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but how much? if price doubles how much does Qd fall? –by 10% –by 50% –by 300%? price elasticity tells us if price doubles how much does Qd fall? –by 10% –by 50% –by 300%? price elasticity tells us
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Chapter 18: ElasticityChapter 18: Elasticity
• Price elasticity–demand–supply
• Cross elasticity• Income elasticity
Basic ideaBasic idea
• We know when P
Qd
Qs
holding other factors constant
but how much?but how much?
• if price doubleshow much does Qd fall?–by 10%–by 50%–by 300%?
• price elasticity tells us
Price Supply Demand1 35 5302 130 4004 320 140
4) a- consider theses two points (1,35) and (2,130)
Line equation is Y= M X + b (Y is the price and X is the quantity)
M= (Y2-Y1)/(X2-X1) M= 2-1/130-35 , M= 1/95Y= (1/95)X + b so, 1=(1/95) * 35 + bB= 60/95Qs= (1/95)P + 60/95
Price Supply Demand1 35 5302 130 4004 320 140
4) b- consider theses two points (1,530) and (2,400)
Line equation is Y= M X + b (Y is the price and X is the quantity)
M= (Y2-Y1)/(X2-X1) M= 2-1/400-530 , M= -1/130Y= (-1/130)X + b so, 1=(-1/130) * 530 + bB= 660/130Qd= (-1/130)P + 660/130
4) C, we know that at the equilibrium Qs = Qd, 4) C, we know that at the equilibrium Qs = Qd, so so
• Qs= (1/95)P + 60/95• Qd= (-1/130)P + 660/130• (1/95)P + 60/95 = (-1/130)P + 660/130• { (1/95) + (1/130)}P = {(660/130)-(60/95)}• P = 244
Price Supply Demand20 400 50030 250 40050 250 400
1- consider theses two points (20,400) and (30,250)
Line equation is Y= M X + b (Y is the price and X is the quantity)
M= (Y2-Y1)/(X2-X1) M= 30-20/250-400 , M= 10/-150Y= (10/-150)X + b so, 20=(10/-150) * 400+ bB= 7000/150Qs= (10/-150) P+ 7000/150
Price Supply Demand20 400 50030 250 40050 250 400
2)- consider theses two points (20,500) and (30,400)
Line equation is Y= M X + b (Y is the price and X is the quantity)
M= (Y2-Y1)/(X2-X1) M= 30-20/400-500 , M= 10/-100Y= (10/-100)X + b so, 20=(10/-150) * 500+ bB= 8000/100Qd= (10/-100) P+ 8000/100
• At equilibrium Qs = Qd• (10/-150) P+ 7000/150=(10/-100) P+
8000/100• ??
I. Price Elasticity of DemandI. Price Elasticity of Demand
example• mocha latte at Starbucks• price rises from $3 to $5 per cup• Qd falls from 15 to 5 cups per hr.
