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You are on page 1of 8

CHAPTER SIX

ELASTICITY, CONSUMER SURPLUS, AND PRODUCER

SURPLUS

CHAPTER OVERVIEW

This chapter is the first of the chapters in Part Two, Microeconomics of Product Markets. Students

will benefit by reviewing hapter !"s demand and supply analysis prior to reading this chapter.

#oth the elasticity coefficient and the total revenue test for measuring price elasticity of demand are

presented in the chapter The chapter reviews a number of applications and presents empirical estimates

for a variety of products. ross$ and income elasticities of demand and price elasticity of supply are

also addressed. %inally, this chapter introduces consumer and producer surplus, as well as efficiency

&deadweight' loss.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to:

1 !efine demand and supply and state the la"s of demand and supply #re$ie" from Chapter %&

' !etermine e(uilibrium price and (uantity from supply and demand graphs and schedules #from

Chapter %&

% !efine price elasticity of demand and compute the coefficient of elasticity gi$en appropriate data on

prices and (uantities

) E*plain the meaning of elastic, inelastic, and unitary price elasticity of demand

+ ,ecogni-e graphs of perfectly elastic and perfectly inelastic demand

6 .se the total-re$enue test to determine "hether elasticity of demand is elastic, inelastic, or unitary

/ 0ist four ma1or determinants of price elasticity of demand

2 E*plain ho" a change in each of the determinants of price elasticity "ould affect the elasticity

coefficient

3 !efine price elasticity of supply and e*plain ho" the producer4s ability to shift resources to

alternati$e uses and time affect price elasticity of supply

10 E*plain cross elasticity of demand and ho" it is used to determine substitute or complementary

products

11 !efine income elasticity and its relationship to normal and inferior goods

1' !efine, measure, and graphically identify consumer surplus

1% !efine, measure, and graphically identify producer surplus

1) 5dentify and e*plain efficiency #or dead"eight& losses using consumer and producer surplus

1+ !efine and identify the terms and concepts listed at end of the chapter

6-1

Chapter 06 - Elasticity, Consumer Surplus, and Producer Surplus

LECTURE NOTES

I. Introduction

A Learning objectives 6 5n this chapter students "ill learn:

1 About price elasticity of demand and ho" it can be applied

' 7he usefulness of the total re$enue test for price elasticity of demand

% About price elasticity of supply and ho" it can be applied

) About cross elasticity of demand and income elasticity of demand

+ About consumer surplus, producer surplus, and efficiency #dead"eight& loss

8 Elasticity of demand measures ho" much the (uantity demanded changes "ith a gi$en change

in price of the item, change in consumers4 income, or change in price of related product

C Price elasticity is a concept that also relates to supply

! 7he chapter e*plores both elasticity of supply and demand and applications of the concept

II. Price Elasticity of Demand

A 0a" of demand tells us that consumers "ill respond to a price decrease by buying more of a

product #other things remaining constant&, but it does not tell us ho" much more

8 The degree of responsiveness or sensitivity of consumers to a change

in price is measured by the concept of price elasticity of demand.

1 5f consumers are relati$ely responsi$e to price changes, demand is said to be elastic

' 5f consumers are relati$ely unresponsi$e to price changes, demand is said to be inelastic

% 9ote that "ith both elastic and inelastic demand, consumers beha$e according to the la" of

demand: that is, they are responsi$e to price changes 7he terms elastic or inelastic

describe the degree of responsi$eness A precise definition of "hat "e mean by

;responsi$e< or ;unresponsi$e< follo"s

4. C!"IDE# T$I" % & 'it of a "tretch

7he Ace bandage stretches a lot "hen force is applied #elastic&: the rubber tie-do"n #not to

be confused "ith a rubber band& mo$es stretches little "hen force is applied #inelastic&

C Price elasticity coefficient and formula:

(uantitative measure of elasticity) E

d

* percentage change in

+uantity, percentage change in price.

1 .sing t"o price-(uantity combinations of a demand schedule, calculate the percentage

change in (uantity by di$iding the absolute change in (uantity by one of the t"o original

(uantities 7hen calculate the percentage change in price by di$iding the absolute change in

price by one of the t"o original prices

' Estimate the elasticity of this region of the demand schedule by comparing the percentage

change in (uantity and the percentage change in price !o not use the ratio formula at this

time Emphasi-e that it is the t"o percentage changes that are being compared "hen

determining elasticity

6-'

Chapter 06 - Elasticity, Consumer Surplus, and Producer Surplus

% Sho" that if the other original (uantity and price "ere used as the denominator that the

percentage changes "ould be different E*plain that a "ay to deal "ith this problem is to

use the a$erage of the t"o (uantities and the a$erage of the t"o prices

) .sing a$erages 6 the midpoint formula

a .sing traditional calculations, the measured elasticity o$er a gi$en range of prices is

sensiti$e to "hether one starts at the higher price and goes do"n, or the lo"er price

and goes up 7he midpoint formula calculates the a$erage elasticity o$er a range of

prices to alle$iate that problem

b 7he midpoint formula for elasticity is:

