# Elasticity and its Application

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Elasticity and its Application
5 Elasticity and its Application Economics P R I N C I P L E S O F N. Gregory Mankiw The 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 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. Second, 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 PowerPoint 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. Please be assured that this PowerPoint presentation is, nonetheless, very consistent with the textbook’s approach. Premium PowerPoint Slides by Ron Cronovich

Calculating Percentage Changes
So, we instead use the midpoint method: end value – start value midpoint 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! ELASTICITY AND ITS APPLICATION 2

Calculating Percentage Changes
Using the midpoint method, the % change in P equals \$250 – \$200 \$225 x 100% = 22.2% The % change in Q equals 12 – 8 10 x 100% = 40.0% These calculations are based on the example shown a few slides back: points A and B on the website demand curve. The price elasticity of demand equals 40/22.2 = 1.8 ELASTICITY AND ITS APPLICATION 3

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 of demand for hotel rooms: if P = \$70, Qd = 5000 if P = \$90, Qd = 3000 4

A C T I V E L E A R N I N G 1 Answers
Use 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 5

Price Elasticity and Total Revenue
Price elasticity of demand = Percentage change in Q Percentage change in P Revenue = P x Q If demand is elastic, then price elast. of demand > 1 % change in Q > % change in P The fall in revenue from lower Q is greater than the increase in revenue from higher P, so revenue falls. ELASTICITY AND ITS APPLICATION 6

Price Elasticity and Total Revenue
Elastic demand (elasticity = 1.8) increased revenue due to higher P Demand for your websites P Q lost revenue due to lower Q \$200 12 If P = \$200, Q = 12 and revenue = \$2400. D \$250 8 If P = \$250, Q = 8 and revenue = \$2000. 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 “Slide Show” mode (presentation mode), all will be fine – try it! Point out to students that the area (outlined in blue) representing lost revenue due to lower Q is larger than the area (outlined in yellow) representing increased revenue due to higher P. Hence, the net effect is a fall in revenue. When D is elastic, a price increase causes revenue to fall. ELASTICITY AND ITS APPLICATION 7

Price Elasticity and Total Revenue
Now, demand is inelastic: elasticity = 0.82 increased revenue due to higher P Demand for your websites P Q lost revenue due to lower Q \$200 12 If P = \$200, Q = 12 and revenue = \$2400. D \$250 10 If P = \$250, Q = 10 and revenue = \$2500. Again, the slide appears cluttered in “Normal” view (edit mode), but everything is fine when displayed in “Slide Show” mode (presentation mode). Point out to students that the area representing lost revenue due to lower Q is smaller than the area representing 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. In that case, an increase in price leaves revenue unchanged: the increase in revenue from higher P exactly offsets the lost revenue due to lower Q. When D is inelastic, a price increase causes revenue to rise. ELASTICITY AND ITS APPLICATION 8

Supply, Demand, and Government Policies
6 Supply, Demand, and Government Policies Economics P R I N C I P L E S O F N. Gregory Mankiw This chapter builds on the previous two (supply & demand and elasticity). Students who learned those chapters well usually do not have much difficulty with the material in Chapter 6. This chapter can usually be covered in about 90 minutes of class time. I have combined the analysis of price ceilings with the rent control example, and I’ve combined the analysis of price floors with the minimum wage example. (In contrast, the textbook presents a generic analysis of price ceilings, then the rent control example, then a generic analysis of price floors, then the minimum wage). Most students learn new concepts better in the context of a specific example rather than a generic analysis, and combining them in this way saves class time. Here’s an idea you might consider: At the end of the class session just prior to the one in which you begin to cover this chapter, ask students to take out a piece of blank paper, and write down whether they think the minimum wage should be increased, and their reason(s). Tell them not to write their names (you want them to be candid), and have them leave their pieces of paper in a pile as they exit the classroom. Later, divide the papers into two groups based on whether they support or oppose increasing the minimum wage. In this PowerPoint file, immediately after this slide, insert new two slides, titling them “Your reasons for raising the minimum wage” and “Your reasons for not raising the minimum wage.” Summarize on each slide the most common reasons students gave. Begin the class session by showing them the results of this impromptu survey (how many students responded each way, and the most common reasons). Tell those students that support a minimum wage increase that their thinking represents that of many educated non-economists. But tell them that economics offers another perspective, and this is something they will learn in this chapter. If you do this, then I recommend rearranging the slides a bit so that the price floor/minimum wage slides come BEFORE the price ceiling/rent control slides. Premium PowerPoint Slides by Ron Cronovich

