# Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. A Lecture Presentation in PowerPoint to accompany Exploring Economics by Robert L. Sexton.

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Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. A Lecture Presentation in PowerPoint to accompany Exploring Economics by Robert L. Sexton and Peter Fortura

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 5.1 Price Elasticity of Demand The law of demand establishes that quantity demanded changes inversely with changes in price, ceteris paribus. But how much does quantity demanded change? This is very important to understand for many economic issues.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 5.1 Price Elasticity of Demand The price elasticity of demand measures how responsive quantity demanded is to a price change. The price elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in price.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Price Elasticity of Demand When economists say the price elasticity of demand is high, it means the quantity demanded changes by a relatively larger amount than the price change. When the price elasticity of demand is low, it means that the quantity demanded changes by a relatively smaller amount than the price change.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Following the law of demand, there is an inverse relationship between price and quantity demanded. For this reason, price elasticity of demand is, in theory, always negative. In practice, however, this quantity is always expressed in absolute value terms, as a positive number, for simplicity. 5.1 Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. If a change in price leads to a larger percentage change in the quantity demanded; demand is said to be elastic. If a change in price leads to a smaller percentage change in the quantity demanded; demand is said to be inelastic. 5.1 Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. A demand curve or a portion of a demand curve can be elastic, unit elastic, or inelastic. A segment of a demand curve is elastic (E d > 1) if the percentage change in quantity demanded is greater than the percentage change in price. A perfectly elastic demand curve is horizontal. The elasticity of demand in this case is infinity because the quantity demanded is infinitely responsive to even a very small percentage change in price. 5.1 Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. A segment of a demand curve is inelastic (E d < 1) if the percentage change in quantity demanded is less than the percentage change in price. A perfectly inelastic demand curve is vertical—the quantity demanded is the same regardless of price. 5.1 Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 3: Inelastic Demand Price Quantity D 0 ED=ED==.20.10 =2 %QD%P%QD%P Q1Q1 P1P1 P0P0 Q0Q0 20%  Q D Price Quantity 0 Q1Q1 P1P1 QDQD PP 10%  P P0P0 Q0Q0 D a. Inelastic Demand (E D < 1) b. Perfectly Inelastic Demand (E D = 0)

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. A segment of a demand curve is unit elastic (E d = 1) if the percentage change in quantity demanded equals the percentage change in the price. 5.1 Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. D P0P0 Q0Q0 Exhibit 4: Unit Elastic Demand Price Quantity 0 %QD%P%QD%P E D ==.10 = 1 10%  P 10%  Q D Q1Q1 P1P1

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. When the demand curve is relatively steep, ceteris paribus, its price elasticity of demand is relatively low (more inelastic). When the demand curve is relatively flat, ceteris paribus, its price elasticity of demand is relatively high (more elastic). 5.1 Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. The price elasticity of demand depends on the availability of close substitutes, the proportion of income spent on the good, and the amount of time people have to adapt to a price change. 5.1 Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Goods with close substitutes tend to have more elastic demands. Goods without close substitutes tend to have less elastic demand. Example: the elasticity of demand for a Ford, Toyota, or a Honda is more elastic than the demand for a car because there are more and better substitutes for a certain type of car than for a car itself. 5.1 Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. The fewer the number of close substitutes, the less elastic the demand curve. Examples: insulin for diabetics, heroin for an addict, and emergency medical care have few, if any, close substitutes. The smaller the proportion of income spent on a good, the lower its elasticity of demand. 5.1 Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. The more time that people have to adapt to a new price change, the greater the elasticity of demand. The more time that passes, the more time consumers have to find or develop suitable substitutes and to plan and implement changes in their patterns of consumption. Hence, the short-run demand curve is generally less elastic than the long-run demand curve. 5.1 Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 5: Short-Run and Long-Run Demand Curves Price D LR D SR Quantity 0 Q1Q1 P1P1 P0P0 Q0Q0 Q2Q2

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 5.2 Total Revenue and Price Elasticity of Demand When demand is relatively price elastic (E d > 1), total revenues will rise as the price declines. This occurs because the percentage increase in the quantity demanded is greater than the percentage reduction in price.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. If the price rises and the quantity demanded falls, then total revenue falls. This occurs because the percentage decrease in the quantity demanded is greater than the percentage increase in price. 5.2 Total Revenue and Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 1: Elastic Demand and Total Revenue Price cb a D ELASTIC Quantity 0 20406080100 A \$10 B \$5

