CONSUMER SURPLUS

Defining Consumer Surplus

Consumer surplus is a measure of the welfare that people gain from the consumption of goods and services, or a measure of the benefits they derive from the exchange of goods.

Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price for the product). The level of consumer surplus is shown by the area under the demand curve and above the ruling market price as illustrated in the diagram below:

Consumer surplus and price elasticity of demand

When the demand for a good or service is perfectly elastic, consumer surplus is zero because the price that people pay matches precisely the price they are willing to pay. This is most likely to happen in highly competitive markets where each individual firm is assumed to be a ‘price taker’ in their chosen market and must sell as much as it can at the ruling market price.

In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand is totally invariant to a price change. Whatever the price, the quantity demanded remains the same (remember out gasoline example earlier in the course).

The majority of demand curves are downward sloping. When demand is inelastic, there is a greater potential consumer surplus because there are some buyers willing to pay a high price to continue consuming the product. This is shown in the diagram below:

Consumer surplus and price elasticity of demand

Changes in demand and consumer surplus

When there is a shift in the demand curve leading to a change in the equilibrium market price and quantity, then the level of consumer surplus will alter. This is shown in the diagrams above. In the left hand diagram, following an increase in demand from D1 to D2, the equilibrium market price rises to from P1 to P2 and the quantity traded expands. There is a higher level of consumer surplus because more is being bought at a higher price than before.

In the diagram on the right we see the effects of a cost reducing innovation which causes an outward shift of market supply, a lower price and an increase in the quantity traded in the market. As a result, there is an increase in consumer welfare shown by a rise in consumer surplus.
Consumer surplus can be used frequently when analysing the impact of government intervention in any market – for example the effects of indirect taxation on cigarettes consumers or the introducing of road pricing schemes such as the London congestion charge.

Applications of Consumer Surplus

Consider the entry of Internet retailers such as Last Minute and Amazon into the markets for travel and books respectively. What impact has their entry into the market had on consumer surplus? Have you benefited from you perceive to be lower prices and better deals as a result of using e-commerce sites offering large discounts compared to high street retailers?

Price discrimination and consumer surplus

Producers often take advantage of consumer surplus when setting prices. If a business can identify groups of consumers within their market who are willing and able to pay different prices for the same products, then sellers may engage in price discrimination – the aim of which is to extract from the purchaser, the price they are willing to pay, thereby turning consumer surplus into extra revenue. Ever noticed the price changes at your local fitness gym?

Airlines are expert at practising this form of yield management, extracting from consumers the price they are willing and able to pay for flying to different destinations are various times of the day, and exploiting variations in elasticity of demand for different types of passenger service. You will always get a better deal / price with airlines such as WestJet and Air Canada if you are prepared to book weeks or months in advance. The airlines are prepared to sell tickets more cheaply then because they get the benefit of cash-flow together with the guarantee of a seat being filled. The nearer the time to take-off, the higher the price. If a businessman is desperate to fly from Vancouver to Toronto in 24 hours time, his or her demand is said to be price inelastic and the corresponding price for the ticket will be much higher. Would you expect profitability per seat sold to vary greatly for airlines, why?

One of the main arguments against firms with monopoly power is that they exploit their monopoly position by raising prices in markets where demand is inelastic, extracting consumer surplus from buyers and increasing profit margins at the same time. Is this a valid argument?

Consumer and Producer Surplus

ARSC 1432 Microeconomics Co-Seminar

SPRING 2009

Consumer Surplus = CS = the difference between what consumers are willing to pay and what they actually pay for a good or service.

Producer Surplus = PS = the difference between what producers are willing to accept for their produce and what they actually receive for a good or service.

Social Surplus = SS = CS + PS

To calculate CS or PS, use the formula for area of a triangle: (½)(base)(height)

Example 1:

Example 2:

Ps = 40 + 4Qs Supply Equation

Pd = 100 – 2Qd Demand Equation

To find Equilibrium Ps*=Pd* at equilibrium they are equal

so 40+4Qs=100-2Qd or 40+4Q=100-2Q since Qs=Qd also

6Q=60 Q*=60/6=10 Equilibrium quantity

Now to find the price Ps*=40+ 4(10) = 80 or Pd*=100-2(10) = 80

So to graph we say how much is the price when the quantity demanded (or supplied) is zero in both equations Ps = 40 + 4(0)= 40 Pd = 100 – 2(0) = 100. These are the intercepts at the Y axis.

To calculate the intercept at the X axis we say how much is the quantity demanded when the price is zero, so 0 = 100 -2Qd 2Qd=100 Qd=100/2=50 there is no need to calculate the X intercept for the supply equation.

Since Consumer Surplus and Producer Surplus are represented by triangles, to calculate their value you can utilize the formula for the area of a triangle =

So Consumer Surplus is equal to ((100-80) x 10)/2 = (20 x 10)/2= 100

and Producer Surplus is equal to ((80-40) x 10)/2 = (40 x 10)/2= 200

So Total Welfare equals Consumer Surplus + Producer Surplus = 100 + 200 = 300

Definition of 'Economic Growth'

An increase in the capacity of an economy to produce goods and services, compared from one period of time to another. Economic growth can be measured in nominal terms, which include inflation, or in real terms, which are adjusted for inflation. For comparing one country's economic growth to another, GDP or GNP per capita should be used as these take into account population differences between countries.

Investopedia explains 'Economic Growth'

Economic growth is usually associated with technological changes. An example is the large growth in the U.S. economy during the introduction of the Internet and the technology that it brought to U.S. industry as a whole. The growth of an economy is thought of not only as an increase in productive capacity but also as an improvement in the quality of life to the people of that economy.

Eco B - 1

ECONOMICS

We may define economic activity as any action that helps in the satisfaction of human wants. It is this activity which forms the subject-matter of the study of economics.

Economics originally developed as a science of statecraft.

Definitions of economics:

1. Wealth definition - by Adam Smith approach/school/thought

2. Welfare definition - by Alfred Marshall

3. Scarcity definition – by Lionel Robbins

4. Growth definition – by Paul A. Samuelson

1 Wealth definition – Wealth has always assumedتظاهر کردن a significant role to control and regulate the economic activity. But with the development of trade, industry and commerce, the role of wealth has become more dominantغالب. Economists in the 18^th and the early 19^th centuries had defined economics as that part of knowledge which relates to wealth.

Adam Smith defined economics as “a science which studies the nature and causes of the wealth of nations”.

2 Welfareآسایش definition – Alfred Marshall defined economics as:

“Political economy or Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment حصولand with the use of the material requisites احتیاج of well-being. Thus it is, on the one side, a study of wealth; and on the other, and more important side, a part of the study of man”.

Marshall was the first to realize the significance of human welfare. He believed that wealth is not an end in itself, it is a means to an end, the ultimate نهاییend being human welfare.

3. Scarcity کمیابی Definition – Lionel Robbins defined economics as ;

“Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses.”

The definition of Robbins bring home the following fundamental conditions:

· Economics is a science – a positive science – because it studies how human beings adjust their multiple wants to scarce means.

· Economics studies human behavior.

· Ends – Ends refer to the human wants which are unlimited.

· Scarce means – Human wants are unlimited while the means (material resources) to satisfy them are limited.

4. Growth Definition - Professor Paul A. Samuelson has propounded اریرایه کردن the growth-centered definition of economics;

“Economics is the study of how man and society choose, with or without the use of money, to employ scarce productive resources which could have alternative uses, to produce various commodities وسیله مناسب over time and distribute them for consumption مصرفnow and in future among various people and groups of society.’

MICRO ECONOMICS

Micro and macro have come to be known as two important approaches to the economic analysis. Micro has been taken from the Greek word ‘Mikros’ which means small. Professor Ragner Frisch coined this term for the first time in 1933, and since then it has become an important approach of economic analysis.

“Micro economics is the study of particular firm, particular household, individual price, wage, income, industry and particular commodity”. (K. E. Boulding)

Scope هدف of Micro Economics:

1. Theory of Demand : In the theory of demand we study the concept of individual demand and market demand, elasticity of demand, equi-marginal principle, consumer’s surplus, etc.

2. Theory of Production : It deals with various factors of production, production function, optimum combination of inputs to maximize the output, returns to a variable factor and returns to scale.

3. Theory of Price Determination : It deals with the determination of commodity price by a firm under different market structures.

4. Theory of factor pricing : It deals with the determination of rent, wages, interest and profit.

Significance of Economics:

1. Significance for academicians ; Economics is logical and systematic science. Economic theory explains how production takes place, how goods are exchanged and finally consumed.

2. Significance for consumers : The ultimate object of economics is to promote human welfare. The law of substitution, for example, helps consumers to maximize their satisfaction from a given income.

3. Significance for the producers ; The aim of producers is to find out the least cost combination. The study of economic theory helps producers to choose the level of output that maximizes profits.

4. Significance in price determination : Theory of price is the most important part of economic theory. Pricing of products is a very difficult decision that the firms have to take under the different market conditions. So economic theory suggest at what time what price should be determined for a unit of commodity at different conditions.

5. Solves problems of income distribution – Distribution of national income among the different factors of production is the most sensitive and difficult problem. The theory of distribution suggests that every factor should be paid according to its marginal productivity.

6. Significance for the administrators – A successful administration is one which offers maximum amenities to the citizens causing the least burden on them. So a good tax-policy helps the administrator (Government) in this regard.

7. Significance for the planners – Several countries have adopted the technique of economic planning to accelerate the pace of their economic growth.

LECTURE NOTES –CH 4

ELASTICITY

My Lecture Notes are written in summary and point form- they emphasize important concepts, do not regurgitate the book, and are consequently not meant to be a replacement of the book- If you want to benefit from these notes you must read the book first (before coming to class).

Learning Outcomes

· Understand the meaning of elasticity of demand

· Understand that elasticity of demand can be with respect to income, other prices or own prices

· Similarly understand the meaning of elasticity of supply, the determinants of supply elasticity and the elasticity of supply in short and long run

· Understand that a tax can have different incidence on demanders and suppliers depending on the elasticity of demand or supply

· Understand normal and inferior goods by examining their income elasticity

· Understand substitutes and complements by examining their cross price elasticity

ELASTICITY OF DEMAND

Refers to responsiveness of demand to changes in own price, or other determinants of demand (or factors that affect demand).

Own price elasticity of demand responsiveness of demand to changes in own price

Cross price elasticity of demand responsiveness of demand to changes in prices of

other products.(substitutes or complements)

Income elasticity of demand responsiveness of demand to changes in income

h= % change in Quantity/ % change in price

Calculating % changes and the importance of average value of X in calculating elasticity of demand for X

The discussion below explains that when you take % change, you can end up with two answers, but you can get a unique answer for % change if you take the change from the average value.

