TheConceptofElasticityand Chapter3 ConsumerandProducer Surplus
McGraw-Hill/Irwin
Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
ChapterOutline
ELASTICITYOFDEMAND ALTERNATIVEWAYSOF UNDERSTANDINGELASTICITY MOREONELASTICITY CONSUMERANDPRODUCER SURPLUS
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YouAreHere
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Elasticity
Elasticity:theresponsivenessofquantitytoa changeinanothervariable PriceElasticityofDemand:the responsivenessofquantitydemandedtoa changeinprice PriceElasticityofSupply:theresponsiveness ofquantitysuppliedtoachangeinprice IncomeElasticityofDemand:the responsivenessofquantitydemandedtoa changeinincome CrossPriceElasticityofDemand:the responsivenessofquantitydemandedofone goodtoachangeinthepriceofanothergood
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TheMathematicalRepresentation ofElasticity
Q %Q Q Elasticity = = %P P 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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Elastic:theconditionofdemandwhen thepercentagechangeinquantityis largerthanthepercentagechangein price Inelastic:theconditionofdemandwhen thepercentagechangeinquantityis smallerthanthepercentagechangein price UnitaryElastic:theconditionofdemand whenthepercentagechangeinquantity isequaltothepercentagechangein price
ElasticityLabels
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AlternativeWaystoUnderstand Elasticity
TheGraphicalExplanation
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TheRelationshipBetweenSlopeand Elasticity Elasticityandtheslopeofthe demandcurvearenotthesamebut theyarerelated. Atagivenpricelevel,elasticityis greaterwithaflatterdemandcurve. Withalineardemandcurve (meaningademandcurvethathas asinglevaluefortheslope) elasticityisgreaterathigherprices
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Figure1
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
Q/t
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Figure2
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
Q/t
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Figure3HigherPricesMeansGreaterElasticity
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 C
25% change (4-3)/4
D
9.1% change (11-10)/11
1 2 3 4 5 6 7 8 9 10 11 12 13
Q/t
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Agoodforwhichtherearenogood substitutesislikelytobeoneforwhichyou mustpaywhateverpriceischarged.Itisalso likelytobeoneforwhichalowerpricewillnot inducesubstantiallygreaterconsumption. Thus,aspricechangesthereisverylittle changeinconsumption,i.e.demandis inelasticandthedemandcurveissteep. Inexpensivegoodsthattakeuplittleofyour incomecanchangeinpriceandyour consumptionwillnotchangedramatically. Thus,atlowprices,demandisinelastic.
The Verbal Explanation
AlternativeWaystoUnderstand Elasticity
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SeeingElasticityThroughTotal Expenditures
TotalExpenditureRule:ifthe priceandtheamountyouspend bothgointhesamedirectionthen demandisinelasticwhileiftheygo inoppositedirectionsdemandis elastic.
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DeterminantsofElasticity
NumberofandClosenessofSubstitutes
Themorealternativesyouhavethelesslikely youaretopayhighpricesforagoodandthe morelikelyyouaretosettleforsomethingthat willdo. Thelongeryouhavetocomeupwith alternativestopayinghighpricesthemore likelyitisyouwillshifttothosealternatives. Thegreatertheportionofthebudgetanitem takesup,thegreatertheelasticityislikelyto be.
Time
PortionoftheBudget
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ExtremesofElasticity
PerfectlyInelastic:theconditionof demandwhenpricechangeshave noeffectonquantity PerfectlyElastic:theconditionof demandwhenpricecannotchange
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ElasticityandtheDemand Curve
HowtheElasticityofDemand AffectsReactionstoPrice Changes
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P
Figure4PerfectlyInelastic Demand
S2
P2
S1
P1
D
Q1=Q2
Q/t
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P
Figure5PerfectlyElastic Demand
S2 S1
P1=P2
D
Q2
Q1
Q/t
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Figure6InelasticDemand
(atmoderateprices)
P
S2 Q1
Q/t
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Figure7ElasticDemand
P
(atmoderateprices)
S2 S1
P2
P1
D
Q2 S1
P2 P1
D
Q2
Q1
Q/t
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InelasticGoods Eggs Food
ElasticityExamples
PriceElasticity 0.06 0.21 0.18 0.08 0.24 0.10 0.89 1.14 3.70 1.77
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HealthCareServices Gasoline(shortrun) Gasoline(longrun) HighwayandBridgeTolls UnitElasticGood(orclosetoit) Shellfish Cars ElasticGoods LuxuryCar ForeignAirTravel
PriceElasticitySupply
Identicalinconcepttoelasticityof demand.
