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Elasticity, Consumer Surplus, and Producer Surplus

Chapter 6

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

–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

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