Say X1= 20 and it increases to X2=30. What is % change in X?

It can be (30-20)/30 = 1/3 if we take the change with respect to new value of X i.e. 30.

It can be (30-20)/20= ½ if we take the change with respect to initial value of X i.e. 20.

To avoid this ambiguity we take % change with respect to average value of X (i.e. the average of the initial and final values of x).

In our example, average value of X is (initial value + new value)/2 = (20+30)/2=25

Now after finding average value we can calculate a unique value for :

% change in X = (new value of X-old value of X)/Av value of X

= (30-20)/ 25= 10/25

Table 4.1

Commodity	Reduction in Price (Cents)	Increase in Qty Demanded (per month)
Cheese	40c per kg	7500 kg
T Shirts	40c per shirt	5000 shirts
CD Players	40c per cd player	100 CD players

Note that the change in price is the same in absolute terms for all products i.e. 40 cents. The data is incomplete as it does not tell us what was the original price or the original quantity demanded- all it tells us is that what happens to demand when price falls by 40 cents

Table 4.2

Product	Unit	Original Price ($) 1	New Price ($) 2	Av Price ($) 3=(1+2)/2	Original Quantity 4	New Quantity 5	Av Quantity 6=(4+5)/2
Cheese	Kg	3.40	3.00	3.20	116250	123750	120000
T shirts	Shirt	16.20	15.80	16.00	197500	202500	200000
CD Players	Player	80.20	79.80	80.00	9950	10050	10000

In table 4.2 we start off with original prices and quantities and see what happens to them once prices fall by 40 c - 116250+7500=123750

Table 4.3

Product	% fall in price (1)	% increase in Qty (2)	Elasticity of demand (h) (3)=2/1
Cheese	12.5	6.25	0.5
T shirts	2.5	2.50	1.0
CD Players	0.5	1.00	2.0

% change in price: (3.4-3)/3.2=0.4/3.2=0.125=12.5%

% change in qty: (116250-123750)/120000=0.625=6.25%

Elasticity= 6.25/12.5=0.5

Interpreting elasticities

Demand elasticity will always have a negative value (because of opp. signs of price and quantity in elasticity formula)

But we always take positive value (that’s an age old convention). The higher the value the more elastic (responsive) the demand when prices change.

See Table Extensions in theory 4.1 in L&R

(The same knowledge is represented below in alternate words)

Q. What value can the elasticity coefficient (i.e. own price elasticity coefficient) take?

A. Value of h is between 0 and infinity

ü When % change in Q is greater than % change in P, demand is said to be elastic - h will take on value of greater than 1 to infinity

ü When % change in Q is less than % change in P, demand is said to be inelastic - h will take on value of less than 1 or more precisely between 0 and 1

ü When Q does not change at all and P changes – elasticity is 0 (Note that while elasticity can be +infinity, it cannot be –infinity or less than zero)

ü When % change in Q = % change in P, demand is said to be unitary elastic

Q. Would we observe a constant own price elasticity of demand along a demand curve?

A. Depends on the slope of the demand curve-

Ø If D curve is a st line demand curve its elasticity changes as we move along the curve (See fig 4-2)

Ø If D is horizontal or vertical elasticity is infinite or zero (see fig 4-3)

Ø If D curve is a hyperbola –it will have unitary elasticity, h=1, ((See Fig 4-3)

Determinants of Elasticity of Demand

----Depends on availability of substitutes- if very close substitutes are available for X, changes in prices of those goods will have a larger effect on quantity consumed of X- Thus a product with close substitutes tends to have an elastic demand and a product with no close substitutes tends to have an inelastic demand

-----Depends on how much time is available to substitute- in SR not many products can be produced or introduced in market but over longer run many substitutes can be developed by suppliers- Thus LR demand for a product is more elastic than SR demand (people change their method of transportation over time –hence demand for gasoline is less elastic in SR than in LR)

Q. Would OPEC oil Producers experience a gain in revenues if they restricted the cartels supply of oil and thereby increased prices?

A. Depends on whether demand for oil is elastic or inelastic- their revenues will only increase if demand is inelastic and revenues would fall if demand is elastic.

Q. Can farmers increase their revenues by dropping prices?

A. Yes only if demand is elastic (fall in price should generate huge increase in demand such that P x Q increases. If demand is inelastic and Q does not increase with fall in price, the total revenue to farmers P x Q would fall with a fall in price.

These ideas can be seen in Fig 3-5 which shows relationship \between total revenue of firms (which is total expenditure of consumers) and quantity demanded..

Note that total expenditure of consumers (which is the same as total revenue of firms producing those products) first rises with increase in quantities purchased and then starts falling despite the fact that more quantities are still being purchased. Note that up to 10,000 units of demand the expenditure is rising and then after 10000 units it starts to fall and goes to zero at 20000 units of consumption demand.

Q. Why may this be so?

A. The expenditure PQ is composed of prices and quantities – therefore DTE= DP x DQ. Along the demand curve prices are throughout falling and quantities are throughout rising so direction of change of TE is inderminate. However, the answer lies in understanding that elasticity of demand (or response of demand to changes in price) is different over the initial range (top LHS) of the demand curve as compared to the latter part (bottom RHS) of the D curve.

Initially the increase in demand is much more than the fall in price so that TE rises- in other words over the initial range of the demand curve demand is more elastic (i.e. change in demand is more than change in price). We note that TEs continually increase till P=2 and D=10000, but after that further fall in prices does not lead to much larger increase in demand (i.e. fall in P is greater than increase in D, therefore TE=PQ falls).

Note that in absolute value demand is continually increasing with fall in prices but at prices less than P=2, the incremental increase in demand is less than the incremental decrease in price. In other words at P less than 2 Demand keeps becoming more and more inelastic. The effect of this demand inelasticity is that TE eventually becomes zero when D=20,000 units.

Price Elasticity of Supply Fig 4-6

Measures the elasticity of supply of goods with respect to changes in market prices.

It is denoted h_s= % change in quantity supplied

% change in market price

The sign of h_sis positive because both numerator and denominator are always positive. The reason that numerator and denominator are both positive is that we are considering the supply curves which have positive slopes.

However, there are special cases of supply curves whose slopes may not be positive-they could be vertical or horizontal. A very steep S curve means that a unit increase (decrease) in price has a very small increase (increase) in Q supplied. It means steeper S curve is less elastic or inelastic.

Vertical S curve has h_s= 0, steeper S curves will have small values of elasticity of supply

Horizontal S curve-has h_s=¥, flatter S curves will have large values of elasticity of supply

Special case of S curve::: Any positively sloped S curve passing through origin will have h_s= 1.

Look at smaller triangle and larger triangle-their angles are equal (similar triangles) therefore ratios of their sides are equal

p/q= Dp/Dq

and we know from definition that h_s= Dq/q

Dp/p

= Dq/Dp . p/q

Substitute for p/q = Dq/Dp . Dp/Dq

= 1 (means that the % change in quantity supplied equals the % change in price)

Determinants of Supply Elasticity?

Depends on how easy it is to substitute factors of production towards the prodn of those goods whose price has risen. Naturally we will not see this substitution in very diverse products cars and cabbages etc, rather close products e.g different kinds of detergents or soaps or other very close substitutes-

How quickly S responds to increase the prodn of the product whose P has risen depends on whether the costs will also rise as substitution in prodn is made- if that’s the case then supply may not be responsive to increase in price.

Generally in SR supply is not that responsive as compared to LR when costs can be better controlled and factors of prodn can be better combined to produce the product whose price has risen. Therefore SR S curves are relatively inelastic compared to LR S curves. (see Fig 4-7)

An Example Where Elasticity Matters (pg 81) Fig 4-8

We are interested to find out who bears a higher burden when a tax is imposed i.e. the consumers or the sellers.

When we say higher burden we mean who bears the loss when a tax is imposed. For example how much of the tax can be passed on to consumers and how much is absorbed will determine who eventually bears the burden of the tax.

The more inelastic the demand curve relative to the supply curve the more burden of a tax will be borne by consumers – This fact is demonstrated in Fig 4-9, but ideas pertaining to “seller price”, “consumer price” and “shift of supply curve” due to excise tax should first be understood through fig 4-8.

Explanation of Fig 4-9

In Fig 4-9 (i) Supply is elastic and demand is inelastic (relative elasticities matter)

Tax levied :

Consumption or demand falls and P rises. Previously Consumer was spending P0Q0 and now PcQ1 .

S falls too- previously suppliers were earning P0Q0 now they earn PcQ1- because price jumps from p0 to pc and D falls from q0 to q1.

Note that consumers’ expenditure has increased much more due to huge rise in price and less drop in quantities- that’s because their demand is inelastic for cigarettes. On the other hand the price for suppliers does not fall as much because of the larger elasticity of their supply curves, hence their new revenue PsQ1 is not much less than previous revenue (p0q0)

Conclusion: Due to inelastic D curve, the price rises much more for consumer and quantity falls less, therefore the consumer ends up paying much more for their consumption – thus in other words the burden of the excise tax falls more on the consumer.

In Fig 4-9 (ii) a tax of $t per pack of cigarettes shifts up the S curve by $t for each and every quantity of cigarette packs. At the higher price of pc consumers only demand q1 packs of cigarettes. Firms are willing to supply q1 demand at price of ps. Note that in the case of elastic D for consumers (it must be the case that they have more substitution possibilities) they are able to drastically reduce their Demand and cut down conspn to q1 from q0.

So while prices per pack have increased by the same amount in case (i) and (ii) [How? Note that the tax in case (i) is the same as tax in case (ii) –the shift up of the S curve is the same], the larger reduction in quantity Demanded in case (ii) prevents the consumers bill from going up too much- Note that in case (i) when demand was inelastic (perhaps not many substitutes were available to consumer), the consumer was not able to reduce demand much in response to the excise tax per pack of cigarettes. Consequently his total bill, P.Q went up (%reduction in quantity was less than the % increase in prices)- thus in case (i) the burden of the tax was higher than in case (ii).

Conclusion: Due to elastic Demand quantity falls much more and price rises much less, therefore less burden falls on consumer.

Payroll Taxes- Applying Eco Concepts 4-2 –p 84 L&R

Payroll taxes are deducted from a persons income. Payroll tax different from income tax which we pay at the end of fiscal year for tax assessment purposes to Revenue Canada. Payroll taxes are deducted from each salary slip by employer. This tax is then deposited by employer to Revenue Canada.

