Download Elasticity, Consumer and Producer Surplus

Chapter Outline
Chapter 3
The Concept of Elasticity
and Consumer and Producer
Surplus
McGraw -Hill/Irwin
© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.
• ELASTICITY OF DEMAND
• ALTERNATIVE WAYS OF
UNDERSTANDING ELASTICITY
• MORE ON ELASTICITY
• CONSUMER AND PRODUCER
SURPLUS
McGraw -Hill/Irwin
The Mathematical Representation of
Elasticity
Elasticity
•
?Q
Q
Elasticity =
=
%?P
?P
P
Elasticity: the responsiveness of quantity to a change in another
variable
•
Price Elasticity of Demand: the responsiveness of quantity
demanded to a change in price
•
Price Elasticity of Supply: the responsiveness of quantity
supplied to a change in price
•
Income Elasticity of Demand: the responsiveness of quantity
demanded to a change in income
•
Cross Price Elasticity of Demand: the responsiveness of
quantity demanded of one good to a change in the price of
another good
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© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.
%? Q
Because the demand curve is downward sloping and
the supply curve is upward sloping the elasticity of
demand is negative and the elasticity of supply is
positive. Often these signs are implicit and ignored.
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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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Alternative Ways to
Understand Elasticity
The Graphical Explanation
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The Relationship Between Slope and
Elasticity
Figure 1
12.5% change (9-8)/8
• Elasticity and the slope of the demand curve
are not the same but they are related.
• At a given price level, elasticity is greater with
a flatter demand curve.
• With a linear demand curve (meaning a
demand curve that has a single value for the
slope) elasticity is greater at higher prices
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P 13
12
11
10
9
8
7
6
5
4
3
2
1
0
25% change (4-3)/4
D1
1 2 3 4 5 6 7 8 9 10 11 12 13
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Figure 3
Higher Prices Means Greater Elasticity
Figure 2
50% change (12-8)/8
P 13
12
11
10
9
8
7
6
5
4
3
2
1
0
12.5% change (9-8)/8
D2
25% change (4-3)/4
1 2 3 4 5 6 7 8 9 10 11 12 13
McGraw -Hill/Irwin
Q/t
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P 13
12
11
10
9
8
7
6
5
4
3
2
1
0
50% change (3-2)/2
A
B
Demand
The Verbal Explanation
• 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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25% change (4-3)/4
C
D
1 2 3 4 5 6 7 8 9 10 11 12 13
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Alternative Ways
to Understand Elasticity
McGraw -Hill/Irwin
Q/t
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9.1% change (11-10)/11
Q/t
© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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2
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
Extremes of Elasticity
• Perfectly Inelastic: the condition of
demand when price changes have no
effect on quantity
• Perfectly Elastic: the condition of
demand when price cannot change
– The longer you have to come up with
alternatives to paying high prices the more
likely it is you will shift to those alternatives.
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Figure 4 Perfectly Inelastic Demand
Elasticity and the Demand Curve
P
How the Elasticity of Demand
Affects Reactions to Price
Changes
S2
P2
S1
P1
D
Q1 =Q2
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Figure 6 Inelastic Demand
Figure 5 Perfectly Elastic Demand
P
Q/t
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(at moderate prices)
P
S2
S2
S1
S1
P2
P 1 =P2
P1
D
D
Q2
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Q1
Q/t
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Q2 Q1
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Q/t
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3
Figure 7 Elastic Demand
Elasticity Examples
(at moderate prices)
P
Inelastic Goods
S2
S1
P2
Price Elasticity
Eggs
-0.06
Gasoline (short-run)
-0.08
Gasoline (long- run)
-0.24
Highway and Bridge Tolls
-0.10
Unit Elastic Good (or close to it)
P1
Shellfish
D
-0.89
Elastic Goods
Q2
McGraw -Hill/Irwin
Q1
Q/t
© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.
Luxury Car
-3.70
Foreign Air Travel
-1.77
McGraw -Hill/Irwin
Market Failure
Consumer and Producer Surplus
• Consumer Surplus: the value you get that
is in excess of what you pay to get it
– On a graph, consumer surplus is the area below
the demand curve and above the price line.
• Producer Surplus:the money the firm gets
that is in excess of its marginal costs
– On a graph, producer surplus is the area below
the price line and above the supply curve.
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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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• 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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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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4
Figure 9
Consumer and Producer Surplus on a Graph
Kick it Up a Notch
•
P
A
Consumer and Producer
Surplus in a Supply and
Demand Model
P*
C
B
0
McGraw -Hill/Irwin
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Q*
Value to the Consumer:
• 0ACQ*
Supply
• Consumers Pay Producers:
• OP*CQ*
• The Variable Cost to Producers:
• OBCQ*
• Consumer Surplus:
• P*AC
Demand • Producer Surplus:
Q/t • BP*C
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Figure 11
The Amount Consumers Pay Producers
Figure 10
The Value to the Consumer
P
P
Supply
Supply
P*
P*
Demand
Demand
0
Q*
McGraw -Hill/Irwin
Q/t
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0
Q*
McGraw -Hill/Irwin
Q/t
© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.
Figure 12
The Variable Cost to Producers
Figure 13
The Consumer Surplus
P
Supply
P*
P
Supply
P*
Demand
0
McGraw -Hill/Irwin
Q*
Demand
Q/t
© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.
0
McGraw -Hill/Irwin
Q*
Q/t
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5
The Optimality of Equilibrium
and Dead Weight Loss
Figure 14
The Producer Surplus
P
Supply
P*
Demand
0
Q*
McGraw -Hill/Irwin
• At equilibrium the sum of producer and
consumer surplus is as big as it can be
(ABC).
• Away from equilibrium the sum of producer
and consumer surplus is smaller. The degree
to which it is smaller is called the dead weight
loss. That is, it is the loss in societal welfare
associated with production being too little or
too great.
Q/t
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Figure 16 Dead Weight Loss
When the Price is Above P*
•
P
Supply
A
P’
E
P*
•
•
C
•
F
B
•
Demand
0 Q’
McGraw -Hill/Irwin
Q*
Q/t•
Value to the Consumer:
• 0AEQ’
Consumers Pay Producers:
• OP’EQ’
The Variable Cost to Producers:
• OBFQ’
Consumer Surplus:
• P’AE
Producer Surplus:
• BP’EF
DWL
• FEC
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Figure 17 Dead Weight Loss
When the Price is Below P*
•
P
Value to the Consumer:
• 0AEQ’
• Consumers Pay Producers:
• OP’FQ’
• The Variable Cost to
Producers:
• OBFQ’
• Consumer Surplus:
• P’AEF
Demand
• Producer Surplus:
Q/t • BP’F
• DWL
• FEC
Supply
A
E
P*
C
P’
F
B
0
Q’
McGraw -Hill/Irwin
Q*
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