wheat elsewhere for $5. imilarly, if you drop your price below $5, then demand for YOUR wheat will become enormous (not literally infinite, but almost infinite ): if other wheat 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 greater when lots of close substitutes are available. In this case, you are selling a product that has many perfect substitutes: the wheat sold by every other farmer is a perfect substitute for the wheat you sell.

Elasticity of a Linear emand Curve $30 20 10 E 200% 40% 5.0 $0 0 20 40 60 E 67% 67% 1.0 E 40% 200% 0.2 The slope of a linear demand curve is constant, but its elasticity is not. ELATICITY AN IT ALICATION 28 The material on this slide is not used anywhere else in the textbook. Therefore, if you are pressed for time and looking for things to cut, you might consider cutting this slide. (Note that this is my personal recommendation and is not necessarily the official position of Greg Mankiw or Cengage/outh- Western.) ue 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 0 to 20 is 200% rather than infinity.) As you move down a linear demand curve, the slope (the ratio of the absolute change in to that in ) remains constant: From the point (0, $30) to the point (20, $20), the rise equals -$10, the run equals +20, so the slope equals -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 the slope again equals - 0.5. However, the percentage changes in these variables do not remain constant, as shown by the different colored elasticity calculations that appear on the slide. The lesson here is that elasticity falls as you move downward & rightward along a linear demand curve. rice Elasticity and Total Revenue Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall? Revenue x A price increase has two effects on revenue: Higher means more revenue on each unit you sell. But you sell fewer units (lower ), due to Law of emand. Which of these two effects is bigger? It depends on the price elasticity. ELATICITY AN IT ALICATION 29 We return to our scenario. It s not hard for students to imagine being in this position running their own 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 require information about the likely effects of the price increase on revenue. That is why elasticity is so helpful, as we will now see.

rice Elasticity and Total Revenue rice elasticity ercentage change in ercentage change in Revenue x If demand is elastic, then price elast. > 1 % change in > % change in The fall in revenue from lower is greater than the increase in revenue from higher, so revenue falls. ELATICITY AN IT ALICATION 30 rice Elasticity and Total Revenue Elastic demand (elasticity 1.8) If $200, 12 and revenue $2400. If $250, 8 and revenue $2000. When is elastic, a price increase causes revenue to fall. $250 $200 increased emand for revenue due your websiteslost to higher revenue due to lower ELATICITY AN IT ALICATION 31 8 12 In the Normal view (edit mode), the labels over the graph look cluttered, like they re on top of each other. This is not a mistake in lide how mode (presentation mode), all will be fine try it! oint out to students that the area (outlined in blue) representing lost revenue due to lower is larger than the area (outlined in yellow) representing increased revenue due to higher. Hence, the net effect is a fall in revenue. rice Elasticity and Total Revenue rice elasticity ercentage change in ercentage change in Revenue x If demand is inelastic, then price elast. < 1 % change in < % change in The fall in revenue from lower is smaller than the increase in revenue from higher, so revenue rises. In our example, suppose that only falls to 10 (instead of 8) when you raise your price to $250. ELATICITY AN IT ALICATION 32

rice Elasticity and Total Revenue Now, demand is inelastic: elasticity 0.82 If $200, 12 and revenue $2400. If $250, 10 and revenue $2500. $250 $200 increased emand for revenue your websites due to higher lost revenue due to lower When is inelastic, 12 a price increase 10 causes revenue to rise. ELATICITY AN IT ALICATION 33 Again, the slide appears cluttered in Normal view (edit mode), but everything is fine when displayed in lide how mode (presentation mode). oint out to students that the area representing lost revenue due to lower is smaller than the area representing increased revenue due to higher. 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. In that case, an increase in price leaves revenue unchanged: the increase in revenue from higher exactly offsets the lost revenue due to lower. A C T I V E L E A R N I N G 2 Elasticity and expenditure/revenue A. harmacies raise the price of insulin by 10%. oes total expenditure on insulin rise or fall? B. As a result of a fare war, the price of a luxury cruise falls 20%. oes luxury cruise companies total revenue rise or fall? These problems, perhaps similar to those you might ask on an exam, are complex in that they test several 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. 34 o far, we ve been talking about how elasticity determines the effects of an increase in on revenue. art (b) asks your students to determine the effects of a decrease in. A C T I V E L E A R N I N G 2 Answers A. harmacies raise the price of insulin by 10%. oes total expenditure on insulin rise or fall? Expenditure x ince demand is inelastic, will fall less than 10%, so expenditure rises. 35