equationequation
% change in Qd% change in P
% change in Qd% change in Qd
new Qd - initial Qdaverage Qd
x 100
midpoint method
exampleexample
5 cups - 15 cups(5+15)/2 cups
x 100
-10 cups10 cups
x 100 = -100%
% change in P% change in P
new P - initial Paverage P
x 100
midpoint method
exampleexample
$5 - $3 ($5+$3)/2
x 100
$2$4
x 100 = 50%
demand elasticitydemand elasticity
% change in Qd% change in P
-100%50%
= -2
• If price of latte increases 1%,Qd of latte decreases 2%
demand elasticitydemand elasticity
• a unit-free measure–compare all goods & services
• changes for different pointson the demand curve
if price elasticity of demandif price elasticity of demand(absolute value)(absolute value)• = 1
unit elastic% change Qd = % change P
• > 1 elastic% change Qd > %change Psensitive to P changes
• < 1 inelastic% change Qd < %change Pnot sensitive to P changes
elastic demandelastic demand(>1)(>1)• flatter curve
P
Q
D
small change in Pbig change in Qd
inelastic demandinelastic demand(<1)(<1)• steep curve
P
QD
big change in Psmall change in Qd
perfectly inelastic demandperfectly inelastic demand
• vertical lineP
QD
change in Pno change in Qd
perfectly elastic demandperfectly elastic demand
• horizontal lineP
Q
D
any change in PQd falls to zero
effect on total revenueeffect on total revenue
• total revenue (TR)= P x Q
• if demand is elastic,–TR falls as price rises
• if demand is inelastic,–TR rises as price rises
example: cup of latteexample: cup of latte
• initial P=$3, Qd = 15.TR = $3 x 15 = $45
• new P = $5, Qd = 5TR = $5 x 5 = $25
• demand for latte is elasticTR falls as P rises
what makes demand elastic or what makes demand elastic or inelastic?inelastic?1. is it a luxury or necessity
– if luxury, demand is elastic– if necessity, demand is inelastic
exampleexample
• mocha latte at Starbucksis a luxury
• a liver transplant is not
2. definition of good– latte at Starbucks,
narrow definition= many substitutes (other brands of coffee, tea)
demand is elastic
–coffee in general,broad definition = fewer substitutesdemand is less elastic
3. time since price change–short time
no time to adjust,demand is inelastic
– long timetime to adjust,demand is elastic
exampleexample
• Price of gas per gallon• the day price rises
–demand inelastic• years later
–demand much more elasticas carpool or buy smaller car
factors 1-3factors 1-3
all get at same issue: • can consumers substitute a cheaper
good easily?– if yes, demand is elastic– if no, demand is inelastic
4. Is item large part of your budget?– if yes, then demand elastic
(forced to change behavior)– if no, then demand inelastic
(no need to change behavior)
exampleexample
• soap– if price doubles, will you buy less?
• rent– if rent doubles?
-- stay on campus?-- more roommates?
II. Price Elasticity of SupplyII. Price Elasticity of Supply
% change in Qs% change in P
exampleexample
• bunch of roses• P = $40/bunch, Qs = 6 (million bunches)• P = $60, Qs = 15
% change Qs% change Qs
15 - 6(6+15)/2
x 100
910.5
x 100 = 86%
% change P% change P
60 - 40(60+40)/2
x 100
2050
x 100 = 40%
supply elasticitysupply elasticity
% change in Qs% change in P
86%40%
= 2.15
• if price rises 1%, Qs rises 2.15%
• unit-free measure• depends on points chosen
on the supply curve
if price elasticity of supplyif price elasticity of supply• = 1
unit elastic% change Qs = % change P
• > 1 elastic% change Qs > %change Psensitive to P changes
• < 1 inelastic% change Qs < %change Pnot sensitive to P changes
inelastic supplyinelastic supply
• steep curveP
QS
big change in Psmall change in Qs
perfectly inelastic supplyperfectly inelastic supply
• vertical lineP
QS
change in Pno change in Qs
elastic supplyelastic supply
• flatter curveP
Q
S
small change in Pbig change in Qs
perfectly elastic supplyperfectly elastic supply
• horizontal lineP
Q
S
any change in PQs falls to zero
what makes supply elastic or what makes supply elastic or inelastic?inelastic?1. production possibilities
Can you make more easily?NO
then supply is inelasticYES
then supply is elastic
exampleexample
• oceanfront property–can’t make more– inelastic supply
• salt–almost an infinite amount–elastic supply
2. time since price change– it takes time to produce– if a short time,
supply is inelastic– if a long time
supply is elastic
exampleexample
• hotel rooms– takes time to build–supply inelastic in short-run,
elastic in long-run
3. Can you store it easily/cheaply?– if yes, then elastic– if no, then inelastic
exampleexample
• bananas–storage time limited–supply inelastic
III. Income Elasticity of DemandIII. Income Elasticity of Demand
• impact of income changes on demand
• size of shift in the demand curve when income changes
equationequation
% change in Qd% change in income
• > 0 normal good• < 0 inferior good
example: jewelryexample: jewelry
• income increases 10%• Qd jewelry increases 35%
income elasticityincome elasticity
% change in Qd jewelry% change in income
35%10%
= 3.5
IV. Cross Elasticity of DemandIV. Cross Elasticity of Demand
• impact of price change ofsubstitutes or complements
• size of shift in demand curve when price of a related good changes
equationequation
% change in Qd% change in P of related good
cross elasticitycross elasticity
• > 0 for substitutes• < 0 for complements
example: Peanut butterexample: Peanut butter
• what happens to Qd of PB,when price of jelly rises?