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. When demand is relatively price inelastic (E d < 1), total revenues will fall as the price declines. Total revenues fall because the percentage increase in the quantity demanded is less than the percentage reduction in price. 5.2 Total Revenue and Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. If the price rises and the quantity demanded falls, then total revenue rises. Total revenue rises because the percentage decrease in the quantity demanded is less than the percentage increase in price. 5.2 Total Revenue and Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 2: Inelastic Demand and Total Revenue Price bc a D INELASTIC Quantity 0 10203040 \$10 A \$5 B

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Total Revenue an Inelastic Demand If the demand for food is inelastic(which is generally the case) a good harvest could result in a reduction in total revenue for farmer’s and a bad harvest could result in an increase in total revenue for farmer’s—see the next two exhibits.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 3: Total Revenue and Inelastic Demand: A Reduction in Supply Price b D a (gain) c (loss) S0S0 Q0Q0 Quantity 0 Q1Q1 S1S1 P0P0 P1P1

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Price of Wheat b D a (loss) c (gain) Quantity of Wheat 0 S0S0 Q0Q0 Q1Q1 S1S1 P1P1 P0P0 Exhibit 3: Total Revenue and Inelastic Demand: An Increase in Supply

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. A straight-line demand curve (having a constant slope) will change price elasticity continuously as you move up or down it. When the price falls on the upper half of the demand curve, there is a negative relationship between price and total revenue. Demand is relatively price elastic. 5.2 Total Revenue and Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. When the price falls on the lower half of the demand curve, there is a positive relationship between price and total revenue. Demand is relatively price inelastic. 5.2 Total Revenue and Price Elasticity of Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 4: Price Elasticity Along a Linear Demand Curve Price c b a Quantity 0 E D > 1 = Elastic D Price fe d Quantity 0 E D < 1 = Inelastic D Midpoint ED = 1 P0P0 Q0Q0 P1P1 Q1Q1 P2P2 Q2Q2 P3P3 Q3Q3 a. Elastic Range Midpoint ED = 1 b. Inelastic Range

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 5.3 Price Elasticity of Supply According to the law of supply, there is a positive relationship between price and quantity supplied, ceteris paribus. But by how much does quantity supplied change as price changes? The price elasticity of supply measures how responsive the quantity sellers are willing to sell is to changes in the price.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 5.3 Price Elasticity of Supply In other words, price elasticity of supply measures the relative change in the quantity supplied that results from a change in price. The price elasticity of supply (Es) is defined as the percentage change in the quantity supplied divided by the percentage change in price.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Goods with a supply elasticity that is greater than 1 (E s > 1 ) are relatively elastic in supply. With that, a 1 percent change in price will result in a greater than 1 percent change in quantity supplied. The extreme case is perfectly elastic supply, where Es = infinity. 5.3 Price Elasticity of Supply

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Goods with a supply elasticity that is less than 1 (E s < 1) are relatively inelastic in supply. This means that a 1 percent change in the price of these goods will induce a proportionately smaller change in the quantity supplied. The extreme case is perfectly inelastic supply, where Es = 0. 5.3 Price Elasticity of Supply

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 1: The Price Elasticity of Supply Price Quantity 0 = = 4 %QS%P%QS%P E S =.20.05 S 20%  Q S 5%  P P0P0 Q0Q0 P1P1 Q1Q1 a. Elastic Supply (E S > 1)

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Price Quantity 0 = =.25.05.20 E S = %QS%P%QS%P S Exhibit 1: The Price Elasticity of Supply P1P1 Q1Q1 P0P0 Q0Q0 20%  P 5%  Q S b. Inelastic Supply (E S < 1)

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 1: The Price Elasticity of Supply Price Quantity 0 Q 0 = Q 1 S P0P0 P1P1 20%  P c. Perfectly Inelastic Supply E S = 0)

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 1: The Price Elasticity of Supply Price Quantity 0 P0P0 Q0Q0 P1P1 S PP d. Perfectly Elastic supply (ES =  )

