Microeconocis - For Exam

CHAPTER
CHAPTER
Economics:
Foundations and Models
Chapter Outline and

Learning Objectives
1.1
Three Key Economic Ideas
1.2
The Economic Problem That

Every Society Must Solve
1.3
Economic Models
1.4
Microeconomics and
Macroeconomics
1.5
A Preview of Important
Economic Terms
APPENDIX: Using Graphs
and Formulas
Pearson Education Limited 2015
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What Is This Class About?

People make choices as they try to attain their goals. Choices are
necessary because we live in a world of scarcity.
Scarcity: A situation in which unlimited wants exceed the limited
resources available to fulfill those wants
Economics is the study of these choices.
Economists study these choices using economic models, simplified
versions of reality used to analyze real-world economic situations.
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Microeconomics and Macroeconomics

Microeconomics is the study of
how households and firms make choices,
how they interact in markets, and
how the government attempts to influence their choices
Macroeconomics is the study of the economy as a whole, including

topics such as inflation, unemployment, and economic growth.
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Three Key Economic Ideas
1.1 LEARNING OBJECTIVE
Explain these three key economic ideas:

1. People are rational;
2. People respond to economic incentives; and
3. Optimal decisions are made at the margin.*
* Marginal Analysis
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1. People Are Rational

Economists generally assume that people are rational.
Rational: Using all available information to achieve your goals.
Rational consumers and firms weigh the benefits and costs of each
action and try to make the best decision possible.
Example: Microsoft doesnt randomly choose the price of its Windows
software; it chooses the price(s) that it thinks will be most profitable.
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2. People Respond to Economic Incentives

As incentives change, so do the actions that people will take.
Example: Changes in several factors have resulted in increased
obesity in Americans over the last couple of decades.
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2. People Respond to Economic Incentives

As incentives change, so do the actions that people will take.
Example: Changes in several factors have resulted in increased
obesity in Americans over the last couple of decades, including:
Decreases in the price of fast food relative to healthful food
Improved non-active entertainment options
Increased availability of health care and insurance, protecting
people against the consequences of their actions
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3. Optimal Decisions Are Made at the Margin

While some decisions are all-or-nothing, most decisions involve doing
a little more or a little less of something.
Example: Should you watch an extra hour of TV, or study instead?
Economists think about decisions like this in terms of the marginal
cost and benefit (MC and MB): the additional cost or benefit
associated with a small amount extra of some action.
Comparing MC and MB is known as marginal analysis.
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Solved Problem 1.1

Manajer Pet Shop yang bersemangat
Seorang manajer pet shop berpikir untuk gerainya selama 10 jam sehari, 2 jam lebih
lama dari biasanya, yaitu 8 jam sehari. Manajer tersebut berpikir bahwa membuka
praktek selama 9 jam akan membawa keuntungan Rp 600 juta setahun.
Apakah Anda setuju / tidak setuju ?
Apa saja informasi tambahan yang Anda perlukan untuk membuat keputusan tersebut?
Solving the Problem

Step 1: Review the chapter material.
Step 2: Explain whether you agree with the managers reasoning.
Si manajer belum melakukan analisis marjinal, jangan setuju dulu.
Perhitungan total keuntungan kalau pet shop buka 10 jam belum tentu berhubungan
dengan keputusan untuk menambah waktu buka selam 2 jam.
Step 3: Explain what additional information you need.
Anda butuh mengetahui marginal revenue dan marginal cost dari akibat menambah jam
buka pet shop selama 2 jam.
Manajer tersebut juga perlu memasukkan non-monetary cost untuk tambahan 2 jam
membuka pet shop, seperti misalnya pengorbanan waktu bersama keluarga, dll.
2013 Pearson Education, Inc. Publishing as Prentice Hall
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Types of Economies
Centrally planned economies result when governments decide what
to produce, how to produce it, and who received the goods and
services.
Market economies result when the decisions of households and
firms determine what is produced, how it is produced, and who
receives the goods and services.
Market: A group of buyers and sellers of a good or service and the
institution or arrangement by which they come together to trade
Mixed economies have features of both of the above. Most
economic decisions result from the interaction of buyers and sellers,
but governments play a significant role in the allocation of resources.
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Efficiency of Economies
Market economies tend to be more efficient than centrally-planned
economies.
Market economies promote:
Productive efficiency, where goods or services are produced at the
lowest possible cost; and
Allocative efficiency, where production is consistent with consumer
preferences: the marginal benefit of production is equal to its marginal
cost
These efficiencies come about because all transactions result from
voluntary exchange: transactions that make both the buyer and
seller better off.
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Calculating the Slope of a Linecontinued

For example,
when the price
of pizza
decreases from
$14 to $12, the
quantity of pizza
demanded
increases from
55 per week to
65 per week.
So, the slope of
this line equals
2 divided by
10, or 0.2.
Figure 1A.4
Calculating the Slope

of a Line
Slope
Change in value on the vertical axis

y Rise
Change in value on the horizontal axis x Run
Slope
Price of pizza
($12 $14) 2
0.2
Quantity of pizza
(65 55)
10
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Formula for a Percentage Change

One important formula is the percentage change, which is the change
in some economic variable, usually from one period to the next,
expressed as a percentage.
Percentage change
Value in the second period Value in the first period

100
Value in the first period
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The Area of a Rectangle

The area of a rectangle is
equal to its base multiplied
by its height; total revenue
is equal to quantity
multiplied by price.
Here, total revenue is equal
to the quantity of 125,000
bottles times the price of
$2.00 per bottle, or
$250,000.
The area of the greenshaded rectangle shows
the firms total revenue.
Area of a rectangle Base Height
Figure 1A.9
Showing a Firms Total

Revenue on a Graph
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The Area of a Triangle

The area of a
triangle is equal to
multiplied by its
base multiplied by
its height.
The area of the
blue-shaded triangle
has a base equal to
150,000 125,000,
or 25,000, and a
height equal to
$2.00 $1.50, or
$0.50.
Therefore, its area
equals 25,000
$0.50, or $6,250.
Area of a triangle
Figure 1A.10
1
Base Height
2
The Area of a Triangle
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Production Possibilities Frontier

A production possibilities frontier (PPF) is a curve showing
the maximum attainable combinations of two products that may
be purchases with available resources and current technology.
Question: Is the PPF a positive or normative tool?
Answer: Positive; it shows what is, not what should be.
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Increasing Marginal Opportunity Costs

On the previous slide,
opportunity costs were
constant.
But opportunity costs are
often increasing.
Why? Some resources are
better suited to one task
than another. The first
resources to switch are
Figure 2.2
Increasing marginal
the one best suited to
opportunity costs
switching.
The more resources already devoted to an activity, the smaller
the payoff to devoting additional resources to that activity.
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Economic Growth on the PPF

As more economic
resources become
available, the economy can
move from point A to point
B, producing more tanks
and more automobiles.
Figure 2.3a
Economic growth
Shifts in the production

possibilities frontier
represent economic
growth.
Economic growth: the ability of the economy to increase the

production of goods and services.
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Technological Change in One Industry

This panel shows
technological improvement
in the automobile industry.
The quantity of tanks that
can be produced remains
unchanged.
As in the previous slide,
many previously
unattainable combinations
are now attainable.
Figure 2.3b
Economic growth
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Gains from Specialization and Tradecontinued

Figure 2.5
Gains from Trade
If you specialize in picking apples, you can pick 20 pounds. If

your neighbor specializes in picking cherries, she can pick 60
pounds.
If you trade 10 pounds of your apples for 15 pounds of your
neighbors cherries, you will be able to consume 10 pounds of
apples and 15 pounds of cherries point B in panel (a).
Your neighbor can now consume 10 pounds of apples and 45
pounds of cherriespoint D in panel (b). You and your neighbor
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Summary of the Gains from Trade

You
Apples
(in pounds)
Production and consumption
without trade
Your Neighbor
Cherries
(in pounds)
Apples
(in pounds)
Cherries
(in pounds)
12
42
Production with trade
20
60
Consumption with trade
10
15
10
45
Gains from trade (increased

consumption)
Table 2.1
A summary of the
gains from trade
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Explaining the Gains from Specialization and Trade

