Chapter 6 Elasticity Consumer Surplus and Producer Surplus

Chapter 6 Elasticity, Consumer Surplus, and Producer Surplus Mc. Graw-Hill/Irwin Copyright © 2009 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Chapter Objectives • • Price elasticity of demand The total revenue test Price elasticity of supply Cross elasticity of demand Income elasticity of demand Consumer & producer surplus Efficiency losses 6 -2

Price Elasticity of Demand • Measuring responsiveness to price changes • Elastic demand – Large change in quantity purchased for given price change • Inelastic demand – Small change in quantity purchased for given price change 6 -3

Price Elasticity of Demand • Price-elasticity coefficient and formula Ed = Percentage Change in Quantity Demanded of Product X Percentage Change in Price of Product X 6 -4

Price Elasticity of Demand • Calculate percentage change • Restate formula Ed = Change in Quantity Demanded of X Original Quantity Demanded of X ÷ Change in Price of X Original Price of X 6 -5

Price Elasticity of Demand • Calculation problem • Starting point matters • Midpoint formula Ed = Change in Quantity Sum of Quantities/2 ÷ Change in Price Sum of Prices/2 6 -6

Interpretations of Elasticity Elastic Demand Ed = . 04. 02 =2 . 01. 02 =. 5 . 02 =1 Inelastic Demand Ed = Unit Elasticity Ed = 6 -7

Price Elasticity of Demand • Why use percentages? – Unit free measure – Compare responsiveness across products • Elimination of the (-) sign • Extreme cases – Perfectly inelastic demand – Perfectly elastic demand 6 -8

The Total Revenue Test • Total Revenue = TR = Px. Q • Inelastic demand – P and TR change in same direction • Elastic demand – P and TR change in opposite direction 6 -9

The Total Revenue Test • Lower price and elastic demand – Blue gain exceeds gold loss P $3 a 2 b 1 D 1 0 10 20 30 40 Q 6 -10

The Total Revenue Test • Lower price and inelastic demand – Gold loss exceeds blue gain P c $4 3 2 d 1 D 2 0 10 20 Q 6 -11

The Total Revenue Test • Lower price and unit-elastic demand – Blue gain equals yellow loss P e $3 2 f 1 D 3 0 10 20 30 Q 6 -12

Elasticity on a Linear Demand Curve (1) Total Quantity of Tickets Demanded Per Week, Thousands 1 2 3 4 5 6 7 8 (2) Price Per Ticket $8 ] 7 ] 6 ] 5 ] 4 ] 3 ] 2 ] 1 (3) Elasticity Coefficient (Ed) 5. 00 2. 60 1. 57 1. 00 0. 64 0. 38 0. 20 (4) Total Revenue (1) X (2) $8, 000 ] 14, 000 ] 18, 000 ] 20, 000 ] 18, 000 ] 14, 000 ] 8, 000 (5) Total-Revenue Test Elastic Unit Elastic Inelastic 6 -13

Price Elasticity and the TR Curve $8 a 7 b 6 c 5 d 4 e 3 f 2 g 1 h D 0 1 2 3 4 5 6 7 8 Elastic Ed > 1 Unit Elastic Ed = 1 Inelastic Ed < 1 Total Revenue (Thousands of Dollars) Quantity Demanded $20 18 16 14 12 10 8 6 4 2 TR 0 1 2 3 4 5 6 7 8 Quantity Demanded 6 -14

Determinants of Elasticity • Substitutability – More substitutes, more elastic demand • Proportion of income – Price relative to income • Luxuries versus necessities – Luxuries are more elastic • Time – More elastic in the long run 6 -15

Applications of Elasticity • Large crop yields – Inelastic demand • Excise taxes – Inelastic demand • Decriminalization of illegal drugs – Elastic or inelastic demand? 6 -16

Price Elasticity of Supply Responsiveness to price changes by producers Es = Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X 6 -17

Price Elasticity of Supply • Market period – Perfectly inelastic supply • Short run – Fixed plant size • Long run – Adjustable plant size – Supply more elastic 6 -18

Price Elasticity of Supply The Market Period • Perfectly inelastic supply P Greatest Price Impact Sm Pm P 0 D 1 D 2 Q 0 Q 6 -19

Price Elasticity of Supply The Short Run • Inelastic supply P Lower Price Impact Ss Ps P 0 D 1 D 2 Q 0 Qs Q 6 -20

Price Elasticity of Supply The Long Run • Elastic supply P Sl Least Price Impact Pl P 0 D 1 D 2 Q 0 Ql Q 6 -21

Price Elasticity of Supply • Applications • Antiques and reproductions – Limited, inelastic supply – Strong demand – Resulting high price • Volatile gold prices – Inelastic supply – Shifting demand 6 -22

Cross Elasticity of Demand • Responsiveness of sales to change in price of another good Exy = Percentage Change in Quantity Demanded of Product X Percentage Change in Price of Product Y 6 -23

Cross Elasticity of Demand • Substitute goods – Positive sign • Complementary goods – Negative sign • Independent goods – Zero 6 -24

Income Elasticity of Demand Ei = Percentage Change in Quantity Demanded Percentage Change in Income • Responsiveness of sales to change in income • Normal goods – positive sign • Inferior goods– negative sign 6 -25

Consumer Surplus • Benefit surplus • Maximum willingness to pay (WTP) less than actual price paid Person Bob Barb Bill Bart Brent Betty Max WTP Actual Price $13 $8 $12 $8 $11 $8 $10 $8 $9 $8 $8 $8 CS $5 $4 $3 $2 $1 $0 6 -26

Consumer Surplus Price (Per Bag) Consumer Surplus Equilibrium Price = $8 P 1 D Q 1 Quantity (Bags) 6 -27

Producer Surplus • Benefit surplus • Actual price received more than minimum acceptable price (AP) Person Carlos Courtney Chuck Cindy Craig Chad Min AP $3 $4 $5 $6 $7 $8 Actual Price $8 $8 $8 PS $5 $4 $3 $2 $1 $0 6 -28

Producer Surplus Price (Per Bag) S Producer Surplus Equilibrium Price = $8 P 1 Quantity (Bags) 6 -29

Efficiency Revisited • Productive and allocative efficiency S Price (Per Bag) Consumer Surplus Equilibrium Price = $8 P 1 Producer Surplus D Q 1 Quantity (Bags) 6 -30

Efficiency Loss • Deadweight loss S Price (Per Bag) Efficiency Losses P 1 D Q 2 Q 1 Q 3 Quantity (Bags) 6 -31

Elasticity and Pricing Power • Competitive markets – No pricing power • Firms with market power – Charge different prices • Differences in group elasticities – Business vs. leisure travelers – Discounting for children – College tuition 6 -32

Key Terms • price elasticity of demand • midpoint formula • elastic demand • inelastic demand • unit elasticity • perfectly inelastic demand • perfectly elastic demand • total revenue (TR) • total-revenue test • price elasticity of supply • market period • short run • long run • cross elasticity of demand • income elasticity of demand • consumer surplus • producer surplus • efficiency losses (deadweight losses) 6 -33

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