3) topic 2 welfare & elasticity 1

Econ 1194Prices and Markets

Topic 2: Introduction to Welfare and Elasticity

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Topic 2 - Contents

1. Consumer Surplus and Producer Surplus

2. Elasticity of Demand

- measurement

- determinants

- elasticity and total revenue

3. Elasticity of Supply

4. Other Demand Elasticities

- Cross price elaticity

- Income elasticity

1. Demand and Marginal Benefit

"By a process of voluntary exchange, resources are shifted to those uses in which the value to consumers, as measured by their willingness to pay, is highest. When resources are being used where their value is highest, we may say that they are being employed (thuê) efficiently.” (Richard Posner, Law and Economics, p.10)

• Marginal benefit is the additional benefit (happiness) received when consuming an additional unit

• The maximum willingness to pay for an additional unit must equal to the additional benefit that unit brings. Hence D = MB.

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Quantity Total Benefit

Marginal Benefit

Willingness to pay

1 10 10 10

2 18 8 8

3 23 5 5

…

1.1 Consumer Surplus

• Consumer surplus is the difference between what the consumers are willing to pay (shown on the demand curve) and what they actually pay (the market price)

• In other words, consumer surplus is the area between the Demand curve and the Price line

• It measures : how much the consumer gains from buying goods in the market, therefore can be interpreted as the welfare of the buyers

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Consumer surplus…

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Price (dollars /bar)

Q (bars/week)

Total consumer surplus in the market for Chocolate

0

Demand

15

$2.00

Total consumer surplus in the

market for chocolate

1. Consumer Surplus

• Remember the D = MB

• Total benefit to consumers,

TB = sum of MB = areas (1) + (2) = obcd

• Total cost to consumers (= total consumer expenditure)

TC = area (2)

• Net benefit to consumers,

NB = TB - TC

= consumer surplus = CS

= area (1)

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1. Consumer Surplus

• Consumer Surplus is the difference between what a consumer is willing to pay for a good (as shown by the demand curve) and what they actually pay when buying it (the market price).

http://www.youtube.com/watch?v=FRPQlbRaAok

1.2 Producer surplus

• The difference between the market price and the minimum price that would be required to induce the producers to supply the good (as shown on the supply curve)

• Producer surplus is the area between the Price line and the Supply curve

• It measures how much the producer gains from selling goods in the market, hence can be interpreted as the welfare of the producers

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Price (dollars/bar)

Q (bars/week)0

Total producer surplus in the market for Chocolate

15

$2.00

Total producer surplus from

selling chocolate Supply

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1.2 Producer Surplus

.

1.2 Producer Surplus

• Competitive supply price measures the opportunity cost of each marginal unit (i.e. the marginal cost MC).

• Supply = MC

• Total revenue to producers,

TR = P x Q

=areas (2a) + (2b) = area (2)

• Total cost to producers,

TC =opportunity cost of resources

=sum of MC

=area (2b)

• Net revenue to producers,

NR =TR - TC

=producer surplus = PS = area (2a)

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1.3 CS and PS – Economic efficiency

• CS and PS are an important tool for measuring the performance of an economic system

• or for assessing the impact of alternative government policies in that system.

fig

CS and PS – Economic efficiency

Pm

Qm

P

QO

Copyright 2001 Pearson Education Australia

S

Producer SurplusPS

CS

D

fig

CS and PS – Economic efficiency

Pm

Too little

P

QO

Copyright 2001 Pearson Education Australia

S

Producer Surplus

PS

D

A

B

Deadweight loss:area A + B

CS

fig

CS and PS – Economic efficiency

Pm

Too much

P

QO

Copyright 2001 Pearson Education Australia

S

Producer Surplus

PS

D

CS

C

D

Negative PS &Negative CS:area C + D

fig

CS and PS – Economic efficiency

Pm

Efficient

P

QO

Copyright 2001 Pearson Education Australia

S

Producer SurplusPS

CS

D

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2. Elasticity of Demand

• This measures the responsiveness of quantity demanded of a good to a change in one of the determinants of demand for that good (assuming all other determinants remain constant).

• Point Elasticity

• Arc Elasticity (or midpoint formula)

• which rearranged becomes

Types of Elasticity of Demand

Rizwan Khan

Elasticity ofDemand

PriceElasticity

IncomeElasticity

Cross PriceElasticity

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2.1 Own Price Elasticity

• This measures the responsiveness of quantity demanded of a particular good to a change in the price of that good (ie, its own price).

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2.1 Own Price Elasticity of Demand - An Example

• This means that for a 1% increase (decrease) in price, quantity demanded has decreased (increased) by 1.36%.

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2.1 Summary of own price elasticity

2.2 Own Price elasticity – its determinants

• Number and closeness of substitutes

• Luxuries vs. Necessities

• Proportion of income spent on the product

• Time period after a price change

• Non-functional factors

–bandwagon effect etc.

Elasticity changes along the demand curve

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Price (dollars/bar)

Q (bars / month0

4

D

$18

$15

6 73

$8

$5

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2.3 Elasticity and Total Revenue Effect of a price change on total revenue

Why?TR = P X Q

If elastic… A decrease in the price by 1 % will result in an increase in demand by more than 1%.

So

TR = P X Q

If inelastic… A decrease in the price by 1 % will result in an increase in demand by less than 1%.

So

TR = P X Q

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2.3 Elasticity & Total Revenue

Summary:

• If demand is elasticelastic, a change in Price will cause Total Revenue to change in the opposite opposite directiondirection.

• If demand is inelasticinelastic, a change in price will cause total revenue to change in the same same direction.direction.

3. Price Elasticity of Supply

Es=

% change in quantity supplied of product X

% change in the price of product X

• The responsiveness of quantity supplied to a change in price of a product.

•The elasticity of supply will be greater the longer the time period under consideration.

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4.1 Cross Price Elasticity of Demand(between commodities X and Y)

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4.1 Cross Price Elasticity of Demand (example 1)

• This means that for a 1% increase (decrease) in the price of bananas, the quantity of apples demanded has increased (decreased) by 0.7%. Bananas and apples are substitute goods.

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4.1 Cross Price Elasticity of Demand (example 2)

• This means that for a 1% increase (decrease) in the price of gas, the quantity demanded of gas stoves decreased (increased) by 1.15%. Gas and gas stoves are complementary goods

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4.1 Cross Elasticity of Demand in Practice

Some Problems with the use of Cross Elasticity of Demand in Practice

•There is no absolute standard for judging what is a ‘high’ or a ‘low’ elasticity of demand

•Cross elasticity of demand can change over time

•Not enough cross elasticity data are available to make it generally applicable.

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4.2 Income Elasticity

.

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4.2 Income Elasticity of Demand (example)

• This means that for a 1% increase (decrease) in average weekly earnings, the quantity demanded of new cars increased (decreased) by 0.84%.

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Summary:Own price, Cross price and Income elasticity

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Next Lecture:

Applications of

Demand and Supply