• PB & jelly are complementsprice jelly = $3 jar, Qd PB = 2 jars per month
price jelly = $4 jar, Qd PB = 1 jar per month
% change in Qd PB% change in Qd PB
1 jar - 2 jars 1.5 jars x 100 = - 66.7%
% change in P of jelly% change in P of jelly$4 - $3
$3.5x 100 = 28.6%
cross price elasticity of PBcross price elasticity of PB
• with respect to price of jelly
% change in Qd PB% change in P jelly
- 66.7%28.6%
= - 2.33
example: Coca-Cola & Pepsiexample: Coca-Cola & Pepsi
• what happens to Qd of C-Cola,when price of Pepsi rises?
• Coca-Cola & Pepsi are substitutesP Pepsi= $1, Qd Coca = 2
P Pepsi= $3 stick, Qd Coca= 2.2
% change in Qd Coca% change in Qd Coca
2.2 - 22.1 x 100 = 9.5%
% change in P of Pepsi% change in P of Pepsi$3 - $1
$2x 100 = 100%
cross price elasticity of Colacross price elasticity of Cola
• with respect to price of Pepsi
% change in Qd Cola% change in P Pepsi
9.5%100%
= .095
summarysummary
• law of demand & supply–direction of change in Qd/Qs
when P changes• price elasticity
–how large are these Qd/Qs changes?
• cross/income elasticity–size of shift in demand curve
Elasticity on a Linear Elasticity on a Linear Demand CurveDemand Curve
1
2
3
4
5
6
7
8
8
7
6
5
4
3
2
1
5.00
2.60
1.57
1.00
0.64
0.38
0.20
$8,000
14,000
18,000
20,000
20,000
18,000
14,000
8,000
Elastic
Elastic
Elastic
Unit Elastic
Inelastic
Inelastic
Inelastic
(1)Total Quantity of
Tickets DemandedPer Week, Thousands
(2)Price Per Ticket
(3)Elasticity
Coefficient (Ed)
(4)Total Revenue
(1) X (2)
(5)Total-Revenue
Test
]]]]]]]
]]]]]]]
Price Elasticity and the Total-Price Elasticity and the Total-Revenue CurveRevenue Curve
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5 6 7 8
Quantity Demanded
Quantity Demanded
Pric
eTo
tal R
even
ue(T
hous
ands
of D
olla
rs) $20
1816141210
8642
$87654321
ab
cd
ef
gh
ElasticEd > 1
Unit ElasticEd = 1
InelasticEd < 1
ElasticEd > 1
Unit ElasticEd = 1
InelasticEd < 1
D
TR
Determinants of Price Elasticity of DemandDeterminants of Price Elasticity of Demand
SubstitutabilitySubstitutability• Substitutes for the product: Generally, the more substitutes, Substitutes for the product: Generally, the more substitutes,
the more elastic the demand.the more elastic the demand.
Proportion of IncomeProportion of Income• The proportion of price relative to income: Generally, the The proportion of price relative to income: Generally, the
larger the expenditure relative to one’s budget, the more larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in elastic the demand, because buyers notice the change in price more.price more.
Luxuries versus NecessitiesLuxuries versus Necessities• Whether the product is a luxury or a necessity: Generally, the Whether the product is a luxury or a necessity: Generally, the
less necessary the item, the more elastic the demand.less necessary the item, the more elastic the demand.
