Chapter 6 Elasticity, Consumer Surplus, and Producer Surplus 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 Quantity Demanded of Product X Ed = Percentage Change in Price of Product X 6-4

Price Elasticity of Demand Calculate percentage change Restate formula Change in Quantity Demanded of X Ed = Original Quantity Demanded of X Change in Price of X ÷ Original Price of X 6-5

Price Elasticity of Demand Calculation problem Starting point matters Midpoint formula Change in Quantity Ed = Sum of Quantities/2 ÷ Change in Price Sum of Prices/2 6-6

Interpretations of Elasticity Elastic Demand Ed = .04 .02 = 2 Inelastic Demand Ed = .01 .02 = .5 Unit Elasticity Ed = .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

The Total Revenue Test Lower price and elastic demand Blue gain exceeds gold loss $3 2 1 0 10 20 30 40 Q P a b D1 6-10

The Total Revenue Test Lower price and inelastic demand Gold loss exceeds blue gain $4 3 2 1 0 10 20 Q P c d D2 6-11

The Total Revenue Test Lower price and unit-elastic demand Blue gain equals yellow loss $3 2 1 0 10 20 30 Q P e f D3 6-12

Elasticity on a Linear Demand Curve (1) Total Quantity of Tickets Demanded Per Week, Thousands (3) Elasticity Coefficient (Ed) (4) Total Revenue (1) X (2) (5) Total-Revenue Test (2) Price Per Ticket 1 2 3 4 5 6 7 8 $8 7 6 5 4 3 2 1 $8,000 14,000 18,000 20,000 8,000 ] 5.00 2.60 1.57 1.00 0.64 0.38 0.20 ] Elastic Unit Elastic Inelastic 6-13

Elasticity and the TR Curve 1 2 3 4 5 6 7 8 Quantity Demanded Price (Thousands of Dollars) Total Revenue $20 18 16 14 12 10 $8 Elastic Ed > 1 a b c d e f g h Unit Elastic Ed = 1 Inelastic Ed < 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 Decriminalization of illegal drugs Elastic or inelastic demand? 6-16

Price Elasticity of Supply Responsiveness to price changes by producers Percentage Change in Quantity Supplied of Product X Es = Percentage Change in Price of Product X 6-17

Price Elasticity of Supply Market period Perfectly inelastic supply Short run Fixed plant size Long run Adjustable plant size Supply more elastic 6-18

Price Elasticity of Supply The Market Period Perfectly inelastic supply P Q Sm Greatest Price Impact Pm P0 D1 D2 Q0 6-19

Price Elasticity of Supply The Short Run Inelastic supply P Q Ss Lower Price Impact Ps P0 D1 D2 Q0 Qs 6-20

Price Elasticity of Supply The Long Run Elastic supply P Q Sl Least Price Impact Pl P0 D1 D2 Q0 Ql 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 Quantity Demanded of Product X Exy = Percentage Change in Price of Product Y 6-23

Cross Elasticity of Demand Substitute goods Positive sign Complementary goods Negative sign Independent goods Zero 6-24

Income Elasticity of Demand Percentage Change in Quantity Demanded Ei = Percentage Change in Income Responsiveness of sales to change in income Normal goods – positive sign Inferior goods– negative sign 6-25

Consumer Surplus Benefit surplus Maximum willingness to pay (WTP) less than actual price paid Person Max WTP Actual Price CS Bob $13 $8 $5 Barb $12 $8 $4 Bill $11 $8 $3 Bart $10 $8 $2 Brent $9 $8 $1 Betty $8 $8 $0 6-26

Consumer Surplus Consumer Surplus Price (Per Bag) Quantity (Bags) Equilibrium Price = $8 Price (Per Bag) P1 D Q1 Quantity (Bags) 6-27

Producer Surplus Benefit surplus Actual price received more than minimum acceptable price (AP) Person Min AP Actual Price PS Carlos $3 $8 $5 Courtney $4 $8 $4 Chuck $5 $8 $3 Cindy $6 $8 $2 Craig $7 $8 $1 Chad $8 $8 $0 6-28

Producer Surplus Producer Surplus Price (Per Bag) Quantity (Bags) S Equilibrium Price = $8 Price (Per Bag) P1 Q1 Quantity (Bags) 6-29

Efficiency Revisited Productive and allocative efficiency Consumer Surplus Equilibrium Price = $8 Price (Per Bag) P1 Producer Surplus D Q1 Quantity (Bags) 6-30

Efficiency Loss Deadweight loss Efficiency Losses Price (Per Bag) Q2 Q1 Q3 Quantity (Bags) 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

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