Who gains and who loses by thee payroll taxes?

The effects of this tax (like excise tax) will be on both prices and quantities. In this case the quantity is quantity of employment and prices are wages (hourly wages) of workers.

A payroll tax deducted by employer drives a wedge between the wage paid by firm (Wf) and wage received by worker (Ww).

When there was no payroll tax the employment was E0 and wage was w0.

With payroll tax, firms have to pay $t/hr to govt. in addition to what they pay to workers.

What happens to employment?

Note that with a rise in wages from w0 to wf (wf-w0 is rise in firms net cost per hour per worker), firms would hire only E1 workers (along their Demand curve for labor). It can be seen that the employment has fallen from E0 to E1.

In this example who bears most of the burden of the tax- firms or labor?

The burden of the tax is determined by how much the wage falls for workers as compared to the increase in the wage (net cost per worker) for firms. With an inelastic Supply curve for labor, workers do not have much option, but to keep working. Hence at lower employment of E1, the wage received by workers falls a lot from the previous level of Wo (note that if S was elastic wage would not have fallen as much when firms reduced their demand for labor). Thus burden of payroll tax is more on workers and less on firms due to the relative inelasticity of labor supply as compared to labor demand by firms.

Conclusion: Payroll taxes increase net cost of hiring for firms and reduce net wages for labor- naturally with higher wages firms hire less, than would be the case without any payroll taxes.

What Determines Income Elasticity (discussion of income consumption curves)

h_Y= % change in quantity demanded

% change in income

↑ Y → ↑ D --- for normal goods; therefore h_Y ≥ 0

↑ Y → ↓ D --- for inferior goods; therefore h_Y≤ 0

Income elasticity of Normal Goods will definitely be positive (greater than 0) but can be greater than unity (elastic) or less than unity (inelastic) depending on whether the change in Q demanded is greater or less than the change in income..

If h_Yis greater than 1, we say that demand is income elastic

If h_Yis less than 1, we say that demand is income inelastic

Defining Inferior and Normal Goods in terms of Elasticity (See table 4-4 for examples of such goods and their empirically observed elasticities)

Inferior Goods have h_Yless than zero

Normal Goods which are inelastic have h_Ybetween zero and one

Normal Goods which are elastic have h_Ygreater than one

Income Consumption Curves (Fig 4-10)

Fig 4-10 shows the effects of change of income on quantity demanded- these curves can have different shapes depending on their income elasticity.

Explanation of Fig 4-10:

Normal goods increase in quantity as income increases – slope is rising upwards Fig 4-10 (i)

Luxury goods (which are also normal goods as opposed to being inferior goods) also increase in quantity as income rises- however there is a difference between normal goods which are necessities and normal goods which are luxuries. In the case of necessities, quantity increases no doubt but at a decreasing rate (How much necessities can you have with high income), however in the case of luxuries the higher the income increases thee more we consume luxuries; hence the ICC will have an increasing slope (note that’s the case after I₁income). See Fig 4-10 (ii)

In the case of inferior goods quantity reduces beyond a certain income- thus a commodity may be a necessity at lower incomes (say potatoes) but becomes an inferior good at higher incomes, and after we have achieved that income level we reduce its consumption. See Fig 4-10 (iii)

Cross Elasticity of Demand

h_xy= % change in Q demanded of X---

% change in price of good Y

- ¥ ≤h_xy≤ ¥

If cross elasticity is >0 it’s a substitute – that is ↑ in price of Y leads to ↑ in D for X – Demand curve of X will shift right

If cross elasticity is <0 it’s a complement – that is ↑ in price of Y leads to ↓in D for X – Demand curve of X will shift left

CHAPTER 5: ELASTICITY (SEE QUIZ #3 AND EXCEL #2; recommended problems and notes)

MULTIPLE CHOICE

1. Point elasticity measures elasticity:

a.	over a given range of a function.
b.	at a spot on a function.
c.	over a given range along a function.
d.	before non-price effects.

ANS: B

2. Arc elasticity is measured:

a.	over a given range of a function.
b.	at a spot on a function.
c.	over a given range along a function.
d.	before non-price effects.

ANS: C

3. With elastic demand, a price increase will:

a.	decrease marginal revenue.
b.	decrease total revenue.
c.	increase total revenue.
d.	decrease marginal revenue and total revenue.

ANS: B

4. With unitary elasticity of demand, a price increase will:

a.	be associated with zero marginal revenue.
b.	decrease total revenue.
c.	increase total revenue.
d.	decrease marginal and total revenue.

ANS: A

5. The demand for a product tends to be inelastic if:

a.	it is expensive.
b.	a small proportion of consumer's income is spent on the good.
c.	consumers are quick to respond to price changes.
d.	it has many substitutes.

ANS: B

6. Two products are complements if the:

a.	cross-price elasticity of demand is less than zero.
b.	cross-price elasticity of demand equals zero.
c.	cross-price elasticity of demand is greater than zero.
d.	price elasticity of demand for each good is greater than zero.

ANS: A

7. If the income elasticity of demand for a good is greater than one, the good is:

a.	a noncyclical normal good.
b.	a cyclical normal good.
c.	neither a normal nor an inferior good.
d.	an inferior good.

ANS: B

8. When the product demand curve is Q = 140 - 10P, and price is decreased from P₁ = $10 to P₂ = $9, the arc price elasticity of demand is:

a.	-0.1
b.	-3
c.	-4
d.	-10

ANS: B

9. If the point price elasticity of demand equals -2 and the marginal cost per unit is $5, the optimal price is:

a.	$5
b.	$10
c.	$2
d.	impossible to determine without further information.

ANS: B

10. The concept of cross-price elasticity is used to examine the responsiveness of demand:

a.	to changes in income.
b.	for one product to changes in the price of another.
c.	to changes in "own" price.
d.	to changes in income.

ANS: B

11. When the cross-price elasticity

= 3:

a.	demand rises by 3% with a 1% increase in the price of X.
b.	the quantity demanded rises by 3% with a 1% increase in the price of X.
c.	the quantity demanded rises by 1% with a 3% increase in the price of X.
d.	demand rises by 1% with a 3% increase in the price of X.

ANS: A

PROBLEMS

12. Elasticity. The demand for mini cassette players can be characterized by the following point elasticities: price elasticity = -2, cross-price elasticity with AA Alkaline batteries = -1.5, and income elasticity = 3. Indicate whether each of the following statements is true or false, and explain your answer.

A.	A price increase for cassette players will decrease both the number of units demanded and the total revenue of sellers.

B.	The cross-price elasticity indicates that a 2% reduction in the price of cassette players will cause a 3% increase in battery demand.

C.	Demand for cassette players is price elastic and they are cyclical normal goods.

D.	Falling battery prices will definitely increase revenues received by sellers of both cassette players and batteries.

E.	A 3% price reduction in cassette players would be necessary to overcome the effects of a 2% decline in income.

ANS:

A.	True. A price increase will always decrease units sold, given a downward sloping demand curve. The negative sign on the price elasticity indicates that this is indeed the case here. The fact that price elasticity equals -2 indicates that demand is elastic with respect to price, and therefore that a price increase will also decrease total revenues.

B.	False. The cross-price elasticity indicates that a 2% decrease in the price of batteries will have the effect of increasing cassette player demand by 3%.

C.	True. Demand is price elastic (see part a). Because the income elasticity is positive, cassette players are a normal good. Moreover, because the income elasticity is greater than one, cassette player demand is also cyclical.

D.	False. A negative cross-price elasticity indicates that cassette players and batteries are compliments. Therefore, falling battery prices will increase the demand for cassette players and resulting revenues for sellers. However, we have no information concerning the price elasticity of demand for batteries, and therefore do not know the effect of falling battery prices on battery revenues.

E.	True. A 3% reduction in price will cause a 6% increase in the quantity of cassette players demanded. A 2% decline in income will cause a 6% fall in demand. These changes will be mutually offsetting.

13. Demand Analysis. The Crank Yankers DVD (season two) has been a hot seller during recent weeks. An analysis of weekly demand shows:

Q = 3,000 - 90P

where Q is DVD sales and P is price.

A.	How many DVDs could be sold at a $20 price?

B.	Calculate the point price elasticity of demand at a price of $20.

ANS:

A.	Q = 3,000 - 90P
	= 3,000 - 90(20)
	= 1,200

B.	The point price elasticity of demand at a price of $20 is calculated as follows:

	= -90
	= -1.5 (elastic)

14. Optimal Price. Last week, Discount Food Stores, Inc. reduced the average price on the 22 ounce size of Dishwashing Liquid by 1%. In response, sales jumped by 8%.

A.	Calculate the point price elasticity of demand for Dishwashing Liquid.

B.	Calculate the optimal price for Dishwashing Liquid if marginal cost is 70¢ per unit.

ANS:

A.
	=
	= -8 (elastic)

B.	The optimal price is found setting MC = MR and solving for P where:
	MC = MR = P
	0.7 = P
	0.7 = 0.875P
	P = 0.8 or 80¢

15. Arc Price Elasticity. Assume that amazon.com dropped the price on a men's Seiko watch (SGF719) from $120 to $60, and sales jumped from 50 to 100 units per day.

A.	Calculate the implied arc price elasticity of demand.

B.	Is a further price decrease warranted? Why or why not?

ANS:

A.
	=
	= -1

B.	No further price decrease is warranted. At P = $60, the E_P = -1. This means that $60 is the revenue-maximizing price and any further decrease in price would cause demand to fall into the inelastic region of the demand curve. In the inelastic region of the demand curve prices are too low because both revenues and profits would rise with an increase in price.

16. Income Elasticity. Deluxe Carpeting, Inc., is a leading manufacturer of stain-resistant carpeting. Demand for Deluxe products is tied to the overall pace of building and remodeling activity and, therefore, is sensitive to changes in national income. The carpet manufacturing industry is highly competitive, so Deluxe's demand is also very price-sensitive.

During the past year, Deluxe sold 28 million square yards (units) of carpeting at an average wholesale price of $16 per unit. This year, GNP per capita is expected to fall from $19,000 to $17,000 as the nation enters a steep recession. Without any price change, Deluxe expects current-year sales to fall to 20 million units.

A.	Calculate the implied arc income elasticity of demand.

B.	Given the projected fall in income, the sales manager believes that current volume of 28 million units could only be maintained with a price cut of $2 per unit. On this basis, calculate the implied arc price elasticity of demand.

