Chapter 03

The Concept
of Elasticity
and
Consumer
and
Producer
Surplus
McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
 Chapter Outline
Elasticity of Demand
Alternative Ways of Understanding
Elasticity
More on Elasticity
Consumer and Producer Surplus
Kick It Up a Notch: Deadweight Loss

3-2
 Elasticity
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 good
3-3
The Mathematical Representation
of Elasticity
Q
%Q Q
Elasticity = =
%P P
P
Because 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.

3-4
 Elasticity 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 price

3-5
Alternative Ways to Understand
Elasticity
The Graphical Explanation

3-6
 The 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 prices.
3-7
 Figure 1
12.5% change (9-8)/8
P 13
12
11
10
9
8
7
6 25% change (4-3)/4
5
4
3
2 D1
1
0
1 2 3 4 5 6 7 8 9 10 11 12 13 Q/t
3-8
 Figure 2
50% change (12-8)/8
P 13
12
11 D2
10
9
8
7
6 25% change (4-3)/4
5
4
3
2
1
0
1 2 3 4 5 6 7 8 9 10 11 12 13 Q/t
3-9
Figure 3 Higher Prices Means Greater Elasticity
12.5% change (9-8)/8
P 13
12
50% change (3-2)/2
11
10 A
9
B
8
7
6 Demand
25% change (4-3)/4
5
4
C
3 D 9.1% change (11-10)/11
2
1
0
1 2 3 4 5 6 7 8 9 10 11 12 13 Q/t
3-10
 Alternative Ways to Understand
Elasticity
The Verbal Explanation
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.
3-11
Seeing 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.

3-12
 Determinants 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.

3-13
 Extremes 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 change

3-14
Elasticity and the Demand
Curve
How the Elasticity of Demand
Affects Reactions to Price
Changes

3-15
 Figure 4 Perfectly Inelastic Demand
P

S2

P2
S1

P1

Q1=Q2
Q/t
3-16
 Figure 5 Perfectly Elastic
P
Demand
S2

S1

P1=P2
D

Q2 Q1
Q/t
3-17
Figure 6 Inelastic Demand
(at moderate prices)
P

S2

S1
P2

P1

Q1
Q2 Q/t
3-18
Figure 7 Elastic Demand
(at moderate prices)
P

S2

S1

P2
P1
D

Q1
Q2 Q/t
3-19
 Elasticity Examples
Inelastic Goods Price Elasticity

Eggs 0.06
Food 0.21
Health Care Services 0.18
Gasoline (short-run) 0.08
Gasoline (long-run) 0.24
Highway and Bridge Tolls 0.10
Unit Elastic Good (or close to it)
Shellfish 0.89
Cars 1.14
Elastic Goods
Luxury Car 3.70
Foreign Air Travel 1.77
Restaurant Meals 2.27
3-20
 Price 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 same

3-21
 Perfectly Inelastic Supply
P S

P2

P1

D2
D1
Q1=Q2 Q/t
3-22
 Inelastic Supply
P
S

P2

P1

D2
D1
Q1 Q2 Q/t
3-23
 Elastic Supply
P

P2

P1

D2
D1
Q1 Q2 Q/t
3-24
 Perfectly Elastic Supply
P

P1=P2 S

D2

D1

Q1 Q2 Q/t
3-25
 Consumer 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.

3-26
 Figure 12
Value to the Consumer: OACQ*
P
A Supply

P* C

B
Demand

0 Q* Q/t
3-27
 Figure 12
Money Consumers Pay Producers: OP*CQ*
P
A Supply

P* C

B
Demand

0 Q* Q/t
3-28
 Figure 12 Consumer Surplus: P*AC
P
Consumer Surplus = = minus
A
Supply

Amount Consumer
pays producer

Value to
P* C
the
Consumer

B Demand

0 Q* Q/t
3-29
 Figure 13 Variable Cost to the
Producer: OBCQ*
P
A Supply

P* C

B
Demand

0 Q*
3-30
 Figure 13 Producer Surplus: BP*C
P Producer Surplus = = minus

A
Supply

Amount consumer
pays producer

P* C

B
Variable Demand
cost to
producer

0 Q* Q/t
3-31
Figure 14 Net Benefit to Society = CS+PS:
BAC
P
Consumer
A Supply
Surplus

P* C Producer
Surplus

B
Demand

0 Q* Q/t
3-32
 Market Failure
Market Failure: the circumstance where the
market outcome is not the economically
efficient outcome
Possible Sources:
Consumption or production can harm an
innocent third party.
A good may not be one for which a
company can profit from selling it though
society profits from its existence.
The buyer may not be able to make a
well-informed choice.
A buyer or seller may have too much
power over the price.
3-33
 Categorizing Goods:
Exclusivity and Rivalry
Exclusivity: the degree to which the
consumption of the good can be
restricted by a seller to only those who
pay for it
Rivalry: the degree to which one
persons consumption reduces the value
of the good for the next consumer

3-34
 Private and Public Goods
Purely private good: a good with the
characteristics of both exclusivity and rivalry
Purely public good: a good with the neither
of the characteristics exclusivity and rivalry
Excludable public good: a good with the
characteristic of exclusivity but not of rivalry
Congestible public good: a good with the
characteristic of rivalry but not of exclusivity

3-35
 Kick it Up a Notch

Consumer and Producer Surplus

in a Supply and Demand Model

3-36
 The Optimality of Equilibrium
and Dead Weight Loss
At equilibrium the sum of producer and
consumer surplus is as big as it can be
(ABC).
Away from equilibrium the sum of
producer and consumer surplus is smaller.
The degree to which it is smaller is called
the dead weight loss. That is, it is the loss
in societal welfare associated with
production being too little or too great.

3-37
 Figure 16 Dead Weight Loss
When the Price is Above P*
Value to the Consumer:
0AEQ
P Consumers Pay Producers:
A
Supply OPEQ
The Variable Cost to Producers:
P E
OBFQ
P* C Consumer Surplus:
PAE
F
Producer Surplus:
B
BPEF
Demand
DWL
0 Q Q* Q/t FEC

3-38
 Figure 17 Dead Weight Loss
When the Price is Below P*
Value to the Consumer:
0AEQ
P Consumers Pay Producers:
Supply OPFQ
A The Variable Cost to
E Producers:
P* OBFQ
C
Consumer Surplus:
P
F PAEF
B Producer Surplus:
Demand BPF
0 Q Q* DWL
Q/t FEC

3-39