A C T I V E L E A R N I N G 2 Answers B. As a result of a fare war, the price of a luxury cruise falls 20%. oes luxury cruise companies total revenue rise or fall? Revenue x The fall in reduces revenue, but increases, which increases revenue. Which effect is bigger? ince demand is elastic, will increase more than 20%, so revenue rises. 36 The first part of the explanation discusses the opposing effects on revenue; its purpose is to clarify the effects of a price decrease on revenue, as we have previously only discussed the effects of a price increase. ALICATION: oes rug Interdiction Increase or ecrease rug-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. emand for illegal drugs is inelastic, due to addiction issues. ELATICITY AN IT ALICATION 37 In the textbook, this application appears near the end of the chapter, and you can easily move these slides 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 the section on price elasticity of demand. It is safe to do so, as this application only requires knowledge of price elasticity. 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. Knowing elasticity helps us understand what might otherwise be a counter-intuitive result (that drug interdiction increases drug-related crime rather than reducing it). Interdiction reduces the supply of drugs. ince demand for drugs is inelastic, rises proportionallymore than falls. olicy 1: Interdiction rice of rugs 2 1 Result: an increase in total spending on drugs, and in drug-related crime new value of drugrelated crime 2 1 uantity of rugs ELATICITY AN IT ALICATION 38 2 1 1 initial value of drugrelated crime By the time all elements have appeared on the screen, the slide will look kind of busy. I think this is okay, because the elements appear on the screen one by one, so students have time to absorb each one before the next one appears. However, if you d rather strip the slide down a bit, here s a suggestion: in Normal view (which one uses to 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 your mouse cursor, a laser pointer, or even your arms and hands) the areas that represent the initial and new values of drug-related crime.

Education reduces the demand for drugs. and fall. Result: A decrease in total spending on drugs, and in drug-related crime. olicy 2: Education rice of rugs 1 2 new value of drugrelated crime 2 1 2 1 initial value of drugrelated crime uantity of rugs ELATICITY AN IT ALICATION 39 rice Elasticity of upply rice elasticity of supply ercentage change in s ercentage change in rice elasticity of supply measures how much s responds to a change in. Loosely speaking, it measures sellers price-sensitivity. Again, use the midpoint method to compute the percentage changes. Most everything in the price elasticity of supply section corresponds to analogous concepts from the price elasticity of demand section. o, it is probably safe to move through this section more quickly. ELATICITY AN IT ALICATION 40 rice Elasticity of upply rice elasticity of supply ercentage change in s ercentage change in Example: rice elasticity of supply equals 16% 8% 2.0 rises by 8% 2 1 rises by 16% 1 2 ELATICITY AN IT ALICATION 41 The Variety of upply 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. Economists classify supply curves according to their elasticity. The next 5 slides present the different classifications, from least to most elastic. ELATICITY AN IT ALICATION 42

erfectly inelastic (one extreme) rice elasticity of supply curve: vertical ellers none 0 % change in % change in rises by 10% ELATICITY AN IT ALICATION 43 2 1 1 0% 10% 0 changes by 0% Inelastic rice elasticity of supply curve: relatively steep ellers relatively low < 1 % change in % change in rises by 10% ELATICITY AN IT ALICATION 44 2 1 < 10% 10% < 1 1 2 rises less than 10% Unit elastic rice elasticity of supply curve: intermediate slope ellers intermediate 1 % change in % change in rises by 10% ELATICITY AN IT ALICATION 45 2 1 1 10% 10% 1 2 rises by 10% Elastic rice elasticity of supply curve: relatively flat ellers relatively high > 1 % change in % change in rises by 10% ELATICITY AN IT ALICATION 46 2 1 > 10% 10% > 1 1 2 rises more than 10% erfectly elastic (the other extreme) rice elasticity of supply curve: horizontal ellers extreme infinity % change in % change in 2 1 changes by 0% ELATICITY AN IT ALICATION 47 1 any % 0% infinity 2 changes by any %