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Time is usually critical in supply elasticities because it is more costly for producers to bring forth and release resources in shorter periods of time. Hence, supply tends to be more elastic in the long run than the short run. 5.3 Price Elasticity of Supply

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 2: Short-run and Long-run Supply Curves Price Quantity 0 S SR S LR P0P0 Q0Q0 P1P1 Q SR Q LR

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. The relative elasticity of supply and demand determines the distribution of the tax burden for a good. If demand has a lower elasticity than supply in the relevant tax region, the largest portion of the tax is paid by the consumer. 5.3 Price Elasticity of Supply and Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. However, if demand is relatively more elastic than supply in the relevant tax region, the largest portion of the tax is paid by the producer. In general, the tax burden falls on the side of the market that is less elastic, which has nothing to do with who actually pays the tax at the time of the purchase. 5.3 Price Elasticity of Supply and Demand

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Tax Paid by Consumer Tax Paid by Producer Exhibit 3: Elasticity and the Burden of Taxation Price Quantity 0 S S + \$.50 tax D Q AT \$1.40.90 Q BT 1.00 \$.50 a. Demand Is Relatively Less Elastic than Supply

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Tax Paid by Consumer Tax Paid by Producer Exhibit 3: Elasticity and the Burden of Taxation Price Quantity 0 D S S + \$.50 tax \$.50 Q BT 1.00.60 Q AT \$1.10 b. Demand Is Relatively More Elastic than Supply

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 5.4 Consumer behaviour In economics we assume that each individual seeks to maximize his or her own well-being or satisfaction. Economists developed the concept of utility to allow them to study the relative levels of satisfaction that consumers get from the consumption of goods and services.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 5.4 Consumer behaviour Marginal utility is the additional satisfaction generated by the last unit of a good that is consumed. Total utility increases with additional consumption. The incremental satisfaction–the marginal utility–that results from the consumption of additional units tends to decline as consumption increases.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 40 30 20 10 12340 Total Utility Quantity of Pizza Slices (per hour) 20 15 10 5 12340 Marginal Utility (per pizza slice) Quantity of Pizza Slices (per hour) Exhibit 1: Total and Marginal Utility Marginal utility Total utility

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 5.4 Consumer and Producer Surplus What a consumer actually pays for a good is usually less than what she is willing to pay. The monetary difference between what the consumer is willing and able to pay and the price the consumer actually pays is called consumer surplus.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. If the consumer is a buyer of several units of a good, the earlier units will have greater marginal value and therefore create more consumer surplus because marginal willingness to pay falls as greater quantities are consumed in any period. 5.4 Consumer and Producer Surplus

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 1: Consumer Surplus for Iced Tea Price of Iced Tea (per glass) Quantity of Iced Tea (by glass) 0 \$3 \$1 Consumer surplus = \$3 + \$1 = \$4 D ICED TEA \$1 Market price \$3 1 \$4 2 \$2 3 \$.50

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 5.4 Consumer and Producer Surplus Consumer surplus is shown graphically as the area under the demand curve (willingness to pay for the units consumed) and above the market price (what must be paid for those units).

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 3: The Impact of an Increase in Supply on Consumer Surplus

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Producer surplus is the difference between what a producer is paid for a good and the seller's cost for producing each unit of the good. Because some units can be produced at a cost that is lower than the market price, the seller receives a surplus, or net benefit, from producing those units. 5.5 Consumer and Producer Surplus

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Producer surplus for a particular unit is the difference between the market price and the seller's cost of producing that unit. Total producer surplus is shown graphically as the area under the market price (what was paid for those units) and above the supply curve (the total cost, or sum of marginal costs, of producing those units). 5.5 Consumer and Producer Surplus

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. A higher market price due to an increase in demand will increase total producer surplus. Part of the added surplus is due to a higher price for the quantity already being produced. Part is due to the expansion of output made profitable by the higher price. 5.5 Consumer and Producer Surplus

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 5: The Impact of an Increase in Demand on Producer Surplus

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. With the tools of consumer and producer surplus, we can better analyze the total gains from exchange. The demand curve represents a collection of maximum prices that consumers are willing and able to pay for additional quantities of a good or service. 5.5 Consumer and Producer Surplus

