Lecture Slides - Efficiency and Elasticities(1) (1).pptx

Econ 1194: Prices and Markets

Lecture 2: Efficiency and Elasticity

Topic 2: Efficiency and ElasticityOutline

1 Efficiency1.1 Consumer Surplus1.2 Producer Surplus1.3 Economic Efficiency

2 Elasticity2.1 Elasticity of Demand2.2 Price Elasticity of Demand2.3 Elasticity and Total Revenue2.4 Income Elasticity of Demand2.5 Cross Price Elasticity of Demand2.6 Price Elasticity of Supply

RMIT University©28/04/2023 RMIT International University Vietnam 2

1. Efficiency• What do economists mean by efficiency?• A market is economically efficient when the marginal benefit to

consumers of the last unit produced is equal to its marginal cost of production. (Hubbard & Obrien, page 105)

• Market efficiency is also achieved when the sum of consumer surplus are maximised


=-Consumer

valueAmount

paidConsumer

surplus

Q0

p*

q*

Demand

P

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

The demand curve reflects the value consumers receive from consuming.

We measure the value consumers received from consuming by their willingness to pay, i.e. the maximum price they are willing to pay at every quantity demanded.

1.1 Consumer Surplus

Consumer surplus: the difference between consumers’ willingness to pay and the amount they actually pay. It is the consumers’ gains from trade, i.e. the benefit of consumers from participating in the market.

Calculating Consumer Surplus• Consumer surplus is the difference between what the consumers’ willing to

pay (shown on the demand curve) and what they actually pay (the market price)

• In other words, consumer surplus is the area between the demand curve and the price line up to the quantity consumed

Class Exercise For the Demand Curve QD= 70 - 2P shown below, calculate the consumer surplus when the price is 20


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

So if P=20 and Q = 30

CS = ½ ((30 x 35 – 20) ) = ½ (20 x 15) = 225

Consumer Surplus

Producer surplus: the difference between producers’ willingness to sell and the amount they actually receive. It is the producers’ gains from trade, i.e. the benefit of producers from participating in the market.

P

Q0

p*

Supply

q*

=-Amountreceived

Producersurplus

Producercost

The supply curve reflects the cost firms incur in producing.

We measure producer cost of production by their willingness to sell, i.e. the minimum price they are wiling to accept at every quantity supplied.

Producer surplus is the area between the supply curve and the price line.

1.2 Producer Surplus

Calculating Producer Surplus• Producer surplus is the amount producers receive (market price) above the

minimum price required to make them supply the good (shown on the supply curve)

• Producer surplus is the area between the price line and the supply curve up to the quantity produced

Class ExerciseFor the Supply Curve QS = 0 + 1.5P shown below, calculate producer surplus when price equals 20


Answer

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

So if P=20 and Q = 30

PS = ½ (30 x 20 ) = 300

Producer Surplus

1.3 Economic Efficiency

• At the equilibrium, the marginal net benefit MNB of producing an additional unit is zero.

• Thus competitive markets maximise– total net benefits of both consumers and producers– sum of CS and PS = areas (1) + (2a)


Economic Efficiency

• So there are losses (i.e. CS and PS are less) when ‘overproducing’….


Economic Efficiency

• and there are losses (i.e. CS and PS are less) when ‘underproducing’….


A quick check

• We can say that the allocation of resources is efficient if:

– producer surplus is maximized.– consumer surplus is maximized.– total surplus is maximized– sellers’ costs are minimized.


2. Elasticity

• Elasticity measures of responsiveness of one variable to another holding all else constant

– if ‘responsive’, refer to as ‘elastic’– if ‘unresponsive’, refer to as ‘inelastic’

• in general εab = elasticity of a with respect to b

• = (% Δ a ) ÷ (% Δ b )where– Δ denotes ‘change in’

– a is the dependent variable, e.g. quantity demanded and– b is some independent variable, e.g. price of the good


2.1 Elasticity of Demand

• This measures the responsiveness of quantity demanded to a change in one of the determinants X of demand (assuming other determinants remain constant)

(or reaction / action)

• Point elasticity is elasticity at a specific point. This calculation of elasticity is used when the changes between two points are likely to be very small

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


XQdd

%

%

QX

XQ

XXX

QQQ

XXXX

QQQQd

d

01

0

0

01

0

01

0

01

100%

100%

Elasticity of Demand

• Note that for the base of the percentage change in calculation of the point elasticity, we are using the starting point (Q0, X0) for Point Elasticity

• We also can use the average

• This is an Arc Elasticity


2,

21010 XXQQ

10

10

10

01

10

01

100

2

%

100

2

%

QQXX

XQ

XXXXX

QQQQQd

d

2.2 Price Elasticity of Demand

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

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

• The midpoint formula is normally preferablewhen calculating the price elasticity of demandbecause it gives the same answer regardlessof the direction of the price change.


PQd

p

%

%

10

10

%%

QQPP

PQd

PQd

p

Price Elasticity of Demand

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

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

1.36% decrease (increase) in quantity demanded


36.1690081005.44

45.481006900

10

10

p

p QQPP

PQd


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

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


Elastic Demand

P

Qty

Inelastic Demand

P

Qty


• If p = , the demand is perfectly elastic.

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


P

Qty

Perfectly inelastic Demand

Perfectly elastic Demand

P

Qty

Elasticity along the Demand Curve

• For a linear demand curve, except in the cases of perfectly inelastic and perfectly elastic demand curve, elasticity varies along the demand curve

– elastic at the ‘high end’– unitary elasticity point– inelastic at the ‘low end’


2.3 Elasticity and Total Revenue

• TR = p × q• if p↑ then q↓ so what happens to TR?

– elastic demand (p > 1) TR↓– unitary elasticity (p = 1) TR constant– inelastic demand (p < 1) TR↑

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


Elasticity and Total Revenue


Determinants of Price Elasticity of Demand

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


2.4 Income Elasticity

• Income elasticity measures the responsiveness of change in quantity demanded as change in income, ceteris paribus.

• Note that: y > 0 for normal goods

y < 0 for inferior goods


10

10

%%

Income%DemandedQuantity %

QQYY

YQd

YQd

y

y

Income Elasticity

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

RMIT University Vietnam Price and Markets 24

2.5 Cross Price Elasticity

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

• Note that: – xy > 0 for substitute goods

– xy < 0 for complementary goods


10

10

%%

XX

YY

Y

XXY

Y

XXY

QQPP

PQPQ

Cross Price Elasticity

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

RMIT University Vietnam Price and Markets 26

2.6 Price Elasticity of Supply

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

• s is positive following the Law of Supply

• s > 1: Elastic Supply

• s < 1: Inelastic Supply

• s = 0: Perfectly Inelastic Supply

• s = : Perfectly Elastic Supply


PQs

s

%

%

Determinants of Elasticity of Supply

• Availability of Inputs: the more availability of inputs, the easier producers can response to the price change, the more elastic supply curve.

• Substitutability of inputs: the more substitutability of inputs, the more elastic supply curve

• Timeframe– Momentary Supply Curve: could be perfectly inelastic or perfectly elastic– Short-run Supply Curve: inelastic supply– Long-run Supply Curve: elastic supply


P P P

Qty Qty Qty

Momentary Supply S/R

Supply L/R Supply

Key terms

• Market Efficiency• Marginal benefit• Marginal cost• Consumer Surplus• Producer surplus• Economic surplus• Deadweight loss


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

Next week:


Topic 3: Industry Analysis and the Costs of Production

Documents

Lecture Slides - Efficiency and Elasticities(1) (1).pptx