Elasticity, Consumer Surplus and

Producer Surplus
The Law of Demand tells us that, other
things equal, consumers buy more of
a product when its price declines and
less when its price increases. But
how much more or less will they
buy?
 Elasticity . . .
 … is a measure of how much buyers and
sellers respond to changes in market
conditions
… allows us to analyze supply and demand
with greater precision.
… a unit free measurement. By using
percentages, we can sensibly compare
consumer responsiveness to changes in the
prices of different products.
 Price Elasticity of Demand
Price elasticity of demand is the percentage
change in quantity demanded given a percent
change in the price.

It is a measure of how much the quantity

demanded of a good responds to a change in
the price of that good.
 Determinants of
Price Elasticity of Demand

 Necessities versus Luxuries

 Availability of Close Substitutes
 Definition of the Market
 Time Horizon
 Determinants of
Price Elasticity of Demand

Demand tends to be more elastic :

if the good is a luxury.
the longer the time period.
the larger the number of close substitutes.
the more narrowly defined the market.
 Computing the Price Elasticity of Demand
Two Measures
1. Point Elasticity- elasticity at one point along
the demand curve.
The price elasticity of demand is computed as
the percentage change in the quantity
demanded divided by the percentage
change in price.
Percentage Change
in Quantity Demanded
Price Elasticity of Demand =
Percentage Change
in Price
 Computing the Price Elasticity of
Demand
Q Q2-Q1
ED = Q1 = Q1
P P2-P1
P1 P1
Where: Q- original quantity demand
P- original price
Q- new quantity demand – original qd
P – new price – original price
Computing the Price Elasticity of Demand
Example: If the price of an ice cream cone increases from
P2.00 to P3.00 and the amount you buy falls from 10 to 8
cones then your elasticity of demand would be calculated as:
Price Qd
P2 10
3 8

(8  10)
10 .2 percent
  .4%
(3  2) .5 percent
2
For every 1% increase in the price of cones, the
quantity demanded will decrease by .4%.
Computing the Price Elasticity of Demand
2. Arc Elasticity- the coefficient of the
price elasticity of demand between
two points along the demand curve.

Epa= Q + P
(Q1 + Q2) / 2 (P1 + P2) / 2
Price Qd
P2 10
3 8
Computing the Price Elasticity of Demand
The downsloping demand curve that price
and quantity demanded are inversely
related. Thus, the price-elasticity
coefficient of demand E d will always
be a negative number.
Ignore the minus sign and simply
present the absolute value of the
elasticity coefficient to avoid an
ambiguity that might otherwise arise.
 Ranges of Elasticity
Inelastic Demand (/E/<1)
Quantity demanded does not respond
strongly to price changes or the changes in
quantity demanded do not vary significantly
with the changes in price.
Price elasticity of demand is less than one.
Price Quantity
Demanded
P 60 160 units
70 150 units
 Ranges of Elasticity
Inelastic Demand (/E/ <1)
.375% For every 1% increase in the price of the
good, the quantity demanded will decrease by
.375%.
Inelastic demand means that the quantity
demanded is not very sensitive to price
changes.
Basic necessities are included in this case like
rice, salt, bread, inferior goods, utilities.
A Variety of Demand Curves

Because the price elasticity of

demand measures how much
quantity demanded responds
to the price, it is closely
related to the slope of the
demand curve.
 Inelastic Demand (/E/<1)

Price

/E/ = .375%
P70

60

Demand

150 160 Quantity

Elastic Demand (/E/ > 1)
Quantity demanded responds strongly to
changes in price.
Price elasticity of demand is greater
than one.

Price Quantity
Demanded
P 10 90
11 70
Elastic Demand (/E/ > 1)
2.22% For every 1% change in the price of
the commodity, there is a corresponding
2.22% decrease in quantity demanded.
Elastic demand means that the quantity
demanded is sensitive to price changes.
A small change in price would cause a
significant or great change in quantity
demanded for the good.
Elastic Demand (/E/ > 1)
Examples are mobiles, gold, jewelry,
houses, cars.

