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Elasticity of Demand
Chapter 5
Slope of Demand Curves
• Demand curves do not all have the same slope
• Slope indicates response of buyers to a change in
price
Which demand curve is most sensitive to price changes?
D1
D1
Price 10%
D1
=>
Qty Demanded
? (how much?)
ELASTICITY OF DEMAND
• Price elasticity of demand: how much quantity
demanded of a good responds to a change in price
• Responsiveness is measured in percentage terms:
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
•
•
•
•
Determinants of Elasticity of
Demand
Availability of Close Substitutes
Necessities versus Luxuries
Proportion of Income
Time Horizon
Demand is more elastic:
•
•
•
•
the larger the number of close substitutes
if the good is a luxury
Good is a larger percent of budget
the longer the time period
Price Elastic or Price
Inelastic?
Gasoline
Soda
Price Inelastic
Price Elastic
No real substitutes
Many substitutes
Heart Surgery
Table Salt
Price Inelastic
Price Inelastic
Necessity &
No real substitutes,
Short time period
Small proportion
of income, no good
substitute
Computing Price Elasticity of
Demand
• Example:
– If the price of an ice cream cone increases from $2.00 to $2.20
– The quantity bought falls from 10 to 8 cones:
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
(10  8)
 100
20%
10

2
(2.20  2.00)
 100 10%
2.00
Variety of Demand Curves
• Inelastic Demand
– Quantity demanded does not respond strongly to
price changes.
– Price elasticity of demand is less than 1
• Elastic Demand
– Quantity demanded responds strongly to changes in
price.
– Price elasticity of demand is greater than 1
Computing Price Elasticity of
Demand
(100  50)
Price
ED 
$5
4
(4.00  5.00)
(100  50)/2
(4.00  5.00)/2
Demand
67 percent

 3
 22 percent
0
50
100 Quantity
Demand is Price Elastic
or Greater than 1---(use absolute values)
The Variety of Demand Curves
• Perfectly Inelastic
– Quantity demanded does not respond to price changes
• Perfectly Elastic
– Quantity demanded changes infinitely with price
change
• Unit Elastic
– Quantity demanded changes by the same percentage
as price
The Variety of Demand Curves
• Price elasticity of demand is closely related to the
slope of the demand curve.
• But it is not the same thing as the slope!
Perfectly Inelastic
(a) Perfectly Inelastic Demand: Elasticity
Equals 0
Price
Demand
$5
4
1. An
increase
in price . . .
0
100
Quantity
2. . . . leaves the quantity demanded unchanged.
Perfectly Elastic
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Price
1. At any price
above $4, quantity
demanded is zero.
$4
Demand
2. At exactly $4,
consumers will
buy any quantity.
0
3. At a price below $4,
quantity demanded is infinite.
Quantity
Inelastic Demand
(b) Inelastic Demand: Elasticity Is Less Than 1
Price
$5
4
1. A 22%
increase
in price . . .
Demand
0
90
100
Quantity
2. . . . leads to an 11% decrease in quantity demanded.
Unit Elastic Demand
(c) Unit Elastic Demand: Elasticity Equals 1
Price
$5
4
Demand
1. A 22%
increase
in price . . .
0
80
100
Quantity
2. . . . leads to a 22% decrease in quantity demanded.
Elastic Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Price
$5
4
Demand
1. A 22%
increase
in price . . .
0
50
100
Quantity
2. . . . leads to a 67% decrease in quantity demanded.
Elasticity & Total Revenue
Chapter 5
Total Revenue
• Total revenue is not profit
• It is the total amount of money received by a
business
• Total Revenue = Price & Quantity Sold
TR  P  Q
Coffee Shop: Price coffee: $2/cup
Qty Sold:
500 per day
Total Revenue = $2 * 500 = $1,000
Profit = TR – all expenses
Total Revenue
Price
When the price is $4, consumers
demand 100 units, and spend $400
on this good.
$4
P × Q = $400
( total revenue)
P
0
Demand
100
Q
Quantity
Elasticity and Total Revenue
• Inelastic demand curve:
in price => a smaller %
in Qty demanded = > TR
• Elastic demand curve
in price => a greater %
in Qty demanded = > TR
Total Revenue & Inelastic
Demand
Price
An Increase in price from $1
to $3 …
Price
… leads to an Increase in total
revenue from $100 to $240
$3
Total Revenue
= $240
$1
Total Revenue = $100 Demand
0
100
Quantity
Demand
0
80
Quantity
Total Revenue & Elastic
Demand
Price
Price
… leads to an decrease in total
revenue from $200 to $100
An Increase in price from $4 to $5 …
$5
$4
Demand
Demand
Total
Revenue = $200
0
50
Total Revenue = $100
Quantity
0
20
Quantity
Note that with each price increase, the Law of Demand still holds – an
increase in price leads to a decrease in the quantity demanded. It is the
change in TR that varies!