C.	Holding all else equal, would a further increase in price result in higher or lower total revenue?

ANS:

A.
	=
	= 3

B.	Without a price decrease, sales this year would total 20 million units. Therefore, it is appropriate to estimate the arc price elasticity from a (before-price-decrease) base of 20 million units:

	=
	= -2.5 (elastic)

C.	Lower. Because carpet demand is in the elastic range, E_P = -2.5, an increase (decrease) in price will result in lower (higher) total revenues.

CHAPTER 6: FORECASTING (SEE Ch.6 on line questions and Quiz #4 and notes)

17. A forecast method based on the informed opinion of several individuals is called:

a.	personal insight.
b.	panel consensus.
c.	the Delphi method.
d.	qualitative analysis.

ANS: B

18. A rhythmic annual pattern in sales or profits is called:

a.	cyclical fluctuation.
b.	secular trend.
c.	trend analysis.
d.	seasonal variation.

ANS: D

19. Growth trend analysis assumes:

a.	constant unit change over time.
b.	irregular percentage change over time.
c.	sporadic unit change over time.
d.	constant percentage change over time.

ANS: D

CHAPTER 7: PRODUCTION (See Quiz #4; recommended problems and notes)

20. The law of diminishing returns:

a.	deals specifically with the diminishing marginal product of fixed input factors.
b.	states that the marginal product of a variable factor must eventually decline as increasingly more is employed.
c.	can be derived deductively.
d.	states that as the quantity of a variable input increases, with the quantities of all other factors being held constant, the resulting output must eventually diminish.

ANS: B

22. When P_X = $60, MP_X = 5 and MP_Y = 2, relative employment levels are optimal provided:

a.	P_Y = 16.7¢.
b.	P_Y = $24.
c.	P_Y = $60.
d.	P_Y = $150.

ANS: B

23. When P_X = $100, MP_X = 10 and MR_Q = $5, the marginal revenue product of X equals:

a.	$100.
b.	$50.
c.	$10.
d.	$5.

ANS: B

24. Total output is maximized when:

a.	average product equals zero.
b.	marginal product is maximized.
c.	average product is maximized.
d.	marginal product equals zero.

ANS: D

25. A firm will maximize profits by employing the quantity of each input where the marginal:

a.	revenue product of each input equals its price.
b.	revenue equals the price of each input.
c.	product of each input is equal.
d.	product of each input equals its price.

ANS: A

26. Optimal Input Mix. Hydraulics Ltd. has designed a pipeline that provides a throughput of 70,000 gallons of water per 24-hour period. If the diameter of the pipeline were increased by 1 inch, throughput would increase by 4,000 gallons per day. Alternatively, throughput could be increased by 6,000 gallons per day using the original pipe diameter with pumps that had 100 more horsepower.


B.	Assuming the cost of additional pump size is $600 per horsepower and the cost of larger diameter pipe is $200,000 per inch, does the original design exhibit the property required for optimal input combinations? If so, why? If not, why not?

ANS:

B.	No. The rule for optimal input proportions is:
	=

	In this instance the question is:


	0.02 0.10

	Here the additional throughput provided by the last dollar spent on more horsepower (0.10 gallons/day) is five times the gain in output resulting from the last dollar spent to increase the pipe diameter (0.02 gallons/day). Thus, horsepower and pipe diameter are not being employed in optimal proportions in this situation.

27. Optimal Input Level. U-Do-It Furniture, Inc., sells hardwood chairs, in both kits and fully assembled forms. Customers who assemble their own chairs benefit from the lower kit price of $35 per chair. "Full-service" customers enjoy the luxury of an assembled chair, but pay a higher price of $60 per chair. Both kit and fully assembled chair prices are stable. The company has observed the following relation between the number of assembly workers employed per day and assembled chair output:

Number of Workers per day	Finished Chairs
0	0
1	5
2	9
3	12
4	14
5	15

A.	Construct a table showing the net marginal revenue product derived from assembly worker employment.

B.	How many assemblers would U-Do-It Furniture employ at a daily wage rate of $75?

C.	What is the highest daily wage rate U-Do-It Furniture would pay to hire four assemblers per day?

ANS:

A.	Because the market for hardwood chairs is perfectly competitive, the $25 price premium for fully assembled chairs versus kits is stable. Thus, the net marginal revenue product of assembler labor (sometimes referred to as the value of marginal product) is:

	Number of Assemblers per Day (1)	Fully Assembled Output (2)	Marginal Product of Labor (3)	Net Marginal Revenue Product of Labor (4)=(3)$25
	0	0	--	--
	1	5	5	$125
	2	9	4	100
	3	12	3	75
	4	14	2	50
	5	15	1	25

B.	From the table above, we see that employment of three assemblers could be justified at a daily wage of $75 because MRP_A=3 = $75. Employment of a fourth assembler could not be justified because MRP_A=4 = $50 < $75.

C.	From the table above, the MRP_A=4 = $50. Thus, a daily wage of $50 per assembler is the most U-Do-It Furniture would be willing to pay to hire a staff of 4 assemblers.

CHAPTER 8: COST AND ESTIMATION (Use recommended problems and notes)

28. Breakeven. Three graduate business students are considering operating a tofu burger stand in the Dalles, Oregon, windsurfing resort area during their summer break. This is an alternative to summer employment with a local fruit cannery where they would earn $7,500 each over the three-month summer period. A fully equipped facility can be leased at a cost of $8,000 for the summer. Additional projected costs are $2,000 for insurance, and 25¢ per unit for materials and supplies. Their tofu burgers would be priced at $1.50 per unit.


C.	What is the economic breakeven number of units for this operation? (Assume a $1.50 price and ignore interest costs associated with the timing of the lease payments.)

ANS C.	The economic breakeven point is reached when:
	Q =
	=
	= 26,000 units

29. Profit Contribution Analysis. Ben Laden Rugs, Inc., sells hand-made cotton rugs to tourists at a price of $50. Of this amount, $40 is profit contribution. Ben Laden is considering an attempt to differentiate his product from several other competitors by using high quality natural herb dyes. Doing so would increase Ben Laden's unit cost by $15 per rug. Current annual profits are $35,000 on 1,000 rug sales.

A.	Assuming average variable costs are constant at all output levels, what is Ben Laden's total cost function before the proposed change?

B.	What will the total cost function be if high quality natural herb dyes are used?

C.	Assume rug prices remain stable at $50. What percentage increase in sales would be necessary to maintain current profit levels?

ANS:

A.	From the definition of profit contribution we know that on a per unit basis:

	Profit contribution = P - AVC
	$40 = $50 - AVC
	AVC = $10 per unit

	Total fixed cost for Ben Laden can be calculated as follows:

	 = TR - TC
	= TR - TVC - TFC
	= (P  Q) - (AVC  Q) - TFC
	$35,000 = $50(1,000) - $10(1,000) - TFC
	$35,000 = $40,000 - TFC
	TFC = $5,000

	Therefore, the total cost function is:
	TC = TFC + (AVC  Q)
	TC = $5,000 + $10Q

B.	By using high quality natural herb dyes, Ben Laden's variable cost would increase by $15 while its fixed costs remain the same. Ben Laden's new total cost function would be:

	TC = $5,000 + $10Q + $15Q
	TC = $5,000 + $25Q

C.	The new number of rug sales necessary to maintain current profit levels would be:

	 = (P  Q) - (AVC  Q) - TFC
	$35,000 = $50Q - $25Q - $5,000
	25Q = 40,000
	Q = 1,600
	Percentage increase in Q = = 0.6 or 60%.

	Thus, a 60% increase in rug sales would be needed to maintain current profit levels.

Elasticity of demand: Elasticity of demand refers to Price elasticity of demand. It responsiveness demand of a goods with the change in price.

Coefficient of Price Elasticity of demand = (E_d)= ( % change in demand) / (% change in price)

Value of E_d	Interpretation
E_d= 0	Perfectly inelastic demand (Demand curve is perpendicular to x-axis)
-1 < E_d < 0	Inelastic demand
E_d< -1	Elastic demand
E_d= - ∞	Perfectly elastic demand (Demand curve is parallel to x-axis)

Cross Price- Elasticity of Demand: This measures the responsiveness of the demand of a goods A to a price change of other goods B (even if price of A remains unchanged).

Coefficient of Cross Price-Elasticity of Demand of A due to price change in B is

E_A,B= (% change in demand of A) / (% change in price of B)

E_A,B< 0: If two goods A and B are complimentary goods then Coefficient of Cross Price-Elasticity of Demand will be negative. i.e. if price of one goods increases then demand of its complimentary goods falls. For example Cars and petrol are complimentary goods. If price of petrol increases then demand of car falls.

E_A,B> 0: If two goods A and B are substitutes then Coefficient of Cross Price-Elasticity of Demand is positive. i.e. if price of one goods increases then demand of its substitute increases and vice-versa. For example, Beef and Chicken are substitutes.

E_A,B=0 : Two goods A and B are independent and price change in B does not affect the demand of A.

Income elasticity of Demand: This measures the responsiveness of demand of goods to the change in income of the consumers.

Coefficient of income elasticity of demand = E_I= (% change in demand) / (% change in real income)

E_I<0 : Coefficient of income elasticity of demand is negative for inferior goods. It means if income of consumer increases then demand of inferior goods fall (as consumer would opt for better goods if they are richer).

1>E_I> 0 : Coefficient of income elasticity of demand is positive for normal goods. It means if income of consumer increases then demand of a normal goods increases.

E_I>1 : For luxury goods or superior goods, Coefficient of income elasticity of demand is greater than 1.

E_I=0 : Increase in income does not affect the demand of Sticky goods and hence Coefficient of income elasticity of demand of sticky goods is zero.

Significance of differences among the three terms

Price elasticity of demand measures responsiveness of the demand of a goods A with the change in price of A only. So when producer is interested in knowing what will be the effect of the price change on the demand of the goods they produce, they will be interested in Price elasticity of demand.

On the other hand cross-price elasticity of demand measures the responsiveness of the demand of goods with the change in price of some other goods B. It reflects how goods A’s demand depends on goods B. Cross price elasticity is useful in determining if two products are substitutes, complementary or independent and the degree of dependence of demand of one product on other.

The Income elasticity of demand does not deal with price. It measures the responsiveness of the demand with the change in income of the consumer. Income elasticity is also helpful in determining if the product is inferior goods, superior goods, sticky goods or normal goods.

Relationship between Total Revenue and Elasticity of demand:

We see in the graph that Total revenue increases as quantity demanded increases from 1 to 4. Somewhere between quantity demanded 4 and 5, Total revenue curve start declining. After that point, as quantity demanded increases, Total revenue curve declines sharply.

