elasticity consumer surplus and producer surplus
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Elasticity, Consumer Surplus, and Producer Surplus
Chapter 6
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-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
Percentage Change in QuantityDemanded of Product X
Percentage Change in Priceof Product X
Ed =
6-4
Price Elasticity of Demand
• Calculate percentage change• Restate formula
Change in Quantity Demanded of X
Original Price of X
Ed =
Change in Price of X
Original Quantity Demanded of X
÷
6-5
Price Elasticity of Demand
• Calculation problem• Starting point matters• Midpoint formula
Change in QuantityEd = Sum of Quantities/2
÷Change in Price
Sum of Prices/2
6-6
Interpretations of Elasticity
Elastic Demand
Inelastic Demand
Unit Elasticity
Ed = .04.02 = 2
Ed = .01.02 = .5
Ed = .02.02 = 1
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 = PxQ
• Inelastic demand–P and TR change in same direction
• Elastic demand–P and TR change in opposite
direction
6-9
$3
2
1
0 10 20 30 40 Q
P
• Lower price and elastic demand–Blue gain exceeds gold loss
a
b
D1
The Total Revenue Test
6-10
$4
3
2
1
0 10 20 Q
P
• Lower price and inelastic demand–Gold loss exceeds blue gain
c
d
D2
The Total Revenue Test
6-11
$3
2
1
0 10 20 30 Q
P
• Lower price and unit-elastic demand–Blue gain equals yellow loss
e
fD3
The Total Revenue Test
6-12
]]]]]]]
Elasticity on a Linear Demand Curve
1
2
3
4
5
6
7
8
$8
7
6
5
4
3
2
1
5.00
2.60
1.57
1.00
0.64
0.38
0.20
$8,000
14,000
18,000
20,000
20,000
18,000
14,000
8,000
Elastic
Elastic
Elastic
Unit Elastic
Inelastic
Inelastic
Inelastic
(1)Total Quantity of
Tickets DemandedPer Week, Thousands
(2)Price Per Ticket
(3)Elasticity
Coefficient (Ed)
(4)Total Revenue
(1) X (2)
(5)Total-Revenue
Test
]]]]]]]
6-13
Elasticity and the TR Curve
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5 6 7 8
Quantity Demanded
Quantity Demanded
Pri
ceT
ota
l Rev
enu
e(T
ho
usa
nd
s o
f D
olla
rs)
$201816141210
8642
$87654321
a
bc
de
fg
h
ElasticEd > 1
Unit ElasticEd = 1
InelasticEd < 1
D
TR
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
Percentage Change in QuantitySupplied of Product X
Percentage Change in Priceof Product X
Es =
Responsiveness to price changes by producers
6-17
Price Elasticity of Supply
• Market period–Perfectly inelastic supply
• Short run–Fixed plant size
• Long run–Adjustable plant size
–Supply more elastic6-18
P
Q
Price Elasticity of Supply
The Market Period• Perfectly inelastic supply
D1 D2
Sm
Q0
Pm
P0
GreatestPrice
Impact
6-19
Price Elasticity of Supply
The Short Run• Inelastic supply
P
Q
D1 D2
Ss
Q0
Ps
P0
Qs
LowerPrice
Impact
6-20
Price Elasticity of Supply
The Long Run• Elastic supply
P
Q
D1 D2
Sl
Q0
Pl
P0
Ql
LeastPrice
Impact
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
Percentage Change in QuantityDemanded of Product X
Percentage Change in Priceof Product Y
Exy =
6-23
Cross Elasticity of Demand
• Substitute goods–Positive sign
• Complementary goods–Negative sign
• Independent goods–Zero
6-24
Income Elasticity of Demand
• Responsiveness of sales to
change in income
• Normal goods – positive sign
• Inferior goods– negative sign
Percentage Change in QuantityDemanded
Percentage Change in IncomeEi =
6-25
Consumer Surplus
• Benefit surplus• Maximum willingness to pay (WTP)
less than actual price paid
Person Max WTP Actual Price CSBob $13 $8 $5Barb $12 $8 $4Bill $11 $8 $3Bart $10 $8 $2Brent $9 $8 $1Betty $8 $8 $0
6-26
Consumer Surplus
D
Pri
ce
(P
er B
ag
)
P1
Q1
Quantity (Bags)
ConsumerSurplus
Equilibrium Price = $8
6-27
Producer Surplus
• Benefit surplus• Actual price received more than
minimum acceptable price (AP)
Person Min AP Actual Price PSCarlos $3 $8 $5Courtney $4 $8 $4Chuck $5 $8 $3Cindy $6 $8 $2Craig $7 $8 $1Chad $8 $8 $0
6-28
Producer Surplus
SP
ric
e (
Per
Ba
g)
P1
Q1
Quantity (Bags)
ProducerSurplus Equilibrium
Price = $8
6-29
Efficiency Revisited
• Productive and allocative efficiency
D
SP
ric
e (
Per
Ba
g)
P1
Q1
Quantity (Bags)
ConsumerSurplus
ProducerSurplus
Equilibrium Price = $8
6-30
Efficiency Loss
• Deadweight loss
D
SP
ric
e (
Per
Ba
g)
P1
Q1
Quantity (Bags)
EfficiencyLosses
Q2 Q3
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
Next Chapter Preview…
Consumer Behavior
6-34