Which demand curve is inelastic?
D1
D
1
Elastic demand curves tend to flat (horizontal)
Inelastic demand curves tend to be steep (vertical)
Linear demand curves:
1) Have a constant slope
2) Do not have constant elasticity
3) Have both elastic & inelastic ranges
4) SLOPE is constant------ELASTICITY changes
Elasticity of Linear Demand Curves
Demand curves have both elastic
& inelastic ranges
Points with high price & low quantity demand is elastic
Points with low price & high quantity demand is inelastic
Linear Demand Curve
Elasticity
Price
Price
from $4 to $5 => TR
from $24 to $20.
$7
Elastic Range: Elasticity > 1
6
5
Price
from $2 to $3 => TR
from $20 to $24
4
3
Inelastic Range: Elasticity < 1
2
1
0
2
4
6
8
10
12
14
Quantity
Price increases leads to:
Total Revenue rising in inelastic ranges
Total Revenue falling in elastic ranges
Total Revenue staying constant in unit elastic
Income Elasticity of Demand
• Income elasticity of demand- how much quantity
demanded responds to a change in consumers’
income
–
EI = % change in Qty Demanded
% change in income
•
•
•
•
Normal Goods have positive Income elasticity
Income elastic:
EI >1
(considered a luxury)
Income inelastic: 1 > EI > 0 (considered a necessity)
Inferior Goods: EI < 0
(negative income elasticity)
Cross-price elasticity of
demand
• How much quantity demanded of one good responds to a
change in price of another good
%change in quantity demanded of good 1
Cross - price elasticity of demand 
%change in price of good 2
• Substitutes have positive cross-price elasticity Ea,b > 0
• Complements have negative cross-price elasticity Ea,b <
0
Summary
• Elastic demand curves are flat
• Inelastic demand curves are steep
• Slope is constant, Elasticity is not
• Linear demand curves have inelastic & elastic ranges
• Total Revenue
=> Prices
elastic goods
• Firms can maximize total revenue by calculating the elasticity
of demand of their product
Taxes & Market
Equilibrium
Chapter 6
How Taxes on Buyers (and Sellers)
Affect Market Outcomes
• When a good is taxed, the quantity sold is smaller
• Buyers and sellers both share the tax burden
• Types of Taxes:
– Sales Tax:
– Excise Tax:
tax on most goods
taxes on specific goods (ex: cigarettes, gasoline, etc…)
• Why tax?
– To raise Government Revenue or
– To decrease consumption of a good (cigarettes)
Elasticity & Tax Incidence
• Tax incidence is the study of who bears the burden of a
tax
• Taxes result in a change in market equilibrium
• Buyers pay more & sellers receive less
– regardless of whom the tax is levied on
Example: Tax on Buyers
• Government places a tax on ice cream of .50 cents
• Does the tax shift the supply or demand curve?
• Supply Curve is not affected
– Determinant of supply did not change (TINE & TP)
• Demand Curve will shift left
– Price of substitute good in effect fell (remember TIPSEN)
Tax on Buyers
Price of
Ice-Cream
Price
Cone
buyers
pay
$3.30
Price
3.00
2.80
without
tax
Price
sellers
receive
Supply, S1
Equilibrium without tax
Tax ($0.50)
New Equilibrium
with tax
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50).
D1
D2
0
90
100
Quantity of
Ice-Cream Cones
Tax on Sellers
Price of
Ice-Cream
Price
Cone
buyers
pay
$3.30
3.00
Price
2.80
without
tax
S2
Equilibrium
with tax
S1
Tax ($0.50)
A tax on sellers
shifts the supply
curve upward
by the amount of
the tax ($0.50).
Equilibrium without tax
Price
sellers
receive
TINE & TP
Demand, D1
Taxes are a
Determinant of supply
0
90
100
Quantity of
Ice-Cream Cones
Elasticity and Tax Incidence
• In what proportions is the burden of the tax divided?
• How do the effects of taxes on sellers compare to those
levied on buyers?
• It depends on the elasticity of demand & the elasticity
of supply.
Supply more elastic than
demand
(a) Elastic Supply, Inelastic Demand
Price
1. When supply is more elastic
than demand . . .
Price buyers pay
Supply
Tax
2. . . . the
incidence of the
tax falls more
heavily on
consumers . . .