A C T I V E L E A R N I N G 1 Price controls
Q P S The market for hotel rooms D Determine effects of: A. \$90 price ceiling B. \$90 price floor C. \$120 price floor A good exercise to break up the lecture, engage students, and assess their learning so far. 10

A C T I V E L E A R N I N G 1 A. \$90 price ceiling
Q P S The market for hotel rooms D The price falls to \$90. Buyers demand 120 rooms, sellers supply 90, leaving a shortage. Price ceiling shortage = 30 11

A C T I V E L E A R N I N G 1 B. \$90 price floor
Q P S The market for hotel rooms D Eq’m price is above the floor, so floor is not binding. P = \$100, Q = 100 rooms. Price floor 12

A C T I V E L E A R N I N G 1 C. \$120 price floor
Q P S The market for hotel rooms D The price rises to \$120. Buyers demand 60 rooms, sellers supply 120, causing a surplus. surplus = 60 Price floor 13

A C T I V E L E A R N I N G 2 Effects of a tax
Q P S The market for hotel rooms D Suppose govt imposes a tax on buyers of \$30 per room. Find new Q, PB, PS, and incidence of tax. These are the same supply and demand curves used in the previous exercise.

A C T I V E L E A R N I N G 2 Answers
Q P S The market for hotel rooms D Q = 80 PB = \$110 PB = Tax PS = \$80 PS = Incidence buyers: \$10 sellers: \$20 First, the equilibrium quantity is the quantity where PB – PS = \$30. This quantity is 80. Next, to find PB, start at Q=80 and go up to the demand curve to see that PB = \$110. To find PS, start at Q=80 and go up to the supply curve to see that PS = \$80. To find incidence, just compare PB and PS to the no-tax equilibrium price, \$100.

Consumers, Producers, and the Efficiency of Markets
7 Consumers, Producers, and the Efficiency of Markets Economics P R I N C I P L E S O F N. Gregory Mankiw This is a very theoretical chapter. Most students in principles-level courses are a bit less patient with theory than with real-world applications. However, you can tell your students that learning the material in this chapter will pay off in (at least) two ways. First, the tools introduced in this chapter (consumer & producer surplus, welfare economics) are used extensively in the real world to assess the costs and benefits of policies and market imperfections. When does a policy do more harm than good? Who does the policy make better off, and who is made worse off? How do the total gains to the winners compare to the total losses incurred by the losers? The following two chapters will use the tools of welfare economics to analyze taxes and international trade (including restrictions on trade). Students typically find these applications very interesting, and they are much easier to learn after students have a good working knowledge of the material covered in this chapter. Second, this chapter illuminates one of the most important ideas in economics: Adam Smith’s invisible hand, a.k.a. the principle that markets are usually a good way to organize economic activity. Note that this analysis assumes perfect competition. When this assumption fails, the market on its own may not maximize society’s well-being. We will study such market failures in later chapters, and we’ll use the tools of welfare economics to see how public policy can improve on the market outcome in such cases. Premium PowerPoint Slides by Ron Cronovich

A C T I V E L E A R N I N G 1 Consumer surplus
demand curve P A. Find marginal buyer’s WTP at Q = 10. B. Find CS for P = \$30. \$ Suppose P falls to \$20. How much will CS increase due to… C. buyers entering the market D. existing buyers paying lower price Q 17

A C T I V E L E A R N I N G 1 Answers
demand curve P A. At Q = 10, marginal buyer’s WTP is \$30. B. CS = ½ x 10 x \$10 = \$50 \$ P falls to \$20. C. CS for the additional buyers = ½ x 10 x \$10 = \$50 D. Increase in CS on initial 10 units = 10 x \$10 = \$100 Q 18

A C T I V E L E A R N I N G 2 Producer surplus
supply curve P A. Find marginal seller’s cost at Q = 10. B. Find total PS for P = \$20. Suppose P rises to \$30. Find the increase in PS due to… C. selling 5 additional units D. getting a higher price on the initial 10 units Q 19

