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Chapter 3
Elasticity and Surplus
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You Are Here
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Elasticity
• One of the most important concepts in economics is
elasticity
• The elasticity of demand and elasticity of supply are
basically the slope of the supply and demand curve
• They are very important for determining the magnitudes
of interventions
• Formally
Elasticity=
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• One kind of annoying thing about this is the P and the
Q
• If it were just:
it would just be the slope of the curve
• For all intensive purposes this is what it is
• Ignoring (or conditioning on Q and P) the larger is the
slope the larger is the elasticity.
• Lets focus on the elasticity of demand.
• I am going to use straight lines because it is the easiest
to think about
• With a linear demand curve elasticity is technically
greater at higher prices but lets not worry about that
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Elasticity Labels
• Elastic : the condition of demand when the
percentage change in quantity is larger than
the percentage change in price
• Inelastic: the condition of demand when the
percentage change in quantity is smaller than
the percentage change in price
• Unitary Elastic: the condition of demand when
the percentage change in quantity is equal to
the percentage change in price
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Inelastic
Perfectly Inelastic
Perfectly Elastic
P
High Elasticity
Medium (Unitary) Elasticity of Demand
Q
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Why Do we Care
• Economic behavior depends a lot on the elasticity of the
demand curve (and of the supply curve)
• As an example lets think about what happens when the
supply curve shifts
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Medium Elasticity
New
Supply
$2.50
P
$2.00
Price
rises
Supply
New Equilibrium
$1.50
Old Equilibrium
$1.00
Quantity
falls
$0.50
Demand
0
0
10
20
30
40
50
Q/t
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Perfectly elastic Demand
New
Supply
$2.50
P
$2.00
Price
doesn’t
change
Quantity
decreases
a lot
Supply
New Equilibrium
$1.50
Old Equilibrium
$1.00
$0.50
Demand
0
0
10
20
30
40
50
Q/t
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Perfectly Inelastic Demand
New
Supply
$2.50
P
$2.00
Price
changes
a lot
Quantity
doesn’t
change
Supply
New Equilibrium
$1.50
Old Equilibrium
$1.00
$0.50
Demand
0
0
10
20
30
40
50
Q/t
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Comparing Elasticities
$2.50
P
$2.00
When Demand is more
elastic price change is
smaller and quantity
change is larger
$1.50
$1.00
$0.50
Low Elasticity
Large Elasticity
0
0
10
20
30
40
50
Q/t
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Alternative Ways to Understand
Elasticity
• A good for which there are no good substitutes
is likely to be one for which you must pay
whatever price is charged. It is also likely to be
one for which a lower price will not induce
substantially greater consumption. Thus, as
price changes there is very little change in
consumption, i.e. demand is inelastic and the
demand curve is steep.
• Inexpensive goods that take up little of your
income can change in price and your
consumption will not change dramatically.
Thus, at low prices, demand is inelastic.
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Seeing Elasticity Through Total Expenditures
• Total Expenditure Rule: if the
price and the amount you spend
both go in the same direction
then demand is inelastic while if
they go in opposite directions
demand is elastic.
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Determinants of Elasticity
• Number of and Closeness of Substitutes
• The more alternatives you have the less likely you are
to pay high prices for a good and the more likely
you are to settle for something that will do.
• Time
• The longer you have to come up with alternatives to
paying high prices the more likely it is you will shift to
those alternatives.
• Portion of the Budget
• The greater the portion of the budget an item takes
up, the greater the elasticity is likely to be.
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Elasticity Examples
Inelastic Goods
Eggs
Food
Health Care Services
Gasoline (short-run)
Gasoline (long-run)
Highway and Bridge Tolls
Unit Elastic Good (or close to it)
Shellfish
Cars
Elastic Goods
Luxury Car
Foreign Air Travel
Restaurant Meals
Price Elasticity
0.06
0.21
0.18
0.08
0.24
0.10
0.89
1.14
3.70
1.77
2.27
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Price Elasticity Supply
• Identical in concept to elasticity of
demand.
• Formula is the Same
• It is also related to the slope of the supply curve but is
not simply the slope of the supply curve.
• Terminology is the same
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Inelastic
Medium (Unitary)
Elasticity of Supply
Perfectly
Inelastic
High Elasticity
Perfectly Elastic
P
Q
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Perfectly elastic Supply
$2.50
P
$2.00
Price
doesn’t
change
Quantity
Increases
a lot
New Equilibrium
$1.50
$1.00
Old
Equilibrium
$0.50
0
0
10
20
30
40
50
Q/t
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Perfectly Inelastic Supply
New Equilibrium
$2.50
P
$2.00
Price
Increases
a lot
Quantity
doesn’t
change
$1.50
$1.00
Old
Equilibrium
$0.50
0
0
10
20
30
40
50
Q/t
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Comparing Elasticities
Low Elasticity
$2.50
P
$2.00
High Elasticity
$1.50
When supply is more
elastic price change is
smaller and quantity
change is larger
$1.00
$0.50
0
0
10
20
30
40
50
Q/t
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Consumer Surplus
I think this is easiest to see in our extensive margin example that we started
with
Name
Willingness to Pay
Jim
$200
Jackie
$400
Bill
$600
Sally
$800
Lisa
$1000
So for Bill the value of the Ipad is $600.
If he could get an Ipad for free this would be worth $600
This gave the demand curve
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Total Consumer Surplus: $600
Lisa
Sally
Bill
Jackie
Jim
In this case Bill, Sally and Lisa all get their Ipads, Jackie and Jim do not
The Value to Lisa is $1000.
