# The Concept of Elasticity and Consumer and Producer Surplus

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```					    The Concept of Elasticity and
Consumer and Producer Surplus

“If you put the federal government in
charge of the Sahara Desert, in five
years there'd be a shortage of sand.”
Milton Friedman
Nobel Laureate, Economics
(1912 – 2006)

   CHAPTER THREE
The Concept of Elasticity

In this chapter:
Elasticity
Price
Income
Extremes

Market Failure and Provision of Public Goods

Government Failure: Theory of Public Choice
• Limits of Majority Voting
Elasticity of Demand

 Law of Demand says when price goes up (down),
people respond by buying less (more).
 But HOW MUCH LESS? (or more)
 Price elasticity of demand is a measure of how
responsive consumers are to price changes.
 Percent change in quantity demanded for every
one percent change in price.

%Δ Qty
ED = %Δ Price
Elastic vs. Inelastic Demand

   If ED > 1, demand is elastic.
 Consumer response is  large relative to the change in price.
 Ex., when the price of a Kindle e-reader goes up, the quantity
demanded of the Kindle will fall by MORE (a larger percentage).

   If ED < 1, demand is inelastic.
 Consumers are  not very responsive to price changes.
 Ex., when the price of toothpaste goes up, the quantity
demanded of toothpaste will fall by LESS (a smaller percentage).

  If ED = 1, demand is unit elastic
1-4    Consumer response is equal to price changes.
Elasticity Examples
Inelastic Goods                      Price Elasticity
Eggs                                 0.06
Food                                 0.21
Health Care Services                 0.18
Gasoline (short-run)                 0.08
Gasoline (long-run)                  0.24
Highway and Bridge Tolls             0.10
Unit Elastic Good (or close to it)
Shellfish                            0.89
Cars                                 1.14
Elastic Goods
Luxury Car                           3.70
Foreign Air Travel                   1.77
Restaurant Meals                     2.27
Determinants of Elasticity

     Necessities vs. Luxuries
   Demand for necessities is relatively inelastic.
   Demand for luxury goods is relatively elastic.

     Availability of Substitutes
   The more alternatives you have the less likely you are
to pay high prices for a good and the more likely you
are to settle for something that will do.
   The greater the availability of substitutes, the greater
the elasticity of demand.

1-6
Determinants of Elasticity

    Time
o The longer you have to come up with alternatives to
paying high prices the more likely it is you will shift to
those alternatives.
o Consumers can adjust easier to price changes in long run
than in short run.
o Long run price elasticity of demand is higher than short
run.

1-7
Determinants of Elasticity

   Relative price to income
   The greater the portion of the budget an item takes up,
the greater the elasticity is likely to be.
   The higher the price in relation to a consumer’s income,
the higher the elasticity of demand.

1-8
Extremes of Elasticity

A horizontal demand curve
= perfectly elastic demand.                       Perfectly elastic (E = )
    Any price increase would
cause demand to fall to             p2
zero

Price
 If  price increases, people

EXAMPLES?
0              q1
Quantity
1-9
Extremes of Elasticity

A vertical demand curve
= perfectly inelastic demand.                     Perfectly inelastic (E = 0)
  Quantity demanded will
not change regardless of
p2
the price change.
 People will buy the same

Price
amount no matter the
p1
price.

EXAMPLES?
0               q1
1-10                                                      Quantity
Market Failure & Provision of Public Goods

 The JOB of the market is to use demand and supply
to find perfectly efficient output.

 Sometimes, for a variety of reasons, the market
mechanism cannot provide the efficient output – this
is market failure.

 When market failure occurs, intervention from the
government may be required.
Market Failure & Provision of Public Goods

 Market failure can occur because some goods are not
well suited to being provided in private markets.

 Goods are categorized based on two characteristics:
   Exclusivity - the degree to which the consumption of the
good can be restricted by a seller to only those who pay
for it.

   Rivalry - the degree to which one person’s consumption
reduces the value of the good for the next consumer.
Market Failure & Provision of Public Goods

Public goods
 Sometimes cannot exclude non-paying consumers.
 Subject to free-rider problem.
 Why should I pay if you can get the same thing without
paying? When I learn that, I’ll quit paying too.
 The private free market will not provide this good because
they cannot make a profit.
 Government will have to provide the good.
 Examples of public goods: national defense, hurricane
warning, police protection, flood-prevention dams, public
TV (until last year)
Market Failure & Provision of Public Goods

Type of Good      Exclusivity   Rivalry Example
Purely Private                            Lunch
Excludable                                  Cable
Public                                      TV
Congestible
Public                                      I-77
Military
Purely Public
Defense
Government Failure: Theory of Public Choice

Government Failure
Enactment of government policies that produce inefficient or
inequitable results.

Public Choice Theory
Study of how government makes economic decisions.

• Consider government to be collection of individuals, each pursuing
his or her own self-interest.
• Individuals remain rational and self-interested even when acting as
voters, politicians and government bureaucrats.
• Just as firms maximize profit, and consumers maximize utility:
• Bureaucrats maximize income, power and longevity
Government Failure: Theory of Public Choice

Limits of Majority Voting
 The voting mechanism can also lead to inefficient outcomes, even when
voters are perfectly informed about costs and benefits.
 Consider a vote for whether a flood-control dam is going to be built:
 The voters that live nearby will likely benefit much more than those living far
away.
 Voters far away may not be willing to pay the costs if they aren’t going to
collect any benefits.
 The dam project is likely to be rejected, even if it was an efficient use of
society’s resources.
 The problem? Voters cannot express the strength of their preference. They
can vote for or against, but not HOW MUCH they are for it, or HOW
AGAINST it they are.
The Concept of Elasticity . . . .

Key Terms:
 Congestible Public Goods    Perfectly Elastic
 Elastic Demand              Perfectly Inelastic
 Elasticity                  Public choice theory
 Excludable Public Goods     Purely public goods
 Exclusivity                 Purely private goods
 Government failure          Rivalry
 Inelastic Demand            Unit Elastic Demand
 Market failure

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 views: 18 posted: 12/4/2011 language: English pages: 17