TimeTime• The amount of time involved: Generally, the longer the time The amount of time involved: Generally, the longer the time
period involved, the more elastic the demand becomes.period involved, the more elastic the demand becomes.
Cross Elasticity of DemandCross Elasticity of Demand
• Substitute Goods – Substitute Goods – Positive SignPositive Sign
• Complementary Goods- Complementary Goods- Negative SignNegative Sign
• Independent Goods – Independent Goods – Zero or Near-Zero or Near-Zero ValueZero Value
Percentage Change in QuantityDemanded of Product X
Percentage Change in Priceof Product Y
Exy =
Income Elasticity of DemandIncome Elasticity of Demand
• Normal Goods – Normal Goods – Positive SignPositive Sign• Inferior Goods- Inferior Goods- Negative SignNegative Sign
Insights into the EconomyInsights into the Economy• Income elasticity of demand helps explain the expansion and Income elasticity of demand helps explain the expansion and
contractions in the economy. As income grows, industries of contractions in the economy. As income grows, industries of products whose income elasticity is high expand rapidly, products whose income elasticity is high expand rapidly, while those of low or negative tend to grow slowly.while those of low or negative tend to grow slowly.
Percentage Change in QuantityDemanded
Percentage Change in IncomeEi =
What you will learn in this What you will learn in this chapter:chapter:
Consumer SurplusProducer SurplusCost Market Failure
How much benefit do producers and consumers receive from the existence of a market?
How is the welfare of consumers and producers affected by changes in market prices?
How are these concepts related to demand and supply curve?
Individual consumer surplus is the net gain to an individual buyer from the purchase of a good. It is equal to the difference between the buyer’s willingness to pay and the price paid.
Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good.
Consumer Surplus and the Demand Curve
New ipodNew ipodHow much you willing to pay for this new ipod?
Student How much you willing to pay
Selling price Your surplus
A
B
C
D
Used textbook Used textbook
59
45
35
25
10
0
1 2 3 4 5 6
Amna
Bader
MAryam
Nawaf
Reem
A consumer’s willingness to pay for a good is the maximum price at which he or she would buy that good.
Potential buyers
Willingness to pay
Amna $59
Bader $45
Maryam $35
Nawaf $25
Reem $10
Used Text Books Market
59
45
35
25
10
0
1 2 3 4 5 6A consumer’s willingness to pay for a good is the maximum price at which he or she would buy that good.
Potential buyers
Willingness to pay
Amna $59
Bader $45
Maryam $35
Nawaf $25
Reem $10
Used Text Books Market
Amna
Bader
MAryam
Nawaf
Reem
59
45
35
25
10
0
1 2 3 4 5 6
Potential buyers
Willingness to pay
Price paid Individual consumer
surplus
Amna $59
Bader $45
Maryam $35
Nawaf $25
Reem $10
Used Text Books Market
$30
$30
$30
---
---
---
---
$29
$15
$5
$30
ICS = Willingness to pay – Price paid
Amna
Bader
MAryam
Nawaf
Reem
Willingness to Pay and Consumer Willingness to Pay and Consumer SurplusSurplusTotal consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good.
The term consumer surplus is often used to refer to both individual and to total consumer surplus.
1 2 3 4 56
59
45
35
25
10
0
Amna Willingness to pay
Price paid Individual consumer
surplus
Bader $59
Maryam $45
Nawaf $35
Reem $25
Amna $10
$30
$30
$30
---
---
---
---
$29
$15
$5
$30
Amna’s CS= $59 - $30 = $29
Bader CS= $45 - $30 = $15
Maryam’s CS= $35 - $30 = $5
Amna
Bader
MAryam
Nawaf
Reem
Demand curve for computersDemand curve for computers
The demand for computers is smooth because there many
potential buyers of consumers. Consumer Surplus equal to the shaded
area: the are below the demand curve but
above the price
Consumer SurplusConsumer Surplus
• difference between what you pay for a good,and what you are WILLING to pay for a good
exampleexample
• market price pizza = $10• my marginal value of 3rd pizza this
week = $12• my consumer surplus = $2
P
Q
D
$10
my demand curvemy demand curve
$12
3
my consumer surplus
P
QD
$10
10,000
total consumer surplus
area between Dand price of pizza
A fall in the price of a good increases consumer surplus through two channels:
A gain to consumers who would have bought at the original price and
A gain to consumers who are persuaded to buy by the lower price.