Price without tax
Price sellers
receive
3. . . . than
on producers.
0
Demand
Quantity
Demand more elastic than
supply
(b) Inelastic Supply, Elastic Demand
Price
1. When demand is more elastic
than supply . . .
Price buyers pay
Supply
Price without tax
3. . . . than on
consumers.
Tax
Price sellers
receive
0
2. . . . the
incidence of
the tax falls
more heavily
on producers . . .
Demand
Quantity
So, how is the burden of the tax divided?
The burden of a tax falls more
heavily on the side of the
market that is less elastic.
Incidence of Tax Summary
• The incidence of a tax does not depend on whether the
tax is levied on buyers or sellers
• It depends on the price elasticities of supply and
demand.
• The burden falls on the side of the market that is less
elastic
Welfare Economics
Chapter 7:
Consumer Surplus
Consumers, Producers & Efficiency
of Markets
• Market equilibrium reflects the way markets allocate
scarce resources
• Whether the market allocation is desirable can be
addressed by welfare economics
• Welfare economics is the study of how the allocation of
resources affects economic well-being
Welfare Economics
• Equilibrium- results in maximum total welfare for
consumers & producers
• Consumer surplus measures economic welfare from
the buyer’s side
• Producer surplus measures economic welfare from the
seller’s side
CONSUMER SURPLUS
• Willingness to pay- the maximum amount that a
buyer will pay for a good
• It measures how much the buyer values the good or
service
• Consumer surplus- the buyer’s willingness to pay for
a good minus the amount the buyer actually pays for it
Demand Schedule & the Demand
Curve
The market demand curve depicts the various
quantities that buyers would be willing to
purchase at different prices.
Consumers value goods differently
Demand Curve
Price of
Album
John’s willingness to pay
$100
Paul’s willingness to pay
80
George’s willingness to pay
70
Ringo’s willingness to pay
50
Demand
0
1
2
3
4
Quantity of
Albums
Equilibrium Price = $80
(a) Price = $80
Price of
Album
John was willing to pay $100
But he only had to pay $80
$100
John’s consumer surplus ($20)
80
John is better
off by $20
70
50
Demand
0
1
2
3
4
Quantity of
Albums
Equilibrium Price = $70
(b) Price = $70
Price of
Album
$100
John’s consumer surplus ($30)
The area below the demand curve &
above the price measures the
consumer surplus in the market.
80
Paul’s consumer
surplus ($10)
70
50
Notice that as
price falls, consumer
surplus rises
Total
consumer
surplus ($40)
Demand
0
1
2
3
4 Quantity of
Albums
Equilibrium Price & Consumer Surplus
(a) Consumer Surplus at Price P
Price
A
This triangle represents the
“welfare” of consumers
Consumer
surplus
P1
B
C
Demand
0
Q1
Quantity
Price falls from P1 to P2
(b) Consumer Surplus at Price P
Price
A
As Price falls, area below
Demand curve increases, so
Consumer Surplus increases
Initial
consumer
surplus
P1
P2
0
C
B
Consumer surplus
to new consumers
F
D
E
Additional consumer
surplus to initial
consumers
Q1
Demand
Q2
Quantity
What Does Consumer Surplus
Measure?
Amount buyers
are willing to pay
-
Amount buyers
actually pay
=
Welfare of Buyers:
Consumer Surplus!
