CHAPTER 4 Elasticity, Consumer Surplus, and Producer Surplus

Transcription

1 Part Two: Microeconomics of Product Markets CHAPTER 4 Elasticity, Consumer Surplus, and Producer Surplus 2010 McGraw-Hill Ryerson Ltd. Slides prepared by Bruno Fullone, George Brown College 1

2 In this chapter you will learn: 4.1 About price elasticity of demand and how it can be applied 4.2 The usefulness of the total revenue test for price elasticity of demand 4.3 About price elasticity of supply and how it can be applied 4.4 About cross elasticity of demand and income elasticity of demand 4.5 To apply the concept of elasticity to various real-world situations 4.6 About consumer surplus, producer surplus, and efficiency losses 2

3 4.1 Price Elasticity of Demand THE LAW OF DEMAND SAYS An increase in price causes a decrease in quantity demanded (and vice-versa) But HOW MUCH does quantity demanded change in response to a change in price? Elasticity gives us a measure of RESPONSIVENESS LO 4.1 3

4 Price Elasticity of Demand When Q D responds STRONGLY to a change in P, demand is ELASTIC When Q D responds WEAKLY to a change in P, demand is INELASTIC LO 4.1 4

5 The Price Elasticity Coefficient and Formula Ed = percentage change in quantity demanded of product X percentage change in price of product X We need to calculate the average price and quantity changes, also known as the midpoint formula. Why? LO 4.1 5

6 The Price Elasticity Coefficient and Formula If the quantity demanded increased from 4 to 5 units the percentage change would be: %ΔQ d = ΔQ d /Q 0 = ¼ x 100 = 25% If the quantity demanded dropped from 5 to 4, the percentage change would be: %ΔQ = ΔQ d /Q 0 = 1/5 x 100 = 20% Which percentage change in Q d do we use? 25% or 20%? To avoid confusion about start and end point we use average change in Q d and the average change in P. LO 4.1 6

7 Price Elasticity of Demand E d change in quantity sum of quantities/2 change in price sum of prices/2 X100 E d Q P ( Q0 Q1 ) / 2 ( P0 P1 ) / 2 1 (4 5) / 2 1 (4 5) / 2 1 LO 4.1 7

8 The Price Elasticity Coefficient and Formula Price elasticity of demand: Use of Percentages Elimination of the Minus Sign Interpretation of E d : Elastic Demand Inelastic Demand Unit Elasticity Extreme Cases LO 4.1 8

9 4.2 The Total-Revenue Test Total revenue (TR) TR = P x Q TR and E d are related If TR changes in the opposite direction from price, demand is elastic If TR changes in the same direction from price, demand is inelastic If TR does not change when price changes, demand is unit elastic LO 4.2 9

10 Elastic Demand Quantity is very responsive to a change in price P P 1 When P changes from P1 to P2, TR increases P 2 D Q 1 Q 2 Q LO

11 Inelastic Demand P P 1 P 2 Quantity is NOT very responsive to a change in price When P changes from P1 to P2, TR decreases Q 1 Q 2 D Q LO

12 Unit Elasticity P % change in quantity is equal to % change in price P 1 P 2 When P changes from P1 to P2, TR does not change D Q 1 Q 2 Q LO

13 Price Elasticity along a Linear Demand Curve For all straight-line and most other demand curves demand is more elastic toward the upper left demand is less elastic toward the lower right LO

14 The Total-Revenue Test TR = P X Q What happens to total revenue when product price changes? 14 LO 4.2

15 Table 4-1 Ed and Total Revenue Qd P Ed TR INELASTIC , , , ,0 LO 4.2 UNIT DEMAND: ELASTIC when price DEMAND: decreases, ELASTIC when totalprice DEMAND: decreases, revenue when price total decreases decreases, revenue total stays the revenue same increases 15

16 Price D Elastic Figure 4-3 Unit Elastic Quantity demanded (thousands) Inelastic Total revenue ($ thousands) Quantity demanded (thousands) LO 4.2 Max TR TR 16

17 Determinants of E d Substitutability Proportion of Income Luxuries versus Necessities Time 17 LO 4.2

18 Applications of E d Large Crop Yields Sales Taxes Decriminalization of Illegal Drugs 18 LO 4.2

19 4.3 Price Elasticity of Supply E s = Percentage change in quantity supplied of product X Percentage change in the price of product X The main determinant of E s is the amount of time producers have for responding to a change in product price LO

