McGraw-Hill/Irwin

Chapter 6
Elasticity, Consumer
Surplus, and
Producer Surplus
Copyright 2009 by The McGraw-Hill Companies, Inc. All

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

Ed =

Percentage Change in Quantity

Demanded of Product X
Percentage Change in Price
of Product X

6-4

Price Elasticity of Demand

Calculate percentage change
Restate formula
Ed =

Change in Quantity Demanded of X

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
Ed =

Change in Quantity
Sum of Quantities/2

Change in Price
Sum of Prices/2

6-6

Interpretations of Elasticity
Elastic Demand

Ed =

.04
.02

=2

.01
.02

= .5

.02
.02

=1

Inelastic Demand

Ed =
Unit Elasticity

Ed =

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

D1

10

20

30

40

Q
6-10

The Total Revenue Test

Lower price and inelastic demand
Gold loss exceeds blue gain
P

$4

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
$3

D3

10

20

30

Q
6-12

Elasticity on a Linear
Demand Curve
(1)
Total Quantity of
Tickets Demanded
Per Week, Thousands

1
2
3
4
5
6
7
8

(2)
Price Per Ticket

$8

7]
6]
5]
4]
3]
2]
1]

(3)
Elasticity
Coefficient (Ed)

5.00
2.60
1.57
1.00
0.64
0.38
0.20

(4)
Total Revenue
(1) X (2)

$8,000

14,000 ]
18,000 ]
20,000 ]
20,000 ]
18,000 ]
14,000 ]
8,000 ]

(5)
Total-Revenue
Test

Elastic
Elastic
Elastic
Unit Elastic
Inelastic
Inelastic
Inelastic
6-13

Price

Elasticity and the TR Curve

$8 a
7
b
6
c
5
d
4
e
3
f
2
g
1

Elastic
Ed > 1
Unit Elastic
Ed = 1
Inelastic
Ed < 1
h

0 1 2 3 4 5 6 7 8

Total Revenue
(Thousands of Dollars)

Quantity Demanded

$20
18
16
14
12
10
8
6
4
2

TR
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

Es =

Percentage Change in Quantity

Supplied of Product X
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

Greatest
Price
Impact

Sm

Pm
P0
D1 D2

Q0

Q
6-19

Price Elasticity of Supply

The Short Run
Inelastic supply
P

Lower
Price
Impact

Ss

Ps
P0
D1 D2

Q0 Qs

Q
6-20

Price Elasticity of Supply

The Long Run
Elastic supply
P
Sl

Least
Price
Impact

Pl
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

Exy =

Percentage Change in Quantity

Demanded of Product X
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

Ei =

Percentage Change in Quantity

Demanded
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
Bob
Barb
Bill
Bart
Brent
Betty

Max WTP Actual Price

$13
$8
$12
$8
$11
$8
$10
$8
$9
$8
$8
$8

CS
$5
$4
$3
$2
$1
$0
6-26

Consumer Surplus

Price (Per Bag)

Consumer
Surplus
Equilibrium
Price = $8

P1

D
Q1

Quantity (Bags)
6-27

Producer Surplus
Benefit surplus
Actual price received more than
minimum acceptable price (AP)
Person
Carlos
Courtney
Chuck
Cindy
Craig
Chad

Min AP
$3
$4
$5
$6
$7
$8

Actual Price
$8
$8
$8
$8
$8
$8

PS
$5
$4
$3
$2
$1
$0
6-28

Producer Surplus

Price (Per Bag)

Producer
Surplus

Equilibrium
Price = $8

P1

Q1

Quantity (Bags)
6-29

Efficiency Revisited
Productive and allocative efficiency
S

Price (Per Bag)

Consumer
Surplus

Equilibrium
Price = $8

P1

Producer
Surplus

Q1

Quantity (Bags)
6-30

Efficiency Loss
Deadweight loss
S

Price (Per Bag)

Efficiency
Losses

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
demand
midpoint formula
elastic demand
inelastic demand
unit elasticity
perfectly inelastic
demand
perfectly elastic
demand
total revenue (TR)
total-revenue test

price elasticity of
supply
market period
short run
long run
cross elasticity of
demand
income elasticity of
demand
consumer surplus
producer surplus
efficiency losses
(deadweight losses)
6-33

Next Chapter Preview

Consumer Behavior

6-34