Now, let us calculate price elasticity of demand:

Quantity Demanded	Price	PED= (∆Q/Q)/( ∆P/P)
1	80	----
2	70	-3.5
3	60	-2
4	50	-1.25
5	40	-0.8
6	30	-0.5
7	20	-0.286
8	10	-0.125

We see that that from quantity demanded is 1 to 4, absolute value of PED is greater than 1. So this is elastic zone. In elastic zone Total Revenue increases as price decreases as percentage change in quantity demanded is higher than the percentage change in price.

Somewhere between quantity demanded 4 and 5, absolute value of PED becomes 1 which is Unit-elastic point. At this point, the percentage change in quantity is equal to the percentage change in price and hence price change does not affect the revenue.

After this point, as price decreases, absolute value of PED becomes less than 1 which is inelastic zone. In inelastic zone, total revenue decreases as price decreases as percentage change in quantity demanded is less than percentage change in price.

10. Elasticities

Essay

1. What is price elasticity of demand? Describe the three ranges of elasticity and their relationship to marginal revenue.

Problems

2. Given appropriate information, calculate the arc price, income, and cross-price elasticities of demand and identify.

3. Given appropriate information, calculate the point price, income, and cross-price elasticities of demand and identify.

Price Elasticity of Demand

When a firm is thinking about setting its price, the responsiveness of quantity demanded to price is very important. The law of demand states that if the relative price of a good rises, the quantity demanded falls. But by how much? If the amount buyers are able and willing to buy is very responsive to changes in the good’s price, then buyers will purchase much less. If it isn’t very responsive, then they will buy about the same amount—only a little bit less.

The term used in economics to refer to this responsiveness is elasticity.

Price elasticity of demand is the percent change in quantity demanded divided by the percent change in the good’s price.

There are two measures of elasticity.

Arc price elasticity of demand Ep= Q2‑Q1/P2‑P1 * P2+P1/Q2+Q1

Point Price elasticity of demand Ep = first derivative of the demand function * P/Q

Qd=65060-20P

derivative = -20

point price elasticity of demand function = -20P/Q

Suppose the price is 2753. Using the demand function, quantity is 10,000. The point price elasticity of demand is:

Ep = -20 * P/Q

= -20 * 2753/10,000

= -5.51

If you are given two prices and the associated quantities demanded, then the arc elasticity of demand can be calculated:

P Qd

500 249,500

550 248,500

Ep = (249,500 – 248,500)/(500-550) * (500+550)/(249500+248500)

= 1000/-50 * 1050/498,000

= -20 * .002108

= -.04217

If you are just given two prices and a demand function, arc elasticity of demand can still be found. First, however, you must substitute the two prices into the demand function and find the quantity demanded.

Ranges of Elasticity

Inelastic‑elasticity is less than one (in absolute value)

Inelastic means that a change in price causes a less than proportional change in quantity demanded. For example, a 1% increase in price causes a less than one percent decrease in quantity demanded.

If demand is inelastic then a higher price raises revenue even though less is sold. And a lower price means less revenue, even though more units are sold.

If demand is inelastic, then marginal revenue is negative. That means an increase in output results in lower revenue and a decrease in quantity leads to more revenue. That’s because a bit more output goes with a lower price and even though more units are sold, the lower price for each unit causes less revenue.

Elastic-elasticity is greater than one in absolute value.

Elastic means that a change in price causes a more than proportional change in quantity demanded. For example, a 1% increase in price causes a more than 1% decrease in quantity demanded.

If demand is elastic, then a higher price lowers revenue and a lower price raises revenue. Even though more is earned for each unit when the price rises, the number of units sold drops so much that revenue is less. And a lower price raises revenue because so many more units are sold even though less is made per unit.

If demand is elastic, marginal revenue is positive. A larger output is associated with more revenue and a smaller output with less revenue.

Unit Elastic - elasticity is equal to one in absolute value.

Unit elastic means that a change in price causes a proportionate change in quantity demanded. For example, a 1% increase in price leads to a 1% decrease in quantity demanded.

If demand is unit elastic, then a higher or lower price leaves revenue unchanged. An increase in price generates more revenue per unit, but the proportionate decrease in units sold leaves revenue unchanged.

If demand is unit elastic, then marginal revenue is equal to zero. If quantity increases, there are more units sold, but the lower price per unit leaves revenue unchanged.

Perfectly Inelastic

Elasticity is equal to zero. This implies that a change in price has no impact on quantity demanded. It is inconsistent with the law of demand.

Perfectly Elastic

Elasticity is infinite. An increase in price, no matter how small, causes quantity demanded to fall to zero. A decrease in price, no matter how small, causes quantity demanded to rise to infinity. While literally not possible, a small firm in a large market selling a product identical to those of its competitors might perceive itself in this position. Any increase in price above what the others’ charge will result in no sales. Lowering the price would not literally result in infinite sales, but charging less than the going price will result in more orders than can possibly be filled.

Income Elasticities

Income elasticity of demand looks at the responsiveness of demand to changes in income. It is the percent change in quantity over the percent change in income.

Arc income elasticity

Arc income elasticity of demand is calculated when given two different levels of income and the quantity demanded at each income level.

Ey= Qd2‑Qd1/y2‑y1 * y2+y1/Qd2+Qd1

Example:

Y Qd

7100 249500

7200 270000

Epy = (249500-270000)/(7100-7200) * (7100+7200)/(249500+270000)

= 5.64

Point Income Elasticity

Point income elasticity of demand is calculated when there is a demand function.

Ey = first derivative of the demand function with respect to income * y/Q

Q^d = -20,000 ‑ 20P + .5A^.5 - 50P_c +.1P_s + 5Y

derivative = 5

point income elasticity = 5y/Q (plug in the value of income and quantity demanded.)

Ey = 5*9000/10,000

= 4.5

income elasticity greater than zero--normal good

income elasticity less than zero--inferior good

income elasticity greater than one--luxury

income elasticity less than one--necessity

Generally, economists define a normal good as one with a negative income elasticity of demand. If income rises, then quantity demanded falls and that’s it. While we say that such goods are lower quality and give those sorts of example, the defining characteristic is what happens to demand when income changes.

Similarly, in income elasticity of demand is positive, then the good is normal, regardless of ones opinion about its quality.

In economics, a luxury is defined as a good with an income elasticity of demand greater than one. That means that a change in income leads to a more than proportional change in quantity demanded. If income rises, quantity demanded rises more than in proportion. If income falls, quantity demanded falls more than in proportion.

In economics, a necessity is a good with income elasticity of demand less than one (but greater than zero. Inferior goods aren’t generally considered necessities.) If income should rise, demand for a necessity rises, but less than in proportion to the increase in income. And vice versa.

Cross Price Elasticity of Demand

Cross-price elasticity demand looks at the responsiveness of the demand for a good to the price of some other good. It is the percent change in quantity of the good divided by the percent change in quantity of some other goods price. The formulas look similar to ordinary price elasticity of demand--

Arc elasticity Ep= Q2‑Q1/Po2‑Po1 * Po2+Po1/Q2+Q1

point elasticity Ep = first derivative of the demand function with respect to some other good * Po/Q

Again, this must be done using the demand function, not the simple one.

Q^d = -20,000 ‑ 20P + .5A^.5 - 50P_c +.1P_s + 5Y

Lets do P_c

derivative = -50

point cross price elasticity = -50P_c /Q (plug in the value of the other goods price and quantity demanded of the good we are working with.)

Epc = -50*6/10000

= -.03

cross price elasticity greater than zero, the goods are substitutes

cross price elasticity less than zero, the goods are complements.

Again, economists define substitute and complement according to these relationships. If the increase in another goods price leads to an increase in the demand for the good, then they are substitutes. While the rationale is that somehow people can use one good instead of another, there is no need to see some obvious way in which people might do this. While we use examples like rice crispies and corn flakes, it doesn’t have to be that obvious.

Complements are the same. If an increase in another goods price leads to a lower demand for the good, then they are complements. The idea is that the goods are somehow used together. And while we give examples like milk and cereal, no such obvious relationship is necessary—just the relationship between the price and quantity demanded.

ANSWERS TO CHECKPOINT EXERCISES

 CHECKPOINT 5.1 Price Elasticity of Demand

1a. The percentage change in price is 8 percent. The midpoint method shows the percentage is

1b. The percentage change in quantity is 4 percent. The midpoint method shows the percentage is

1c. The demand for Internet services is inelastic because the percentage change in quantity demanded is less than the percentage change in price.

1d. The demand for AOL service is more elastic than the demand for Internet service because more substitutes exist for AOL service in particular than for Internet service in general. AOL service is a more narrowly defined service.

1e. The price elasticity of demand = (4 percent) ÷ (8 percent) = 0.5.

1f. The initial total revenue is $24 a month ´ 204 million subscribers, which is $4,896 million a month. The new total revenue is $26 a month ´ 196 million subscribers, which is $5,096 million a month. So total revenue increases by $5,096 million a month - $4,896 million a month, which is $200 million a month.

1g. The price elasticity of demand is useful because it allows us to make precise predictions about how much demanders change the quantity they demand when the price changes. For instance, if the price elasticity of demand for AOL is 0.5, then AOL can determine that a 10 percent increase in the price of their service will decrease the quantity that people demand by 5 percent.

1h. The demand for Internet service is unit elastic at a price higher than $25 a month. At $25 a month, the elasticity equals 0.5. As we move up along a linear demand curve, the price elasticity of demand increases. So the demand for Internet service is unit elastic at the midpoint of the demand curve, which is at a price greater than $25 a month.

 CHECKPOINT 5.2 Price Elasticity of Supply

1a. The supply of asparagus is elastic. The percentage change in the quantity supplied is greater than the percentage change in the price.

1b. The supply of asparagus over this large price range is elastic because there is the possibility of plowing the crop under and producing nothing. Once harvested, asparagus is not very storable, which makes supply more inelastic.

1c. The percentage change in the quantity supplied of asparagus is

which is 200 percent. The percentage change in the price of asparagus is

which is 100 percent. So the price elasticity of supply = (200 percent) ÷ (100 percent) = 2.0.

1d. As time passes, the elasticity of supply increases. After all the technologically possible ways of adjusting production have been exploited, the supply of asparagus becomes extremely elastic.

2. The percentage change in the price of roses is ($40) ÷ ($60) ´ 100 = 66.7 percent. The percentage change in the quantity of roses supplied is (18 million bunches) ÷ (15 million bunches) ´ 100 = 120 percent. So the price elasticity of supply equals (120 percent) ÷ (66.7 percent), which is 1.80.

