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 Next Chapter Preview… Consumer Behavior 6-34