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

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

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

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

Copyright 2008 The McGraw-Hill Companies18-1

6Elasticity, Consumer Surplus, and Producer Surplus

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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

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Elasticity of demandElasticity of demand• Elasticity of demand measures how much the quantity Elasticity of demand measures how much the quantity

demanded changes with a given change in price of the item, demanded changes with a given change in price of the item, change in consumers’ income, or change in price of related change in consumers’ income, or change in price of related product.product.

Price Elasticity of DemandPrice Elasticity of Demand• The law of demand tells us that consumers will respond to a The law of demand tells us that consumers will respond to a

price decrease by buying more of a product (other things price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more.remaining constant), but it does not tell us how much more.

• The degree of responsiveness or sensitivity of consumers to The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price a change in price is measured by the concept of price elasticity of demand.elasticity of demand.

• Relatively Elastic or InelasticRelatively Elastic or Inelastic• If consumers are relatively responsive to price changes, If consumers are relatively responsive to price changes,

demand is said to be demand is said to be elasticelastic..

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• If consumers are relatively unresponsive to price changes, If consumers are relatively unresponsive to price changes, demand is said to be inelastic.demand is said to be inelastic.

• Note that with both elastic and inelastic demand, consumers Note that with both elastic and inelastic demand, consumers behave according to the law of demand; that is, they are behave according to the law of demand; that is, they are responsive to price changes. The terms elastic or inelastic responsive to price changes. The terms elastic or inelastic describe the degree of responsiveness. A precise definition describe the degree of responsiveness. A precise definition of what we mean by “responsive” or “unresponsive” follows.of what we mean by “responsive” or “unresponsive” follows.

• Price elasticity formula.Price elasticity formula.• Quantitative measure of elasticity Quantitative measure of elasticity • Ep = (percentage change in quantity) ÷ (percentage change Ep = (percentage change in quantity) ÷ (percentage change

in price)in price)

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Price Elasticity of Demand

• Price-Elasticity Coefficient and Formula

Percentage Change in QuantityDemanded of Product X

Percentage Change in Priceof Product X

Ed =

O 18.1

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Price Elasticity of Demand

• Formula RestatedChange in Quantity Demanded of X

Original Price of X

Ed =

Change in Price of X

Original Quantity Demanded of X

÷

• Using Averages• Midpoint Formula

Change in QuantityEd = Sum of Quantities/2

÷Change in Price

Sum of Prices/2

W 18.1

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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 = -1and Ed = (4-6)/(4+6)/2 / (6-4)/(6+4)/2 = -1

Which is the same in either case

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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.

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• Interpretations of Interpretations of EEdd

• If the coefficient of elasticity of demand is a number greater 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 elastic; if the coefficient is less than one, we say demand is inelastic. In other words, the than one, we say demand is inelastic. In other words, the quantity demanded is “relatively responsive” when Ed is quantity demanded is “relatively responsive” when Ed is greater than 1 and “relatively unresponsive” when Ed is less greater than 1 and “relatively unresponsive” when Ed is less than 1. A special case is if the coefficient equals one; this is than 1. A special case is if the coefficient equals one; this is called unit elasticity. called unit elasticity.

• Note: Inelastic demand does not mean that consumers are Note: Inelastic demand does not mean that consumers are

completely unresponsive. This extreme situation called completely unresponsive. This extreme situation called perfectly inelastic demand would be very rare, and the perfectly inelastic demand would be very rare, and the demand curve would be verticaldemand curve would be vertical

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• Likewise, elastic demand does not mean consumers are Likewise, elastic demand does not mean consumers are completely responsive to a price change. This extreme completely responsive to a price change. This extreme situation, in which a small price reduction would cause situation, in which a small price reduction would cause buyers to increase their purchases from zero to all that it is buyers to increase their purchases from zero to all that it is possible to obtain, is perfectly elastic demand, and the possible to obtain, is perfectly elastic demand, and the demand curve would be horizontal.demand curve would be horizontal.

Note:Note:

1.1. relatively elastic Erelatively elastic Epp > 1, > 1,

2.2. unitary elastic Eunitary elastic Epp = 1, = 1,

3.3. relative inelastic Erelative inelastic Epp < 1, < 1,

Extreme casesExtreme cases

4.4. perfectly elastic Eperfectly elastic Epp = = ∞∞, ,

5.5. perfectly inelastic Eperfectly inelastic Epp =0. =0.

