1. Copyright 2008 The McGraw-Hill Companies 18-1 6 Elasticity, Consumer Surplus, and Producer Surplus

2. Copyright 2008 The McGraw-Hill Companies 18-2 Chapter Objectives Price Elasticity of Demand and How It Can Be Applied The Usefulness of the Total Revenue Test for Price Elasticity of Demand Price Elasticity of Supply and How It Can Be Applied Cross Elasticity of Demand and Income Elasticity of Demand Consumer Surplus, Producer Surplus, and Efficiency Losses

3. Copyright 2008 The McGraw-Hill Companies 18-3 Elasticity of demand Elasticity of demand measures how much the quantity demanded changes with a given change in price of the item, change in consumers’ income, or change in price of related product.Elasticity of demand measures how much the quantity demanded changes with a given change in price of the item, change in consumers’ income, or change in price of related product. Price Elasticity of Demand The law of demand tells us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more.The law of demand tells us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more. The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand.The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand. Relatively Elastic or InelasticRelatively Elastic or Inelastic If consumers are relatively responsive to price changes, demand is said to be elastic.If consumers are relatively responsive to price changes, demand is said to be elastic.

4. Copyright 2008 The McGraw-Hill Companies 18-4 If consumers are relatively unresponsive to price changes, demand is said to be inelastic.If consumers are relatively unresponsive to price changes, demand is said to be inelastic. Note that with both elastic and inelastic demand, consumers behave according to the law of demand; that is, they are responsive to price changes. The terms elastic or inelastic describe the degree of responsiveness. A precise definition of what we mean by “responsive” or “unresponsive” follows.Note that with both elastic and inelastic demand, consumers behave according to the law of demand; that is, they are responsive to price changes. The terms elastic or inelastic describe the degree of responsiveness. A precise definition of what we mean by “responsive” or “unresponsive” follows. Price elasticity formula.Price elasticity formula. Quantitative measure of elasticityQuantitative measure of elasticity Ep = (percentage change in quantity) ÷ (percentage change in price)Ep = (percentage change in quantity) ÷ (percentage change in price)

5. Copyright 2008 The McGraw-Hill Companies 18-5 Price Elasticity of Demand Price-Elasticity Coefficient and Formula Percentage Change in Quantity Demanded of Product X Percentage Change in Price of Product X E d = O 18.1

6. Copyright 2008 The McGraw-Hill Companies 18-6 Price Elasticity of Demand Formula Restated Change in Quantity Demanded of X Original Price of X E d = Change in Price of X Original Quantity Demanded of X ÷ Using Averages Midpoint Formula Change in Quantity E d = Sum of Quantities/2 ÷ Change in Price Sum of Prices/2 W 18.1

7. Copyright 2008 The McGraw-Hill Companies 18-7 Why the midpoint formula If p increases from 4 to 6, as a result the quantity demanded decreases from 6 to 4 Let us calculate elasticity starting from a change in p from 4 to 6: Ed = (6-4)/4 / (4-6)/6 = -.67 If we assume that the price goes down from 6 to 4 and as a result the quantity will increase from 4 to 6: Ed = (4-6)/6 / (6-4)/4 = -1.5 Now if we use the midpoint formula we got: Ed = (6-4)/(6+4)/2 / (4-6)/(4+6)/2 = -1 and Ed = (4-6)/(4+6)/2 / (6-4)/(6+4)/2 = -1 Which is the same in either case

8. Copyright 2008 The McGraw-Hill Companies 18-8 Why Use Percentages? The percentages changes are compared, not the absolute changes. Absolute changes depend on choice of units. For example, a change in the price of a $10,000 car by $1 and is very different than a change in the price a of $1 can of beer by $1. The auto’s price is rising by a fraction of a percent while the beer price is rising 100 percent. Percentages also make it possible to compare elasticities of demand for different products. Elimination of the Minus Sign Because of the inverse relationship between price and quantity demanded, the actual elasticity of demand will be a negative number. However, we ignore the minus sign and use the absolute value of both percentage changes.

