Download Chapter 3 The Concept of Elasticity and Consumer and Producer

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
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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
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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.
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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
• 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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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
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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
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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.
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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.
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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
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Elasticity and the Demand Curve
How the Elasticity of Demand
Affects Reactions to Price
Changes
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Figure 4 Perfectly Inelastic Demand
P
S2
P2
S1
P1
D
Q1=Q2
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Q/t
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Figure 5 Perfectly Elastic Demand
P
S2
S1
P1=P2
D
Q2
McGraw-Hill/Irwin
Q1
Q/t
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Figure 6 Inelastic Demand
(at moderate prices)
P
S2
S1
P2
P1
D
Q2 Q1
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Q/t
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Figure 7 Elastic Demand
(at moderate prices)
P
S2
S1
P2
P1
D
Q2
McGraw-Hill/Irwin
Q1
Q/t
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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
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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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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.
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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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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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Kick it Up a Notch
Consumer and Producer
Surplus in a Supply and
Demand Model
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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
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Figure 12
The Variable Cost to Producers
P
Supply
P*
Demand
0
McGraw-Hill/Irwin
Q*
Q/t
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Figure 13
The Consumer Surplus
P
Supply
P*
Demand
0
McGraw-Hill/Irwin
Q*
Q/t
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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.
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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.