 CHECKPOINT 5.3 Cross Elasticity and Income Elasticity

1a. Cola and pizza are complements because they are goods that are consumed together. More rigorously, the cross elasticity of demand for the two is negative (when the price of a pizza falls, the quantity of cola demanded increases) which means the two are complement.

1b. The cross elasticity of demand for cola with respect to pizza equals the percentage change in the quantity of cola divided by the percentage change in the price of a pizza. The percentage change in the quantity of cola equals

which is 50 percent. The percentage change in the price of a pizza is

which is -25 percent. So the cross elasticity of demand for cola with respect to pizza is (50 percent) ÷(-25 percent), which is -2.00.

1c. Pizza and burgers are substitutes. A burger can be consumed in place of a pizza. More rigorously, the cross elasticity of demand for the two is positive (when in the price of pizza falls, the quantity of burgers demanded decreases) which means the two are substitutes.

1d. The cross elasticity of demand for burgers with respect to pizza equals the percentage change in the quantity of burgers divided by the percentage change in the price of a pizza. Part (a) shows that the percentage change in the price of pizza is -25 percent. The percentage change in the quantity of burgers is

which is -66.67 percent. So the cross elasticity of demand for burgers with respect to pizza is (–66.67 percent) ÷ (-25 percent), which is 2.67.

1e. The owner can determine how the quantities of burgers and cola he or she sells will change if the price of a nearby pizza place changes the price of its pizza.

2a. Frozen fish cakes are an inferior good because as income in Miami increases, the quantity demanded decreases. The income elasticity is negative and the negative elasticity indicates that frozen fish cakes are an inferior good.

2b. The income elasticity of demand for frozen fish cakes is (-5 percent) ÷ (10 percent) = -0.50.

2c. The income elasticity of demand for fresh fish is (15 percent) ÷(10 percent) = 1.50.

2d. The owner of a fresh fish shop can use these two elasticities to predict how sales of fresh and frozen fish change when people’s income change. For instance, if the economy in Miami goes into a recession so that people’s incomes generally fall, the owner can predict that the quantity of frozen fish demanded will increase and the quantity of fresh fish demanded will decrease. As a result, the owner can stock more frozen fish and less fresh fish.

Answers to chapter CHECKPOINT EXERCISES

1a. The price elasticity of demand is (2 percent) ¸ (20 percent), which is 0.10. (Recall that when calculating the price elasticity of demand, we use absolute values or magnitudes and ignore the minus sign.) So, the demand for home heating oil is inelastic because the percentage change in quantity demanded is less than the percentage change in price

1b. Because the demand for home heating oil is inelastic, it is likely to be a necessity.

1c. Total revenue increases as the price of home heating oil increases. When the demand for a good is inelastic, price and total revenue change in the same direction.

1d. The cross elasticity of demand for wool sweaters with respect to home heating oil is

1e. Home heating oil and sweaters are substitutes because as the price of home heating oil rises, you can stay warm by using less home heating oil and putting on a sweater. The cross elasticity of demand for a substitute is positive.

2a. The percentage change in the quantity of movie tickets demanded equals

which is 100 percent. The percentage change in the price of a movie ticket equals

which is 25 percent. So the demand for movie tickets is elastic because the percentage change in the quantity demanded is larger than the percentage change in price.

2b. Because the demand is elastic, the fall in the price of a movie ticket increases the total revenue from the sale of movie tickets. When the price is $9 a ticket, the total revenue is $9 a ticket ´ 100 tickets, which is $900. When the price is $7 a ticket, the total revenue is $7 a ticket ´ 300 tickets, which is $2,100. So the total revenue increases by $1,200.

2c. The price elasticity of demand for movie tickets is the percentage change in the quantity of movie tickets demanded divided by the percentage change in the price of a movie ticket. The percentage change in the quantity of movie tickets demanded equals

which is 100 percent. The percentage change in the price of a movie ticket equals

which is 25 percent. So the price elasticity of demand for movie tickets is 100 percent ¸ 25 percent, which is 4.00.

3. Because the price elasticity of demand for cookies is 1.5, Pete should lower the price of cookies to raise his total revenue. Because demand is elastic a decrease in the price of cookies will bring about a larger percentage increase in the quantity demanded than the percentage fall in price.

4a. Because the total revenue did not change, the percentage change in bananas demanded equals the percentage increase in price. Using the midpoint method, the percentage increase in the price equals ($1.00 ¸ $1.50) = 66.67 percent. So the quantity of bananas demanded decreased by 66.67 percent.

4b. The demand for bananas is unit elastic because the percentage increase in the price equals the percentage decrease in the quantity of bananas demanded.

5a. The percentage change in the quantity demanded of plane rides equals the price elasticity of demand for plane rides multiplied by the percentage change in the price of a plane ride, which is (0.5) ´ (10 percent) = 5 percent.

5b. The percentage change in the quantity demanded of train rides equals the cross elasticity of demand for train rides with respect to the price of a plane ride multiplied by the percentage change in the price of a plane ride, which is (0.4) ´ (10 percent) = 4 percent.

5c. The percentage change in the quantity demanded of train rides equals the price elasticity of demand for train rides multiplied by the percentage change in the price of a train ride, which is (0.2) ´ (10 percent) = 2 percent.

5d. From the answer to part (b), when the price of a plane ride rises 10 percent, the quantity of train rides demanded increases 4 percent. The price rise of a train ride necessary to decrease the quantity demanded by 4 percent is 20 percent because a 20 percent increase in the price of train ride decreases the quantity demanded by (0.2) ´ (20 percent) = 4 percent.

5e. In part (d), the change in the price of a plane ride leads to a movement along the demand curve for plane rides and a shift in the demand curve for train rides.

6a. The demand for club memberships increases with income, so club membership is a normal good. Because the percentage change in the quantity of club memberships demanded increased by more than the percentage change in income, the demand for club memberships is income elastic.

6b. The demand for spring water increases with income, so it is a normal good. Because the percentage change in the quantity of spring water demanded increased by less than the percentage change in income, the demand for spring water is income inelastic.

6c. The demand for soft drinks decreases with income, so it is an inferior good.

6d. The demand for club memberships is income elastic and equals 15 percent ¸ 10 percent, which is 1.5. The demand for spring water is income inelastic and equals 5 percent ¸ 10 percent, which is 0.5.

6e. Club memberships and spring water are normal goods. Soft drinks are an inferior good.

7a. The price elasticity of demand for bus rides is inelastic because the price elasticity of demand is less than 1.0. When the elasticity is less than 1.0, an increase in the price of a bus fare brings about a percentage decrease in the quantity of bus rides demanded that is smaller than the percentage increase in price.

7b. An increase in the price of bus fares increases the bus company’s total revenue. Because the demand is inelastic, an increase in the price of the fare leads to a smaller percentage decrease in the quantity of bus rides demanded than the percentage increase in the fare. As a result, total revenue increases.

7c. Bus rides and gasoline are substitutes. As the price of gasoline increases, it becomes more expensive to drive your car and you might decide to take a bus to work. The cross elasticity of demand between bus rides and gasoline is positive, indicating that the two are substitutes.

7d. The cross elasticity of demand for bus rides with respect to gasoline is 0.2, so bus rides increase by (10 percent) ´ (0.2), which is 2 percent.

7e. The income elasticity of demand is -0.1, so bus rides decrease by (-0.1) ´ (5 percent), which is -0.5 percent.

7f. In Pioneer Ville, a bus ride is an inferior good because the income elasticity of demand is negative. As income increases, fewer bus rides are demanded.

7g. In Pioneer Ville, bus rides and gasoline are substitutes because the cross elasticity of demand is positive. As the price of gas increases, the quantity of bus rides demanded increases.

8. Your expenditure on haircuts and food will more than double because the income elasticity of demand for both exceeds 1.0. Only if the income elasticity of demand equals 1.0 will the expenditure on a good or service change proportionally with income.

9a. Rearranging the price elasticity of demand formula shows that the percentage change in the price of wheat equals the percentage change in the quantity demanded divided by the price elasticity of demand. So the percentage change in the price of wheat is (2 percent) ¸ (0.5), which is 4 percent.

9b. The estimated price elasticity of demand for pasta is equal to the percentage change in the quantity demanded of pasta divided by the estimated change in the price of pasta. So the estimated price elasticity of demand for pasta is (8 percent) ¸ (25 percent), which is 0.32.

9c. The estimated cross elasticity of demand for pasta sauce with respect to the price of pasta is equal to the percentage change in the quantity demanded of pasta sauce divided by the estimated change in the price of pasta. So the estimated cross elasticity of demand for pasta sauce with respect to the price of pasta is -(5 percent) ¸ (25 percent), which is -0.2.

10. Probably most students would continue to buy about the same number of textbooks if the price of textbooks rose. So, the total expenditure on textbooks would increase. In this case, the student’s demand for textbooks is inelastic.

chapter SIX

elasticity, consumer surplus, and Producer Surplus

CHAPTER OVERVIEW

This chapter is the first of the chapters in Part Two, “Microeconomics of Product Markets.” Students will benefit by reviewing Chapter 3’s demand and supply analysis prior to reading this chapter.

Both the elasticity coefficient and the total revenue test for measuring price elasticity of demand are presented in the chapter The chapter reviews a number of applications and presents empirical estimates for a variety of products. Cross- and income elasticities of demand and price elasticity of supply are also addressed. Finally, this chapter introduces consumer and producer surplus, as well as efficiency (deadweight) loss.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to:

1. Define demand and supply and state the laws of demand and supply (review from Chapter 3).

2. Determine equilibrium price and quantity from supply and demand graphs and schedules (from Chapter 3).

3. Define price elasticity of demand and compute the coefficient of elasticity given appropriate data on prices and quantities.

4. Explain the meaning of elastic, inelastic, and unitary price elasticity of demand.

5. Recognize graphs of perfectly elastic and perfectly inelastic demand.

6. Use the total‑revenue test to determine whether elasticity of demand is elastic, inelastic, or unitary.

7. List four major determinants of price elasticity of demand.

8. Explain how a change in each of the determinants of price elasticity would affect the elasticity coefficient.

9. Define price elasticity of supply and explain how the producer’s ability to shift resources to alternative uses and time affect price elasticity of supply.

10. Explain cross elasticity of demand and how it is used to determine substitute or complementary products.

11. Define income elasticity and its relationship to normal and inferior goods.

12. Define, measure, and graphically identify consumer surplus.

13. Define, measure, and graphically identify producer surplus.

14. Identify and explain efficiency (or deadweight) losses using consumer and producer surplus.

15. Define and identify the terms and concepts listed at end of the chapter.

LECTURE NOTES

I. Introduction

A. Learning objectives – In this chapter students will learn:

1. About price elasticity of demand and how it can be applied.

2. The usefulness of the total revenue test for price elasticity of demand.

3. About price elasticity of supply and how it can be applied.

4. About cross elasticity of demand and income elasticity of demand.

5. About consumer surplus, producer surplus, and efficiency (deadweight) loss.

B. Elasticity of demand measures how much the quantity demanded changes with a given change in price of the item, change in consumers’ income, or change in price of related product.