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Price Elasticity of DemandPrice Elasticity of Demand

• Interpretations of Ed

Elastic Demand

Inelastic Demand

Unit Elasticity

Ed = .04.02 = 2

Ed = .01.02 = .5

Ed = .02.02 = 1

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Price Elasticity of DemandExtreme CasesExtreme Cases

Perfectly Inelastic Demand

Perfectly Elastic Demand0

P

Q

P

0Q

D1

D2

PerfectlyInelasticDemand(Ed = 0)

PerfectlyElasticDemand(Ed = ∞)

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$3

2

1

0 10 20 30 40 Q

P

The Total Revenue TestThe Total Revenue TestElastic demand and the total-revenue test:Elastic demand and the total-revenue test: • Demand is elastic if a decrease in price results in a rise in 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, or if an increase in price results in a decline in total revenue. (Price and revenue move in opposite total revenue. (Price and revenue move in opposite directions).directions).

a

b

D1

W 18.2

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$4

3

2

1

0 10 20 Q

P

The Total Revenue TestThe Total Revenue TestInelastic demand and the total-revenue test:Inelastic demand and the total-revenue test: • Demand is inelastic if a decrease in price results in a fall in 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 total revenue, or an increase in price results in a rise in total revenue. (Price and revenue move in same direction).revenue. (Price and revenue move in same direction).

c

d

D2

W 18.2

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$3

2

1

0 10 20 30 Q

P

The Total Revenue TestThe Total Revenue TestUnit elasticity and the total-revenue test: Unit elasticity and the total-revenue test: • Demand has unit elasticity if total revenue does not change Demand has unit elasticity if total revenue does not change

when the price changes.when the price changes.

e

fD3

W 18.2

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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

]]]]]]]

]]]]]]]

Price Elasticity of Demand for Movie Price Elasticity of Demand for Movie Tickets as Measured by the ElasticityTickets as Measured by the ElasticityCoefficient and the Total-Revenue TestCoefficient and the Total-Revenue Test

Graphically…

G 18.1

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Price Elasticity and the Total-Revenue 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

ElasticEd > 1

Unit ElasticEd = 1

InelasticEd < 1

D

TR

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Determinants of Price Elasticity of DemandDeterminants of Price Elasticity of Demand

SubstitutabilitySubstitutability

• Substitutes for the product: Generally, the more substitutes, Substitutes for the product: Generally, the more substitutes, the more elastic the demand.the more elastic the demand.

Proportion of IncomeProportion of Income

• The proportion of price relative to income: Generally, the The proportion of price relative to income: Generally, the larger the expenditure relative to one’s budget, the more larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in elastic the demand, because buyers notice the change in price more.price more.

Luxuries versus NecessitiesLuxuries versus Necessities

• Whether the product is a luxury or a necessity: Generally, Whether the product is a luxury or a necessity: Generally, the less necessary the item, the more elastic the demand.the less necessary the item, the more elastic the demand.

TimeTime

• The amount of time involved: Generally, the longer the time The amount of time involved: Generally, the longer the time period involved, the more elastic the demand becomes.period involved, the more elastic the demand becomes.

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Price Elasticity of SupplyPrice Elasticity of Supply

• The concept of price elasticity also applies to supply. The The concept of price elasticity also applies to supply. The elasticity formula is the same as that for demand, but we elasticity formula is the same as that for demand, but we must substitute the word “supplied” for the word must substitute the word “supplied” for the word “demanded” everywhere in the formula.“demanded” everywhere in the formula.

Es = % Es = % ∆∆ in quantity supplied / % in quantity supplied / % ∆∆ in price in price

• As with price elasticity of demand, the midpoints formula is As with price elasticity of demand, the midpoints formula is more accuratemore accurate.

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P

Q

Price Elasticity of Supply

O 18.2Percentage Change in Quantity

Supplied of Product X

Percentage Change in Priceof Product X

Es =

Price Elasticity of Supply: The Market Period

Immediate Market Period:Not Enough Time to Shift Resources

D1 D2

Sm

Q0

Pm

P0

GreatestPrice

Impact

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Price Elasticity of Supply

O 18.2Percentage Change in Quantity

Supplied of Product X

Percentage Change in Priceof Product X

Es =

Inelastic Supply Es < 1 Short Run:Resources Not Easily Shifted to Alternative Uses

P

Q

D1 D2

Ss

Q0

Ps

P0

Qs

LowerPrice

Impact

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Price Elasticity of Supply

O 18.2Percentage Change in Quantity

Supplied of Product X

Percentage Change in Priceof Product X

Es =

Elastic Supply Es > 1Long Run:Resources Easily Shifted to Alternative Uses

P

Q

D1 D2

Sl

Q0

Pl

P0

Ql

LeastPrice

Impact

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Cross Elasticity of DemandCross Elasticity of Demand

