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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
Percentage Change in Price of Product X

Ed =

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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


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Price Elasticity of Demand


Calculation problem Starting point matters Midpoint formula
Ed =
Change in Quantity Sum of Quantities/2

Sum of Prices/2

Change in Price

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Interpretations of Elasticity
Elastic Demand
.04 .02

Ed =
Inelastic Demand

=2

Ed =
Unit Elasticity

.01 .02

= .5

Ed =

.02 .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
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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

b
1

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

f
1

D3

10

20

30

Q
6-12

Elasticity on a Linear Demand Curve


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

(2) Price Per Ticket

1 2 3 4 5 6

$8

7
8

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

5.00 2.60 1.57 1.00 0.64 0.38

$8,000

0.20

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

Elastic Elastic Elastic Unit Elastic Inelastic Inelastic

Inelastic
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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

Price

0 1 2 3 4 5 6 7 8
Quantity Demanded

Total Revenue (Thousands of Dollars)

$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


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Price Elasticity of Supply


Market period
Perfectly inelastic supply

Short run
Fixed plant size

Long run
Adjustable plant size Supply more elastic
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Price Elasticity of Supply


The Market Period Perfectly inelastic supply

Sm

Greatest Price Impact

Pm P0

D1 D2

Q0

Q
6-19

Price Elasticity of Supply


The Short Run Inelastic supply
P

Ss

Lower Price Impact

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

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 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
P1

Equilibrium Price = $8

Q1

Quantity (Bags)
6-29

Efficiency Revisited
Productive and allocative efficiency
Consumer Surplus Price (Per Bag)
S

Equilibrium Price = $8
P1

Producer Surplus
D
Q1

Quantity (Bags)
6-30

Efficiency Loss
Deadweight loss
Efficiency Losses Price (Per Bag)
S

P1

D
Q2 Q1 Q3
6-31

Quantity (Bags)

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

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Consumer Behavior

6-34