Let’s see these two channels in the following graph…
How Changing Prices Affect Consumer Surplus
59
45
35
25
10
0
$30
Amna’s CS= $59 - $20 = $39
Bader’s CS= $45 - $20 = $25
$20
Nawaf’s CS= $25 - $20 = $5
$29
$15 $5
Maryam’s CS= $35 - $20 = $15
200,000
Quantity of computers
$5000
Price of Computers
$1500
1 million
Consumer surplus
Increase in Consumer surplus to original buyers
Consumer surplus gained by new buyers
Producer Surplus and the Supply Producer Surplus and the Supply CurveCurveA potential seller’s cost is the lowest price at which he or she is willing to sell a good.
Individual producer surplus is the net gain to a seller from selling a good. It is equal to the difference between the price received and the seller’s cost.
Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good.
The Supply Curve for Used Textbooks
Producer Surplus in the Used-Textbook Market
Producer Surplus
The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price.
When the price of a good rises, producer surplus increases through two channels:
The gains of those who would have supplied the good even at the original, lower price and
The gains of those who are induced to supply the good by the higher price.
Let’s consider the impact of a rise in the market price on the producer surplus in the following graph…
Changes in Producer Surplus
A Rise in the Price Increases Producer Surplus
Putting it together: Total SurplusPutting it together: Total Surplus The total surplus generated in a market
is the total net gain to consumers and producers from trading in the market. It is the sum of the producer and the consumer surplus.
The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organize economic activity.
Total Surplus
1. If the price is set at $600:CS = PS = TR =2. If the price is set at $400:CS = PS = TR =3. If the price is set at $600, then dropped to $400:CS = PS = TR =
AB + C + EB + C + E +G
A + B + C + D E + F E + F + G + H
A+ D B + C + E + F B + C + E + G + F + H
Consumer SurplusConsumer SurplusCalculating from the graphCalculating from the graph
We can calculate the consumer surplus in this example using the information provided on the graph along with the formula for
a triangle: (BASE x HEIGHT)/2
Base = 40 – 0 = 40
Height = 3600 – 2000 = 1600
CS = (40 X 1600)/2 = 32000
Producer SurplusCalculating from the graph
As with consumer surplus, we can calculate the producer surplus in this example using the information provided on the graph along with the formula for
a triangle: (BASE x HEIGHT)/2
Base = 40 – 0 = 40
Height = 2000 – 400 = 1600
CS = (40 X 1600)/2 = 32000
Ann, Betty, and Carol are three buyers of shoes. Their demand curves are shown below in terms of their willingness to pay.
Number of Pairs
willingness to pay of:
Ann Betty Carol
First $100 $80 $90
Second 20 40 30
Third 10 30 10
Fourth 5 10 2
Fifth 2 5 1
a) If the price of shoes is $15, how many pairs will Ann buy?
a) If the price of shoes is $15, how many pairs will Betty buy?
c) If the price of shoes is $15, how many pairs will Carol buy?
d) If the price of shoes is $15, how many pairs of shoes will be bought in total?
e) What will Ann's consumer surplus be at this price? $
f) What will the total consumers' surplus be? $
232
7
= 100- 15 +20 – 15 = 90
= 90 + 105 + 90 = 285
Consumer SurplusConsumer Surplus• The benefit (utility) surplus received by the consumer in a market The benefit (utility) surplus received by the consumer in a market
is called consumer surplus is called consumer surplus ))the difference between the maximum the difference between the maximum price the consumer is willing to pay and the actual price he pays).price the consumer is willing to pay and the actual price he pays).