How could both of you benefit from trade, when your neighbor
was so much better than you?
Economists say your neighbor had an absolute advantage in
both cherry- and apple-picking, but you had a comparative
advantage in picking apples.
Absolute advantage: The ability of an individual, a firm, or a
country to produce more of a good or service than competitors,
using the same amount of resources.
Comparative advantage: The ability of an individual, a firm, or
a country to produce a good or service at a lower opportunity
cost than competitors.
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Comparative Advantage and the Gains from Trade

Opportunity Cost of Picking
1 Pound of Apples
Opportunity Cost of Picking

1 Pound of Cherries
You
1 pound of cherries
1 pound of apples
Your Neighbor
2 pounds of cherries
0.5 pound of apples
Table 2.2
Opportunity costs of
picking apples and
cherries
The basis for trade is comparative advantage, not absolute

advantage.
Individuals, firms, and countries are better off if they
specialize in producing goods and services for which they
have a comparative advantage and obtain the other goods
and services they need by trading.
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The Two Key Groups in a Modern Economy

Two key groups participate in the
modern economy:
Households consist of
individuals who provide the
factors of production: labor,
capital, natural resources, and
entrepreneurial ability.
Households receive
payments for these factors
by selling them to firms in
factor markets.
Firms supply goods and

services to product markets;
households buy these products
from the firms.
All types of work
Physical capital used

to produce other
goods
Land, water, oil, ore,

raw materials, etc.
The ability to bring

together factors of
production
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The Circular-Flow Diagram

Circular-flow diagram: A model
that illustrates how participants in
markets are linked.
Households provide factors of
production to firms.
Firms provide goods and
services to households.
Firms pay money to
households for the
factors of production.
Households pay money to
firms for the goods and services.
Figure 2.6
The circular-flow
diagram
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The Circular-Flow Diagrama Simplified Model

Like all economic models,
the circular-flow diagram is
a simplified version of
reality:
No government
No financial system
No foreign buyers and
sellers of goods
We will explore these
sectors in later chapters.
Figure 2.6
The circular-flow
diagram
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The Gains from Free Markets

A free market is one with few government restrictions on how a
good or service can be produced or sold, or on how a factor of
production can be employed.
Countries that come closest to the free market benchmark have
been more successful than those with centrally planned
economies in providing their people with rising living standards.
This concept is not new: Adam Smith argued for free markets in
his 1776 treatise, An Inquiry into the Nature and Causes of the
Wealth of Nations.
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The Beauty of the Market Mechanism

It is not immediately obvious that markets will do better than
centrally-planned systems for satisfying human desires.
After all, individuals are acting only in their own rational selfinterest.
But markets with flexible prices allow the collective actions of
households and firms to signal the relative worth of goods and
services.
In this way, the invisible hand allows individual responses to
collectively end up satisfying the wants of consumers.
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The Role of the Entrepreneur

An entrepreneur is someone who brings together the factors of
productionland, labor, and capitalto produce goods and
services.
The best entrepreneurs create products that consumers never
even knew they wanted.
If I had asked my customers what they wanted, they would
have said a faster horse.
- Henry Ford
Entrepreneurs make a vital contribution to economic growth,
often with considerable personal risk and sacrifice.
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The Legal Basis of a Successful Market System

In a free market, government does not restrict how firms
produce and sell goods, or how they employ factors of
production.
However governments must provide a sound legal environment
that will allow the market system to succeed, including:
Protection of private property
When criminals can take your wages or profits, households
and firms have little incentive to work hard.
Property rightsthe rights individuals or firms have to the
exclusive use of their property, including the right to buy or
sell itare essential here.
Enforcement of contracts and property rights
Important for transactions across time to occur.
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What Determines the Price of a Smartphone?

Demand for smartphones
How many smartphones do consumers want to buy?
Affected by price of the smartphones
Affected by other factors, including prices of other goods
Supply of smartphones
How many smartphones are producers willing to sell?
Affected by price of the smartphones
Affected by other factors, including prices of other goods
We will analyze these in a perfectly competitive market: a

market with (1) many buyers and sellers, (2) all firms selling
identical products, and (3) no barriers to new firms entering the
market.
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Demand Schedules and Quantity Demanded

Demand schedule: A table that shows the relationship
between the price of a product and the quantity of the product
demanded.
Quantity demanded: The amount of a good or service that a
consumer is willing and able to purchase at a given price.
Figure 3.1
A demand schedule
and a demand curve
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Demand Curve and Market Demand

Demand curve: A curve that shows the relationship between
the price of a product and the quantity of the product
demanded.
Market demand: the demand by all the consumers of a given
good or service.
Figure 3.1
A demand schedule
and a demand curve
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Ceteris Paribus
When drawing the demand curve, we assume ceteris
paribus.
Ceteris paribus (all else equal) condition: The
requirement that when analyzing the relationship between
two variablessuch as price and quantity demandedother
variables must be held constant.
Figure 3.1
A demand schedule
and a demand curve
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The Law of Demand

Law of demand: The rule that, holding everything else
constant, when the price of a product falls, the quantity
demanded of the product will increase, and when the price of
a product rises, the quantity demanded of the product will
decrease.
Implication: Demand curve slopes downward
Figure 3.1
A demand schedule
and a demand curve
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What Explains the Law of Demand?

When the price of a product falls, two effects cause consumers
to purchase more of it:
The product has become cheaper relative to other goods, so
consumers substitute toward it. This is the substitution
effect.
The consumer now has greater purchasing power, and elects
to purchase more goods overall. This is income effect.
Substitution effect: The change in the quantity demanded of a

good that results from a change in price making the good more
or less expensive relative to other goods that are substitutes.
Income effect: The change in the quantity demanded of a good
that results from the effect of a change in the goods price on
consumers purchasing power.
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Increase and Decrease in Demand

A change in
something other than
price that affects
demand causes the
entire demand curve
to shift.
A shift to the right (D1
to D2) is an increase
in demand.
A shift to the left (D1
to D3) is a decrease
in demand.
Figure 3.2
Shifting the demand curve

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Shifts of the Demand Curve

As the demand
curve shifts, the
quantity demanded
will change, even if
the price doesnt
change.
The quantity
demanded changes
at every possible
price.
P1
Q2
Figure 3.2
Q1
Q3
Shifting the demand curve

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What Factors Influence Market Demand?

Income of consumers
Increase in income increases demand if product is normal,
decreases demand if product is inferior.
Prices of related goods
Increase in price of related good increases demand if products
are substitutes, decreases demand if products are
complements
Tastes
Population and demographics
Expected future prices
We will discuss how each of these affects demand.
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Change in Income of consumers

Normal good:
A good for which the demand increases as
income rises, and decreases as income falls.
Examples:
Clothing
Restaurant meals
Vacations
Effect of increase in income,

if good is normal
Inferior good:
A good for which the demand decreases as
income rises, and increases as income falls.
Examples:
Second-hand clothing
Ramen noodles
Are smartphones normal or inferior goods?
Effect of increase in income,

if good is inferior
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Change in the Price of Related Goods

Substitutes:
Goods and services that can be used for
the same purpose.
Examples:
Big Mac and Whopper
Ford F-150 and Dodge Ram
Jeans and Khakis
Complements:
Goods and services that are used together.
Examples:
Big Mac and McDonalds fries
Hot dogs and hot dog buns
Left shoes and right shoes
Effect on demand for Big

Macs, if price of Whopper
increases
Effect on demand for Big

Macs, if price of McDonalds
fries increases
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Making Are Tablets Substitutes

the
Connection
Tablet computers and e-readers are not
for E-readers?
identical products, but they are similar.