9. Copyright 2008 The McGraw-Hill Companies 18-9 Interpretations of E dInterpretations of E d If the coefficient of elasticity of demand is a number greater than one, we say demand is elastic; if the coefficient is less than one, we say demand is inelastic. In other words, the quantity demanded is “relatively responsive” when Ed is greater than 1 and “relatively unresponsive” when Ed is less than 1. A special case is if the coefficient equals one; this is called unit elasticity.If the coefficient of elasticity of demand is a number greater than one, we say demand is elastic; if the coefficient is less than one, we say demand is inelastic. In other words, the quantity demanded is “relatively responsive” when Ed is greater than 1 and “relatively unresponsive” when Ed is less than 1. A special case is if the coefficient equals one; this is called unit elasticity. Note: Inelastic demand does not mean that consumers are completely unresponsive. This extreme situation called perfectly inelastic demand would be very rare, and the demand curve would be verticalNote: Inelastic demand does not mean that consumers are completely unresponsive. This extreme situation called perfectly inelastic demand would be very rare, and the demand curve would be vertical

10. Copyright 2008 The McGraw-Hill Companies 18-10 Likewise, elastic demand does not mean consumers are completely responsive to a price change. This extreme situation, in which a small price reduction would cause buyers to increase their purchases from zero to all that it is possible to obtain, is perfectly elastic demand, and the demand curve would be horizontal.Likewise, elastic demand does not mean consumers are completely responsive to a price change. This extreme situation, in which a small price reduction would cause buyers to increase their purchases from zero to all that it is possible to obtain, is perfectly elastic demand, and the demand curve would be horizontal.Note: 1.relatively elastic E p > 1, 2.unitary elastic E p = 1, 3.relative inelastic E p < 1, Extreme cases 4.perfectly elastic E p = ∞, 5.perfectly inelastic E p =0.

11. Copyright 2008 The McGraw-Hill Companies 18-11 Price Elasticity of Demand Interpretations of E d Elastic Demand Inelastic Demand Unit Elasticity E d =.04.02 = 2E d =.01.02 =.5E d =.02 = 1

12. Copyright 2008 The McGraw-Hill Companies 18-12 Price Elasticity of Demand Extreme Cases Perfectly Inelastic Demand Perfectly Elastic Demand 0 P Q P 0 Q D1D1 D2D2 Perfectly Inelastic Demand (E d = 0) Perfectly Elastic Demand (E d = ∞)

13. Copyright 2008 The McGraw-Hill Companies 18-13 $3 2 1 0 10 20 30 40 Q P The Total Revenue Test Elastic demand and the total-revenue test: Demand is elastic if a decrease in price results in a rise in total revenue, or if an increase in price results in a decline in total revenue. (Price and revenue move in opposite directions).Demand is elastic if a decrease in price results in a rise in total revenue, or if an increase in price results in a decline in total revenue. (Price and revenue move in opposite directions). a b D1D1 W 18.2

14. Copyright 2008 The McGraw-Hill Companies 18-14 $4 3 2 1 0 10 20 Q P The Total Revenue Test Inelastic demand and the total-revenue test: Demand is inelastic if a decrease in price results in a fall in total revenue, or an increase in price results in a rise in total revenue. (Price and revenue move in same direction).Demand is inelastic if a decrease in price results in a fall in total revenue, or an increase in price results in a rise in total revenue. (Price and revenue move in same direction). c d D2D2 W 18.2

15. Copyright 2008 The McGraw-Hill Companies 18-15 $3 2 1 0 10 20 30 Q P The Total Revenue Test Unit elasticity and the total-revenue test: Demand has unit elasticity if total revenue does not change when the price changes.Demand has unit elasticity if total revenue does not change when the price changes. e f D3D3 W 18.2

16. Copyright 2008 The McGraw-Hill Companies 18-16 Elasticity on a Linear Demand Curve 1234567812345678 8765432187654321 5.00 2.60 1.57 1.00 0.64 0.38 0.20 $8,000 14,000 18,000 20,000 18,000 14,000 8,000 Elastic Unit Elastic Inelastic (1) Total Quantity of Tickets Demanded Per Week, Thousands (2) Price Per Ticket (3) Elasticity Coefficient (E d ) (4) Total Revenue (1) X (2) (5) Total-Revenue Test ] ] ] ] ] ] ] ] ] ] ] ] ] ] Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity Coefficient and the Total-Revenue Test Graphically… G 18.1