The availability of substitute goods tends

to make the demand for a commodity
elastic.
 Elastic Demand
- Elasticity is greater than 1
Price

/E/=2.22%
1. A .10% P11
increase
in price... 10

Demand

70 90 Quantity
2. ...leads to a .22% decrease in quantity.
Perfectly Inelastic Demand (/E/ = 0)

Quantity demanded does not respond to

price changes.
The quantity demanded remains relatively
the same even though prices increase
or decrease.
Price Quantity
Demanded
P 20 150
40 150
0.00 Zero divided by any number is zero.
a 1% change in the price results in no
change whatsoever in the quantity
demanded

Coefficient is 0 because there is no

response to a change in price.

E.g. acute diabetic’s demand for insulin

addict’s demand for heroin
 Perfectly Inelastic Demand

Price Demand

1. An P40 /E/ = 0
increase
in price... 20

150 Quantity
2. ...leaves the quantity demanded unchanged.
Perfectly Elastic Demand (/E/=∞)
Price remains the same or changes
negligibly, but quantity demanded
changes.
Any quantity changes is not brought
about by price changes.
Price Quantity
Demanded
P 20 150
20 100
Perfectly Elastic Demand (/E/=∞)
∞ Any number divided by zero is not
equal to zero but to infinity.
More of an extreme case.
A small price reduction causes buyers
to increase their purchases from zero
to all they can obtain.
Examples: seasonal fruits, medicines.
 Perfectly Elastic Demand
- Elasticity equals infinity
Price
1. At any price
above P20, quantity
demanded is zero.

P20 Demand

2. At exactly P20,
consumers will
buy any quantity.

3. At a price below P20, Quantity

quantity demanded is infinite.
Unitary Elastic Demand (/E/ = 1)
Quantity demanded changes by the
same percentage as the price.
Unitary Elastic Demand indicates that
the percentage change in the price
of the good will equal the
percentage change in the demand
for thePrice
good. Quantity Demanded
P3 150
4 120
Unitary Elastic Demand (/E/ = 1)
1 For every 1% increase in price, there will
be a corresponding 1% decrease in
quantity demanded.

The corresponding change in QD is in direct

proportion to the change in its price.
 Unitary Elastic Demand

Price

/E/ = 1
1. A 1% P4
increase
in price... 3

Demand

120 150 Quantity

2. ...leads to a 1% decrease in quantity.
 Income Elasticity of Demand
Income elasticity of demand measures how
much the quantity demanded of a good
responds to a change in consumers’ income.
It is computed as the percentage change in
the quantity demanded divided by the
percentage change in income.
 Computing Income Elasticity

Percentage Change
Income Elasticity = in Quantity Demanded
of Demand Percentage Change
in Income
 Computing Income Elasticity
Q Q2-Q1
ED = Y1 = Q1
Y Y2-Y1
Y1 = Y1
Where: Q- original quantity demand
Y- original income
Q- new quantity demand – original qd
Y – new income – original income
 Cross Elasticity of Demand
 Measures how sensitive consumer
purchases of one product are to a change
in the price of some other product.
Percentage change in
quantity demanded
of product X
Cross elasticity of demand =
Percentage change in
price of product Y
 Cross Elasticity of Demand

∆ Qa ∆ Pb ∆ Qa Pb
EC = -------
Q
÷ -------
P
= -----
∆P
x ----
a b b Qa

Where Ec = cross elasticity of demand

Q = Original demand for product A
P = Original Price of product B
∆ Q = New demand for prod. A – Original
quantity demanded
∆ P = New price for prod. B – Original Price
Cross Elasticity Original New
Price Quantity Price Quantity