Total Welfare = Consumer Surplus + Producer Surplus
Welfare Economics Part II
Chapter 7:
Producer Surplus
PRODUCER SURPLUS
• Producer surplus = the amount a seller is paid for a
good minus the seller’s marginal cost
• It measures the benefit to sellers participating in a
market
• Just as consumer surplus is related to the demand
curve, producer surplus is related to the supply
curve
Supply Schedule & Supply Curve
Equilibrium Price = $600
(a) Price = $600
Price of
House
Painting
Supply
Price Received = $600
Marginal Cost = $500
$900
Producer Surplus = $100
800
600
500
Grandma’s producer
surplus ($100)
0
1
2
3
4
Quantity of
Houses Painted
Equilibrium Price = $800
(b) Price = $800
Price of
House
Painting
$900
Supply
Total
producer
surplus ($500)
800
600
Georgia’s producer
surplus ($200)
500
Grandma’s producer
surplus ($300)
0
1
2
3
4
Quantity of
Houses Painted
(a) Producer Surplus at Price P
Price
Supply
The area below price & above
supply curve = producer surplus
P1
B
Producer
surplus
C
A
0
Q1
Quantity
(b) Producer Surplus at Price P
Price
Supply
Additional producer
surplus to initial
producers
P2
P1
D
As Price
Producer Surplus
E
F
B
Initial
producer
surplus
C
Producer surplus
to new producers
A
0
Q1
Q2
Quantity
EFFICIENCY vs. EQUITY
• Efficiency = resource allocation which maximizes the
total surplus received by all members of society
• Equity = the fairness of the distribution of well-being
among the various buyers and sellers
– Equity is not addressed in free markets
• Free markets naturally (invisible hand) maximize
efficiency by maximizing total welfare (consumer surplus +
producer surplus)
Total Welfare
• Consumer Surplus = Value to buyers – Amount paid by buyers
• Producer Surplus
= Amount received by sellers – Cost to sellers
• Total Surplus (welfare) = Consumer Surplus + Producer Surplus
• Therefore:
• Total Surplus = Value to buyers – Cost to sellers
Market Equilibrium
Price A
= Total
Welfare
D
Supply
Consumer
surplus
Equilibrium
price
E
Producer
surplus
B
Demand
C
0
Equilibrium
quantity
Quantity
Evaluating Free Market
Equilibrium
• Free markets allocate the supply of goods to buyers
who value them most highly (willingness to pay)
• Free markets allocate the demand for goods to sellers
who can produce goods at least cost
• Free markets produce the quantity of goods that
maximizes the sum of consumer & producer surplus (Total
Welfare/Surplus)
Efficiency of Equilibrium Quantity
Price
Supply
Value
to
buyers
Cost
to
sellers
Cost
to
sellers
0
Value
to
buyers
Equilibrium
quantity
Value to buyers is greater
than cost to sellers.
Value to buyers is less
than cost to sellers.
Demand
Quantity
Worksheet:
Lesson 1, Activity 9
• Please complete side 2 of the Consumer/Producer
Surplus worksheet
Welfare Economics Part II
Chapter 7:
Producer Surplus
PRODUCER SURPLUS
• Producer surplus = the amount a seller is paid for a
good minus the seller’s marginal cost
• It measures the benefit to sellers participating in a
market
• Just as consumer surplus is related to the demand
curve, producer surplus is related to the supply
curve
Supply Schedule & Supply Curve
Equilibrium Price = $600
(a) Price = $600
Price of
House
Painting
Supply
Price Received = $600
Marginal Cost = $500
$900
Producer Surplus = $100
800
600
500
Grandma’s producer
surplus ($100)
0
1
2
3
4
Quantity of
Houses Painted
Equilibrium Price = $800
(b) Price = $800
Price of
House
Painting
$900
Supply
Total
producer
surplus ($500)
800
600
Georgia’s producer
surplus ($200)
500
Grandma’s producer
surplus ($300)
0
1
2
3
4
Quantity of
Houses Painted
(a) Producer Surplus at Price P
Price
Supply
The area below price & above
supply curve = producer surplus
P1
B
Producer
surplus
C
A
0
Q1
Quantity
(b) Producer Surplus at Price P
Price
Supply
Additional producer
surplus to initial
producers
P2
P1
D
As Price
Producer Surplus
E
F
B
Initial
producer
surplus
C
Producer surplus
to new producers
A
0
Q1
Q2
Quantity
EFFICIENCY vs. EQUITY
• Efficiency = resource allocation which maximizes the
total surplus received by all members of society
• Equity = the fairness of the distribution of well-being
among the various buyers and sellers
– Equity is not addressed in free markets
• Free markets naturally (invisible hand) maximize
efficiency by maximizing total welfare (consumer surplus +
producer surplus)
Total Welfare
• Consumer Surplus = Value to buyers – Amount paid by buyers
• Producer Surplus
= Amount received by sellers – Cost to sellers
• Total Surplus (welfare) = Consumer Surplus + Producer Surplus
• Therefore:
• Total Surplus = Value to buyers – Cost to sellers
Market Equilibrium
Price A
= Total
Welfare
D
Supply
Consumer
surplus
Equilibrium
price
E
Producer
surplus
B
Demand
C
0
Equilibrium
quantity
Quantity
Evaluating Free Market
Equilibrium
• Free markets allocate the supply of goods to buyers
who value them most highly (willingness to pay)
• Free markets allocate the demand for goods to sellers
who can produce goods at least cost
• Free markets produce the quantity of goods that
maximizes the sum of consumer & producer surplus (Total
Welfare/Surplus)
Efficiency of Equilibrium Quantity
Price
Supply
Value
to
buyers
Cost
to
sellers
Cost
to
sellers
0
Value
to
buyers
Equilibrium
quantity
Value to buyers is greater
than cost to sellers.
Value to buyers is less
than cost to sellers.
Demand
Quantity