E

d

= >#change in ?&@#sum of ?4s@'&A di$ided by >#change in P&@#sum of P4s@'&A

c Ba$e the students calculate each of the percentage changes separately to determine

"hether the demand is elastic or inelastic After the students ha$e determined the type

of elasticity, then ha$e them insert the percentage changes into the formula

d Students should practice the e*ercise in 7able 61 #Cey ?uestion '&

6-%

Chapter 06 - Elasticity, Consumer Surplus, and Producer Surplus

+ Emphasis: 7he percentages changes are compared, not the absolute changes

a Absolute changes depend on choice of units Dor e*ample, a change in the price of a

E10,000 car by E1 and is $ery different than a change in the price a of E1 can of beer

by E1 7he auto4s price is rising by a fraction of a percent "hile the beer rice is rising

100 percent

b Percentages also maFe it possible to compare elasticities of demand for different

products

6 'ecause of the inverse relationship bet-een price and +uantity

demanded) the actual elasticity of demand -ill be a negative

number. $o-ever) -e ignore the minus sign and use absolute value

of both percentage changes

/ If the coefficient of elasticity of demand is a number greater than one) -e say demand

is elastic. if the coefficient is less than one) -e say demand is inelastic. In other -ords)

the +uantity demanded is /relatively responsive0 -hen Ed is greater than 1 and

/relatively unresponsive0 -hen Ed is less than 1. & special case is if the coefficient

e+uals one. this is called unit elasticity.

2 9ote: 5nelastic demand does not mean that consumers are completely unresponsi$e 7his

e*treme situation called perfectly inelastic demand "ould be $ery rare, and the demand

cur$e "ould be $ertical

3 0iFe"ise, elastic demand does not mean consumers are completely responsi$e to a price

change 7his e*treme situation, in "hich a small price reduction "ould cause buyers to

increase their purchases from -ero to all that it is possible to obtain, is perfectly elastic

demand, and the demand cur$e "ould be hori-ontal

! Graphical analysis:

1 5llustrate graphically perfectly elastic, relati$ely elastic, unitary elastic, relati$e inelastic,

and perfectly inelastic #Digures 61 and 6'&

' .sing Digure 6', e*plain that elasticity $aries o$er range of prices

a !emand is more elastic in upper left portion of cur$e #because price is higher, (uantity

smaller&

b !emand is more inelastic in lo"er right portion of cur$e #because price is lo"er,

(uantity larger&

% 5t is impossible to 1udge elasticity of a single demand cur$e by its flatness or steepness,

since demand elasticity can measure both elastic and inelastic at different points on the

same demand cur$e

6-)

Chapter 06 - Elasticity, Consumer Surplus, and Producer Surplus

E Total2revenue test is the easiest -ay to judge -hether demand is elastic or inelastic. 7his

test can be used in place of elasticity formula, unless there is a need to determine the elasticity

coefficient

1 Elastic demand and the total-re$enue test: !emand is elastic if a decrease in price results in

a rise in total re$enue, or if an increase in price results in a decline in total re$enue #Price

and re$enue mo$e in opposite directions&

' 5nelastic demand and the total-re$enue test: !emand is inelastic if a decrease in price

results in a fall in total re$enue, or an increase in price results in a rise in total re$enue

#Price and re$enue mo$e in same direction&

% .nit elasticity and the total-re$enue test: !emand has unit elasticity if total re$enue does

not change "hen the price changes

) 7he graphical representation of the relationship bet"een total re$enue and price elasticity

is sho"n in Digure 6'

+ 7able 6' pro$ides a summary of the rules and concepts related to elasticity of demand

D There are several determinants of the price elasticity of demand.

1 "ubstitutes for the product3 Generally, the more substitutes, the more elastic the demand

' The proportion of price relative to income: Generally, the larger the e*penditure relati$e

to one4s budget, the more elastic the demand, because buyers notice the change in price

more

% 4hether the product is a lu5ury or a necessity: Generally, the less necessary the item,

the more elastic the demand

) The amount of time involved: Generally, the longer the time period in$ol$ed, the more

elastic the demand becomes

G 7able 6% presents some real-"orld price elasticities .se the determinants discussed to see if

the actual elasticities are e(ui$alent to "hat one "ould predict

B 7here are many practical applications of the price elasticity of demand

1 5nelastic demand for agricultural products helps to e*plain "hy bumper crops depress the

prices and total re$enues for farmers

' Go$ernments looF at elasticity of demand "hen le$ying e*cise ta*es E*cise ta*es on

products "ith inelastic demand "ill raise the most re$enue and ha$e the least impact on

(uantity demanded for those products

% !emand for cocaine is highly inelastic and presents problems for la" enforcement