The eterminants of upply Elasticity The more easily sellers can change the quantity they produce, the greater the price elasticity of supply. Example: upply of beachfront property is harder 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. This section is not perfectly analogous to the section on the determinants of the price elasticity, but it s similar enough that you can probably cover it more quickly and with much less hand-holding. ELATICITY AN IT ALICATION 48 A C T I V E L E A R N I N G 3 Elasticity and changes in equilibrium The supply of beachfront property is inelastic. The supply of new cars is elastic. uppose population growth causes demand for both goods to double (at each price, d doubles). For which product will change the most? For which product will change the most? This is one of the roblems and Applications at the end of the chapter. 49 A C T I V E L E A R N I N G 3 Answers When supply is inelastic, an increase in demand has a bigger impact on price than on quantity. 2 1 1 Beachfront property (inelastic supply): 2 1 A 2 B 50 In this slide and the next, the initial price and quantity and the two demand curves are the same. The only difference is the elasticity of supply and slope of the supply curve. [The curve shifts to the right, but not in a parallel fashion: at each price, quantity demanded is twice as high, so the new curve will be flatter than the initial one.] In the text box containing the verbal explanation, bigger impact is shorthand for bigger percentage impact or bigger proportional impact. A C T I V E L E A R N I N G 3 Answers When supply is elastic, an increase in demand has a bigger impact on quantity than on price. 2 1 1 2 New cars (elastic supply): A B 1 2 51

How the rice Elasticity of upply Can Vary $15 4 $3 12 elasticity > 1 100 200 elasticity < 1 ELATICITY AN IT ALICATION 52 500 525 upply often becomes less elastic as rises, due to capacity limits. This 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 100 to 120 (or 67%). Because 67% > 29%, price elasticity of supply is greater than one. When the price rises from $12 to $15 (22%), quantity rises from 500 to 525 (about 5%), so price elasticity of supply is less 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 doesn t take 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: there s little or no excess capacity, they are already running their factories and machines at a high level of intensity. To increase output further, they might have to pay their workers overtime, and their machines experience more wear and tear and therefore require more repairs. o, at high levels of output, it takes a much larger price increase to make firms willing to increase output further. Eventually, firms bump up against their capacity constraints, and simply cannot increase output in response 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. Real-world example: In the peak summer driving season, gasoline demand is highest. Many refineries are producing near capacity, so the supply curve is steep. In other months, when demand is lower, refineries have more excess capacity, and the supply curve is not as steep.

Other Elasticities Income elasticity : measures the response of d to a change in consumer income Income elasticity ercent change in d ercent change in income Recall from Chapter 4: An increase in income causes an increase in demand for a normal good. Hence, for normal goods, income elasticity > 0. For inferior goods, income elasticity < 0. This topic and the next one (cross-price elasticity) do not appear anywhere else in the book. Instructors who are pressed for time may consider cutting these topics. (This is merely my suggestion, not the official position of Greg Mankiw or Cengage/outh-Western.) ELATICITY AN IT ALICATION 53 Other Elasticities Cross-price elasticity : measures the response for one good to changes in the price of another good Cross-price elast. % change in d 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) ELATICITY AN IT ALICATION 54 Cross-rice Elasticities in the News As Gas Costs oar, Buyers Flock to mall Cars -New York Times, 5/2/2008 Gas rices rive tudents to Online Courses -Chronicle of Higher Education, 7/8/2008 Gas prices knock bicycle sales, repairs into higher gear -Associated ress, 5/11/2008 Camel demand soars in India (as a substitute for gas-guzzling tractors ) -Financial Times, 5/2/2008 High gas prices drive farmer to switch to mules -Associated ress, 5/21/2008 ELATICITY AN IT ALICATION 55 I found all of these at Greg Mankiw s blog, at http://gregmankiw.blogspot.com. Most were posted during May 2008; the one about online courses is from July 2008. He adds new ones periodically as he finds them. If you d like to see the actual articles, start at Mankiw s blog and search on cross-price elasticity. You ll get a list of all of his posts on this topic, with links to the articles. (If any of the links are broken, try Googling the article s title/headline.) CHATER UMMARY Elasticity measures the responsiveness of d or s to one of its determinants. rice elasticity equals percentage change in d divided by percentage change in. When it s 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. 56

CHATER UMMARY emand is less elastic in the short run, for necessities, for broadly defined goods, or for goods with few close substitutes. rice elasticity of supply equals percentage change in s divided by percentage change in. When it s less than one, supply is inelastic. When greater than one, supply is elastic. rice elasticity of supply is greater in the long run than in the short run. 57 CHATER UMMARY The income elasticity measures how much quantity demanded responds to changes in buyers incomes. The cross-price elasticity measures how much demand for one good responds to changes in the price of another good. 58