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
Ed =
Percentage Change in Quantity
Demanded of Product X
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
Ed =
Change in Quantity
Sum of Quantities/2
Change in Price
÷Sum of Prices/2
6-6
Interpretations of Elasticity
Elastic Demand
Ed =
.04
.02
=2
.01
.02
= .5
.02
.02
=1
Inelastic Demand
Ed =
Unit Elasticity
Ed =
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
P
$3
a
2
b
1
D1
0
10
20
30
40
Q
6-10
The Total Revenue Test
• Lower price and inelastic demand
–Gold loss exceeds blue gain
P
c
$4
3
2
d
1
D2
0
10
20
Q
6-11
The Total Revenue Test
• Lower price and unit-elastic demand
– Blue gain equals yellow loss
P
e
$3
2
f
1
D3
0
10
20
30
Q
6-12
Elasticity on a Linear
Demand Curve
(1)
Total Quantity of
Tickets Demanded
Per Week, Thousands
1
2
3
4
5
6
7
8
(2)
Price Per Ticket
$8
]
7
]
6
]
5
]
4
]
3
]
2
]
1
(3)
Elasticity
Coefficient (Ed)
5.00
2.60
1.57
1.00
0.64
0.38
0.20
(4)
Total Revenue
(1) X (2)
$8,000
]
14,000
]
18,000
]
20,000
]
20,000
]
18,000
]
14,000
]
8,000
(5)
Total-Revenue
Test
Elastic
Elastic
Elastic
Unit Elastic
Inelastic
Inelastic
Inelastic
6-13
Price
Elasticity and the TR Curve
$8 a
7
b
6
c
5
d
4
e
3
f
2
g
1
Elastic
Ed > 1
Unit Elastic
Ed = 1
Inelastic
Ed < 1
h
D
0 1 2 3 4 5 6 7 8
Total Revenue
(Thousands of Dollars)
Quantity Demanded
$20
18
16
14
12
10
8
6
4
2
TR
0 1 2 3 4 5 6 7 8
Quantity Demanded
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
Responsiveness to price
changes by producers
Es =
Percentage Change in Quantity
Supplied of Product X
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
Greatest
Price
Impact
Sm
Pm
P0
D1 D2
Q0
Q
6-19
Price Elasticity of Supply
The Short Run
• Inelastic supply
P
Lower
Price
Impact
Ss
Ps
P0
D1 D2
Q0 Qs
Q
6-20
Price Elasticity of Supply
The Long Run
• Elastic supply
P
Sl
Least
Price
Impact
Pl
P0
D1 D2
Q0 Ql
Q
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
Exy =
Percentage Change in Quantity
Demanded of Product X
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
Ei =
Percentage Change in Quantity
Demanded
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
Bob
Barb
Bill
Bart
Brent
Betty
Max WTP Actual Price
$13
$8
$12
$8
$11
$8
$10
$8
$9
$8
$8
$8
CS
$5
$4
$3
$2
$1
$0
6-26
Consumer Surplus
Price (Per Bag)
Consumer
Surplus
Equilibrium
Price = $8
P1
D
Q1
Quantity (Bags)
6-27
Producer Surplus
• Benefit surplus
• Actual price received more than
minimum acceptable price (AP)
Person
Carlos
Courtney
Chuck
Cindy
Craig
Chad
Min AP
$3
$4
$5
$6
$7
$8
Actual Price
$8
$8
$8
$8
$8
$8
PS
$5
$4
$3
$2
$1
$0
6-28
Producer Surplus
Price (Per Bag)
S
Producer
Surplus
Equilibrium
Price = $8
P1
Q1
Quantity (Bags)
6-29
Efficiency Revisited
• Productive and allocative efficiency
S
Price (Per Bag)
Consumer
Surplus
Equilibrium
Price = $8
P1
Producer
Surplus
D
Q1
Quantity (Bags)
6-30
Efficiency Loss
• Deadweight loss
S
Price (Per Bag)
Efficiency
Losses
P1
D
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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Consumer Behavior
6-34