Econ 1194: Prices and Markets

Lecture 2: Efficiency and Elasticity

Topic 2: Efficiency and Elasticity

Outline
1

Efficiency
1.1 Consumer Surplus
1.2 Producer Surplus
1.3 Economic Efficiency

Elasticity
2.1 Elasticity of Demand
2.2 Price Elasticity of Demand
2.3 Elasticity and Total Revenue
2.4 Income Elasticity of Demand
2.5 Cross Price Elasticity of Demand
2.6 Price Elasticity of Supply

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1. Efficiency
What do economists mean by efficiency?
A market is economically efficient when the marginal benefit to
consumers of the last unit produced is equal to its marginal cost of
production. (Hubbard & Obrien, page 105)

Market efficiency is also achieved when the sum of consumer

surplus are maximised
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1.1 Consumer Surplus

The demand curve reflects the value consumers receive from
consuming.
We measure the value consumers received from consuming by their
willingness to pay, i.e. the maximum price they are willing to pay at every
quantity demanded.
Consumer surplus: the difference between consumers willingness to
pay and the amount they actually pay. It is the consumers gains from
trade, i.e. the benefit of consumers from participating in the market.

Consumer surplus is the area between the demand curve and the
price line.

p*

Consumer Amount Consumer

value - paid = surplus

Demand
0

q*

Calculating Consumer Surplus

Consumer surplus is the difference between what the consumers willing to
pay (shown on the demand curve) and what they actually pay (the market price)
In other words, consumer surplus is the area between the demand curve and
the price line up to the quantity consumed
Class Exercise
For the Demand Curve QD= 70 - 2P shown below, calculate the consumer
surplus when the price is 20
Consumer
Surplus

Area of a triangle= 1/2 (Base * Height)

So if P=20 and Q = 30
CS = ((30 x 35 20) )
= (20 x 15)
= 225

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1.2 Producer Surplus

The supply curve reflects the cost firms incur in producing.
We measure producer cost of production by their willingness to sell, i.e. the minimum
price they are wiling to accept at every quantity supplied.
Producer surplus: the difference between producers willingness to sell
and the amount they actually receive. It is the producers gains from
trade, i.e. the benefit of producers from participating in the market.

Producer surplus is the area between the supply curve and

the price line.

Supply

p*

Amount Producer Producer

received - cost = surplus

q*

Calculating Producer Surplus

Producer surplus is the amount producers receive (market price) above the
minimum price required to make them supply the good (shown on the supply
curve)
Producer surplus is the area between the price line and the supply curve up
to the quantity produced
Class Exercise
For the Supply Curve QS = 0 + 1.5P shown below, calculate producer surplus
when price equals 20
Answer
Producer
Surplus

Area of a triangle= 1/2 (Base * Height)

So if P=20 and Q = 30
PS = (30 x 20 )
= 300

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1.3

Economic Efficiency

At the equilibrium, the marginal net benefit MNB of producing an additional

unit is zero.
Thus competitive markets maximise
total net benefits of both consumers and producers
sum of CS and PS = areas (1) + (2a)

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Economic Efficiency
So there are losses (i.e. CS and PS are less) when overproducing.

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Economic Efficiency
and there are losses (i.e. CS and PS are less) when underproducing.

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A quick check
We can say that the allocation of resources is efficient if:
producer surplus is maximized.
consumer surplus is maximized.
total surplus is maximized
sellers costs are minimized.

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2. Elasticity
Elasticity measures of responsiveness of one variable to another holding all
else constant
if responsive, refer to as elastic
if unresponsive, refer to as inelastic
in general ab = elasticity of a with respect to b
= (% a ) (% b )
where
denotes change in
a is the dependent variable, e.g. quantity demanded and
b is some independent variable, e.g. price of the good

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2.1

Elasticity of Demand

This measures the responsiveness of quantity demanded to a change in one

of the determinants X of demand (assuming other determinants remain
constant)

% Qd
% X

(or reaction / action)

Point elasticity is elasticity at a specific point. This calculation of elasticity is

used when the changes between two points are likely to be very small

Q1 Q0

%Qd
100
Q0

X1 X 0
% X
100

X0

Q1 Q0
X0
Q X

Q0
X 1 X 0 X Q

Note that for the base of the percentage change we are using the starting
point (Q0, X0)

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Elasticity of Demand
Note that for the base of the percentage change in calculation of the point
elasticity, we are using the starting point (Q0, X0) for Point Elasticity
Q0 Q1 X 0 X 1
,

2
2

We also can use the average

Q1 Q0

100
Q0 Q1

Q X 0 X 1

2
d

X1 X 0
X Q0 Q1

%X
100
X 0 X1

2
%Qd

This is an Arc Elasticity

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2.2

Price Elasticity of Demand

As price increases from p0 to p1, quantity demanded decreases from q0 to q1

Price elasticity of demand measures the responsiveness of quantity
demanded to a change in price of a product, all else constant

% Qd

% P

The midpoint formula is normally preferable

when calculating the price elasticity of demand
because it gives the same answer regardless
of the direction of the price change.

