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Chapter 3 The Concept of Elasticity and Consumer and Producer Surplus McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Outline • ELASTICITY OF DEMAND • ALTERNATIVE WAYS OF UNDERSTANDING ELASTICITY • MORE ON ELASTICITY • CONSUMER AND PRODUCER SURPLUS McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity • 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 McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. The Mathematical Representation of Elasticity ΔQ %ΔQ Q Elasticity = = %ΔP ΔP P 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. McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Alternative Ways to Understand Elasticity The Graphical Explanation McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. The Relationship Between Slope and Elasticity • 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 McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 1 12.5% change (9-8)/8 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 McGraw-Hill/Irwin Q/t © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 2 50% change (12-8)/8 P 13 12 11 10 9 8 7 6 5 4 3 2 1 0 D2 25% change (4-3)/4 1 2 3 4 5 6 7 8 9 10 11 12 13 McGraw-Hill/Irwin Q/t © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 3 Higher Prices Means Greater Elasticity 12.5% change (9-8)/8 P 13 12 11 10 9 8 7 6 5 4 3 2 1 0 50% change (3-2)/2 A B Demand 25% change (4-3)/4 C D 1 2 3 4 5 6 7 8 9 10 11 12 13 McGraw-Hill/Irwin 9.1% change (11-10)/11 Q/t © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Alternative Ways to Understand Elasticity 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. McGraw-Hill/Irwin © 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. McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity and the Demand Curve How the Elasticity of Demand Affects Reactions to Price Changes McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 4 Perfectly Inelastic Demand P S2 P2 S1 P1 D Q1=Q2 McGraw-Hill/Irwin Q/t © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 5 Perfectly Elastic Demand P S2 S1 P1=P2 D Q2 McGraw-Hill/Irwin Q1 Q/t © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 6 Inelastic Demand (at moderate prices) P S2 S1 P2 P1 D Q2 Q1 McGraw-Hill/Irwin Q/t © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 7 Elastic Demand (at moderate prices) P S2 S1 P2 P1 D Q2 McGraw-Hill/Irwin Q1 Q/t © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Elasticity Examples Inelastic Goods Price Elasticity Eggs Gasoline (short-run) Gasoline (long-run) Highway and Bridge Tolls -0.06 -0.08 -0.24 -0.10 Unit Elastic Good (or close to it) Shellfish Elastic Goods -0.89 Luxury Car Foreign Air Travel McGraw-Hill/Irwin -3.70 -1.77 © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Failure • 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. McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Kick it Up a Notch Consumer and Producer Surplus in a Supply and Demand Model McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 9 Consumer and Producer Surplus on a Graph P A P* C B 0 Q* McGraw-Hill/Irwin • 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 © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 10 The Value to the Consumer P Supply P* Demand 0 McGraw-Hill/Irwin Q* Q/t © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 11 The Amount Consumers Pay Producers P Supply P* Demand 0 McGraw-Hill/Irwin Q* Q/t © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 12 The Variable Cost to Producers P Supply P* Demand 0 McGraw-Hill/Irwin Q* Q/t © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 13 The Consumer Surplus P Supply P* Demand 0 McGraw-Hill/Irwin Q* Q/t © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 14 The Producer Surplus P Supply P* Demand 0 McGraw-Hill/Irwin Q* Q/t © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. The Optimality of Equilibrium and Dead Weight Loss • 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. McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 16 Dead Weight Loss When the Price is Above P* P A P’ E P* C F B 0 Q’ McGraw-Hill/Irwin Q* • Value to the Consumer: • 0AEQ’ Supply • Consumers Pay Producers: • OP’EQ’ • The Variable Cost to Producers: • OBFQ’ • Consumer Surplus: • P’AE Demand• Producer Surplus: • BP’EF Q/t• DWL • FEC © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 17 Dead Weight Loss When the Price is Below P* P A E P* C P’ F B 0 Q’ McGraw-Hill/Irwin Q* • Value to the Consumer: • 0AEQ’ Supply • Consumers Pay Producers: • OP’FQ’ • The Variable Cost to Producers: • OBFQ’ • Consumer Surplus: Demand • P’AEF • Producer Surplus: Q/t • BP’F • DWL • FEC © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.