• The utility surplus arises because all consumers pay the The utility surplus arises because all consumers pay the equilibrium price even though many would be willing to pay more equilibrium price even though many would be willing to pay more than that price to obtain the product. Consider this examplethan that price to obtain the product. Consider this example
ConsumerConsumer max pricemax price actual priceactual price consumer surplusconsumer surplusAA 13 13 8 8 55BB 12 12 8 8 44CC 11 11 8 8 33DD 10 10 8 8 22EE 9 9 8 8 11FF 8 8 8 8 0 0
D
Pric
e (P
er B
ag)
P1
Q1
Quantity (Bags)
ConsumerSurplus
Equilibrium Price = $8
O 18.3
Consumer SurplusConsumer Surplus
Producer Surplus• Producers also receive a benefit surplus which is the
difference between the actual price a producer receives and the minimum acceptable price (determined at the supply curve). Most sellers are willing to accept a lower than the market price to sell the product.
• There is a direct relationship between equilibrium price and producer surplus. Consider this example
Producer Producer max pricemax price actual priceactual price producer surplusproducer surplusGG 3 3 8 8 55HH 4 4 8 8 44II 5 5 8 8 33JJ 6 6 8 8 22KK 7 7 8 8 11LL 8 8 8 8 0 0
•
Producer SurplusProducer Surplus
SPr
ice
(Per
Bag
)
P1
Q1
Quantity (Bags)
ProducerSurplus
Equilibrium Price = $8
Efficiency Revisited• All markets that have downward slopping demand and upward
slopping supply curves yield consumer and producer surplus.
• The equilibrium quantity in these markets reflect economic efficiency.
• Productive efficiency is achieved because competition forces producers to minimize their costs.
• Allocative efficiency is also achieved because the correct quantity at which MB (points on the demand curve or the maximum willingness to pay) equals MC (points on the supply curve or the minimum acceptable price). At equilibrium consumer surplus and producer surplus are maximized.
• Allocative efficiency occurs at quantity levels where three Allocative efficiency occurs at quantity levels where three conditions exit:conditions exit:
1.1. MB = MCMB = MC2.2. Maximum willingness to pay = minimum acceptable priceMaximum willingness to pay = minimum acceptable price3.3. Combined consumer and producer surplus is at a Combined consumer and producer surplus is at a
maximummaximum
Consumer and Producer SurplusConsumer and Producer SurplusEfficiency Revisited
D
SPr
ice
(Per
Bag
)
P1
Q1
Quantity (Bags)
ConsumerSurplus
ProducerSurplus
Equilibrium Price = $8
Efficiency losses (deadweight loss)Efficiency losses (deadweight loss)• Efficiency losses are reductions of combined consumer and Efficiency losses are reductions of combined consumer and
producer surplus associated with underproduction (produce producer surplus associated with underproduction (produce less than equilibrium quantity) or overproduction (produce less than equilibrium quantity) or overproduction (produce more than equilibrium quantity). more than equilibrium quantity).
• UnderproductionUnderproduction: at Q2 there is a deadweight loss equals : at Q2 there is a deadweight loss equals dec. dec.
• OverproductionOverproduction: at Q3 there is a deadweight loss equals : at Q3 there is a deadweight loss equals cfg.cfg.
• Since both consumers and producers are members of the Since both consumers and producers are members of the society, these losses are efficiency loss or a deadweight society, these losses are efficiency loss or a deadweight lossloss
Consumer and Producer Consumer and Producer SurplusSurplusEfficiency Revisited
D
SPr
ice
(Per
Bag
)
P1
Q1
Quantity (Bags)
EfficiencyLosses
Q2 Q3
Efficiency Losses (Deadweight Losses)
a
b
c
d
e
f
g