C. Price elasticity is a concept that also relates to supply.

D. The chapter explores both elasticity of supply and demand and applications of the concept.

II. Price Elasticity of Demand

A. Law of demand tells us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more.

B. The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand.

1. If consumers are relatively responsive to price changes, demand is said to be elastic.

2. If consumers are relatively unresponsive to price changes, demand is said to be inelastic.

3. Note that with both elastic and inelastic demand, consumers behave according to the law of demand; that is, they are responsive to price changes. The terms elastic or inelastic describe the degree of responsiveness. A precise definition of what we mean by “responsive” or “unresponsive” follows.

4. CONSIDER THIS … A Bit of a Stretch

The Ace bandage stretches a lot when force is applied (elastic); the rubber tie-down (not to be confused with a rubber band) moves stretches little when force is applied (inelastic).

C. Price elasticity coefficient and formula:

Quantitative measure of elasticity, Ed = percentage change in quantity/ percentage change in price.

1. Using two price-quantity combinations of a demand schedule, calculate the percentage change in quantity by dividing the absolute change in quantity by one of the two original quantities. Then calculate the percentage change in price by dividing the absolute change in price by one of the two original prices.

2. Estimate the elasticity of this region of the demand schedule by comparing the percentage change in quantity and the percentage change in price. Do not use the ratio formula at this time. Emphasize that it is the two percentage changes that are being compared when determining elasticity.

3. Show that if the other original quantity and price were used as the denominator that the percentage changes would be different. Explain that a way to deal with this problem is to use the average of the two quantities and the average of the two prices.

4. Using averages – the midpoint formula

a. Using traditional calculations, the measured elasticity over a given range of prices is sensitive to whether one starts at the higher price and goes down, or the lower price and goes up. The midpoint formula calculates the average elasticity over a range of prices to alleviate that problem.

b. The midpoint formula for elasticity is:

Ed = [(change in Q)/(sum of Q’s/2)] divided by [(change in P)/(sum of P’s/2)]

c. Have the students calculate each of the percentage changes separately to determine whether the demand is elastic or inelastic. After the students have determined the type of elasticity, then have them insert the percentage changes into the formula.

d. Students should practice the exercise in Table 6.1. (Key Question 2)

5. Emphasis: The percentages changes are compared, not the absolute changes.

a. Absolute changes depend on choice of units. For example, a change in the price of a $10,000 car by $1 and is very different than a change in the price a of $1 can of beer by $1. The auto’s price is rising by a fraction of a percent while the beer rice is rising 100 percent.

b. Percentages also make it possible to compare elasticities of demand for different products.

6. Because of the inverse relationship between price and quantity demanded, the actual elasticity of demand will be a negative number. However, we ignore the minus sign and use absolute value of both percentage changes.

7. If the coefficient of elasticity of demand is a number greater than one, we say demand is elastic; if the coefficient is less than one, we say demand is inelastic. In other words, the quantity demanded is “relatively responsive” when Ed is greater than 1 and “relatively unresponsive” when Ed is less than 1. A special case is if the coefficient equals one; this is called unit elasticity.

8. Note: Inelastic demand does not mean that consumers are completely unresponsive. This extreme situation called perfectly inelastic demand would be very rare, and the demand curve would be vertical.

9. Likewise, elastic demand does not mean consumers are completely responsive to a price change. This extreme situation, in which a small price reduction would cause buyers to increase their purchases from zero to all that it is possible to obtain, is perfectly elastic demand, and the demand curve would be horizontal.

D. Graphical analysis:

1. Illustrate graphically perfectly elastic, relatively elastic, unitary elastic, relative inelastic, and perfectly inelastic. (Figures 6.1 and 6.2)

2. Using Figure 6.2, explain that elasticity varies over range of prices.

a. Demand is more elastic in upper left portion of curve (because price is higher, quantity smaller).

b. Demand is more inelastic in lower right portion of curve (because price is lower, quantity larger).

3. It is impossible to judge elasticity of a single demand curve by its flatness or steepness, since demand elasticity can measure both elastic and inelastic at different points on the same demand curve.

E. Total-revenue test is the easiest way to judge whether demand is elastic or inelastic. This test can be used in place of elasticity formula, unless there is a need to determine the elasticity coefficient.

1. Elastic demand and the total-revenue test: Demand is elastic if a decrease in price results in a rise in total revenue, or if an increase in price results in a decline in total revenue. (Price and revenue move in opposite directions).

2. Inelastic demand and the total-revenue test: Demand is inelastic if a decrease in price results in a fall in total revenue, or an increase in price results in a rise in total revenue. (Price and revenue move in same direction).

3. Unit elasticity and the total-revenue test: Demand has unit elasticity if total revenue does not change when the price changes.

4. The graphical representation of the relationship between total revenue and price elasticity is shown in Figure 6.2.

5. Table 6.2 provides a summary of the rules and concepts related to elasticity of demand.

F. There are several determinants of the price elasticity of demand.

1. Substitutes for the product: Generally, the more substitutes, the more elastic the demand.

2. The proportion of price relative to income: Generally, the larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in price more.

3. Whether the product is a luxury or a necessity: Generally, the less necessary the item, the more elastic the demand.

4. The amount of time involved: Generally, the longer the time period involved, the more elastic the demand becomes.

G. Table 6.3 presents some real‑world price elasticities. Use the determinants discussed to see if the actual elasticities are equivalent to what one would predict.

H. There are many practical applications of the price elasticity of demand.

1. Inelastic demand for agricultural products helps to explain why bumper crops depress the prices and total revenues for farmers.

2. Governments look at elasticity of demand when levying excise taxes. Excise taxes on products with inelastic demand will raise the most revenue and have the least impact on quantity demanded for those products.

3. Demand for cocaine is highly inelastic and presents problems for law enforcement. Stricter enforcement reduces supply, raises prices and revenues for sellers, and provides more incentives for sellers to remain in business. Crime may also increase as buyers have to find more money to buy their drugs.

a. Opponents of legalization think that occasional users or “dabblers” have a more elastic demand and would increase their use at lower, legal prices.

b. Removal of the legal prohibitions might make drug use more socially acceptable and shift demand to the right.

III. Price Elasticity of Supply

A. The concept of price elasticity also applies to supply. The elasticity formula is the same as that for demand, but we must substitute the word “supplied” for the word “demanded” everywhere in the formula.

Es = percentage change in quantity supplied / percentage change in price

As with price elasticity of demand, the midpoints formula is more accurate.

B. The ease of shifting resources between alternative uses is very important in price elasticity of supply because it will determine how much flexibility a producer has to adjust his/her output to a change in the price. The degree of flexibility, and therefore the time period, will be different in different industries. (Figure 6.4)

1. The market period is so short that elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical. In this situation, it is virtually impossible for producers to adjust their resources and change the quantity supplied. (Think of adjustments on a farm once the crop has been planted.)

2. The short‑run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price change. Industrial producers are able to make some output changes by having workers work overtime or by bringing on an extra shift.

3. The long‑run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changed more relative to a small change in price, as in Figure 6.4c. The producer has time to build a new plant.

C. Applications of the price elasticity of supply.

1. Antiques and other non-reproducible commodities are inelastic in supply, sometimes the supply is perfectly inelastic. This makes their prices highly susceptible to fluctuations in demand.

2. Gold prices are volatile because the supply of gold is highly inelastic, and unstable demand resulting from speculation causes prices to fluctuate significantly.

IV. Cross elasticity and income elasticity of demand:

A. Cross elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded for another product. Numerically, the formula is shown for products X and Y.

Exy = (percentage change in quantity of X) / (percentage change in price of Y)

1. If cross elasticity is positive, then X and Y are substitutes.

2. If cross elasticity is negative, then X and Y are complements.

3. Note: if cross elasticity is zero, then X and Y are unrelated, independent products.

B. Income elasticity of demand refers to the percentage change in quantity demanded that results from some percentage change in consumer incomes.

Ei = (percentage change in quantity demanded) / (percentage change in income)

1. A positive income elasticity indicates a normal or superior good.

2. A negative income elasticity indicates an inferior good.

3. Those industries that are income elastic will expand at a higher rate as the economy grows.

V. Consumer and Producer Surplus

A. Consumer Surplus

1. Definition – the difference between the maximum price a consumer is (or consumers are) willing to pay for a product and the actual price.

2. The surplus, measurable in dollar terms, reflects the extra utility gained from paying a lower price than what is required to obtain the good.

3. Consumer surplus can be measured by calculating the difference between the maximum willingness to pay and the actual price for each consumer, and then summing those differences.

4. Consumer surplus is measured and represented graphically by the area under the demand curve and above the equilibrium price. (Figure 6.5)

5. Consumer surplus and price are inversely related – all else equal, a higher price reduces consumer surplus.

B. Producer Surplus

1. Definition – the difference between the actual price a producer receives (or producers receive) and the minimum acceptable price.

2. Producer surplus can be measured by calculating the difference between the minimum acceptable price and the actual price for each unit sold, and then summing those differences.

3. Producer surplus is measured and represented graphically by the area above the supply curve and below the equilibrium price. (Figure 6.6)

4. Producer surplus and price are directly related – all else equal, a higher price increases producer surplus.

VI. Efficiency Revisited and Efficiency Losses

A. Efficiency is attained at equilibrium, where the combined consumer and producer surplus is maximized. (Figure 6.7)

1. Consumers receive utility up to their maximum willingness to pay, but only have to pay the equilibrium price.

2. Producers receive the equilibrium price for each unit, but it only costs the minimum acceptable price to produce.

3. Allocative efficiency occurs at quantity levels where three conditions exist:

a. MB = MC

b. Maximum willingness to pay = minimum acceptable price.

c. Combined consumer and producer surplus is at a maximum.

B. Efficiency (Deadweight) Losses

1. Underproduction reduces both consumer and producer surplus, and efficiency is lost because both buyers and sellers would be willing to exchange a higher quantity.

2. Overproduction causes inefficiency because past the equilibrium quantity, it costs society more to produce the good than it is worth to the consumer in terms of willingness to pay.

Price Elasticity of Supply

Definition of price elasticity of supply

Price elasticity of supply measures the relationship between change in quantity supplied and a change in price.

