3) topic 2 welfare & elasticity 1

Econ 1194
Prices and Markets

Topic 2: Introduction to Welfare and Elasticity

Topic 2 - Contents
1. Consumer Surplus and Producer Surplus

2. Elasticity of Demand
- measurement
- determinants
- elasticity and total revenue

3. Elasticity of Supply

4. Other Demand Elasticities
- Cross price elaticity
- Income elasticity

RMIT University Vietnam Price and Markets 2

1. Demand and Marginal Benefit
"By a process of voluntary exchange, resources are shifted to those uses in which the
value to consumers, as measured by their willingness to pay, is highest. When
resources are being used where their value is highest, we may say that they are being
employed (thuê) efficiently.” (Richard Posner, Law and Economics, p.10)

• Marginal benefit is the additional benefit (happiness) received when
consuming an additional unit

Quantity Total Marginal Willingness
Benefit Benefit to pay
1 10 10 10
2 18 8 8
3 23 5 5
…

• The maximum willingness to pay for an additional unit must equal to the
additional benefit that unit brings. Hence D = MB.

RMIT University©25/02/13 RMIT International University Vietnam 3

1.1 Consumer Surplus

• Consumer surplus is the difference between what the consumers
are willing to pay (shown on the demand curve) and what they actually
pay (the market price)

• In other words, consumer surplus is the area between the Demand
curve and the Price line

• It measures : how much the consumer gains from buying goods in the
market, therefore can be interpreted as the welfare of the buyers


Total consumer surplus in the market for
Consumer surplus…
Chocolate
Price
(dollars /bar)
Total consumer
surplus in the
market for
chocolate

$2.00

Demand
0
15 Q (bars/week)


1. Consumer Surplus

• Remember the D = MB
• Total benefit to consumers,
TB = sum of MB = areas (1) + (2) = obcd

• Total cost to consumers (= total consumer expenditure)
TC = area (2)
• Net benefit to consumers,
NB = TB - TC
= consumer surplus = CS
= area (1)


1. Consumer Surplus
• Consumer Surplus is the difference between what a consumer is willing to
pay for a good (as shown by the demand curve) and what they actually pay
when buying it (the market price).

http://www.youtube.com/watch?v=FRPQlbRaAok


1.2 Producer surplus
• The difference between the market price and the minimum
price that would be required to induce the producers to
supply the good (as shown on the supply curve)

• Producer surplus is the area between the Price line and the
Supply curve

• It measures how much the producer gains from selling
goods in the market, hence can be interpreted as the
welfare of the producers

Total producer surplus in the market for
Chocolate
Price Total producer
(dollars/bar) surplus from
selling chocolate Supply

$2.00

0
15 Q (bars/week)


1.2 Producer Surplus
.


1.2 Producer Surplus
• Competitive supply price measures the opportunity cost of each marginal unit
(i.e. the marginal cost MC).
• Supply = MC
• Total revenue to producers,
TR = P x Q
=areas (2a) + (2b) = area (2)
• Total cost to producers,
TC =opportunity cost of resources
=sum of MC
=area (2b)
• Net revenue to producers,
NR =TR - TC
=producer surplus = PS = area (2a)


1.3 CS and PS – Economic efficiency

• CS and PS are an important tool for measuring the
performance of an economic system

• or for assessing the impact of alternative
government policies in that system.

P
CS and PS – Economic efficiency

S

CS
Pm

Producer
PS
Surplus

D

O Qm Q
fig Copyright 2001 Pearson Education Australia

P
Deadweight loss:
area A + B S

CS

A
Pm
B
Producer
PS
Surplus

D

O Too little Q

P

S

CS
C Negative PS &
Negative CS:
Pm area C + D
D
Producer
PS
Surplus

D

O Too much Q

P

S

CS
Pm

Producer
PS
Surplus

D

O Efficient Q

2. Elasticity of Demand
• This measures the responsiveness of quantity demanded of a good to a change
in one of the determinants of demand for that good (assuming all other
determinants remain constant).

• Point Elasticity

• Arc Elasticity (or midpoint formula)

• which rearranged becomes


Types of Elasticity of Demand

Elasticity of
Demand

Price Income Cross Price
Elasticity Elasticity Elasticity

Rizwan Khan

2.1 Own Price Elasticity
• This measures the responsiveness of quantity demanded
of a particular good to a change in the price of that good
(ie, its own price).


2.1 Own Price Elasticity of Demand - An
Example

• This means that for a 1% increase (decrease) in price, quantity demanded
has decreased (increased) by 1.36%.


2.1 Summary of own price elasticity


2.2 Own Price elasticity – its
determinants
• Number and closeness of substitutes
• Luxuries vs. Necessities
• Proportion of income spent on the product
• Time period after a price change
• Non-functional factors
–bandwagon effect etc.

Elasticity changes along the demand curve
Price
(dollars/bar)

$18

$15

$8

$5
D
0
3 4 6 7 Q (bars / month


2.3 Elasticity and Total Revenue
Effect of a price change on total revenue


Why?
TR = P X Q
If elastic… A decrease in the price by 1 % will result in an increase in
demand by more than 1%.
So

TR = P X Q

If inelastic… A decrease in the price by 1 % will result in an increase in
demand by less than 1%.
So

TR = P X Q


2.3 Elasticity & Total Revenue

Summary:
• If demand is elastic, a change in Price will cause
elastic
Total Revenue to change in the opposite
direction.
direction

• If demand is inelastic, a change in price will
inelastic
cause total revenue to change in the same
direction.

3. Price Elasticity of Supply

• The responsiveness of quantity supplied to a
change in price of a product.

% change in quantity
supplied of product X
Es=
% change in
the price of product X

•The elasticity of supply will be greater the longer the time
period under consideration.

4.1 Cross Price Elasticity of Demand
(between commodities X and Y)


(example 1)

• This means that for a 1% increase (decrease) in the price of
bananas, the quantity of apples demanded has increased
(decreased) by 0.7%. Bananas and apples are substitute goods.


(example 2)

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


4.1 Cross Elasticity of Demand in Practice

Some Problems with the use of Cross Elasticity of Demand
in Practice
•There is no absolute standard for judging what is a ‘high’
or a ‘low’ elasticity of demand
•Cross elasticity of demand can change over time
•Not enough cross elasticity data are available to make it
generally applicable.


4.2 Income Elasticity

.


4.2 Income Elasticity of Demand (example)

• This means that for a 1% increase (decrease) in average weekly earnings,
the quantity demanded of new cars increased (decreased) by 0.84%.


Summary:
Own price, Cross price and Income elasticity


.

Next Lecture:

Applications of
Demand and Supply


3) topic 2 welfare & elasticity 1

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