To see whether consumers view tablets
as substitutes for e-readers, we need
to look at data.
As tablets have become more popular
in the early 2010s, worldwide sales of
e-readers have fallen:
2011: 23 million
2012: 16 million
2013: 5.8 million (forecast)
It seems consumers have decided that
tablets are a close substitute for e-readers.
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Change in Tastes or Population/demographics

Tastes
If consumers tastes change, they may buy
more or less of the product.
Example:
If consumers become more concerned about
eating healthily, they might decrease their
demand for fast food.
Population and demographics
Increases in the number of people buying
something will increase the amount
demanded.
Example: An increase in the elderly
population increases the
demand
for medical care.
Effect on demand for fast food,

if consumers want to eat
healthy
Effect on demand for medical

care, as the population ages
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Change in Expectations about Future Prices

Consumers decide which products to buy
and when to buy them.
Future products are substitutes for
current products
An expected increase in the price
tomorrow increases demand today.
An expected decrease in the price
tomorrow decreases demand today.
Effect on todays gasoline

demand, if price will rise tomorrow
Example:
If you found out the price of gasoline would
go up tomorrow, you would increase your
demand today.
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Making Apples Policy on Product Speculation

the
Connection
Apple strongly discourages its employees from speculating about
when a new model will appear. Why?
Suppose a customer learns that a new iPad model will be available
next month.
The new model is a potential substitute for the current model.
The price of the current model will likely fall next month.
Both effects decrease current demand (bad for Apple!).
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Change in Demand vs. Change in Quantity Demanded

A change in the price
of the product being
examined causes a
movement along the
demand curve.
This is a change
in quantity
demanded.
Any other change
affecting demand
causes the entire
demand curve to
shift.
This is a change
Figure 3.3
A change in demand
versus a change in
quantity demanded
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Supply Schedules and Supply Curves

Supply schedule: A table that shows the relationship between
the price of a product and the quantity of the product supplied.
Quantity supplied: The amount of a good or service that a firm
is willing and able to supply at a given price.
Supply curve: A curve that shows the relationship between the
price of a product and the quantity of the product supplied.
Figure 3.4
A supply schedule
and a supply curve
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The Law of Supply

The law of supply: The rule that, holding everything else
constant, increases in price cause increases in the quantity
supplied, and decreases in price cause decreases in the
quantity supplied.
Implication: supply curves slope upward.
Figure 3.4
A supply schedule
and a supply curve
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Shifts of the Supply Curve

As the supply curve
shifts, the quantity
supplied will change,
even if the price
doesnt change.
The quantity
supplied changes at
every possible price.
P1
Q2
Figure 3.5
Q1
Q3
Shifting the supply curve

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Variables that Shift Market Supply

Prices of inputs
Technological change
Prices of substitutes in production
Number of firms in the market
Expected future prices
We will discuss how each of these affects supply.
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Changes in Prices of Inputs

Inputs are things used in the production of a
good or service.
Examples of inputs for smartphones:
Computer processor
Plastic housing
Labor
Effect of an increase in the

price of input goods
An increase in the price of an input

decreases the profitability of selling the good,
causing a decrease in supply.
A decrease in the price of an input increases
the profitability of selling the good, causing an
increase in supply.
Effect of a decrease in the

price of input goods
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Technological Change
A firm may experience a positive or negative
change in its ability to produce a given level of
output with a given quantity of inputs. This is a
technological change.
Changes raise or lower firms costs, hence
their supply of the good.
Examples:
A new, more productive variety of wheat would
increase the supply of wheat.
Governmental restrictions on land use for
agriculture might decrease the supply of wheat.
Effect of a positive change

in technology
Effect of a negative change

in technology
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Prices of Substitutes, and Number of Firms

Many firms can produce and sell more than
one product.
Example:
An Illinois farmer can plant corn or soybeans. If
the price of soybeans rises, he will plant
(supply) less corn.
Effect on the supply of corn,

of an increase in the price of
soybeans
More firms in the market will result in more

product available at a given price (greater
supply).
Fewer firms supply decreases.
Effect of a increase in the

number of firms
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Change in Expected Future Prices

If a firm anticipates that the price of its
product will be higher in the future, it
might decrease its supply today in order
to increase it in the future.
What types of products could be stored
like this?
Perishable products, or
Non-perishable products
Effect of an increase in
future expected price of a
good
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Change in Supply vs. Change in Quantity Supplied

A change in the price
of the product being
examined causes a
movement along the
supply curve.
This is a change
in quantity
supplied.
Any other change
affecting supply
causes the entire
supply curve to shift.
This is a change
in supply.
Figure 3.6
A change in supply
versus a change in
quantity supplied
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Market Equilibrium Price and Quantity

In this market:
The equilibrium price of
a smartphone is $200,
and
The equilibrium quantity
of a smartphone is 10
million smartphones per
week.
Since buyers and sellers
want to trade the same
quantity at the price of
$200, we do not expect the
price to change.
Figure 3.7
Market equilibrium
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A Surplus in the Market for Smartphones

At a price of $250,
consumers want to
buy 9 million
smartphones, while
producers want to
sell 11 million.
This gives a surplus of 2
million smartphones: a
situation in which quantity
supplied is greater than
quantity demanded.
Prediction: sellers will
compete amongst
Figure 3.8
The effect of surpluses and

shortages on the market price
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A Shortage in the Market for Smartphones

At a price of $100,
consumers want to
buy 12 million
smartphones, while
producers want to
sell 8 million.
This gives a shortage of 4
million smartphones: a
situation in which quantity
demanded is greater than
quantity supplied.
Prediction: sellers will
realize they can increase
the price and still sell as
many smartphones, so the
Figure 3.8
The effect of surpluses and

shortages on the market price
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The Usefulness of the Demand and Supply Model

Predictions about price and quantity in our model require us to
know supply and demand curves.
Typically, we know price and quantity, but do not know the
curves that generate them.
The power of the demand and supply model is in its ability to
predict directional changes in price and quantity traded.
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The Effect of Shifts in Supply on Equilibrium

Suppose Amazon enters
the smartphone market:
More smartphones are
supplied at any given
pricean increase in
supply from S1 to S2.
Equilibrium price falls
from P1 to P2.
Equilibrium quantity rises
from Q1 to.
Figure 3.9
The effect of an
increase in supply on
equilibrium
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How Much Will Price and Quantity Change?

By how much will price
fall? By how much will
quantity rise?
We cannot say, without
knowing more
information.
For now, we can only
predict that price will fall
and quantity traded will
rise.
Figure 3.9
The effect of an
increase in supply on
equilibrium
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The Effect of Shifts in Demand on Equilibrium

Suppose incomes
increase. What happens
to the equilibrium in the
smartphone market?
Smartphones are a
normal good, so as
income rises, demand
shifts to the right (D1 to
D2).
Equilibrium price rises (P1
to P2).
Equilibrium quantity rises
Figure 3.10
The effect of an
increase in demand on
equilibrium
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Effects of Changes in Demand or Supply

The table summarizes what happens when the demand
curve shifts or the supply curve shifts, with the other curve
remaining unchanged.
Supply Curve
Unchanged
Demand Curve Unchanged
Q unchanged
P unchanged
Demand Curve Shifts to the

Right
Q increases
P increases

Left
Q decreases
P decreases
Supply Curve Shifts

to the Right
Q increases
P decreases
Table 3.3
Supply Curve Shifts

to the Left
Q decreases
P increases
How shifts in demand

and supply affect
equilibrium price (P)
and quantity (Q)
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Shifts in Demand and Supply over Time

Over time, it is likely that
both demand and supply
will change.
For example, as new firms
enter the market for
smartphones and incomes
increase, we expect
The supply of
smartphones will shift to
the right, and
The demand for
smartphones will shift to
the right.
Figure 3.11a
Shifts in demand and

supply over time:
demand shifting more
than supply
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Demand Shifting More Than Supply

What does our model
predict?
S ( P and Q )
D ( P and Q )
So we can be sure
equilibrium quantity will
rise; but the effect on
equilibrium price is not
clear.
This panel shows demand
Figure 3.11a

supply over time:
demand shifting more
than supply
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Supply Shifting More Than Demand

This panel shows supply
shifting more than demand:
quantity rises, but
equilibrium price falls.
Without knowing the
relative size of the changes,
the effect on equilibrium
price is ambiguous.
It is possible, but unlikely,
that the equilibrium price
will remain unchanged.
Figure 3.11b

supply over time:
supply shifting more
than demand
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Effect of Changes in Demand or Supplyredux

We can now fill in the rest of Table 3.3.
The cell in red is the example that we just did.
Supply Curve
Unchanged
Supply Curve Shifts

to the Right
Supply Curve Shifts

to the Left
Demand Curve Unchanged
Q unchanged
P unchanged
Q increases
P decreases
Q decreases
P increases

Right
Q increases
P increases
Q increases
P increases or
decreases
Q increases or
decreases
P increases

Left
Q decreases
P decreases
Q increases or
decreases
P decreases
Q decreases
P increases or
decreases
Table 3.3
How shifts in demand

and supply affect
equilibrium price (P)
and quantity (Q)
69 of 45
Making
the
Connection
Blu-ray Players (part B)
Supply increased as additional firms started manufacturing Blu-ray

players and input costs fell.
70 of 51
Shifts of a Curve vs. Movements along a Curve

Suppose an increase in supply occurs. We now know:
Equilibrium quantity will increase, and
Equilibrium price will decrease
It is tempting to believe the decrease in price will cause an
increase in demand. But this is incorrect.
The decrease in price will cause a movement along with
demand curve, but not an increase in demand.
Why? The demand curve already describes how much of the
good consumers want to buy, at any given price.
When the price change occurs, we just look at the demand
curve to see what happens to how much consumers want to
buy.
71 of 45
72 of 45
Consumer Surplus and Producer Surplus
Distinguish between the concepts of consumer surplus and producer surplus.
73 of 54
Consumer and Producer Surplus

Surplus (noun): Something that remains
above what is used or needed
Economists use the idea of surplus to refer to the benefit that
people derive from engaging in market transactions.
Consumer surplus is the difference between the highest price
a consumer is willing to pay for a good or service and the actual
price the consumer receives.
Producer surplus is the difference between the lowest price a
firm would be willing to accept for a good or service and the
price it actually receives.
74 of 45
How Much Output is Efficient?

