The elasticity of demand, and consumer surplus.

Friedman, Microeconomics, chapter 6.

Where we are

Big ideas • Consumer surplus is the extra pleasure you

get over-and-above the price of commodities. It makes life worth living

• The elasticity of demand reflects how much consumption falls if prices rise, or vice versa.

• The elasticity of demand reflects both need and how easy it is to replace a product.

• Capitalists try to turn consumer surplus into profits by raising prices without losing sales. They need to reduce demand elasticity.

I like dogs because they give me more pleasure than I lose by paying for

them.

Consumer surplus: the extra pleasure we get from consuming.

No surplus on the last, or marginal purchase.

Last unit price = MUWe pay just as much as

our pleasure.Surplus only from

inframarginal purchases, before the marginal purchase.

Buy until MU=price

You get no net pleasure from the last unit because MU=price!

MU diminishes. Therefore before the last, MU>price for previous (inframarginal) items.

This is surplus!It is the inframarginal that makes you happy!

You get consumer surplus from every purchase before the final one

Beer MU Price Consumer surplus or MU-price

1 15 1.25 13.75

2 10 1.25 8.75

3 6 1.25 4.75

4 3 1.25 1.75

5 2 1.25 .75

6 (The marginal beer) 1.25 1.25 0

7 0.5 1.25 -.75

8 .25 1.25 -1

9 0 1.25 -1.25

When I buy wine, I buy until the last glass is just worth the cost

This means that until then, each gives me more pleasure than it cost.

This is surplus.

Surplus falls on additional purchases

Because of diminishing marginal utility – of course! (You knew that!)

How to find total surplus First figure out how many glasses you will buy. (Buy

until MU=price, or 2 glasses.) Then figure out how much surplus on each glass you

buy, or MU-price. On first glass, MU-price = $10-5=$5. On second glass, MU-price=$5-5=0. Total: $5+0=$5.

The Elasticity of Demand is the relative change in quantity demanded for a

change in priceThe elasticity is the

percentage change in quantity divided by the percentage change in price.

This tells you how responsive demand is to price changes

Some people would keep their puppies at any priceThat is inelastic demand!

Demand elasticity depends on two things

Can you do without the service.

(Could you live without puppy love?)

Can you find another source if the price rises?

(I need gas but I could get it from another gas station.)

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High and low demand elasticity

Inelastic demand: large change in price, small change in quantity

Elastic demand: large change in quantity for a small change in price

Quantity

Price

“Necessities” don’t necessarily have inelastic demand

Highly elastic demand:It is easy to stop buying

when prices rise.Consumers either do

without or they find another way to get it.

Inelastic demand:It is hard to stop buying

even when prices rise.Consumers can’t do

without and they can’t find another way to get it.

It is not only about whether you need the product

The elasticity of demand for Dunkin Donuts may be low even though you don’t need donuts because almost no one else makes good donuts.

The elasticity of demand for penicillin from Merck is high even though it may save your life because others make penicillin and there are other antibiotics

Companies want inelastic demand

Then they can raise prices and increase profits without losing sales

They try to make you think you need their product, and to distinguish theirs from their rivals.

Some things come in inelastic demand because they are distinct,

even unique

Demand elasticity for these depends on how important they are.

Two ways to reduce elasticity of demand

Make people think that life without the product is not worth living.

Reduce alternative sources of supply.

Harass and destroy the competition.

Advertising is about persuading you that you need things

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They would have you think that their product, and only their product, will

make you sexy and happy

Sometimes they have it wrong

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Created scarcity is the key to power and profit

Make your product special, unique, and you reduce the elasticity of demand, allowing you to raise prices and profit.

Ways to create scarcity:1. Branding: create a

reputation for quality2. Control access to

technology3. Control access to essential

resources

Capitalism is about profit, not use value. Companies want little

monopolies with low elasticity of demand

They brand name, and grab resources, and technology to restrict consumer choices.

Trademarks, patents, restrictive labor contracts, land-grabs.

Microsoft, the RIAA, the drug companies: all do this to increase profits.

Artificial scarcity allows companies to “milk the consumer surplus”

Consumer surplus makes life worth living.

It is the extra value you get from consumption beyond what you pay.

It is the value from your “inframarginal” purchases.

By raising prices, artificial scarcity reduces consumer surplus and makes

you less happy

Even, unhappy

So, down with artificial scarcity!

Down with monopoly profits!

Take-away points• Consumer surplus is the extra pleasure you get

over-and-above the price of commodities.• The elasticity of demand tells how much you will

reduce consumption if prices go up, or how much more you will buy if prices fall.

• The elasticity of demand reflects how much you need the product, and how easy it is to find substitutes.

• Capitalists try to turn surplus into profits by raising prices. To do this, they need to lower the elasticity of demand by reducing substitution and competition.