A C T I V E L E A R N I N G 2 Answers
supply curve P A. At Q = 10, marginal cost = \$20 B. PS = ½ x 10 x \$20 = \$100 P rises to \$30. C. PS on additional units = ½ x 5 x \$10 = \$25 D. Increase in PS on initial 10 units = 10 x \$10 = \$100 Q 20

Application: The Costs of Taxation
8 Application: The Costs of Taxation Economics P R I N C I P L E S O F N. Gregory Mankiw This chapter builds very closely on material from the previous three chapters: it uses the tools of welfare economics (from Chapter 7) to analyze the effects of a tax (introduced in Chapter 6). It explores the relationship between the price elasticities of demand and supply (Chapter 5) with the deadweight loss of the tax. Covering this chapter immediately after the previous three will reinforce the concepts students learned in those chapters. The material in chapter 8 is important. The government must raise revenue to pay for the police, the court system, interstate highways, national defense, public education, and so forth. The government must choose which goods to tax and how much to tax each one. Effective tax policy generates the needed revenue while striving for (the sometimes conflicting goals of) efficiency and equity. This is not one of the longer chapters; most instructors cover it in 1.5 or 2 hours of class time. But if you’re pressed for time and looking for things to cut, you might consider cutting some of these (my personal suggestions, not the official recommendations of Greg Mankiw or South-Western/Cengage): Revenue and the size of the tax, the Laffer Curve DWL and the size of the tax Active Learning 3, the slide with the discussion question on whether to tax groceries or meals at fancy restaurants Active Learning 2 Premium PowerPoint Slides by Ron Cronovich

A C T I V E L E A R N I N G 1 Answers to A
The market for airplane tickets P Q \$ CS = ½ x \$200 x 100 = \$10,000 D S PS = ½ x \$200 x 100 = \$10,000 P = Total surplus = \$10,000 + \$10,000 = \$20,000 22

A C T I V E L E A R N I N G 1 Answers to B
A \$100 tax on airplane tickets P Q \$ CS = ½ x \$150 x 75 = \$5,625 D S PS = \$5,625 PB = Tax revenue = \$100 x 75 = \$7,500 PS = To compute DWL, simply subtract total surplus with the tax (\$18750) from total surplus without the tax (\$20,000, which was computed on the preceding slide). Equivalently, compute the area of the blue shaded triangle: ½ x (100-75) x (\$250 – \$150) = \$1250. Total surplus = \$18,750 DWL = \$1,250 23

9 Application: International Trade Economics P R I N C I P L E S O F N. Gregory Mankiw This relatively short chapter has a few main objectives: Welfare analysis of free trade in a good that a country exports, relative to no trade. Welfare analysis of free trade in a good that the country imports, relative to no trade. Welfare analysis of a tariff, relative to free trade in a good the country imports. The most common arguments for restricting imports, and the economist’s response to each. Premium PowerPoint Slides by Ron Cronovich

A C T I V E L E A R N I N G 1 Analysis of trade

A C T I V E L E A R N I N G 1 Answers
Under free trade, domestic consumers demand 600 domestic producers supply 200 imports = 400 P Q Plasma TVs D S \$3000 PD > PW, so this country will import plasma TV sets from abroad. The quantity of imports is simply the difference between the quantity demanded by domestic consumers and the quantity supplied by domestic firms at the world price. \$1500 200 600 imports 26

A C T I V E L E A R N I N G 1 Answers
Without trade, CS = A PS = B + C Total surplus = A + B + C With trade, CS = A + B + D PS = C Total surplus = A + B + C + D P Q Plasma TVs D S gains from trade A \$3000 B D Trade benefits consumers in this case because it allows them to buy plasma TVs at lower prices, so more consumers can afford plasma TVs if imports are allowed. The gains to consumers appear on the graph as the area (B+D), which represents the increase in consumer surplus when the country allows trade. In this example, trade harms domestic producers because they now must sell their plasma TVs at a lower price. As a result, they produce a smaller quantity, earn less revenue, and likely let go of some of their workers. These losses are represented on the graph by the area B , which represents the fall in producer surplus resulting from trade. As the graph shows, the gains to consumers outweigh the losses to producers: total surplus increases by the amount D, which represents the gains from trade in plasma TV sets. \$1500 C imports 27