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Chapter 18: Elasticity Chapter 18: Elasticity Price elasticity demand supply Cross elasticity Income elasticity

Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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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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Page 1: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

Chapter 18: ElasticityChapter 18: Elasticity

• Price elasticity–demand–supply

• Cross elasticity• Income elasticity

Page 2: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

Basic ideaBasic idea

• We know when P

Qd

Qs

holding other factors constant

Page 3: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

but how much?but how much?

• if price doubleshow much does Qd fall?–by 10%–by 50%–by 300%?

• price elasticity tells us

Page 4: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 5: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 6: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 7: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 8: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 9: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

• At equilibrium Qs = Qd• (10/-150) P+ 7000/150=(10/-100) P+

8000/100• ??

Page 10: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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.

Page 11: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

equationequation

% change in Qd% change in P

Page 12: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

% change in Qd% change in Qd

new Qd - initial Qdaverage Qd

x 100

midpoint method

Page 13: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

exampleexample

5 cups - 15 cups(5+15)/2 cups

x 100

-10 cups10 cups

x 100 = -100%

Page 14: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

% change in P% change in P

new P - initial Paverage P

x 100

midpoint method

Page 15: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

exampleexample

$5 - $3 ($5+$3)/2

x 100

$2$4

x 100 = 50%

Page 16: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

demand elasticitydemand elasticity

% change in Qd% change in P

-100%50%

= -2

Page 17: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

• If price of latte increases 1%,Qd of latte decreases 2%

Page 18: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

demand elasticitydemand elasticity

• a unit-free measure–compare all goods & services

• changes for different pointson the demand curve

Page 19: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 20: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

• < 1 inelastic% change Qd < %change Pnot sensitive to P changes

Page 21: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

elastic demandelastic demand(>1)(>1)• flatter curve

P

Q

D

small change in Pbig change in Qd

Page 22: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

inelastic demandinelastic demand(<1)(<1)• steep curve

P

QD

big change in Psmall change in Qd

Page 23: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

perfectly inelastic demandperfectly inelastic demand

• vertical lineP

QD

change in Pno change in Qd

Page 24: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

perfectly elastic demandperfectly elastic demand

• horizontal lineP

Q

D

any change in PQd falls to zero

Page 25: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 26: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 27: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 28: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

exampleexample

• mocha latte at Starbucksis a luxury

• a liver transplant is not

Page 29: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 30: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

3. time since price change–short time

no time to adjust,demand is inelastic

– long timetime to adjust,demand is elastic

Page 31: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

exampleexample

• Price of gas per gallon• the day price rises

–demand inelastic• years later

–demand much more elasticas carpool or buy smaller car

Page 32: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 33: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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)

Page 34: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

exampleexample

• soap– if price doubles, will you buy less?

• rent– if rent doubles?

-- stay on campus?-- more roommates?

Page 35: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

II. Price Elasticity of SupplyII. Price Elasticity of Supply

% change in Qs% change in P

Page 36: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

exampleexample

• bunch of roses• P = $40/bunch, Qs = 6 (million bunches)• P = $60, Qs = 15

Page 37: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

% change Qs% change Qs

15 - 6(6+15)/2

x 100

910.5

x 100 = 86%

Page 38: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

% change P% change P

60 - 40(60+40)/2

x 100

2050

x 100 = 40%

Page 39: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

supply elasticitysupply elasticity

% change in Qs% change in P

86%40%

= 2.15

Page 40: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

• if price rises 1%, Qs rises 2.15%

• unit-free measure• depends on points chosen

on the supply curve

Page 41: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 42: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

• < 1 inelastic% change Qs < %change Pnot sensitive to P changes

Page 43: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

inelastic supplyinelastic supply

• steep curveP

QS

big change in Psmall change in Qs

Page 44: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

perfectly inelastic supplyperfectly inelastic supply

• vertical lineP

QS

change in Pno change in Qs

Page 45: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

elastic supplyelastic supply

• flatter curveP

Q

S

small change in Pbig change in Qs

Page 46: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

perfectly elastic supplyperfectly elastic supply

• horizontal lineP

Q

S

any change in PQs falls to zero

Page 47: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 48: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

exampleexample

• oceanfront property–can’t make more– inelastic supply

• salt–almost an infinite amount–elastic supply

Page 49: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

2. time since price change– it takes time to produce– if a short time,

supply is inelastic– if a long time

supply is elastic

Page 50: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

exampleexample

• hotel rooms– takes time to build–supply inelastic in short-run,

elastic in long-run

Page 51: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

3. Can you store it easily/cheaply?– if yes, then elastic– if no, then inelastic

Page 52: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

exampleexample

• bananas–storage time limited–supply inelastic

Page 53: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 54: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

equationequation

% change in Qd% change in income

• > 0 normal good• < 0 inferior good

Page 55: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

example: jewelryexample: jewelry

• income increases 10%• Qd jewelry increases 35%

Page 56: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

income elasticityincome elasticity

% change in Qd jewelry% change in income

35%10%

= 3.5

Page 57: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 58: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

equationequation

% change in Qd% change in P of related good

Page 59: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

cross elasticitycross elasticity

• > 0 for substitutes• < 0 for complements

Page 60: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 61: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

% 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%

Page 62: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 63: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 64: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

% 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%

Page 65: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 66: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 67: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

]]]]]]]

]]]]]]]

Page 68: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 69: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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.

Page 70: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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 =

Page 71: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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 =

Page 72: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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?

Page 73: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 74: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 75: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

Used textbook Used textbook

Page 76: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 77: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 78: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 79: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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.

Page 80: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 81: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 82: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

Consumer SurplusConsumer Surplus

• difference between what you pay for a good,and what you are WILLING to pay for a good

Page 83: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

exampleexample

• market price pizza = $10• my marginal value of 3rd pizza this

week = $12• my consumer surplus = $2

Page 84: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

P

Q

D

$10

my demand curvemy demand curve

$12

3

my consumer surplus

Page 85: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

P

QD

$10

10,000

total consumer surplus

area between Dand price of pizza

Page 86: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 87: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 88: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 89: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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.

Page 90: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

The Supply Curve for Used Textbooks

Page 91: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

Producer Surplus in the Used-Textbook Market

Page 92: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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.

Page 93: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity 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

Page 94: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

A Rise in the Price Increases Producer Surplus

Page 95: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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.

Page 96: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

Total Surplus

Page 97: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…
Page 98: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 99: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 100: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 101: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 102: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

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D

Pric

e (P

er B

ag)

P1

Q1

Quantity (Bags)

ConsumerSurplus

Equilibrium Price = $8

O 18.3

Consumer SurplusConsumer Surplus

Page 104: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

Page 105: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

Producer SurplusProducer Surplus

SPr

ice

(Per

Bag

)

P1

Q1

Quantity (Bags)

ProducerSurplus

Equilibrium Price = $8

Page 106: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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.

Page 107: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

• 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

Page 108: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

Consumer and Producer SurplusConsumer and Producer SurplusEfficiency Revisited

D

SPr

ice

(Per

Bag

)

P1

Q1

Quantity (Bags)

ConsumerSurplus

ProducerSurplus

Equilibrium Price = $8

Page 109: Chapter 18: Elasticity Price elasticity –demand –supply Cross elasticity Income elasticity Price…

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

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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