If supply is elastic, producers can increase output without a rise in cost or a time delay
If supply is inelastic, firms find it hard to change production in a given time period.

The formula for price elasticity of supply is:

% change in quantity supplied

% change in price

When Pes > 1, then supply is price elastic
When Pes < 1, then supply is price inelastic
When Pes = 0, supply is perfectly inelastic
When Pes = infinity, supply is perfectly elastic following a change in demand

Factors that Affect Price Elasticity of Supply

(1) Spare production capacity

If there is plenty of spare capacity then a business should be able to increase its output without a rise in costs and therefore supply will be elastic in response to a change in demand. The supply of goods and services is often most elastic in a recession, when there is plenty of spare labour and capital resources available to step up output as the economy recovers.

(2) Stocks of finished products and components

If stocks of raw materials and finished products are at a high level then a firm is able to respond to a change in demand quickly by supplying these stocks onto the market - supply will be elastic. Conversely when stocks are low, dwindling supplies force prices higher and unless stocks can be replenished, supply will be inelastic in response to a change in demand.

(3) The ease and cost of factor substitution

If both capital and labour resources are occupationally mobile then the elasticity of supply for a product is higher than if capital and labour cannot easily and quickly be switched

(4) Time period involved in the production process

Supply is more price elastic the longer the time period that a firm is allowed to adjust its production levels. In some agricultural markets for example, the momentary supply is fixed and is determined mainly by planting decisions made months before, and also climatic conditions, which affect the overall production yield.

An empty restaurant – plenty of spare capacity to meet any rise in demand!	When telecommunications networks get congested at peak times, the elasticity of supply to meet rising demand may be low
Stocks in a warehouse – businesses with plentiful stocks can supply quickly and easily onto the market when demand changes	For many agricultural products there are time lags in the production process which means that elasticity of supply is very low in the immediate or momentary time period

Supply curves with different price elasticity of supply

The non-linear supply curve

A non linear supply curve has a changing price elasticity of supply throughout its length. This is illustrated in the diagram below.

Useful applications of price elasticity of demand and supply

Elasticity of demand and supply is tested in virtually every area of the AS economics syllabus. The key is to understand the various factors that determine the responsiveness of consumers and producers to changes in price. The elasticity will affect the ways in which price and output will change in a market. And elasticity is also significant in determining some of the effects of changes in government policy when the state chooses to intervene in the price mechanism.

Some relevant issues that directly use elasticity of demand and supply include:

Taxation: The effects of indirect taxes and subsidies on the level of demand and output in a market e.g. the effectiveness of the congestion charge in reducing road congestion; or the impact of higher duties on cigarettes on the demand for tobacco and associated externality effects
Changes in the exchange rate: The impact of changes in the exchange rate on the demand for exports and imports
Exploiting monopoly power in a market: The extent to which a firm or firms with monopoly power can raise prices in markets to extract consumer surplus and turn it into extra profit (producer surplus)
Government intervention in the market: The effects of the government introducing a minimum price (price floor) or maximum price (price ceiling) into a market

Elasticity of demand and supply also affects the operation of the price mechanism as a means of rationing scarce goods and services among competing uses and in determining how producers respond to the incentive of a higher market price.

Chapter

4	ELASTICITY

Outline

I. Price Elasticity of Demand

A. Figure 4.1 shows how the demand curve influences the price and quantity responses that result from a given change in supply. The figure highlights the need for a measure of the responsiveness of the quantity demanded to a price change.

B. The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buyers’ plans remain the same.

C. Calculating Elasticity

1. The price elasticity of demand is equal to

2. To calculate the price elasticity of demand, we express the change in price as a percentage of the average price—the midpoint between the initial and new price.

3. Similarly we express the change in the quantity demanded as a percentage of the average quantity demanded—the average of the initial and new quantity.

4. Figure 4.2 shows what is needed to calculate the price elasticity of demand for pizza: The percentage change in quantity demanded is %Q, and the percentage change in price is %P. We calculate %Q as Q/Qave and we calculate %P as P/Pave so we calculate the price elasticity of demand as (Q/Qave)/(P/Pave).

a) By using the average price and average quantity, the elasticity is the same value whether the price rises or falls.

b) The ratio of two proportionate changes is the same as the ratio of two percentage changes. The measure is “units-free” because it is a ratio of two percentage changes and the percentages cancel out. Changing the units of measurement of price or quantity leave the value of the elasticity the same.

c) The demand elasticity formula yields a negative value, because price and quantity move in opposite directions. However, it is the magnitude, or absolute value, of the measure that reveals how responsive the quantity change has been to a price change. So we use the magnitude or the absolute value of the price elasticity of demand.

D. Inelastic and Elastic Demand

Demand can be inelastic, unit elastic, or elastic, and can range from zero to infinity.

1. If the quantity demanded doesn’t change when the price changes, the price elasticity of demand is zero and demand is perfectly inelastic. The demand curve is vertical. Figure 4.3a illustrates this case.

2. If the percentage change in the quantity demanded equals the percentage change in price, the value of the price elasticity of demand equals 1 and demand is unit elastic. Figure 4.3b illustrates this case—a demand curve with ever declining slope. (Note that a unit elastic demand curve is not linear.)

3. Between the two previous cases, the percentage change in the quantity demanded is smaller than the percentage change in price so that the value of the price elasticity of demand is less than 1 and demand is inelastic.

4. If the percentage change in the quantity demanded is infinitely large when the price barely changes, the value of the price elasticity of demand is infinite and demand is perfectly elastic. The demand curve is horizontal. Figure 4.3c illustrates this case.

5. If the percentage change in the quantity demanded is greater than the percentage change in price, the value of the price elasticity of demand is greater than 1 and demand is elastic.

E. Elasticity Along a Straight-Line Demand Curve

1. While moving along a linear demand curve, the demand becomes less elastic as the price falls. Figure 4.4 illustrates this fact.

2. Demand is unit elastic at the mid-point of the demand curve.

E. Total Revenue and Elasticity

1. The total revenue from the sale of good equals the price of the good multiplied by the quantity sold.

2. The change in total revenue from a change in price depends upon the elasticity of demand:

a) If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent, and total revenue increases.

b) If demand is inelastic, a 1 percent price cut decreases the quantity sold by more than 1 percent, and total revenue decreases.

c) If demand is unitary elastic, a 1 percent price cut increases the quantity sold by 1 percent, and total revenue remains unchanged.

3. The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from a price change (when all other influences on the quantity demanded remain unchanged).

a) If a price cut increases total revenue, then demand is elastic.

b) If a price cut decreases total revenue, then demand is inelastic.

c) If a price cut leaves total revenue unchanged, then demand is unitary elastic.

4. Figure 4.5 shows the relationship between elasticity of demand for pizzas and the total revenues from pizza sales across the entire demand curve for pizza.

F. The Factors That Influence the Elasticity of Demand

The magnitude of the elasticity of demand depends on three factors:

1. The closeness of substitutes:

a) The closer the substitutes for a good or service, the more elastic the demand for it.

b) Necessities, such as food or housing, generally have inelastic demand.

c) Luxuries, such as exotic vacations, generally have elastic demand.

2. The proportion of income spent on the good.

a) The greater the proportion of income consumers spend on a good, the larger is the demand elasticity for that good.

b) Figure 4.6 shows the proportion of income spent on food in different countries. This table shows how the magnitude of the price elasticity of demand for food rises as the fraction of income spent on food increases.

3. The time elapsed since a price change.

a) The more time consumers have to adjust to a price change the more elastic the demand for that good.

II. More Elasticities of Demand

A. Cross Elasticity of Demand

1. The cross elasticity of demand is a measure of the responsiveness of demand for a good to a change in the price of a substitute or a compliment, other things remaining the same.

2. The formula for the cross elasticity of demand is:

a) The cross elasticity of demand for a substitute is positive. Figure 4.7 shows the increase in the quantity of pizza demanded when the price of hamburger (a substitute for pizza) rises.

b) The cross elasticity of demand for a complement is negative. Figure 4.7 shows the decrease in the quantity of pizza demanded when the price of a soft drink (a complement of pizza) rises.

B. Income Elasticity of Demand

1. The income elasticity of demand measures the responsiveness of the demand for a good or service to a change in income, other things remaining the same.

2. The formula for the income elasticity of demand is:

a) If the income elasticity of demand is greater than 1, demand is income elastic and the good is a normal good.

b) If the income elasticity of demand is positive but less than 1, demand is income inelastic and the good is a normal good.

c) If the income elasticity of demand is negative the good is an inferior good.

3. Table 4.2 shows estimates of income elasticity of demand for various goods and services.

4. Figure 4.8 shows estimates of the income elasticity for food in different countries. In countries with high average incomes per person, the size of the income elasticity of demand for food is smaller.

III. Elasticity of Supply

A. Figure 4.9 shows how the supply curve influences the price and quantity responses that result from a given change in demand and highlights the need for a measure of the responsiveness of the quantity supplied to a price change.

B. The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain the same.

C. Calculating the Elasticity of Supply

1. The formula for the elasticity of supply is:

2. Figure 4.10 shows three cases of the elasticity of supply.

a) Supply is perfectly inelastic if the elasticity of supply equals 0. In this case, as Figure 4.10a shows, the supply curve is vertical.

b) Supply is unit elastic if the elasticity of supply equals 1. In this case, as Figure 4.10b shows, the supply curve is linear and passes through the origin. The slope of the supply curve is irrelevant.

c) Supply is perfectly elastic if the elasticity of supply is infinite. In this case, as Figure 4.10c shows, the supply curve is horizontal.

D. The Factors That Influence the Elasticity of Supply

The elasticity of supply depends on

1. Resource substitution possibilities: The easier it is to substitute among the resources used to produce a good or service, the greater is its elasticity of supply.

2. The time frame for supply decisions: The more time that passes after a price change, the greater is the elasticity of supply.

E. Table 4.3 provides a glossary of the all elasticity measures.

Nice Information In 24

Friday, December 20, 2013

Principles of Economics and Bangladesh Economy for IBB Exam

Definition of 'Economic Growth'

Investopedia explains 'Economic Growth'

Arc price elasticity of demand Ep= Q2‑Q1/P2‑P1 * P2+P1/Q2+Q1

Point Price elasticity of demand Ep = first derivative of the demand function * P/Q

Ranges of Elasticity

Perfectly Inelastic

Perfectly Elastic

Point Income Elasticity

Cross Price Elasticity of Demand

CHAPTER OVERVIEW

INSTRUCTIONAL OBJECTIVES

LECTURE NOTES

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