Elasticity Consumer Surplus and Producer Surplus Chapter 6

Elasticity, Consumer Surplus, and Producer Surplus Chapter 6 LECTURE 5 & 6 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 • The responsiveness (or sensitivity) of consumers to a change in a product’s price • 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 ▫ the degree to which demand is price elastic or inelastic is measured by the coefficient Ed 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 ▫ This formula averages the two prices and the two quantities as the reference points for computing the percentages. Ed = Change in Quantity Sum of Quantities/2 ÷ Change in Price Sum of Prices/2 6 -6

Midpoint formula example • Suppose price increases for a good from $3 to $4 causing the quantity demanded to fall from 20 to 10 units in response to the price change. • Computing the price elasticity coefficient. 10 Ed = (10 + 20) / 2 = 2. 3 ÷ $1 ($ 3 + $ 4) /2

Elimination of the minus sign • Price and quantity demanded are inversely related, hence the price elasticity of demand coefficient will always be negative. • The magnitude (or size) of the coefficient is important. • Economist usually ignore the minus sign and simply present the absolute value of the elasticity coefficient.

Interpretations of Elasticity • Elastic Demand Ed = . 04. 02 =2 • Inelastic Demand Ed = . 01. 02 Ed = . 02 Ed < 1 =. 5 • Unit Elasticity. 02 E d >1 Ed = 1 =1 6 -9

Price Elasticity of Demand • Why use percentages? ▫ Unit free measure ▫ Compare responsiveness across products • Elimination of the (-) sign 6 -10

Extreme cases

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 • Unit Elastic demand ▫ TR does not change when P changes 6 -12

The Total Revenue Test Elastic Demand • At point a on D 1, TR=$20 • At point b on D 1, TR =$40 P $3 a 2 b 1 • Price falls, TR rises D 1 0 10 20 30 40 Q 6 -13

The Total Revenue Test Inelastic Demand • At point c on D 2, TR=$40 P c $4 3 • At point d on D 2, TR =$20 2 d • Price falls, TR decreases 1 D 2 0 10 20 Q 6 -14

The Total Revenue Test Unit Elastic Demand • At point e on D 3, TR=$30 • At point f on D 3, TR =$30 P e $3 2 f 1 • Price falls, TR does not change. D 3 0 10 20 30 Q 6 -15

Price Elasticity on a Linear Demand Curve • Elasticity coefficients declines moving from higher to lower prices. 6 -16

The Relationship between Price Elasticity and the TR Curve illustrated • When price falls and TR increases, demand is elastic. • When price falls and TR is unchanged, demand is unit elastic. • When price falls and TR declines, demand is inelastic. 6 -17

The Relationship between Price Elasticity and the TR Curve illustrated

A Summary of Price Elasticity of Demand

Determinants of Price Elasticity of Demand • 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 -20

Applications of Elasticity • Large crop yields ▫ Inelastic demand • Excise taxes ▫ Inelastic demand • Decriminalization of illegal drugs ▫ Elastic or inelastic demand? 6 -21

Price Elasticity of Supply • The responsiveness (or sensitivity) of producers to a change in a product’s price • Supply is elastic if producers are relatively responsive to price changes • Supply is inelastic if producers are relatively insensitive to price changes 6 -22

The Price Elasticity Coefficient and For • The degree to which supply is price elastic or inelastic is measured with the coefficient Es: Es = Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X

Calculating Price Elasticity of Supply using the Midpoint Formula • Suppose the price of a good rises from $4 to $6 and producers respond by increasing supply from 10 to 14 units. • What is the coefficient of price elasticity of supply in this example?

Price Elasticity of Supply – The Market Period • The Market period (Perfectly inelastic supply): • The time immediately after a change in market price is too short for producers to respond with a change in quantity supplied. • Short run (Fixed plant size) ▫ The time too short to change plant capacity but long enough to use fixed plant more or less extensively • Long run (Adjustable plant size) ▫ The time long enough for firms to adjust their plant sizes and for new firms to enter (or existing firms to leave) the industry. ▫ Supply more elastic 6 -25

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 -26

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 -27

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 -28

Price Elasticity of Supply • Applications • Antiques and reproductions ▫ Limited, inelastic supply ▫ Strong demand ▫ Resulting high price • Volatile gold prices ▫ Inelastic supply ▫ Shifting demand 6 -29

Cross Elasticity of Demand • Measures how sensitive consumer purchases of one product are to a change in the price of a different, but related product Exy = Percentage Change in Quantity Demanded of Product X Percentage Change in Price of Product Y 6 -30

Classifying Cross Elasticity of Demand “Related” Goods • Substitute goods ▫ Positive cross elasticity of demand relationship • Complementary goods ▫ Negative cross elasticity of demand relationship • Independent goods ▫ Zero or near zero cross elasticity of demand relationships 6 -31

Income Elasticity of Demand • Measures the degree to which consumers respond to a change in their incomes by buying more or less of a particular product Ei = Percentage Change in Quantity Demanded Percentage Change in Income 6 -32

Classifying goods in terms of Income Elasticity of Demand • Normal goods – the Income Elasticity of Demand is positive sign • Inferior goods– the Income Elasticity of Demand coefficient is negative sign

Cross and Income Elasticities of Demand

Consumer Surplus • The difference between the maximum price a consumer was willing to pay and the actual market equilibrium price of the product. 6 -35

Consumer Surplus

Producer Surplus Price (Per Bag) • The difference between the actual price a producers receive for a good and the minimum acceptable price. S Producer Surplus P 1 Q 1 Equilibrium Price = $8 Quantity (Bags)

Producer Surplus

Efficiency Revisited S Consumer Surplus Price (Per Bag) • Productive and allocative efficiency Equilibrium Price = $8 P 1 Producer Surplus D Q 1 Quantity (Bags) 6 -39

Efficiency Loss • Deadweight loss S Price (Per Bag) Efficiency Losses P 1 D Q 2 Q 1 Q 3 Quantity (Bags) 6 -40

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 -41

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 -42

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