She pays $600, so her surplus is $400
Sally’s Value is $800 so her surplus is $200
Bill’s value is $600 so he gets no surplus
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Now lets think about this in a more more standard
(and general) context
$2.50
P
$2.00
Consumer Surplus
$1.50
Total Consumer Value
$1.00
Total that consumers
pay
$0.50
Demand
0
0
10
20
30
40
50
Q/t
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Now the firm
$2.50
P
$2.00
Producer Surplus
Total firms receive in
revenue
$1.50
$1.00
$0.50
0
0
10
20
Variable costs
to producer
Demand
30
50
40
Q/t
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Total Combined Surplus
$2.50
P
$2.00
$1.50
$1.00
$0.50
Demand
0
0
10
20
30
40
50
Q/t
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Market Efficiency
•One can see from this why people think markets are
efficient
•Suppose rather than having the market choose Q we
decided to do it ourselves.
•Could we do any better in terms of total surplus.
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Now lets think about this in a more more standard (and
general) context
What if we chose a lower Q?
$2.50
P
$2.00
Surplus Now
Total surplus is lower
$1.50
$1.00
Deadweight
Loss
$0.50
I did not say anything about
how surplus is
distributed-could be more
equitable
0
0
10
20
30
40
50
Q/t
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What if we chose a higher Q?
$2.50
P
$2.00
This bit is actually negative,
Costs are higher than users valuation
$1.50
Thus Total surplus is
lower
$1.00
$0.50
0
0
10
20
30
40
50
Q/t
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Do Markets Always Work Well?
• No, for many reasons markets may fail
• Market Failure: the circumstance where the market
outcome is not the economically efficient outcome
• Possible Sources:
• Consumption or production can harm an innocent
third party.
• A good may not be one for which a company can
profit from selling it though society profits from its
existence.
• The buyer may not be able to make a well-informed
choice.
• A buyer or seller may have too much power over the
price.
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Categorizing Goods:
Exclusivity and Rivalry
• Exclusivity: the degree to which the
consumption of the good can be
restricted by a seller to only those
who pay for it
• Rivalry: the degree to which one
person’s consumption reduces the
value of the good for the next
consumer
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Private and Public Goods
• Purely private good: a good with the
characteristics of both exclusivity and rivalry
• Purely public good: a good with the neither of
the characteristics exclusivity and rivalry
• Excludable public good: a good with the
characteristic of exclusivity but not of rivalry
• Congestible public good: a good with the
characteristic of rivalry but not of exclusivity
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Taxes
• I am mostly following Guell quite closely
• However here I will not, I think this is a good time in the
course to talk about taxes
• The book talks about specific aspects in many places in
the book
• I want to make some general points
• Think about a $1.00 tax on the good (like gas tax)
• Very similar to standard sales tax (just a percentage rather
than a level)
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Tax Example
Consumer
surplus
$2.50
P
Government
$2.00
revenue
Producer
surplus
Effective price
consumer pays
Before I would have bought 25 units if
price was $1.25. Now if price is $0.25 it
costs me $1.50 so I buy 25 units
$1.50
Deadweight
loss
Demand from
consumers perspective
$1.00
Price firm
gets $0.50
Actual Demand
0
0
10
20
30
40
50
Q/t
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Incidence
•It doesn’t matter here at all whether the tax was imposed
on the producer or consumer
•You get exactly the same result either way
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Producer pays tax
Consumer
surplus
$2.50
P
Government
$2.00
revenue
Producer
surplus
Effective
price firm
gets
New supply curve
firms act like price is
P-$1.00
Price consumer pays
Before I would have sold 20 units if
price was $1.50. Now if price is $2.50,
I get $1.50 so I sell 20 units
$1.50
Dead Weight
loss
It is exactly the same as
before
$1.00
$0.50
0
0
10
20
30
40
50
Q/t
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Taxes and elasticity
• A really really important issue here is that the deadweight
loss depends upon the elasticity
• Suppose elasticity of supply or demand were zero
• There are a bunch of different ways to do this, but
suppose elasticity of demand is zero and tax is on
producer
• Then consider the case in which elasticity of supply is zero
and tax is on consumer
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Perfectly Inelastic Demand
Price consumer pays
New supply curve
firms act like price is
P-$1.00
$2.50
P
Government
revenue $2.00
I would sell 20 units
whether there are
taxes or not
$1.50
$1.00
This means there is no
deadweight loss
Effective price
that firm gets
$0.50
0
0
10
20
30
40
50
Q/t
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Perfectly Elastic Supply
$2.50
P
Government
$2.00
revenue
Producer
surplus
Effective price
consumer pays
$1.50
New demand curve
Workers act like price is
P+$1.00
$1.00
Price firm
gets $0.50
No deadweight
loss
0
0
10
20
30
40
50
Q/t
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•More generally the size of the deadweight loss depends
on the elasticity
•The larger the elasticity the larger the deadweight loss
•For similar reason the larger the elasticity the smaller the
government revenue
•For that reason Governments should tax things with low
elasticity
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Think about what happens as elasticity increases?
Deadweight Loss Rises and Government
Revenue Falls
$2.50
P
$2.00
Both are bad so we
don’t want to tax
things that are high
elasticity
$1.50
New demand curve
Workers act like price is
P+$1.00
$1.00
$0.50
0
0
10
20
30
40
50
Q/t
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Stop Coddling the Super-Rich
Warren Buffett, New York Times, Aug. 11 2011
“According to a theory I sometimes hear, I should have thrown a fit
and refused to invest because of the elevated tax rates on capital gains
and dividends.
I didn’t refuse, nor did others. I have worked with investors for 60
years and I have yet to see anyone — not even when capital gains
rates were 39.9 percent in 1976-77 — shy away from a sensible
investment because of the tax rate on the potential gain.”
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