Demand for :
Good a 50 30
Good b 10 100 15 60

EC = ∆Qa x Pb = 30-50 x 10 = -20 x 10 = 200

∆Pb Qa 15-10 50 5 50 250
-.8. The demand for good a is inelastic to the
change in the price of good b because the value
is less than 1.
 Cross Elasticity of Demand
• Substitute Goods
– If cross elasticity of demand is positive,
meaning that the sales of a moves in the
same direction as a change in the price of b,
then a and b are substitute goods.
– The larger is the positive cross elasticity
coefficient, the greater the substitutability
between the two products.
 Cross Elasticity of Demand
• Complementary Goods
– If cross elasticity of demand is negative, we
know that a and b “go together”; an
increase in the price of one decreases the
demand for the other
– The larger the negative cross elasticity
coefficient, the greater is the
complementarity between the two goods
 Cross Elasticity of Demand: What now?
• Degree of substitutability of products measured by
the cross elasticity coefficient is important to
business and government
– E.g. Sprite vs. Coca-cola
• A low cross elasticity would indicate that Coke
and Sprite are weak substitutes for each other
and that a lower price for Sprite would have
little effect on Coke sales
– E.g. Pepsi vs. Coca-cola
• High cross elasticity make them strong
substitutes for each other
• Block merger if it would lessen competition
• Low or zero cross elasticity would give minimal
effect on competition
 Price Elasticity of Supply
Price elasticity of supply is the percentage
change in quantity supplied resulting from a
percent change in price.
It is a measure of how much the quantity
supplied of a good responds to a change in the
price of that good.
 Computing the Price Elasticity of Supply

The price elasticity of supply is

computed as the percentage change
in the quantity supplied divided by
the percentage change in price.
Percentage Change in
Quantity Supplied
Elasticity of Supply =
Percentage Change
in Price
 Ranges of Elasticity

Perfectly Elastic
ES = 
Relatively Elastic
ES > 1
Unit Elastic
ES = 1
 Ranges of Elasticity

 Relatively Inelastic

ES < 1
 Perfectly Inelastic

ES = 0
Elastic supply means that the quantity
supplied is sensitive to the price.
Inelastic supply means that the quantity
supplied is not very sensitive to the price.
 Any supply curve that is a straight
line from the origin such as shown
above is a
unit-elastic supply curve.

(c) Unit elastic

P rice pe r un it

S"
E =S 1
$10

Quantity
0 10 20
per period
 (b) Perfectly inelastic

S'
Price per unit

E=S 0

0 Quantity per period

Q

The most unresponsive relationship is

where there is no change in the quantity
supplied regardless of the price where the
supply curve is perfectly vertical.
 (a) Perfectly elastic
Price per unit

E= S

p S

0 Quantity per period

At one extreme is the horizontal supply

curve. Here producers will supply none
of the good at a price below p, but will
supply any amount at a price of p
 Consumer Surplus

Willingness to pay is the maximum

price that a buyer is willing and able to
pay for a good.
It measures how much the buyer
values the good or service.
 Consumer Surplus

Consumer surplus is the

amount a buyer is willing to pay
for a good minus the amount
the buyer actually pays for it.
 Consumer Surplus
If the market price is at or below what you
are willing to pay for a good, you buy it.

If the market price is below what you are

willing to pay for a pair of (your favorite)
jeans, your purchase will result in consumer
surplus: the difference between the price
that you were willing to pay and the
(market) price you actually paid.
Measuring Consumer Surplus with the Demand
Curve...
Price
Price = P80

$100
Buyer A’s consumer surplus (P20)
80
70

50

Demand

0 1 2 3 4 Quantity
Measuring Consumer Surplus with the Demand Curve...

Price Price = P70

P100
Buyer A’s consumer surplus (P30)
80 Buyer B’s consumer surplus (P10)
70

50 Total consumer
surplus (P40)

Demand

0 1 2 3 4 Quantity
 Consumer Surplus and the Market
Demand
P
Total consumer surplus
= Σ ( Max Price – Mkt Price)/2
55 = [7 (P55-25)]/2
50 = [7 (P30)]/2
45 = 210/2
40 = 105
35
30
25 Price = P25
20
15
10
5 D
Q
0 1 2 3 4 5 6 7 8 9 10 11
 Consumer surplus = the area above the price and below the
demand curve

100 Consumer surplus = {400(100-35)}/2

= 13000

Consumer Surplus

35 P = 35

0 400
 Consumer Surplus and A Price Increase

100 Consumer surplus = {270(100-60)}/2

= 5400

Consumer
Surplus
60 P = 60

35

0 270 400
 Producer Surplus

Producer surplus is the amount a seller

is paid minus the cost of production.

