Chapter 6

Elasticity,
Consumer Surplus,
and Producer
Surplus
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Objectives
• Price elasticity of demand
• The total revenue test
• Price elasticity of supply
• Cross elasticity of demand
• Income elasticity of demand
• Consumer & producer surplus
• Efficiency losses
6-2
 Price Elasticity of Demand
• Measuring responsiveness to
price changes
• Elastic demand
– Large change in quantity
purchased for given price change
• Inelastic demand
– Small change in quantity
purchased for given price change
6-3
 Price Elasticity of Demand

• Price-elasticity coefficient
and formula

Percentage Change in Quantity

Demanded of Product X
Ed =
Percentage Change in Price
of Product X

6-4
 Price Elasticity of Demand
• Calculate percentage change
• Restate formula

Change in Quantity Demanded of X

Ed =
Original Quantity Demanded of X

Change in Price of X
÷ Original Price of X

6-5
 Price Elasticity of Demand
• Calculation problem
• Starting point matters
• Midpoint formula

Change in Quantity Change in Price

Ed = Sum of Quantities/2
÷ Sum of Prices/2

6-6
 Interpretations of Elasticity

Elastic Demand
.04
Ed = .02
=2
Inelastic Demand
.01
Ed = .02
= .5
Unit Elasticity
.02
Ed = .02
=1
6-7
 Price Elasticity of Demand

• Why use percentages?

– Unit free measure
– Compare responsiveness across
products
• Elimination of the (-) sign
• Extreme cases
– Perfectly inelastic demand
– Perfectly elastic demand
6-8
 The Total Revenue Test
• Total Revenue = TR = PxQ
• Inelastic demand
– P and TR change in same direction
• Elastic demand
– P and TR change in opposite
direction

6-9
 The Total Revenue Test
• Lower price and elastic demand
– Blue gain exceeds gold loss
P
$3

a
2

b
1 D1

0 10 20 30 40 Q
6-10
 The Total Revenue Test
• Lower price and inelastic demand
– Gold loss exceeds blue gain
P
c
$4

2
d

1
D2
0 10 20 Q
6-11
 The Total Revenue Test
• Lower price and unit-elastic demand
– Blue gain equals yellow loss

P
e
$3

f
1 D3

0 10 20 30 Q
6-12
 Elasticity on a Linear
Demand Curve

(1)
Total Quantity of (3) (4) (5)
Tickets Demanded (2) Elasticity Total Revenue Total-Revenue
Per Week, Thousands Price Per Ticket Coefficient (Ed) (1) X (2) Test

1 $8 $8,000
2 7
] 5.00
14,000
] Elastic

3 6
] 2.60
18,000
] Elastic

4 5
] 1.57
20,000
] Elastic
] 1.00 ] Unit Elastic
5 4 20,000
] 0.64 ] Inelastic
6 3 18,000
7 2
] 0.38
14,000
] Inelastic

8 1
] 0.20
8,000
] Inelastic

6-13
Elasticity and the TR Curve
Elastic
$8 a Ed > 1
7
6
b Unit Elastic
c
Ed = 1

Price
5
d
4 e Inelastic
3 Ed < 1
f
2 g
1 h D
0 1 2 3 4 5 6 7 8
(Thousands of Dollars) Quantity Demanded

$20
18
Total Revenue

16
14
12
10
8
6 TR
4
2
0 1 2 3 4 5 6 7 8
Quantity Demanded
6-14
 Determinants of Elasticity
• Substitutability
– More substitutes, more elastic
demand
• Proportion of income
– Price relative to income
• Luxuries versus necessities
– Luxuries are more elastic
• Time
– More elastic in the long run 6-15
 Applications of Elasticity

• Large crop yields

– Inelastic demand
• Excise taxes
– Inelastic demand
• Decriminalization of illegal
drugs
– Elastic or inelastic demand?

6-16
 Price Elasticity of Supply

Responsiveness to price
changes by producers

Percentage Change in Quantity

Supplied of Product X
Es = Percentage Change in Price
of Product X

6-17
 Price Elasticity of Supply
• Market period
– Perfectly inelastic supply
• Short run
– Fixed plant size
• Long run
– Adjustable plant size
– Supply more elastic
6-18
 Price Elasticity of Supply

The Market Period

• Perfectly inelastic supply

P
Sm

Greatest Pm
Price
Impact P0

D1 D2
Q0 Q
6-19
 Price Elasticity of Supply

The Short Run

• Inelastic supply

P
Ss

Lower
Price Ps
Impact P0

D1 D2
Q0 Qs Q
6-20
 Price Elasticity of Supply

The Long Run

• Elastic supply

Sl
Least
Price Pl
Impact P0

D1 D2
Q0 Ql Q
6-21
 Price Elasticity of Supply
• Applications
• Antiques and reproductions
– Limited, inelastic supply
– Strong demand
– Resulting high price
• Volatile gold prices
– Inelastic supply
– Shifting demand
6-22
 Cross Elasticity of Demand

• Responsiveness of sales to
change in price of another good

Percentage Change in Quantity

Demanded of Product X
Exy =
Percentage Change in Price
of Product Y

6-23
 Cross Elasticity of Demand

• Substitute goods
– Positive sign
• Complementary goods
– Negative sign
• Independent goods
– Zero

6-24
 Income Elasticity of Demand
Percentage Change in Quantity
Demanded
Ei = Percentage Change in Income

• Responsiveness of sales to
change in income
• Normal goods – positive sign
• Inferior goods– negative sign
6-25
 Consumer Surplus
• Benefit surplus
• Maximum willingness to pay (WTP)
less than actual price paid
Person Max WTP Actual Price CS
Bob $13 $8 $5
Barb $12 $8 $4
Bill $11 $8 $3
Bart $10 $8 $2
Brent $9 $8 $1
Betty $8 $8 $0
6-26
 Consumer Surplus

Consumer
Surplus
Price (Per Bag)

Equilibrium
Price = $8
P1

D
Q1
Quantity (Bags)
6-27
 Producer Surplus
• Benefit surplus
• Actual price received more than
minimum acceptable price (AP)
Person Min AP Actual Price PS
Carlos $3 $8 $5
Courtney $4 $8 $4
Chuck $5 $8 $3
Cindy $6 $8 $2
Craig $7 $8 $1
Chad $8 $8 $0
6-28
 Producer Surplus

Price (Per Bag) S

Producer
Surplus Equilibrium
Price = $8
P1

Q1
Quantity (Bags)
6-29
 Efficiency Revisited
• Productive and allocative efficiency
S
Consumer
Surplus
Price (Per Bag)

Equilibrium
Price = $8
P1

Producer
Surplus
D
Q1
Quantity (Bags)
6-30
 Efficiency Loss

• Deadweight loss
S
Efficiency
Losses
Price (Per Bag)

P1

D
Q2 Q1 Q3
Quantity (Bags)
6-31
 Elasticity and Pricing Power
• Competitive markets
– No pricing power
• Firms with market power
– Charge different prices
• Differences in group elasticities
– Business vs. leisure travelers
– Discounting for children
– College tuition
6-32
 Key Terms
• price elasticity of • price elasticity of
demand supply
• midpoint formula • market period
• elastic demand • short run
• inelastic demand • long run
• unit elasticity • cross elasticity of
• perfectly inelastic demand
demand • income elasticity of
• perfectly elastic demand
demand • consumer surplus
• total revenue (TR) • producer surplus
• total-revenue test • efficiency losses
(deadweight losses)
6-33
Next Chapter Preview…

Consumer Behavior

6-34