17. Copyright 2008 The McGraw-Hill Companies 18-17 Price Elasticity and the Total-Revenue Curve 012345678 012345678 Quantity Demanded Price Total Revenue (Thousands of Dollars) $20 18 16 14 12 10 8 6 4 2 $8 7 6 5 4 3 2 1 a b c d e f g h Elastic E d > 1 Unit Elastic E d = 1 Inelastic E d < 1 Elastic E d > 1 Unit Elastic E d = 1 Inelastic E d < 1 D TR

18. Copyright 2008 The McGraw-Hill Companies 18-18 Determinants of Price Elasticity of Demand Substitutability Substitutes for the product: Generally, the more substitutes, the more elastic the demand.Substitutes for the product: Generally, the more substitutes, the more elastic the demand. Proportion of Income The proportion of price relative to income: Generally, the larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in price more.The proportion of price relative to income: Generally, the larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in price more. Luxuries versus Necessities Whether the product is a luxury or a necessity: Generally, the less necessary the item, the more elastic the demand.Whether the product is a luxury or a necessity: Generally, the less necessary the item, the more elastic the demand.Time The amount of time involved: Generally, the longer the time period involved, the more elastic the demand becomes.The amount of time involved: Generally, the longer the time period involved, the more elastic the demand becomes.

19. Copyright 2008 The McGraw-Hill Companies 18-19 Price Elasticity of Supply The concept of price elasticity also applies to supply. The elasticity formula is the same as that for demand, but we must substitute the word “supplied” for the word “demanded” everywhere in the formula.The concept of price elasticity also applies to supply. The elasticity formula is the same as that for demand, but we must substitute the word “supplied” for the word “demanded” everywhere in the formula. Es = % ∆ in quantity supplied / % ∆ in price As with price elasticity of demand, the midpoints formula is more accurateAs with price elasticity of demand, the midpoints formula is more accurate.

20. Copyright 2008 The McGraw-Hill Companies 18-20 P Q Price Elasticity of Supply O 18.2 Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X E s = Price Elasticity of Supply: The Market Period Immediate Market Period: Not Enough Time to Shift Resources D1D1 D2D2 SmSm Q0Q0 PmPm P0P0 Greatest Price Impact

21. Copyright 2008 The McGraw-Hill Companies 18-21 Price Elasticity of Supply O 18.2 Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X E s = Inelastic Supply E s < 1 Short Run: Resources Not Easily Shifted to Alternative Uses P Q D1D1 D2D2 SsSs Q0Q0 PsPs P0P0 QsQs Lower Price Impact

22. Copyright 2008 The McGraw-Hill Companies 18-22 Price Elasticity of Supply O 18.2 Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X E s = Elastic Supply E s > 1 Long Run: Resources Easily Shifted to Alternative Uses P Q D1D1 D2D2 SlSl Q0Q0 PlPl P0P0 QlQl Least Price Impact

23. Copyright 2008 The McGraw-Hill Companies 18-23 Cross Elasticity of Demand Substitute Goods – Positive SignSubstitute Goods – Positive Sign Complementary Goods- Negative SignComplementary Goods- Negative Sign Independent Goods – Zero or Near-Zero ValueIndependent Goods – Zero or Near-Zero Value Percentage Change in Quantity Demanded of Product X Percentage Change in Price of Product Y E xy =

24. Copyright 2008 The McGraw-Hill Companies 18-24 Income Elasticity of Demand Normal Goods – Positive SignNormal Goods – Positive Sign Inferior Goods- Negative SignInferior Goods- Negative Sign Insights into the Economy Income elasticity of demand helps explain the expansion and contractions in the economy. As income grows, industries of products whose income elasticity is high expand rapidly, while those of low or negative tend to grow slowly.Income elasticity of demand helps explain the expansion and contractions in the economy. As income grows, industries of products whose income elasticity is high expand rapidly, while those of low or negative tend to grow slowly. Percentage Change in Quantity Demanded Percentage Change in Income E i =