It measures the benefit to sellers

participating in a market.
 Producer Surplus
• The seller’s cost: the lowest price a seller is willing to
accept for a good: (marginal cost of production)
• Producer surplus: the difference between the
(market) price a seller actually receives and his/her
(seller’s) cost
• A seller would not sell below his/her cost
• If the market price is below a seller’s cost the seller
will leave the market
Measuring Producer Surplus with the Supply
Curve...
Price Price = P600
Supply

P900
800

600
500

Seller A’s producer

surplus (P100)

0 1 2 3 4 Quantity
Measuring Producer Surplus with the Supply
Curve...
Price Price = P800
Supply
Total
producer
surplus (P500)
P900
800

Seller B’s producer

600 surplus (P200)
500

Seller A’s producer

surplus (P300)

0 1 2 3 4 Quantity
 Total Surplus
S
100

Consumer
Surplus
60
Producer
Surplus

10 D

0 270
 Deadweight loss: (B +F) Created when quantities are less
than (greater than) the allocatively efficient level of output.
By failing to produce a product for
100 which a consumer is willing to pay,
society suffers loss or benefits. S
85

B Maximum willingness to
60 pay by consumers
F exceeds the minimum
30
acceptable price of seller.

10 D

Q
0 100 270
Output levels that are either less than or greater
than the equilibrium output create efficiency
losses, also called deadweight losses. These
losses are reductions in the combined amount of
consumer surplus and producer surplus.

Underproduction creates efficiency losses because

output is not being produced for which maximum
willingness to pay exceeds minimum acceptable
price.

Overproduction creates efficiency losses because

output is being produced
for which minimum acceptable price exceeds
maximum willingness to pay.
PROJECTING
THE FUTURE
Two methods of making a forecast:
1. Average Arithmetic Growth Rate
2. Least Square regression method
 Average Arithmetic Growth Rate

• Formula:
% Growth = current sale – previous sale x 100
Rate previous sale

Average growth rate = ∑ % GR

(AGR) N-1
 Given:
Year Sales (in million % Growth Rate
pesos)
2004 P 23.2
2005 24.1 3.88 %
2006 40.3 67.22
2007 30.2 (25.06)
2008 35.8 18.54
2009 15.6 (56.42)
2010 24.9 59.62
2011 25.8 3.61
2012 52.7 104.26
∑ % GR = 175.65
 Computations:
% GR 1 = 24.1 – 23.2 x 100 = 3.88%
23.2
% GR 2 = 40.3 – 24.1 x 100 = 67.22%
24.1
% GR 3 = 30.2 – 40.3 x 100 = (25.06%)
40.3
AGR = 175.65 = 21.96%
9-1
 Projected Values
Year 2013 = 121.96 % x 52.7 = P 64.27
Year 2014 = 121.96 % x 64.27 = P 78.38
Year 2015 = 121.96 x 78.38 = ______
Year 2016 = 121.96 x _____ = ______
Year 2017 = 121.96 x _____ = ______
 Trend Line using the
Least Squares Method
Note: Trend line can be characterized as a line of
best fit since the sum of the square deviations is
at a minimum.
Trend Line – best approximates the actual values
Y1 = a + bx
Where: a = ∑ Y b = ∑ XY
N ∑ X2
 Given:
Year Sales (Y) X XY X2
2004 23.2 -4 -92.8 16
2005 24.1 -3 72.3 9
2006 40.3 -2 80.6 4
2007 30.2 -1 30.2 1
2008 35.8 0 0 0
2009 15.6 1 15.6 1
2010 24.9 2 49.8 4
2011 25.8 3 77.4 9
2012 52.7 4 210.8 16
∑Y = 272.60 ∑XY = 77.7 ∑X2 = 60
 Computations
a = ∑Y = 272.60 = 30.29
N 9
B = ∑XY = 77.7 = 1.3
∑X2 60
Year 2013 = 30.29 + 1.3 (5) = P 36.79 million
Year 2014 = 30.29 + 1.3 (6) = P 38.09
Year 2015 = 30.29 + 1.3 (7) = _______
Year 2016 = 30.29 + 1.3 (8) = _______
Year 2017 = 30.29 + 1.3 (9) = _______
 Theory of the Consumer Behavior
• Describes how the consumers allocate
incomes among different goods and services
to maximize their well-being.
 UTILITY
Utility – a measure of the satisfaction,
happiness, or benefit that results from the
consumption of a good.
Util – an artificial construct used to measure
utility.
Total Utility – the total satisfaction a person
receives from consuming a particular
quantity
of a good.
Marginal Utility – the additional utility a person
receives from consuming an additional unit
of a good.
MU = change in TU/change in quantity
 The Utility Function
• Formula that assigns a level of utility to individual
market baskets.
• Function relationship between utility and
consumption.

