Chapter 3: The Concept of Elasticity and Consumer and Producer Surplus

3.1 Elasticity of Demand

• Definition: Elasticity measures the responsiveness of quantity to changes in another variable.

  • Price Elasticity of Demand: Responsiveness of quantity demanded to a change in price.

  • Income Elasticity of Demand: Responsiveness of quantity demanded to a change in income.

  • Cross-Price Elasticity of Demand: Responsiveness of quantity demanded of one good to a change in the price of another good.

3.2 Types of Elasticity

• Elastic Demand: Percentage change in quantity demanded > percentage change in price.

• Inelastic Demand: Percentage change in quantity demanded < percentage change in price.

• Unitary Elastic Demand: Percentage change in quantity demanded = percentage change in price.

3.3 Mathematical Representation of Elasticity

• Demand curves slope downward (negative elasticity), while supply curves slope upward (positive elasticity). It is common to ignore the signs in elasticity calculations.

3.4 Graphical Representation of Elasticity

• Slope vs. Elasticity: Elasticity is greater with a flatter demand curve; for linear demand curves, elasticity increases at higher prices.

  • Total Expenditure Rule: If both price and spending move in the same direction, demand is inelastic; oppositely indicates elastic demand.

3.4.1 Determinants of Elasticity of Demand

• Number and Closeness of Substitutes: More substitutes increase elasticity.

• Time: More time leads to easier substitution and greater elasticity.

• Budget Portion: Goods that consume a larger share of the budget tend to be more elastic.

• Ability to Extend Use of Goods: If consumers can prolong existing goods’ usage, they delay purchases, contributing to elastic demand.

3.5 Extremes of Elasticity

• Perfectly Inelastic Demand: Quantity does not change despite price changes (demand curve is vertical).

• Perfectly Elastic Demand: Any price change results in quantity demanded changing immediately (demand curve is horizontal).

3.6 Consumer and Producer Surplus

• Consumer Surplus: The difference between what consumers are willing to pay versus what they actually pay. Represented as the area below the demand curve and above the price line.

• Producer Surplus: The difference between what producers receive versus the minimum they would be willing to accept. Represented as the area above the supply curve and below the price line.

• Net Benefit to Society: Total surplus is the combined consumer and producer surplus, maximizing welfare at equilibrium.

3.7 Comparing Gains and Losses

• Consumer and producer surplus analysis helps economists evaluate the impacts of economic policies such as minimum wage or rent controls.

3.8 Market Failure

• Market Failure: When market outcomes do not achieve economic efficiency. Possible causes include:

  • Externalities affecting third parties.

  • Goods with societal benefit but without profit incentive.

  • Poor consumer choice information.

  • Excessive buyer or seller power affecting prices.

3.9 Categorizing Goods

• Exclusivity: Ability to restrict consumption to those who pay.

• Rivalry: When one person's consumption diminishes the value for others.

• Goods Overview:

  • Purely Private Goods: Both exclusive and rival.

  • Purely Public Goods: Neither exclusive nor rival.

  • Excludable Public Goods: Exclusive but not rival.

  • Congestible Public Goods: Rival but not exclusive.

  • Network Goods: Dependent on others consuming for utility (e.g., telephones).

3.10 Deadweight Loss

• Deadweight Loss (DWL): The loss of economic efficiency when equilibrium is not achieved, quantifying the welfare loss when production is insufficient or excessive.

  • Impact of Price Changes: Analyzes surplus changes that result from price being above or below equilibrium, highlighting importance for societal welfare.