Stricter enforcement reduces supply, raises prices and re$enues for sellers, and pro$ides

more incenti$es for sellers to remain in business Crime may also increase as buyers ha$e

to find more money to buy their drugs

a Hpponents of legali-ation thinF that occasional users or ;dabblers< ha$e a more elastic

demand and "ould increase their use at lo"er, legal prices

b ,emo$al of the legal prohibitions might maFe drug use more socially acceptable and

shift demand to the right

6-+

Chapter 06 - Elasticity, Consumer Surplus, and Producer Surplus

III. Price Elasticity of "upply

A 7he concept of price elasticity also applies to supply 7he elasticity formula is the same as that

for demand, but "e must substitute the "ord ;supplied< for the "ord ;demanded< e$ery"here

in the formula

E

s

* percentage change in +uantity supplied , percentage change in

price

As "ith price elasticity of demand, the midpoints formula is more accurate

8 7he ease of shifting resources bet"een alternati$e uses is $ery important in price elasticity of

supply because it "ill determine ho" much fle*ibility a producer has to ad1ust his@her output to

a change in the price 7he degree of fle*ibility, and therefore the time period, "ill be different in

different industries #Digure 6)&

1 7he marFet period is so short that elasticity of supply is inelastic: it could be almost

perfectly inelastic or $ertical 5n this situation, it is $irtually impossible for producers to

ad1ust their resources and change the (uantity supplied #7hinF of ad1ustments on a farm

once the crop has been planted&

' 7he short-run supply elasticity is more elastic than the marFet period and "ill depend on

the ability of producers to respond to price change 5ndustrial producers are able to maFe

some output changes by ha$ing "orFers "orF o$ertime or by bringing on an e*tra shift

% 7he long-run supply elasticity is the most elastic, because more ad1ustments can be made

o$er time and (uantity can be changed more relati$e to a small change in price, as in

Digure 6)c 7he producer has time to build a ne" plant

C Applications of the price elasticity of supply

1 Anti(ues and other non-reproducible commodities are inelastic in supply, sometimes the

supply is perfectly inelastic 7his maFes their prices highly susceptible to fluctuations

in demand

' Gold prices are $olatile because the supply of gold is highly inelastic, and unstable

demand resulting from speculation causes prices to fluctuate significantly

I6. Cross elasticity and income elasticity of demand3

A Cross elasticity of demand refers to the effect of a change in a product4s price on the (uantity

demanded for another product 9umerically, the formula is sho"n for products I and J

E

5y

* 7percentage change in +uantity of 89 , 7percentage change in

price of :9

1. If cross elasticity is positive) then 8 and : are substitutes.

;. If cross elasticity is negative) then 8 and : are complements.

<. !ote3 if cross elasticity is =ero) then 8 and : are unrelated) independent products.

6-6

Chapter 06 - Elasticity, Consumer Surplus, and Producer Surplus

8 5ncome elasticity of demand refers to the percentage change in (uantity demanded that results

from some percentage change in consumer incomes

E

i

* 7percentage change in +uantity demanded9 , 7percentage

change in income9

1. & positive income elasticity indicates a normal or superior good.

;. & negative income elasticity indicates an inferior good.

<. Those industries that are income elastic -ill e5pand at a higher rate as the economy

gro-s.

6. Consumer and Producer "urplus

A Consumer "urplus

1 Definition > the difference bet-een the ma5imum price a consumer is 7or consumers

are9 -illing to pay for a product and the actual price.

' 7he surplus, measurable in dollar terms, reflects the e*tra utility gained from paying a

lo"er price than "hat is re(uired to obtain the good

% Consumer surplus can be measured by calculating the difference bet"een the ma*imum

"illingness to pay and the actual price for each consumer, and then summing those

differences

) Consumer surplus is measured and represented graphically by the area under the demand

cur$e and abo$e the e(uilibrium price #Digure 6+&

+ Consumer surplus and price are in$ersely related 6 all else e(ual, a higher price reduces

consumer surplus

8 Producer "urplus

1 Definition > the difference bet-een the actual price a producer receives 7or producers

receive9 and the minimum acceptable price.

' Producer surplus can be measured by calculating the difference bet"een the minimum

acceptable price and the actual price for each unit sold, and then summing those

differences

% Producer surplus is measured and represented graphically by the area abo$e the supply

cur$e and belo" the e(uilibrium price #Digure 66&

) Producer surplus and price are directly related 6 all else e(ual, a higher price increases

producer surplus

6-/

Chapter 06 - Elasticity, Consumer Surplus, and Producer Surplus

6I. Efficiency #evisited and Efficiency Losses

A Efficiency is attained at e(uilibrium, "here the combined consumer and producer surplus is

ma*imi-ed #Digure 6/&

1 Consumers recei$e utility up to their ma*imum "illingness to pay, but only ha$e to pay

the e(uilibrium price

' Producers recei$e the e(uilibrium price for each unit, but it only costs the minimum

acceptable price to produce

% Allocati$e efficiency occurs at (uantity le$els "here three conditions e*ist:

a K8 = KC

b Ka*imum "illingness to pay = minimum acceptable price

c Combined consumer and producer surplus is at a ma*imum

8 Efficiency #!ead"eight& 0osses

1 .nderproduction reduces both consumer and producer surplus, and efficiency is lost

because both buyers and sellers "ould be "illing to e*change a higher (uantity

' H$erproduction causes inefficiency because past the e(uilibrium (uantity, it costs society

more to produce the good than it is "orth to the consumer in terms of "illingness to

pay

6-2

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