20 Figure 4-4 Time and the Elasticity of Supply Immediate Market Period P o P S m A Large Increase in Price - An increase in Perfect Inelastic Supply demand without P m enough time to change supply causes... D 2 D 1 Q o LO 4.3 Q 20

21 P Short Run An Increase in Price - P m P s P o Time and the Elasticity of Supply More elastic Supply S s An increase in demand with some supply response will cause... D 2 D 1 Q o Q s LO 4.3 Q 21

22 P D 2 Long Run A small Increase in Price - P m P L P o Time and the Elasticity of Supply less elastic Supply An increase in demand in the long run allows a greater supply response... S L D 1 LO 4.3 Q o Q L Q 22

23 Applications of Price Elasticity of Supply Antiques and Reproductions Volatile Gold Prices 23 LO 4.3

24 4.4 Cross Elasticity of Demand E xy = Percentage change in quantity demanded of product X Percentage change in the price of product Y Substitute Goods - positive sign Complementary Goods - negative sign Independent Goods - near zero LO

25 Cross Elasticity of Demand Applications Coca-Cola vs. Sprite Assessing competition 25 LO 4.4

26 Income Elasticity of Demand E i = Normal Goods - positive sign Inferior Goods - negative sign Percentage change in quantity demanded Percentage change in income Insights to the Economy LO

27 Price 4.5 Elasticity and Real World Applications Figure 4-5 The Incidence of a Tax Quantity LO 4.5 Tax of $2 per unit S shifts up $2 Equilibrium price rises to $9 Consumer s burden is the amount of the price increase = $1 Firm s burden = tax-consumer s burden =$2 - $1 = $1 27

28 Figure 4-6 Demand Elasticity and the Incidence of a Tax S 1 S P e P1 TAX Producer bears most of the tax burden P a D Q 1 Q 0 Tax incidence and elastic demand LO

29 Demand Elasticity and the Incidence of a Tax St S Pi P1 Pb TAX Consumer bears most of the tax burden D Q 1 Q 2 Tax incidence and inelastic demand LO

30 Figure 4-7 Supply Elasticity and the Incidence of a Tax S t S P e P 1 P a TAX Consumer bears most of the tax burden D Q 1 Q 0 Tax incidence and elastic supply LO

31 Supply Elasticity and the Incidence of a Tax S t S P i P 1 TAX Producer bears most of the tax burden P a D Tax incidence and inelastic supply LO 4.5 Q 1 Q 0 31

32 4.6 Consumer and Producer Surplus Consumer surplus is the benefit surplus received by a consumer or consumers in a market is the difference between the maximum price a consumer is willing to pay for a product and the actual price 32 LO 4.6

33 P Figure 4-8 Consumer Surplus Consumer Surplus Equilibrium Price = $8 LO 4.6 D Q 33

34 Table 4-5 Consumer Surplus Person Maximum price willing Actual Price Consumer surplus to pay Bob (=$13-$8) Barb (=$12-$8) Bill (=$11-$8) Bart (=$10-$8) LO

35 P Figure 4-9 Producer Surplus S Producer Surplus Equilibrium Price = $8 LO 4.6 Q 35

36 Table 4-6 Producer Surplus Person Maximum acceptable price Carlos 3 8 Actual Price Consumer r surplus 8 5 (= $8 $3) 8 4 (= $8 $4) Courtn ey 4 8 Chuck 5 8 Cindy 6 8 LO (= $8 $5) 8 2 (= $8 $6) 8 1 (= $8 $7) 8 0 (= $8 $8) 36

37 Figure 4-10 Efficiency Revisited P Consumer Surplus Producer Surplus Allocative Efficiency is achieved since CS and PS are maximized LO 4.6 S Equilibrium Price = $8 D Q 37

38 Figure 4-11 Efficiency Losses (or Deadweight Losses) P Quantity levels less than S efficiency quantity create efficiency losses Efficiency Losses Equilibrium Price = $8 LO 4.6 D Q 38

39 The Last Word: Elasticities and Pricing Power Differences in price elasticities of demand are often exploited by suppliers, consider Price airlines charge business versus leisure travellers Charges for children versus adults at hair stylists or ski resorts, etc. Colleges and universities that offer financial aid to low-income students 39 Chapter 4

40 Chapter 4 Summary 4.1 Price Elasticity of Demand 4.2 The Total-Revenue Test 4.3 Price Elasticity of Supply 4.4 Cross Elasticity and Income Elasticity of Demand 4.5 Elasticity and Real-World Applications - Sales Taxes 4.6 Consumer and Producer Surplus Chapter 4 40