• Substitute Goods – Substitute Goods – Positive SignPositive Sign

• Complementary Goods- Complementary Goods- Negative SignNegative Sign

• Independent Goods – Independent Goods – Zero or Near-Zero Zero or Near-Zero ValueValue

Percentage Change in QuantityDemanded of Product X

Percentage Change in Priceof Product Y

Exy =

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Income Elasticity of DemandIncome Elasticity of Demand

• Normal Goods – Normal Goods – Positive SignPositive Sign

• Inferior Goods- Inferior Goods- Negative SignNegative Sign

Insights into the EconomyInsights into the Economy

• Income elasticity of demand helps explain the expansion and Income elasticity of demand helps explain the expansion and

contractions in the economy. As income grows, industries of contractions in the economy. As income grows, industries of

products whose income elasticity is high expand rapidly, products whose income elasticity is high expand rapidly,

while those of low or negative tend to grow slowly.while those of low or negative tend to grow slowly.

Percentage Change in QuantityDemanded

Percentage Change in IncomeEi =

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Consumer SurplusConsumer Surplus• The benefit (utility) surplus received by the consumer in a market The benefit (utility) surplus received by the consumer in a market

is called consumer surplus is called consumer surplus ))the difference between the maximum the difference between the maximum price the consumer is willing to pay and the actual price he pays).price the consumer is willing to pay and the actual price he pays).

• The utility surplus arises because all consumers pay the The utility surplus arises because all consumers pay the equilibrium price even though many would be willing to pay more equilibrium price even though many would be willing to pay more than that price to obtain the product. Consider this examplethan that price to obtain the product. Consider this example

ConsumerConsumer max pricemax price actual priceactual price consumer surplusconsumer surplusAA 13 13 8 8 55

BB 12 12 8 8 44

CC 11 11 8 8 33

DD 10 10 8 8 22

EE 9 9 8 8 11

FF 8 8 8 8 0 0

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D

Pri

ce

(P

er B

ag

)

P1

Q1

Quantity (Bags)

ConsumerSurplus

Equilibrium Price = $8

O 18.3

Consumer SurplusConsumer Surplus

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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 Producer min pricemin price actual priceactual price producer surplusproducer surplusGG 3 3 8 8 55HH 4 4 8 8 44II 5 5 8 8 33JJ 6 6 8 8 22KK 7 7 8 8 11LL 8 8 8 8 0 0

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Producer SurplusProducer Surplus

SP

ric

e (

Per

Ba

g)

P1

Q1

Quantity (Bags)

ProducerSurplus

Equilibrium Price = $8

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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.

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• 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 Allocative efficiency occurs at quantity levels where three conditions exit:conditions exit:

1.1. MB = MCMB = MC

2.2. Maximum willingness to pay = minimum acceptable priceMaximum willingness to pay = minimum acceptable price

3.3. Combined consumer and producer surplus is at a Combined consumer and producer surplus is at a maximummaximum

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Consumer and Producer SurplusEfficiency Revisited

D

SP

ric

e (

Per

Ba

g)

P1

Q1

Quantity (Bags)

ConsumerSurplus

ProducerSurplus

Equilibrium Price = $8

W 18.3

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Efficiency losses (deadweight loss)Efficiency losses (deadweight loss)• Efficiency losses are reductions of combined consumer and Efficiency losses are reductions of combined consumer and

producer surplus associated with underproduction (produce producer surplus associated with underproduction (produce less than equilibrium quantity) or overproduction (produce less than equilibrium quantity) or overproduction (produce more than equilibrium quantity). more than equilibrium quantity).

• UnderproductionUnderproduction: at Q2 there is a deadweight loss equals : at Q2 there is a deadweight loss equals dec. dec.

• OverproductionOverproduction: at Q3 there is a deadweight loss equals : at Q3 there is a deadweight loss equals cfg.cfg.

• Since both consumers and producers are members of the Since both consumers and producers are members of the society, these losses are efficiency loss or a deadweight society, these losses are efficiency loss or a deadweight lossloss

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Consumer and Producer Surplus

Efficiency Revisited

D

SP

ric

e (

Per

Ba

g)

P1

Q1

Quantity (Bags)

EfficiencyLosses

Q2 Q3

Efficiency Losses (Deadweight Losses)

a

b

c

d

e

f

g

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