FormulaistheSame Itisalsorelatedtotheslopeofthe supplycurvebutisnotsimplythe slopeofthesupplycurve. Terminologyisthesame
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Perfectly Inelastic Supply
P S
P2
P1
D2 D1
Q1=Q2
Q/t
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Inelastic Supply
P S
P2
P1
D2 D1
Q1 Q2
Q/t
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Elastic Supply
P
S
P2 P1
D2 D1
Q1 Q2
Q/t
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Perfectly Elastic Supply
P
P1=P2
S D2 D1
Q1 Q2
Q/t
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ConsumerandProducer Surplus
ConsumerSurplus:thevalueyouget thatisinexcessofwhatyoupaytogetit
Onagraph,consumersurplusisthearea belowthedemandcurveandabovetheprice line.
ProducerSurplus:themoneythefirm getsthatisinexcessofitsmarginalcosts
Onagraph,producersurplusisthearea belowthepricelineandabovethesupply curve.
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Figure12 ValuetotheConsumer:OACQ*
P A Supply
P*
C
B 0 Q*
Demand Q/t
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Figure12 MoneyConsumersPayProducers:OP*CQ*
P A Supply
P*
C
B 0 Q*
Demand Q/t
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Figure12ConsumerSurplus: P*AC
P
Consumer Surplus = = minus
A Supply
Amount Consumer pays producer Value to the Consumer
P*
C
B 0 Q*
Demand Q/t
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Figure13VariableCosttothe Producer:OBCQ*
P A Supply
P*
C
B 0 Q*
Demand
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Figure13ProducerSurplus:BP*C
P A Supply
Amount consumer pays producer
Producer Surplus =
=
minus
P*
C
Variable cost to producer
B 0 Q*
Demand Q/t
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Figure14NetBenefittoSociety= CS+PS:BAC
P A Consumer Surplus Supply
P*
C
Producer Surplus
B 0 Q*
Demand Q/t
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MarketFailure:thecircumstancewhere themarketoutcomeisnottheeconomically efficientoutcome PossibleSources: Consumptionorproductioncanharm aninnocentthirdparty. Agoodmaynotbeoneforwhicha companycanprofitfromsellingit thoughsocietyprofitsfromits existence. Thebuyermaynotbeabletomakea wellinformedchoice. Abuyerorsellermayhavetoomuch powerovertheprice.
MarketFailure
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CategorizingGoods: ExclusivityandRivalry
Exclusivity:thedegreetowhichthe consumptionofthegoodcanbe restrictedbyasellertoonlythose whopayforit Rivalry:thedegreetowhichone personsconsumptionreducesthe valueofthegoodforthenext consumer
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PrivateandPublicGoods
Purelyprivategood:agoodwiththe characteristicsofbothexclusivityandrivalry Purelypublicgood:agoodwiththeneither ofthecharacteristicsexclusivityandrivalry Excludablepublicgood:agoodwiththe characteristicofexclusivitybutnotofrivalry Congestiblepublicgood:agoodwiththe characteristicofrivalrybutnotofexclusivity
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KickitUpaNotch
ConsumerandProducer SurplusinaSupplyand DemandModel
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Atequilibriumthesumofproducerand consumersurplusisasbigasitcanbe (ABC). Awayfromequilibriumthesumof producerandconsumersurplusis smaller.Thedegreetowhichitis smalleriscalledthedeadweightloss. Thatis,itisthelossinsocietalwelfare associatedwithproductionbeingtoo littleortoogreat.
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TheOptimalityofEquilibrium andDeadWeightLoss
Figure16DeadWeightLoss WhenthePriceisAboveP*
P
A P P*
Supply
E C F
B
Demand
0 Q Q*
Q/t
Value to the Consumer: 0AEQ Consumers Pay Producers: OPEQ The Variable Cost to Producers: OBFQ Consumer Surplus: PAE Producer Surplus: BPEF DWL FEC
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Figure17DeadWeightLoss WhenthePriceisBelowP*
P
A
Supply
E C F
P* P B
Demand
0 Q Q*
Q/t
Value to the Consumer: 0AEQ Consumers Pay Producers: OPFQ The Variable Cost to Producers: OBFQ Consumer Surplus: PAEF Producer Surplus: BPF DWL FEC
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