We can think about efficiency in a market in two ways:
1. A market is efficient if all trades take place where the
marginal benefit exceeds the marginal cost, and no other
trades take place.
2. A market is efficient if it maximizes the sum of consumer and
producer surplus (i.e. the total net benefit to consumers and
firms), known as the economic surplus.
Economic efficiency: A market outcome in which the marginal
benefit to consumers of the last unit produced is equal to its
marginal cost of production and in which the sum of consumer
and producer surplus is at a maximum.
75 of 45
The Efficiency of Competitive Equilibrium

Recall that the
demand curve
describes the marginal
benefit of each
additional cup of tea,
while the supply curve
describes the marginal
cost of each additional
cup of tea.
If the quantity is too
Figure 4.5
Marginal benefit equals marginal cost
only at competitive equilibrium
low, the value to
consumers
If the quantityofisthe
toonext
high, the cost to producers of the last unit is
unit
exceeds
the
costconsumers derive from it.
greater
than the
value
to producers.
Only at the competitive equilibrium is the last unit valued by
consumers and producers equallyeconomic efficiency.
76 of 45
The Efficiency of Competitive EquilibriumSurplus

The figure shows
the economic
surplus (the sum of
consumer and
producer surplus) in
the market for chai
tea.
At the competitive
equilibrium quantity,
Figure 4.6
Economic surplus equals the sum of
the economic
consumer surplus and producer surplus
surplus is
maximized. Our two concepts of economic efficiency
result in the same level of output!
77 of 45
Economic Surplus If the Market is Not in Equilibrium
Figure 4.7
When a market is not

in equilibrium, there is
a deadweight loss
When the price of chai tea is $2.20 instead of $2.00,

consumer surplus declines from an amount equal to the sum
of areas A, B, and C to just area A.
Producer surplus increases from the sum of areas D and E to
the sum of areas B and D.
Economic surplus decreases by the sum of areas C and E.
78 of 45
Deadweight Loss Resulting From Non-Equilibrium Quantity
Figure 4.7
When a market is not

in equilibrium, there is
a deadweight loss
The reduction in economic surplus resulting from a market not

being in competitive equilibrium is known as deadweight
loss.
Deadweight loss can be thought of as the amount of
inefficiency in a market. In competitive equilibrium,
79 of 45
Government Intervention in the Market:

Price Floors and Price Ceilings
Explain the economic effect of government-imposed price floors and price

ceilings.
80 of 54
Price Ceilings and Price Floors

One option a government has for affecting a market is the
imposition of a price ceiling or a price floor.
Price ceiling: A legally determined maximum price that
sellers can charge.
Price floor: A legally determined minimum price that
sellers may receive.
Price ceilings and floors in the USA are uncommon, but include:
Minimum wages
Rent controls
Agricultural price controls
81 of 45
Price Floors: Agricultural Price Supports

The equilibrium price in the
market for wheat is $3.00 per
bushel; 2.0 billion bushels are
traded at this price.
If wheat farmers convince the
government to impose a price
floor of $3.50 per bushel,
quantity traded falls to 1.8
billion.
Area A is the surplus
transferred from consumers to
producers.
Figure 4.8
The economic effect of

a price floor in the
wheat market
82 of 45
Price Floors: It Gets Worse

Unfortunately, the situation
may be even worse.
If farmers do not realize they
will not be able to sell all of
their wheat, they will produce
2.2 billion bushels.
This results in a surplus, or
excess supply, of 400 million
bushels of wheat.
Figure 4.8

a price floor in the
wheat market
83 of 45
Making Price Floors

the
Connection
Supporters of the minimum
in Labor Markets
wage see it as a way of

raising the incomes of lowskilled workers.
Opponents argue that it
results in fewer jobs and
imposes large costs on
small businesses.
Assuming the minimum
wage does decrease
employment, it must result
in a deadweight loss for
society.
84 of 51
Price Ceilings: Rent Controls

Without rent control, the
equilibrium rent is $2,500 per
month.
At that price, 2,000,000
apartments would be rented.
If the government imposes a
rent ceiling of $1,500, the
quantity of apartments
supplied falls to 1,900,000,
and the quantity of
apartments
demanded increases to
2,100,000,
resulting in a shortage of
Figure 4.9

a rent ceiling
85 of 45
Price Ceilings: the Effect of Rent Controls

Producer surplus equal to the
area of the blue rectangle A
is transferred from landlords
to renters.
There is a deadweight loss
equal to the areas of yellow
triangles B and C.
This deadweight loss
corresponds to the surplus
that would have been derived
from apartments that are no
longer rented.
Figure 4.9

a rent ceiling
86 of 45
87 of 45
Pollution is an Externality
No one sets out to create pollution; pollution is an unintended
by-product of various activities.
Pollution would not be a problem if pollution only affected the
person who created it; people would create pollution only until
its marginal cost equaled its marginal benefit.
But pollution is an example of an externality: a benefit or cost
that affects someone who is not directly involved in the
production or consumption of a good or service.
Think of an externality like a side-effect.
88 of 45
Cost of Electricity Production

When firms produce electricity, they have costs of production:
Buildings
Equipment
Fuel
Labor, etc.
Those firms make their decisions about how much to produce
based on these private costs.
But the social cost is higher: the cost to society includes both
the private cost and the external cost of the pollution.
89 of 45
Externalities in the Electricity Production Market

Supply curve S1 represents
just the marginal private
cost that the electricity
producer has to pay.
Supply curve S2 represents
the marginal social cost,
which includes the costs to
those affected by pollution.
The optimal level of
production for society is
QEfficient; at this quantity, the
marginal cost to society is
just equal to the marginal
Figure 5.1
The effect of pollution

on economic efficiency
90 of 45
Inefficiency Due to Negative Externalities

However the market
equilibrium results from the
decisions of producers, who
see their cost of production
given by S1.
Price (PMarket) is too low and
quantity (QMarket) is too high:
the cost to society of the
additional electricity exceeds
its benefit to society.
Deadweight loss results.
When there is a negative
externality in producing a
good or service, too much of
the good or service will be
Figure 5.1
The effect of pollution

on economic efficiency
91 of 45
Externalities
Pollution is an example of a negative externality in production.
Negative externalities might result from consumption.
Example: cigarette smoke
Externalities might also be positive, with social benefits
exceeding private benefits.
Example: college education
Private benefit: the benefit received by the consumer of a good
or service.
Social benefit: The total benefit from consuming a good or
service including both the private benefit and any external
benefit.
92 of 45
Externalities in the College Education Market

College educations have
positive externalities.
The marginal social benefit
from a college education is
greater than the marginal
private benefit to college
students.
Because only the marginal
private benefit is represented
in the market demand curve
D1, the quantity of college
educations
produced,
When
there is
a positive Q
externality
Market,
in
is consuming
too low. a good or service, too
Figure 5.2
The effect of a positive

externality on
economic efficiency
little of the good or service will be

produced at market equilibrium.
93 of 45
Externalities and Market Failure

If there are negative or positive externalities, the market
equilibrium will not result in the efficient quantity being
produced.
There will be deadweight loss.
This is an example of market failure: a situation in which the
market fails to produce the efficient level of output.
The larger the externality, the greater is likely to be the size of
the deadweight lossthe extent of the market failure.
94 of 45
What Causes Externalities?