TU(total utility)=Function of Q (Consumption)

MU(marginal utility)=∆TU
∆Q
 The Utility Function
Consumption Total Utility Marginal Utility
1 7
2 13
3 18 Compute for the
4 22
Marginal Utility
5 25
6 27
7 28
8 28
9 27
10 25
11 22
12 18
13 13
14 7
15 0
 The Utility Function
Consumption Total Utility Marginal Utility
1 7 7
2 13 6
3 18 5
4 22 4
5 25 3
6 27 2
7 28 1
8 28 0
9 27 -1
10 25 -2
11 22 -3
12 18 -4
13 13 -5
14 7 -6
15 0 -7
• Relationship of marginal utility
and total utility
-a positive marginal utility
increases the total utility, while
the effect is opposite when
marginal utility is negative.
Law of Diminishing Marginal Utility
For a given period, the marginal utility
gained by consuming equal successive
units of a good will decline as the amount
consumed increases.

Why? Because a consumer will eventually

become saturated or “filled up” with that
particular product.
• Diminishing Marginal Utility expresses a
philosophy of “variety as the spice of life”
– most people prefer to have one or few
of a lot of different goods rather than a
great many of only a few goods.
 Exceptions to DMU
1. Cases of addiction
2. Compulsive buying – the individual
gets “turned-on” by the act of
buying.
3. Conspicuous buying – to impress
others
4. Set completion – collection of items
 Consumption
• The Indifference Curve
-Contains varying combination in the
consumption of the commodities that yield the
same level of total utility.
-A line that represents all the possible
combinations of two goods between which an
individual is indifferent.
-The curve presents various combinations of two
goods which give same level of satisfaction to the
consumer.
• Indifference Map
- A family of indifference curves
showing the complete set of
consumer taste and preferences.
- A set of indifference curves that
describe a person’s preference for all
combinations of two commodities.
 Consumption
• The Budget Line
• The budget line shows all the
combinations of any two products
that can be purchased, given the
prices of the products and the
consumer’s money income.
B=(Pf)(Qf)+(Pc)(Qc)
• Factors Affecting the Budget Line
1. Income changes- the location of the
budget line varies with money income. An
increase in money income shifts the budget
line to the right; a decrease in money income
shifts it to the left.
2. Price changes - a change in product prices
also shifts the budget line. A decline in the
prices of both products—the equivalent of an
increase in real income—shifts the curve to
the right.
 Consumption
Budget = Php 500.00 Budget = Php 1,000.00 Budget = Php 2,000.00
Food Clothing Food Clothing Food Clothing
10 0 20 0 0
1 16 32
2 4 24
4 8 12
2 4 8 16
5 0 10 0
 Consumption
Budget = Php 500.00 Budget = Php 1,000.00 Budget = Php 2,000.00
Food Clothing Food Clothing Food Clothing
10 0 20 0 40 0
8 1 16 2 32 4
6 2 12 4 24 8
4 3 8 6 16 12
2 4 4 8 8 16
0 5 0 10 0 20