P0 P1
% Qd
Qd

% P
P
Q0 Q1

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Price Elasticity of Demand

E.g. Price = $4.00, Qd = 8,100Kg
Price = $4.50, Qd = 6,900Kg

Qd
P0 P1
6900 8100
4 4.5
p

P Q0 Q1
4.5 4
8100 6900

p 1.36
The negative sign means the demand follows the Law of Demand
Take the absolute value
Unit free measure
1.36 means a 1% increase (decrease) in price of the good results in a
1.36% decrease (increase) in quantity demanded

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Price Elasticity of Demand

If p > 1, the demand is elastic. For 1 % increase in the price of the good, the
quantity demanded decrease by more than 1%. %Qd > %P
P

Elastic
Demand
Qty

If p < 1, the demand is inelastic. For 1 % increase in the price of the good,
the quantity demanded decrease by less than 1%. %Qd < %P
P

Inelastic
Demand
Qty

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Price Elasticity of Demand

If p = , the demand is perfectly elastic.
P

Perfectly
elastic
Demand

Qty

If p = 0, the demand is perfectly inelastic. %Qd = 0 regardless of the price

P

Perfectly
inelastic
Demand

Qty
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Elasticity along the Demand Curve

For a linear demand curve, except in the cases of perfectly inelastic and
perfectly elastic demand curve, elasticity varies along the demand curve
elastic at the high end
unitary elasticity point
inelastic at the low end

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2.3

Elasticity and Total Revenue

TR = p q
if p then q so what happens to TR?
elastic demand (p > 1) TR
unitary elasticity (p = 1) TR constant
inelastic demand (p < 1) TR
if p then q so what happens to TR?
elastic demand (p > 1) TR
unitary elasticity (p = 1) TR constant
inelastic demand (p < 1) TR

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Elasticity and Total Revenue

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Determinants of Price Elasticity of Demand

Substitutability with other goods
Luxuries vs. Necessities
Proportion of income spent on good
Timeframe

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2.4

Income Elasticity

Income elasticity measures the responsiveness of change in quantity

demanded as change in income, ceteris paribus.

%Quantity Demanded %Qd

y

%Income
%Y
Qd Y0 Y1
y

Y Q0 Q1
Note that:

y > 0 for normal goods

y < 0 for inferior goods

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Income Elasticity

This means that for a 1% increase (decrease) in average weekly earnings,

the quantity demanded of new cars increased (decreased) by 0.84%.

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2.5 Cross Price Elasticity

Cross price elasticity measures the responsiveness of change in quantity
demanded for good X with respect to the price of good Y change, ceteris
paribus.

XY

%Q X

%PY

XY

Q X
P PY 1
Y0
PY QX 0 QX 1

Note that:
xy > 0 for substitute goods
xy < 0 for complementary goods

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Cross Price Elasticity

This means that for a 1% increase (decrease) in the price of gas, the quantity
demanded of gas stoves decreased (increased) by 1.15%.

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2.6 Price Elasticity of Supply

The responsiveness of quantity supplied to a change in price of a product, all
else constant

% Qs
s
% P
s is positive following the Law of Supply
s > 1: Elastic Supply
s < 1: Inelastic Supply
s = 0: Perfectly Inelastic Supply
s = : Perfectly Elastic Supply

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Determinants of Elasticity of Supply

Availability of Inputs: the more availability of inputs, the easier producers can
response to the price change, the more elastic supply curve.
Substitutability of inputs: the more substitutability of inputs, the more elastic
supply curve
Timeframe
Momentary Supply Curve: could be perfectly inelastic or perfectly elastic
Short-run Supply Curve: inelastic supply
Long-run Supply Curve: elastic supply
P

Momentary
Supply

S/R
Supply

Qty

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P
L/R
Supply

Qty

Qty

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Key terms

Market Efficiency

Marginal benefit
Marginal cost
Consumer Surplus
Producer surplus
Economic surplus
Deadweight loss

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Elasticity
Cross price Elasticity
Income elasticity of demand
Elastic Demand
Inelastic demand
Price elasticity of supply
Total revenue
Unitary elasticity

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Next week:

Topic 3: Industry Analysis

and the Costs of Production

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