Externalities arise because of incomplete property rights, or
from the difficulty of enforcing property rights in certain
situations.
Suppose a farmer and a paper mill share a stream.
If no-one owns the stream, the paper mill will discharge
waste into the stream, making it unusable for the farmer.
If the farmer owns the stream, he can
Prevent the mill from discharging into the stream, or

Allow the mill to discharge for a fee, if that is beneficial to him.
Either way, good property rights avoid the market failure.

Property rights: The rights individuals or businesses have to
the exclusive use of their property, including the right to buy or95 of 45
Private Solutions to Externalities: The Coase Theorem
Discuss the Coase theorem and explain how private bargaining can lead to
economic efficiency in a market with an externality.
96 of 54
Is Zero Pollution Efficient?

The previous slide suggested that avoiding pollution altogether
is the best solution.
But what if the paper mill saves a lot of money by discharging
into the stream, and the farmer has an alternative water supply?
Much of the time, a non-zero amount of pollution is optimal,
determined by where the marginal benefit from pollution is just
equal to the marginal cost of pollution.
Or equivalently, the marginal cost of pollution reduction
equals the marginal benefit from pollution reduction.
97 of 45
An Efficient Amount of Pollution

This graph shows
pollution reduction,
which has both costs
and benefits.
10 units of pollution
reduction is too much;
the cost of the last unit
exceeds the benefit.
7 units of pollution
reduction is too little;
the benefit of the next
unit exceeds the cost.
8.5 units is efficient; the
marginal cost just
Figure 5.3
The marginal benefit from

pollution reduction should
equal the marginal cost
98 of 45
The Net Benefit of Changing to the Efficient Level

Increasing the reduction in
sulfur dioxide emissions from
7.0 million tons to 8.5 million
tons results in total benefits
equal to the sum of the areas
A and B under the marginal
benefits curve.
The total cost of this
decrease in pollution is equal
to the area B under the
marginal cost curve.
The total benefits are greater
than the total costs by an
amount equal to the area of
triangle A.
Figure 5.4
The benefits of reducing

pollution to the optimal level
are greater than the costs
99 of 45
Can Private Parties Achieve the Efficient Level?

In principle, private parties
could achieve the efficient
level of pollution.
People feeling the cost of the
additional pollution (A+B)
could pay polluters an
amount equal to B; then
polluters would choose not to
pollute.
But if the benefits of pollution
reduction are felt diffusely (by
many widespread people),
achieving this outcome is
Figure 5.4
The benefits of reducing

pollution to the optimal level
are greater than the costs
100 of
The Coase Theorem

Nobel laureate Ronald Coase argued that private parties could
solve the externality problem through private bargaining,
provided
Property rights are assigned and enforceable, and
Transaction costs are low.
Transaction costs: The costs in time and other resources that
parties incur in the process of agreeing to and carrying out an
exchange of goods or services.
The Coase Theorem also requires that parties have full
information about the costs and benefits involved.
101 of
The Coase Theorem and Property Rights

Perhaps Coases most important observation was that it did not
matter to whom property rights were assigned.
In the example of the paper mill and the farmer, we said that if
the farmer had enforceable property rights over the stream, the
externality problem could be resolved.
But the same is true if the paper mill owns the stream!
Can you explain why?
102 of
Government Policies to Deal with Externalities
Analyze government policies to achieve economic efficiency in a market with an

externality.
103 of
When Can Two Wrongs Make a Right?

In chapter 4, we learned that taxes caused inefficiency
(deadweight loss) by moving the level of production away from
the efficient level.
In this chapter, externalities cause inefficiency for the same
reason.
A tax of just the right size could cause these two effects to
cancel out, returning us to the efficient level of production.
104 of
Corrective Taxes for Negative Externalities

Utilities do not bear the cost
of pollution, so they
produce too much.
If the government imposes
a tax equal to the cost of
the pollution, the utilities will
internalize the externality.
The supply curve will shift
up, from S1 to S2.
The market equilibrium
quantity falls to the
economically efficient level.
Figure 5.5

externality, a tax can lead to
the efficient level of output
105 of
Effect of the Corrective Taxes

The price of electricity
will rise from PMarket,
which does not include
the cost of acid rain, to
PEfficient, which does
include the cost.
Consumers pay the
price PEfficient, while
producers receive a
price P, which is equal
to PEfficient minus the
amount of the tax.
Figure 5.5

externality, a tax can lead to
the efficient level of output
106 of
Can Taxes Solve Positive Externalities Too?

Taxes worked to solve the problem of negative externalities
because:
Negative externalities caused too much to be produced, while
Taxes reduced the amount of output.
When there are positive externalities, too little will be produced.
Taxes wont work; but subsidies might.
Subsidy: An amount paid to producers or consumers to
encourage the production or consumption of a good.
107 of
Corrective Subsidies for Positive Externalities

Individuals make decisions
about whether or not to
consume a college
education, with a resulting
market price and quantity.
But what if there are
positive externalities to a
college education?
It is good for us all if
other people are smart
and make good
decisions.
This is an argument for a
Figure 5.6
When there is a positive

externality, a subsidy can bring
about the efficient level of output
108 of
Effect of the Corrective Subsidies

The subsidy will cause
the demand curve to
shift up, from D1 to D2.
The market equilibrium
quantity will shift from
QMarket to QEfficient, the
economically efficient
equilibrium quantity.
Producers receive the
price PEfficient, while
consumers pay a price
P, which is equal to
PEfficient minus the
Figure 5.6
When there is a positive

externality, a subsidy can bring
about the efficient level of output
109 of
Corrective Taxes and Subsidies

The taxes and subsidies seen in the last few slides correct the
externality problem.
They are known as Pigovian taxes and subsidies, after the
English economist Arthur Cecil Pigou, who first demonstrated
the use of government taxes and subsidies in bringing about an
efficient level of output in the presence of externalities.
Pigovian taxes are especially popular with economists, because
they increase efficiency while bringing in tax revenue; then (in
theory) this allows inefficiency-causing taxes in other markets to
be reduced, a double dividend of taxation.
110 of
Making Should We Tax Cigarettes and Soda?

the
Connection
The consumption of cigarettes and soda are thought to have negative
externalities. Why?
Both cigarettes and soda have negative health consequences.
This by itself is not sufficient to be a negative externality
But peoples medical expenses are shared with others, either via
public or private health insurance.
Therefore we expect there to be too much consumption of cigarettes
and soda, and they are candidates for Pigovian taxes.
In general, cigarettes are taxed much more heavily than soda. Is this
appropriate?
111 of
Making
the
Connection
Should We Tax Cigarettes and Soda?cont.
112 of
Alternatives to Taxation for Solving Externalities

The traditional solution to the externality problem is commandand-control: an approach that involves the government
imposing quantitative limits on the amount of pollution firms are
allowed to emit, or requiring firms to install specific pollutioncontrol devices.
Example: Requiring car manufacturers to equip cars with
catalytic converters.
Problem: What if firms have very different costs of reducing
pollution? It may not be efficient for them to reduce pollution by
the same amount.
113 of
Two Car Manufacturers

Suppose Ford can reduce pollution in its cars very cheaply,
while GM has very high costs of reducing pollution.
If we want to achieve a particular level of pollution-reduction, it
would be efficient to ask Ford to reduce pollution more than GM.
But this doesnt seem fair to Ford; why should GM be held to a
lesser standard?
The efficient solution has Ford perform more pollution reduction,
but have GM compensate Ford; both companies can be made
better off, compared with requiring both to reduce pollution by a
moderate amount, while keeping the amount of pollution
reduction the same.
114 of
Tradable Emissions Permits

This is the concept behind tradable emissions permits, also
known as cap-and-trade:
The government establishes an allowable amount of
emissions.
Emissions permits are distributed.
Firms can trade emissions permits.
Firms with high costs of reducing pollution will buy permits form
firms with low costs of reducing pollution, ensuring that
pollution is reduced at the lowest possible cost.
Hence the market is used to achieve efficient pollution

reduction.
115 of
Criticisms of Cap-and-Trade
Environmentalists object to cap-and-trade as it gives firms
licenses to pollute.
But pollution has a benefit: it allows cheap production.
Every production decision uses up some scarce resource:
time, natural resources, clean air, etc.
In this sense, paying for using the clean air seems
appropriate.
A more serious concern is that cap-and-trade may produce hotspots, locations where a lot of pollution takes place.
This would be the case if the firms with high costs of
pollution-reduction were geographically close.
Do you think this is likely?
117 of
Why has Cap-and-Trade Lost Its Popularity?