25. Copyright 2008 The McGraw-Hill Companies 18-25 Consumer Surplus The benefit (utility) surplus received by the consumer in a market is called consumer surplus )the difference between the maximum price the consumer is willing to pay and the actual price he pays).The benefit (utility) surplus received by the consumer in a market is called consumer surplus )the difference between the maximum price the consumer is willing to pay and the actual price he pays). The utility surplus arises because all consumers pay the equilibrium price even though many would be willing to pay more than that price to obtain the product. Consider this exampleThe utility surplus arises because all consumers pay the equilibrium price even though many would be willing to pay more than that price to obtain the product. Consider this example Consumermax priceactual priceconsumer surplus A 13 85 B 12 84 C 11 83 D 10 82 E 9 81 F 8 80

26. Copyright 2008 The McGraw-Hill Companies 18-26 D Price (Per Bag) P1P1 Q1Q1 Quantity (Bags) Consumer Surplus Equilibrium Price = $8 O 18.3 Consumer Surplus

27. Copyright 2008 The McGraw-Hill Companies 18-27 Producer Surplus Producers also receive a benefit surplus which is the difference between the actual price a producer receives and the minimum acceptable price (determined at the supply curve). Most sellers are willing to accept a lower than the market price to sell the product. There is a direct relationship between equilibrium price and producer surplus. Consider this example Producer min priceactual priceproducer surplus Producer min priceactual priceproducer surplus G 3 85 H 4 84 I 5 83 J 6 82 K 7 81 L 8 80

28. Copyright 2008 The McGraw-Hill Companies 18-28 Producer Surplus S Price (Per Bag) P1P1 Q1Q1 Quantity (Bags) Producer Surplus Equilibrium Price = $8

29. Copyright 2008 The McGraw-Hill Companies 18-29 Efficiency Revisited All markets that have downward slopping demand and upward slopping supply curves yield consumer and producer surplus. The equilibrium quantity in these markets reflect economic efficiency. Productive efficiency is achieved because competition forces producers to minimize their costs.

30. Copyright 2008 The McGraw-Hill Companies 18-30 Allocative efficiency is also achieved because the correct quantity at which MB (points on the demand curve or the maximum willingness to pay) equals MC (points on the supply curve or the minimum acceptable price). At equilibrium consumer surplus and producer surplus are maximized. Allocative efficiency occurs at quantity levels where three conditions exit:Allocative efficiency occurs at quantity levels where three conditions exit: 1.MB = MC 2.Maximum willingness to pay = minimum acceptable price 3.Combined consumer and producer surplus is at a maximum

31. Copyright 2008 The McGraw-Hill Companies 18-31 Consumer and Producer Surplus Efficiency Revisited D S Price (Per Bag) P1P1 Q1Q1 Quantity (Bags) Consumer Surplus Producer Surplus Equilibrium Price = $8 W 18.3

32. Copyright 2008 The McGraw-Hill Companies 18-32 Efficiency losses (deadweight loss) Efficiency losses are reductions of combined consumer and producer surplus associated with underproduction (produce less than equilibrium quantity) or overproduction (produce more than equilibrium quantity).Efficiency losses are reductions of combined consumer and producer surplus associated with underproduction (produce less than equilibrium quantity) or overproduction (produce more than equilibrium quantity). Underproduction: at Q2 there is a deadweight loss equals dec.Underproduction: at Q2 there is a deadweight loss equals dec. Overproduction: at Q3 there is a deadweight loss equals cfg.Overproduction: at Q3 there is a deadweight loss equals cfg. Since both consumers and producers are members of the society, these losses are efficiency loss or a deadweight lossSince both consumers and producers are members of the society, these losses are efficiency loss or a deadweight loss

33. Copyright 2008 The McGraw-Hill Companies 18-33 Consumer and Producer Surplus Efficiency Revisited D S Price (Per Bag) P1P1 Q1Q1 Quantity (Bags) Efficiency Losses Q2Q2 Q3Q3 Efficiency Losses (Deadweight Losses) a b c d e f g

34. Copyright 2008 The McGraw-Hill Companies 18-34