Chapter 6: Elasticity, Consumer Surplus, and Producer Surplus

Price elasticity of demand - Responsiveness of consumers to a price change * Relatively elastic - Modest price changes cause large changes in quantity purchased * Relatively inelastic - Substantial price changes cause small changes in quantity purchased * Elasticity of demand = Percent change in quantity demanded of product X / Percent change in price of product X * Midpoint formula - Averages the 2 prices and the 2 quantities as reference points for computing percentages

Why use percentages? * Choice of units can arbitrarily affect impression of buyer responsiveness * Can correctly compare consumer responsiveness to changes in prices of different products
Ignore minus sign + present absolute value of elasticity coefficient to avoid ambiguities
Interpretations of elasticity of demand * Elastic - Specific percent change in price results in a larger percent change in quantity demanded; elasticity of demand greater than 1 * Inelastic - Specific percent change in price results in a smaller percent change in quantity demanded; elasticity of demand less than 1 * Unit elasticity - Percent change in price is equal to resulting percent change in quantity demanded; elasticity of demand equals 1 * Perfectly inelastic - Price-elasticity coefficient equals 0; no response to change in price * Perfectly elastic - A small price reduction causes buyers to increase purchases from 0 to all they can obtain; price-elasticity coefficient equals infinity

Total revenue - Total amount seller receives from sale of a product in a particular time period; price * quantity sold
Total-revenue test - Test to infer whether demand is elastic or inelastic * Elastic - Decrease in price → Increase in total revenue * Inelastic - Decrease in price → Decrease in total revenue * Unit elastic - Increase or decrease in price → Total revenue unchanged
Price elasticity along a linear demand curve * Price elasticity coefficient for a demand curve declines as we move from higher to lower prices * Changes from more elastic to more inelastic * Slope cannot be used to judge elasticity
Determinants of price elasticity of demand * Substitutability - More substitute goods available → Greater price elasticity of demand * Proportion of income - Higher the price of a good relative to consumers’ incomes → Greater price elasticity of demand * Luxuries vs. necessities - Good considered to be luxury rather than necessity → Greater price elasticity of demand * Time - Longer time period → Greater price elasticity o demand (consumers have more time to adjust to changes in price)
Applications of price elasticity of demand * Large crop yields - Demand for farm products is highly inelastic; increases in output → lower prices of farm products + total revenues of farmers * Excise taxes - Levying excises on products w/ inelastic demand * Decriminalization of illegal drugs - Legalization → Would reduce drug trafficking by taking the profit out of it (would reduce street prices)
Price elasticity of supply - How easily/quickly producers can shift resources b/w alternative uses * Elastic - Quantity supplied by producers relatively responsive to price changes * Inelastic - Quantity supplied relatively insensitive to price changes * Elasticity of supply = Percent change in quantity supplied of product X / Percent change in price of product X * Market period - Period that occurs when the time immediately after a change in market price is too short for producers to respond with a change in quantity supplied * Short run - Period of time too short to change plant capacity but long enough to use the fixed-sized plant more or less intensively * Ex. Farmer cannot change land or machinery, but can change amount of labor + fertilizer * Long run - Period of time that is long enough for firms to adjust plant sizes + for firms to enter or leave the industry * Ex. Farmer has time to acquire more land and machinery + more farmers may be attracted to tomato farming by higher prices
Applications of price elasticity of supply * Antiques + reproductions - High prices of antiques result from strong demand + limited, highly inelastic supply * Volatile gold prices - Price of gold increases sometimes, decreases other times; inelastic supply of gold → small changes in demand produce large changes in price
Cross elasticity of demand - How sensitive consumer purchases of one product are to a change in the price of another product * Cross price elasticity = Percent change in quantity demanded of product X / Percent change in price of product Y * Substitute goods - Increase in price of good X → Increase in demand for good Y * Complementary goods - Increase in price of good X → Decrease in demand for good Y * Independent goods - 2 products being considered are unrelated

Income elasticity of demand - Degree to which consumers respond to a change in their incomes by buying more or less of a particular good * Income elasticity = Percent change in quantity demanded / Percent change in income * Normal goods - Income rises → Demand increases * Inferior goods - Income rises → Demand decreases

Consumer surplus - Benefit surplus received by consumers in a market * Difference between the maximum price a consumer is willing to pay and the actual price * Arises b/c all consumers pay equilibrium price even though many are willing to pay more than that * Add together individual consumer surpluses → Obtain collective consumer surplus in market * Consumer surplus + price are inversely related

Producer surplus - Benefit surplus received by producers in a market * Difference between the actual price a producer receives and the minimum acceptable price * Arises b/c most sellers willing to accept lower-than-equilibrium price if that’s required to sell the product * Add together individual producer surpluses → Obtain collective producer surplus in market * Producer surplus + price are directly related

Efficiency * Productive efficiency - Competition forces producers to use best techniques + combos of resources * Allocative efficiency - Correct quantity of output produced relative to other goods + services * When consumer surplus + producer surplus is at maximum size * MB = MC * Maximum willingness to pay = minimum acceptable price * Competitive markets produce equilibrium prices + quantities that maximize consumer + producer surplus * Efficiency losses - Reductions of combined consumer + producer surplus * Deadweight loss - Efficiency loss to society * Example: Producing an item for which the maximum willingness to pay is $7 and the minimum acceptable price is $10 subtracts $3 from society’s net benefits