Cap-and-trade has lost some of its popularity recently.
Why? Cap-and-trade alters who pays for pollution:
When pollution is unregulated, all consumers bear the
consequences of pollution.
When cap-and-trade is enacted, the cost of pollution is borne
directly by firms.
Polluting firms tend to be able to organize better lobbying
efforts, because consumers feel the cost of pollution diffusely.
This illustrates the classic special-interest problem in politics:
small groups are better able to organize than large groups,
even when the large groups might benefit a lot from
organizing.
118 of
Four Categories of Goods
Explain how goods can be categorized on the basis of whether they are rival or
excludable and use graphs to illustrate the efficient quantities of public goods
and common resources.
119 of
Attributes of Goods and Services

We have seen that markets are better at providing the efficient
level of some goods and services than others.
This is related to some important attributes of the goods and
services: whether their consumption is rival and/or excludable.
Rivalry: The situation that occurs when one persons
consuming a unit of a good means no one else can consume it.
Excludability: The situation in which anyone who does not pay
for a good cannot consume it.
120 of
The Four Categories of Goods
Figure 5.7
Four categories of
goods
121 of
Efficient Provision of the Categories of Goods

Markets tend to be good at providing efficient levels of private
goods. Why?
The person making decisions about how much to purchase
tends to be the only one benefiting from the good, so only
their preferences matter.
Markets are not so good at providing efficient levels of the other
types of goods. Why?
People can free-ride on public goods, enjoying the benefits
from them without paying for them.
People have little incentive to conserve common resources,
leading them to be over-consumed.
Profit-maximization tends to lead too many people to be
excluded from quasi-public goods.
122 of
Constructing Market Demand CurvesPrivate Goods
Figure 5.8
Constructing the market demand curve for a private good
The market demand curve for private goods is determined by

adding horizontally the quantity of the good demanded at each
price by each consumer.
In panel (a), Jill demands 2 hamburgers when the price is $4.00,
and in panel (b), Joe demands 4 hamburgers when the price is
$4.00.
So, a quantity of 6 hamburgers and a price of $4.00 is a point 123
onof
Constructing Market Demand CurvesPublic Goods

To find the demand curve for a
public good, we add up the price
at which each consumer is willing
to purchase each quantity of the
good.
In panel (a), Jill is willing to pay
$8 per hour for a security guard to
provide 10 hours of protection.
In panel (b), Joe is willing to pay
$10 for that level of protection.
Therefore, in panel (c), the price
of $18 per hour and the quantity
of 10 hours will be a point on the
demandFigure
curve
security the
guard
5.9 forConstructing
demand
curve for a public good
services.
124 of
Efficient Production of a Public Good

Once we know the market
demand curve, determining
the efficient level of
production of a public good
is the same as for a private
good: it is where the
demand and supply curves
intersect.
But finding this market
demand curve can be
difficult; consumers may not
have incentives to reveal
their willingness to pay for
public goods.
Cost-benefit analysis can
be useful to determine the
Figure 5.10
The optimal quantity of

a public good
125 of
Efficient Consumption of a Public Resource

Common resources tend to be over-consumed. Why?
While people cannot be excluded from the resource, their
consumption is rival, depleting the resource for other people.
This can be thought of as a negative externality.
Ideally, we would make people pay for their consumption, as
with Pigovian taxes.
When this is not possible, the situation is referred to as the
Tragedy of the commons, with the common resource being
overused.
126 of
Common Resources: Efficient Level of Consumption

For a common resource
such as wood from a
forest, the efficient level
of use, QEfficient, is
determined by the
intersection of the
demand curvewhich
represents the marginal
benefit received by
consumersand S2,
Figure 5.11 Overuse of a common
which represents the
resource
marginal
social cost
of
But each individual
tree-cutter
ignores the external cost, resulting
cutting
the
wood.
in Q
wood
being cut. As the quantity is not optimal, there is
Actual
deadweight loss as a result.

127 of
128 of
The Price Elasticity of Demand and Its Measurement
Define price elasticity of demand and understand how to measure it.
129 of
Measuring Responsiveness to Price Changes

Although we saw consumers did change the amount of gasoline
they bought, they didnt appear to change it by very much.
How can we come up with a sensible way to measure how
much quantity changes when price changes?
One idea is to look at the slope of the demand curve.
But this wont work, since the value of the slope depends on
the units used to measure on the axes.
130 of
Price Elasticity of Demand

A better way to measure responsiveness of quantity demanded
is to think in terms of percentage changes.
This avoids the problem with units of measurement.
Price elasticity of demand
Percentage change in quantity demanded

Percentage change in price
Although the slope and price elasticity of demand are related, they
are not the same thing.
Since price and quantity change in opposite directions on the demand
curve, the price elasticity of demand is a negative number.
However we often refer to more negative elasticities as being
larger or higher.
131 of
Price Elasticity of Demand Terminology

A large value for the price elasticity of demand means that
quantity demanded changes a lot in response to a price
change.
Formally, we say demand is price elastic if its price elasticity of
demand is larger (in absolute value) than 1.
So a 10% increase in price would result in a greater than
10% decrease in quantity demanded.
Demand is price inelastic if its price elasticity of demand is
smaller (in absolute value) than 1.
That is, close to zero, indicating that quantity demanded
changes little in response to a price change.
Demand is unit price elastic if the price elasticity of demand is
132 of
Elastic and Inelastic Demand

Along D1, cutting the price
from $4.00 to $3.70
increases the number of
gallons sold from 1,000
per day to 1,200 per day,
so demand is elastic
between point A and point
B.
Along D2, cutting the price
from $4.00 to $3.70
increases the number of
gallons sold from 1,000
per day only to 1,050 per
day, so demand is
Figure 6.1
Elastic and inelastic

demand
133 of
Percentage Changes and the Midpoint formula

Percentage changes have the unfortunate characteristic that the
percentage change from A to B is not the negative of the
percentage change from B to A.
Example: On the previous slide, from point A to point B, quantity
increased from 1000 to 1200, an increase of 20%.
However from B to A, quantity decreases by 16.7%.
This would mean the elasticity from A to B was different from
the elasticity from B to A, an undesirable characteristic.
To avoid this, we calculate percentage changes
the
( A Busing
)
Percentage Change
midpoint formula:
A B
134 of
The Midpoint Formula

The midpoint formula avoids the confusion of whether we are
going from A to B or from B to A: we use the average of A and
B in the denominator instead of choosing one of them.
Price elasticity of demand becomes:
(Q2 Q1 ) ( P2 P1 )
Q1 Q2 P1 P2
2
2
The first term is the percentage change in quantity, using the midpoint
formula.
The second term is the percentage change in price, using the
midpoint formula.
135 of
Calculating Price Elasticity of Demandpart 1

At your gas station, you cut
price from $3.50 per gallon
to $3.30 per gallon.
Gasoline sales went up
from 2000 to 2500 gallons
per day.
To calculate this price
elasticity, we first need the
2,000 2,500
average
quantity
and price:
Average quantity
2,250
2
Average price
$3.50 $3.30
$3.40
2
136 of

Now calculate the
percentage change in
Percentageand
change
quantity
price:2,500 2,000
in quantity demanded
Percentage change
in price
2,250
22.2%
100
$3.30 $3.50
100
$3.40
5.9%
Then price elasticity of

demand is the ratio of these
two:
Price elasticity
22.2%
of demand
5.9%
3.8
This is greater in absolute value than 1, so we say that demand in

this range is price elastic.
137 of

What if the quantity had
only increased to 2100?
remains the same (-5.9%).
Percentage change in
quantity is now:
2,100 2,000
100
in quantity demanded
2,050
4.9%
Percentage change
So price elasticity of
demand is now
Price elasticity
4.9%
of demand
5.9%
0.8
This is smaller (in absolute value) than -1, so demand is inelastic.

138 of
Observations About Elasticity

While slope and elasticity are not the same, they are related:
If two demand curves go through the same point, the one
with the higher slope also has the higher (more negative)
elasticity.
A vertical demand curve means that quantity demanded does
not change as price changes.
So elasticity is zero.
A vertical demand curve is perfectly inelastic.
A horizontal demand curve means quantity demanded is
infinitely responsive to price changes.
Elasticity is infinite.
A horizontal demand curve is perfectly elastic.
139 of
Summary of Price Elasticity of Demandpart 1

If demand is
then the absolute value

of price elasticity is
Table 6.1
Summary of
the price
elasticity of
demand
140 of

If demand is

Table 6.1
Summary of
the price
elasticity of
demand
141 of

If demand is

Table 6.1
Summary of
the price
elasticity of
demand
142 of
Do People Respond to Changes in the Price of Gasoline?

We can now use our knowledge to answer this question in
economic terms.
Gasoline demand is inelastic: the quantity demanded does
not change much as the price of gasoline changes.
It is not perfectly inelastic: it is somewhat responsive to price.
Which panel shows this?
143 of
The Determinants of the Price Elasticity of Demand
Understand the determinants of the price elasticity of demand.
144 of
What Determines the Price Elasticity of Demand?

Why do some goods have a high price elasticity of demand,
while others have a low price elasticity of demand?
There are several characteristics of the good, of the market, etc.
that determine this.
1. The availability of close substitutes
If a product has more substitutes available, it will have more
elastic demand.
Example: There are few substitutes for gasoline, so its price
elasticity of demand is low.
Example: There are many substitutes for Nikes (Reeboks,
Adidas, etc.), so their price elasticity of demand is high.
145 of
More Determinants of the Price Elasticity of Demand

2. The passage of time
Over time, people can adjust their buying habits more easily.
Elasticity is higher in the long run than the short run.
Example: If the price of gasoline rises, it takes a while for
people to adjust their gasoline consumption. How might they do
that?
. Buying a more fuel-efficient car
. Moving closer to work
3. Whether the good is a luxury or a necessity
People are more flexible with luxuries than necessities, so price
elasticity of demand is higher for luxuries.
Example: Many people consider milk and bread necessities;
they will buy them every week almost regardless of the price.
146 of
And if the price goes down, they wont drastically increase their
Yet More Determinants of the Price Elasticity of Demand

4. The definition of the market
The more narrowly defined the market, the more substitutes are
available, and hence the more elastic is demand.
Example: You might believe there is no good substitute for
jeans, so your demand for jeans is very inelastic.
But if you consider different brands of jeans, you might be more
sensitive to the price of a particular brand.
5. The share of a good in a consumers budget
If a good is a small portion of your budget, you will likely not be
very sensitive to its price.
Example: You might buy table salt once a year or less; changes
in its price will not affect very much how much you buy.
Example: Changes in the price of housing do affect where
people choose to live.
147 of
Some Real-World Price Elasticities of Demand

Product
Estimated
Elasticity
Product
Estimated
Elasticity
Books (Barnes & Noble)
4.00
Bread
0.40
Books (Amazon)
0.60
Water (residential use)
0.38
DVDs (Amazon)
3.10
Chicken
0.37
Post Raisin Bran
2.50
Cocaine
0.28
Automobiles
1.95
Cigarettes
0.25
Tide (liquid detergent)
3.92
Beer
0.29
Coca-Cola
1.22
Catholic school attendance
0.19
Grapes
1.18
Residential natural gas
0.09
Restaurant meals
0.67
Gasoline
0.06
Health insurance (low-income

households)
0.65
Milk
0.04
Sugar
0.04
Table 6.2
Estimated real-world price

elasticities of demand
148 of
Making Price Elasticity of Demand for Breakfast

the
Connection
What is the price elasticity of demand for breakfast cereal?
Cereal
The answer depends on whether you mean:

A particular brand of a particular breakfast cereal
A particular category of breakfast cereal
Breakfast cereal in general
The further down the list we go, the more broadly the market is
defined, and hence the fewer close substitutes are available.
So we would expect the price elasticity of demand to become
smaller as we move down the list.
And so it does:
Price elasticity
Cereal
of demand
Post Raisin Bran
2.5
All family breakfast cereals
1.8
All types of breakfast cereal
0.9
149 of
The Relationship between Price Elasticity of Demand

and Total Revenue
Understand the relationship between the price elasticity of demand and total
revenue.
150 of
Elasticity and the Pricing Decision

If you are a business owner, you need to decide how to price
your product.
How many customers will I gain if I cut my price?
What will happen to my total revenue if I cut my price?
Total revenue: The total amount of funds received by a seller of
a good or service, calculated by multiplying the price per unit by
the number of units sold.
Knowing the price elasticity of demand for your product can
help to answer these questions.
151 of
Effect of Cutting Price with Different Elasticities

Suppose demand for your product is relatively price inelastic.
Customers are not very sensitive to the price of your product.
As you decrease the price, you expect to gain few additional
customers.
The few additional customers do not compensate for the
lost revenue, so overall revenue goes down.
Suppose demand for your product is relatively price elastic.
Customers are very sensitive to the price of your product.
As you decrease the price, you expect to gain many
additional customers.
The many additional customers more than compensate
for the lost revenue, so overall revenue goes up.
152 of
Cutting Price When Demand Is Inelastic

Revenue before price
cut (at A):
1,000 x $4.00
= $4,000
Revenue after price cut
(at B):
1,050 x $3.70
= $3,885
The decrease in price
does not generate
enough extra
customers (area E) to
offset revenue loss
Figure 6.2a
The relationship between price

elasticity and total revenue
153 of
Cutting Price When Demand Is Elastic

Revenue before price
cut (at A):
1,000 x $4.00
= $4,000
Revenue after price cut
(at B):
1,200 x $3.70
= $4,440
The decrease in price
generates enough extra
customers (area E) to
more than offset
revenue loss (area C).
Figure 6.2b
The relationship between price

elasticity and total revenue
154 of
Why Are Elasticity and Total Revenue Related?

The formula for price elasticity of demand is:
So if this is greater than 1 (in absolute terms) then quantity demanded

goes up by a higher percentage than price, raising the revenue.
A special case occurs when price elasticity of demand is -1: the
percentage change in quantity demanded equals the percentage
change in price, so revenue does not change.
155 of
Total Revenue Along a Linear Demand Curve

Suppose we have a linear
demand curve.
What happens to total revenue
as price increases?
Initially, total revenue rises,
suggesting demand is
inelastic.
But then total revenue starts
to fall, suggesting demand is
elastic!
Figure 6.3
Elasticity is not
constant along a linear
demand curve
156 of
Total Revenue Along a Linear Demand Curvecont.

The data from the table are
plotted in the graphs.
As price decreases from $8,
revenue riseshence demand is
elastic.
As price continues to fall,
revenue eventually flattens out
demand is unit elastic.
Then as price falls even further,
revenue begins to falldemand
is inelastic.
Figure 6.3
Elasticity is not
constant along a linear
demand curve
157 of
Price Elasticity of Demand and Revenue

If demand is
then...
because...
elastic
an increase in price
reduces revenue
the decrease in quantity demanded is proportionally

greater than the increase in price.
elastic
a decrease in price
increases revenue
the increase in quantity demanded is proportionally

greater than the decrease in price.
inelastic
increases revenue

smaller than the increase in price.
inelastic
a decrease in price
reduces revenue

smaller than the decrease in price.
unit elastic
does not affect
revenue

the same as than the increase in price.
unit elastic
a decrease in price
does not affect
revenue

the same as than the decrease in price.
Table 6.3
The relationship between

price elasticity and revenue
158 of
Estimating Price Elasticity of Demand

We can see that knowing the price elasticity of demand would
be very useful for a firm. But how can a firm know this
information?
For a well-established product, economists can use historical
data to estimate the demand curve.
To calculate the price elasticity of demand for a new product,
firms often rely on market experiments.
With market experiments, firms try different prices and observe
the change in quantity demanded that results.
159 of
Other Demand Elasticities
Define cross-price elasticity of demand and income elasticity of demand and

understand their determinants and how they are measured.
160 of
Cross-Price Elasticity of Demand

When we examined demand in Chapter 3, we discussed substitutes
and complements.
Substitutes: Goods and services that can be used for the same
purpose.
Complements: Goods and services that are used together.
Cross-price elasticity of demand measures the strength of
substitute or complement relationships between goods:
Cross - price elasticity of demand
Percentage change in quantity demanded of one good

Percentage change in price of another good
161 of
Summary of the Cross-Price Elasticity of Demand
If the
products are
then the crossprice elasticity of

demand will be
Example
substitutes
positive
Two brands of tablet

computers
complements
negative
Tablet computers and

applications downloaded from
online stores
zero
Tablet computers and peanut

butter
unrelated
Table 6.4
Summary of cross-price
elasticity of demand
162 of
Income Elasticity of Demand

When we examined demand in Chapter 3, we discussed normal
and inferior goods.
Normal goods: Goods and services for which the quantity
demanded increases as income increases
Inferior goods: Goods and services for which the quantity
demanded falls as income increases
Income elasticity of demand measures the strength of the
effect of income on quantity demanded:
Income elasticity of demand

Percentage change in income
163 of
Summary of Income Elasticity of Demand

If the income elasticity
of demand is
then the good is
Example
positive but less than 1
normal and a necessity
Bread
positive and greater than 1 normal and a luxury
Caviar
negative
Ramen
noodles
inferior
Necessity: A normal good with a

quantity demanded that responds
less than proportionally to a price
change.
Luxury: A normal good with a
quantity demanded that responds
more than proportionally to a price
change.
Table 6.5
Summary of income
elasticity of demand
164 of
Elasticities of Alcoholic Beverages
Making
the
Connection
Christopher Ruhm of the University

of Virginia and colleagues estimated
elasticities for various alcoholic
beverages. According to their study:
Price elasticity of
demand for beer
0.30
Demand for beer is price inelastic.
Cross-price elasticity of 0.83

demand between beer
and wine
Cross-price elasticity of 0.50
demand between beer
and spirits
Income elasticity of
demand for beer
0.09
Beer and wine are complements.

Beer and spirits are also
complements, but the relationship is
not as strong.
Beer is a normal good; a necessity.
Are any of these results surprising to you?

Why or why not?
165 of
Using Elasticity to Analyze the Disappearing Family

Farm
Use price elasticity and income elasticity to analyze economic issues.
166 of
Stylized Facts About Farming in the United States

Over the last century farms have become much more efficient
at producing food.
This might appear to make farming more profitable, and
hence encourage more people into farming.
But the number of people in farming has fallen substantially (23
million in 1950, 3 million in 2011).
Why have productivity gains in farming led to fewer people
choosing to farm?
167 of
Elasticity and the Disappearing Family Farm

In 1950, U.S. farmers
produced 1.0 billion
bushels of wheat at a
price of $19.29 per
bushel.
Over the next 60
years, rapid
increases in farm
productivity caused a
large shift to the right
in the supply curve
for wheat.
Figure 6.4
Elasticity and the

disappearing family farm
168 of
Elasticity and the Disappearing Family Farmcont.

Income elasticity of
demand for wheat is
low, so demand for
wheat increased little
over this period.
Demand for wheat is
also inelastic, so the
large shift in the supply
curve and the small
shift in the demand
curve resulted in a
sharp decline in the
price of wheat.
Figure 6.4
Elasticity and the

disappearing family farm
169 of
The Price Elasticity of Supply and Its Measurement
Define price elasticity of supply and understand its main determinants and how it
is measured.
170 of
Price Elasticity of Supply

Price elasticity of supply is very much analogous to price
elasticity of demand:
Price elasticity of supply
Percentage change in quantity supplied

So the same sort of calculation methods apply (midpoint formula,

etc.)
171 of
Determinants of the Price Elasticity of Supply

Price elasticity of supply depends on the ability and willingness
of firms to alter the quantity they produce as price increases.
The time period in question is critically important for determining
the price elasticity of supply.
Suppose the wholesale price of grapes doubled overnight:
Farmers could do little to increase their quantity immediately;
the initial price elasticity of supply would be close to 0.
Over time, farmers could plant more fields in grapes; so over
the course of several years, the price elasticity of supply
would rise.
172 of
Making
the
Connection
Why Are Oil Prices So Unstable?
Oil producers cannot change

output very quickly.
When demand increases
suddenly, price rises, acting
as a rationing mechanism for
the increased demand.
On the other hand, during a

recession, demand for oil
falls.
Oil producers cannot adjust
their output quickly, so the
price falls dramatically.
173 of
Terminology for Price Elasticity of Supplypart 1

Much the same terminology applies to price elasticity of supply
as to price elasticity of demand: elastic, inelastic, unit-elastic,
perfectly elastic, and perfectly inelastic all have similar
meanings.
If supply is
Table 6.6
then the value of price elasticity is
Summary of the price

elasticity of supply
174 of

If supply is
Table 6.6

175 of

If supply is
Table 6.6

176 of
Why Is Knowing Price Elasticity of Supply Useful?

Knowing the price elasticity of supply can help us to predict the
effect that a change in demand will have.
When demand increases, we know equilibrium price and
quantity will increase.
But if supply is inelastic, quantity supplied cannot change much
in response to the demand change; so price will rise a lot.
If supply is elastic, price will rise much less.
The next two slides illustrate these statements.
177 of
Parking on the 4th of JulyInelastic Supply

DemandTypical represents the
typical demand for parking
spaces on a summer
weekend at a beach resort.
DemandJuly 4 represents
demand on the 4th of July.
When supply is inelastic,
the price increase will be
large.
Figure 6.5a
Changes in price depend on

the price elasticity of supply
178 of
Parking on the 4th of JulyElastic Supply

If supply is
elastic instead,
then the
resulting price
change will be
much smaller.
Figure 6.5b
Changes in price depend on

the price elasticity of supply
179 of
Summary of Elasticitiespart 1
Price Elasticity of Demand
Formula:
Percentagechangein quantitydemanded
Percentagechangeinprice
(Q 2 Q1 ) (P 2 P1 )
MidpointFormula:
Q 2 Q1 P1 P2
2
2
Absolute Value
of Price Elasticity
Effect on Total Revenue

of an Increase in Price
Elastic
Greater than 1
Total revenue falls
Inelastic
Less than 1
Total revenue rises
Unit elastic
Equal to 1
Total revenue unchanged
Table 6.7
Summary of elasticities
180 of
Cross-Price Elasticity of Demand
Formula:
Percentagechangein quantitydemandedof one good

Percentagechangeinpriceof anothergood
Types of Products
Value of Cross-Price Elasticity
Substitutes
Positive
Complements
Negative
Unrelated
Zero
Income Elasticity of Demand
Formula:
Percentagechangein quantitydemanded
Percentagechangeinincome
Types of Products
Value of Income Elasticity
Normal and a necessity
Positive but less than 1
Normal and a luxury
Positive and greater than 1
Inferior
Negative
Table 6.7
181 of
Price Elasticity of Supply
Formula:
Percentagechangein quantitysupplied
Percentagechangein price
Value of Price Elasticity
Elastic
Greater than 1
Inelastic
Less than 1
Unit elastic
Equal to 1
Table 6.7
182 of

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CHAPTER

Chapter Outline and

Three Key Economic Ideas

The Economic Problem That

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What Is This Class About?

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Microeconomics and Macroeconomics

Macroeconomics is the study of the economy as a whole, including

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Three Key Economic Ideas

1.1 LEARNING OBJECTIVE

Explain these three key economic ideas:

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1. People Are Rational

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2. People Respond to Economic Incentives

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2. People Respond to Economic Incentives

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3. Optimal Decisions Are Made at the Margin

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Solved Problem 1.1

Solving the Problem

Calculating the Slope of a Linecontinued

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Calculating the Slope

Change in value on the vertical axis

Change in value on the horizontal axis x Run

Formula for a Percentage Change

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Value in the second period Value in the first period

The Area of a Rectangle

Area of a rectangle Base Height

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Showing a Firms Total

The Area of a Triangle

The Area of a Triangle

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Production Possibilities Frontier

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Increasing Marginal Opportunity Costs

Economic Growth on the PPF

Shifts in the production

Economic growth: the ability of the economy to increase the

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Technological Change in One Industry

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Gains from Specialization and Tradecontinued

Gains from Trade

If you specialize in picking apples, you can pick 20 pounds. If

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Summary of the Gains from Trade

Production with trade

Consumption with trade

Gains from trade (increased

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Explaining the Gains from Specialization and Trade

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Comparative Advantage and the Gains from Trade