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. The supply curve represents a collection of minimum prices that suppliers require to be willing to supply additional quantities of that good or service. At the market equilibrium, consumers receive consumer surplus and producers receive producer surplus. Both benefit from trading every unit up to the market equilibrium output. 5.5 Consumer and Producer Surplus

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Buyers purchase each good, except for the very last unit, for less than the maximum amount that they would have been willing to pay. Sellers receive more than the minimum amount they would have been willing to accept to supply the good. 5.5 Consumer and Producer Surplus

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Once the equilibrium output is reached at the equilibrium price, all of the mutually beneficial trade opportunities between the suppliers and the demanders will have taken place. The sum of consumer and producer surplus is maximized. 5.5 Consumer and Producer Surplus

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. The total welfare gain to the economy from trade in a good is the sum of the consumer and producer surplus created. Consumers benefit from additional amounts of consumer surplus and producers benefit from additional amounts of producer surplus. 5.5 Consumer and Producer Surplus

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Improvements in welfare come from additions to both consumer and producer surplus. In competitive markets, where there are large numbers of buyers and sellers at the market equilibrium price and quantity, the net gains to society are as large as possible. 5.5 Consumer and Producer Surplus

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. CS PS Exhibit 6: Consumer and Producer Surplus D S Price Quantity 12 34 5 4 3 \$8 7 6 2 1 0

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 5.6 The Welfare Effects of Taxes and Price Controls We can use consumer and producer surplus to measure the welfare effects of various government programs, such as taxes and price controls.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 1: The Supply and Demand of a Tax Price Quantity Tax Revenue T  Q 1 PSPS Supply Demand Q0Q0 Tax Q1Q1 PBPB

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. That is, the more elastic the curves are, the greater the change in output and the larger the deadweight loss. 5.6 The Welfare Effects of Taxes and Price Controls

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 3: Elasticity and Deadweight Loss Price Quantity 0 \$.50 Tax D S Q1Q1 Q0Q0 Deadweight loss is relatively small.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 3: Elasticity and Deadweight Loss Price Quantity 0 \$.50 Tax D S Q0Q0 Q1Q1 Deadweight loss is relatively small.

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 3: Elasticity and Deadweight Loss Price D Quantity 0 \$.50 Tax Deadweight loss relatively large. S Q1Q1 Q0Q0

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Elasticity differences can help us understand tax policy. Those goods that are heavily taxed often have a relatively inelastic demand curve in the short run. This means that the burden falls mainly on the buyer. It also means that the deadweight loss to society is smaller than if the demand curve was more elastic. 5.6 The Welfare Effects of Taxes and Price Controls

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. We can see the welfare effects of a price ceiling by observing the change in consumer and producer surplus from the implementation of the price ceiling. Consumers can now buy at a lower price, but cannot buy as much as before (since suppliers will not supply as much). 5.6 The Welfare Effects of Taxes and Price Controls

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Producers lose producer surplus from the lower imposed ceiling price. The net loss is the resulting deadweight loss triangle, just as with a tax. 5.6 The Welfare Effects of Taxes and Price Controls

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 4: Welfare Effects of a Price Ceiling

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. We can also use consumer and producer surplus to see the welfare effects of a price floor, where the government buys up the surplus. Consumers lose consumer surplus due to the higher price floor, and must also pay taxes to pay for the buying and storing of the unsold (to consumers) output. 5.6 The Welfare Effects of Taxes and Price Controls

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Producers gain producer surplus from the higher prices and greater output (since the government buys up what is not sold on the market). On net, there is a deadweight loss from the price floor, illustrated in Exhibit 6. 5.6 The Welfare Effects of Taxes and Price Controls

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 5: Agricultural Price Supports Price of Cheese S Price Floor 0 \$4 P Quantity of Cheese D Surplus the government must absorb QSQS QDQD DA C B \$3 Q

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Exhibit 6: Welfare Effects of a Price Floor When Government Buys the Surplus

Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Deficiency Payment Program If govt. sets target price at P 1, producers will supply Q S and sell all they can at the market price P M. PS increases by area bcd and CS increases by area higf; the cost to govt. bcdehigf is greater than the sum of CS and PS and the deadweight loss is area e.