The Concept of Elasticity and Consumer and Producer Surplus

1. 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) THREE

2. 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

3. %Δ Qty ED = %Δ Price 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.

4. 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 • Consumer response is equal to price changes.

5. Elasticity Examples

6. 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.

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

8. 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.

9. Perfectly elastic (E = ) p2 Price p1 q1 0 Quantity Extremes of Elasticity A horizontal demand curve = perfectly elastic demand. • Any price increase would cause demand to fall to zero • If price increases, people will not buy it. EXAMPLES?

10. Perfectly inelastic (E = 0) p2 Price p1 q1 0 Quantity Extremes of Elasticity A vertical demand curve = perfectly inelastic demand. • Quantity demanded will not change regardless of the price change. • People will buy the same amount no matter the price. EXAMPLES?

11. 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.

12. 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.

13. 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)

14. Market Failure & Provision of Public Goods

15. 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: • Politicians maximize votes • Bureaucrats maximize income, power and longevity

16. 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.

17. The Concept of Elasticity . . . . • Key Terms: • Congestible Public Goods • Elastic Demand • Elasticity • Excludable Public Goods • Exclusivity • Government failure • Inelastic Demand • Market failure • Perfectly Elastic • Perfectly Inelastic • Public choice theory • Purely public goods • Purely private goods • Rivalry • Unit Elastic Demand