Chapter 3 The Concept of Elasticity and Consumer and Producer SurplusChapter OutlineYou Are HereElasticityThe Mathematical Representation of ElasticityElasticity LabelsAlternative Ways to Understand ElasticityThe Relationship Between Slope and ElasticityFigure 1Slide 10Figure 3 Higher Prices Means Greater ElasticitySlide 12Seeing Elasticity Through Total ExpendituresDeterminants of ElasticityExtremes of ElasticityElasticity and the Demand CurveFigure 4 Perfectly Inelastic DemandFigure 5 Perfectly Elastic DemandFigure 6 Inelastic Demand (at moderate prices)Figure 7 Elastic Demand (at moderate prices)Elasticity ExamplesPrice Elasticity SupplySlide 23Slide 24Slide 25Slide 26Consumer and Producer SurplusFigure 12 Value to the Consumer: OACQ*Figure 12 Money Consumers Pay Producers: OP*CQ*Figure 12 Consumer Surplus: P*ACFigure 13 Variable Cost to the Producer: OBCQ*Slide 32Slide 33Market FailureCategorizing Goods: Exclusivity and RivalryPrivate and Public GoodsKick it Up a NotchThe Optimality of Equilibrium and Dead Weight LossFigure 16 Dead Weight Loss When the Price is Above P*Figure 17 Dead Weight Loss When the Price is Below P*Chapter 3The Concept of Elasticity and Consumer and Producer SurplusCopyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin3-2Chapter Outline•ELASTICITY OF DEMAND•ALTERNATIVE WAYS OF UNDERSTANDING ELASTICITY•MORE ON ELASTICITY•CONSUMER AND PRODUCER SURPLUS3-3You Are Here3-4Elasticity•Elasticity: the responsiveness of quantity to a change in another variable•Price Elasticity of Demand: the responsiveness of quantity demanded to a change in price•Price Elasticity of Supply: the responsiveness of quantity supplied to a change in price•Income Elasticity of Demand: the responsiveness of quantity demanded to a change in income•Cross Price Elasticity of Demand: the responsiveness of quantity demanded of one good to a change in the price of another good3-5The Mathematical Representation of ElasticityElasticity =%ΔQ%ΔP=ΔQΔPQPBecause the demand curve is downward sloping and the supply curve is upward sloping the elasticity of demand is negative and the elasticity of supply is positive. Often these signs are implicit and ignored.3-6Elasticity Labels•Elastic : the condition of demand when the percentage change in quantity is larger than the percentage change in price•Inelastic: the condition of demand when the percentage change in quantity is smaller than the percentage change in price•Unitary Elastic: the condition of demand when the percentage change in quantity is equal to the percentage change in price3-7Alternative Ways to Understand ElasticityThe Graphical Explanation3-8The Relationship Between Slope and Elasticity•Elasticity and the slope of the demand curve are not the same but they are related.•At a given price level, elasticity is greater with a flatter demand curve.•With a linear demand curve (meaning a demand curve that has a single value for the slope) elasticity is greater at higher prices3-9Figure 1D1Q/tP 1312111098765432101 2 3 4 5 6 7 8 9 10 11 12 13 12.5% change (9-8)/825% change (4-3)/43-10Figure 2D2Q/tP 1312111098765432101 2 3 4 5 6 7 8 9 10 11 12 13 50% change (12-8)/825% change (4-3)/43-11Figure 3 Higher Prices Means Greater ElasticityDemandQ/tP 1312111098765432101 2 3 4 5 6 7 8 9 10 11 12 13 BACD12.5% change (9-8)/825% change (4-3)/450% change (3-2)/29.1% change (11-10)/113-12Alternative Ways to Understand Elasticity•A good for which there are no good substitutes is likely to be one for which you must pay whatever price is charged. It is also likely to be one for which a lower price will not induce substantially greater consumption. Thus, as price changes there is very little change in consumption, i.e. demand is inelastic and the demand curve is steep.•Inexpensive goods that take up little of your income can change in price and your consumption will not change dramatically. Thus, at low prices, demand is inelastic.The Verbal Explanation3-13Seeing Elasticity Through Total Expenditures•Total Expenditure Rule: if the price and the amount you spend both go in the same direction then demand is inelastic while if they go in opposite directions demand is elastic.3-14Determinants of Elasticity•Number of and Closeness of Substitutes–The more alternatives you have the less likely you are to pay high prices for a good and the more likely you are to settle for something that will do.•Time–The longer you have to come up with alternatives to paying high prices the more likely it is you will shift to those alternatives.•Portion of the Budget–The greater the portion of the budget an item takes up, the greater the elasticity is likely to be.3-15Extremes of Elasticity•Perfectly Inelastic: the condition of demand when price changes have no effect on quantity•Perfectly Elastic: the condition of demand when price cannot change3-16Elasticity and the Demand CurveHow the Elasticity of Demand Affects Reactions to Price Changes3-17Figure 4 Perfectly Inelastic DemandDQ/tPS2Q1=Q2P2S1P13-18Figure 5 Perfectly Elastic DemandQ/tPDS2 P1=P2Q2S1Q13-19Figure 6 Inelastic Demand (at moderate prices)PQ/tDS1P1Q1Q2S2P23-20Figure 7 Elastic Demand(at moderate prices)Q/tPQ1DS1P1S2P2Q23-21Elasticity ExamplesInelastic Goods Price ElasticityEggs 0.06Food 0.21Health Care Services 0.18Gasoline (short-run) 0.08Gasoline (long-run) 0.24Highway and Bridge Tolls 0.10Unit Elastic Good (or close to it)Shellfish 0.89Cars 1.14Elastic GoodsLuxury Car 3.70Foreign Air Travel 1.77Restaurant Meals 2.273-22Price Elasticity Supply•Identical in concept to elasticity of demand.–Formula is the Same–It is also related to the slope of the supply curve but is not simply the slope of the supply curve.–Terminology is the same3-23SQ/tPD2Q1=Q2P2D1P1Perfectly Inelastic Supply3-24PQ/tP1Q1Q2P2SD2D1Inelastic Supply3-25Q/tPQ1P1P2Q2SD2D1Elastic Supply3-26Q/tP P1=P2Q2Q1SD2D1Perfectly Elastic Supply3-27Consumer and Producer Surplus•Consumer Surplus: the value you get that is in excess of what you pay to get it –On a graph, consumer surplus is the area below the demand curve and above the price line.•Producer Surplus: the money the firm gets that is in excess of its marginal costs–On a graph, producer surplus is the area below the price line and above the supply curve.3-28Figure 12 Value to the Consumer: OACQ*Q/tP0SupplyDemandP*Q*ABC3-29Figure 12 Money Consumers Pay Producers: