Week03

(10/10/2014 11:00-12:20):
Zhi Li, TA Section BD
zhili@uw.edu

TTh 3-4pm:
Savery 319F

All the other times: Fishery Sciences Building 238B
Outline:
1. Elasticity
a. Price elasticity of demand: definition by words and formula
b. Elastic and inelastic: characteristics, determinants, graphs, along a linear demand
curve
c. Price changes and total revenues (def.)
d. Other elasticity: cross-price, income
e. Elasticity of supply: determinants
2. Consumer and producer surplus
a. Definition
b. Derive demand curve
c. Marginal benefit and cost
d. Surplus in a market

Some Definitions
Price elasticity of demand measures responsiveness of quantity demanded to price changes in
terms of percentage changes
Price elasticity of demand =

Percentage change in quantity demanded

Percentage change in price

Midpoint formula
Price elasticity of demand =

(Q2 Q1 ) ( P2 P1 )

Q1 + Q2 P1 + P2

2 2

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 exactly equal to (negative) 1.

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.

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.

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.
Consumer surplus measures the net benefit to consumers from participating in a market rather than
the total benefit.
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.
Producer surplus measures the net benefit received by producers from participating in a market
Marginal benefit, the additional benefit to a consumer from consuming one more unit of a good or
service.
Marginal cost: the additional cost to a firm of producing one more unit of a good or service.
Consumer surplus in a market is equal to the total benefit received by consumers minus the total
amount they must pay to buy the good or service.
Producer surplus in a market is equal to the total amount firms receive from consumers minus
the cost of producing the good or service.

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Exercises
1. Over the past 60 years, there is a rapid increase in farm productivity in the wheat market. The average
income of consumers is also much higher than before.
What happens to the equilibrium price and quantity in the wheat market if
Demand for wheat is inelastic;
Income elasticity of demand is low.
Illustrate your answer with a demand and supply graph.

2. Due to unfavorable weather conditions, there has been a reduction in the quantity of California oranges
produced this year. However the orange growers have reported an increase in their total revenues. Some
commentators have questioned the validity of this report, expressing skepticism that a smaller crop of
oranges should be worth more than a larger crop.
a) Use supply and demand curves to describe what happened in the orange market.
b) Use relevant economic concepts to evaluate the commentators skepticism.
The graph is similar to the one above except that the supply shifts to the left.
The demand for oranges must be inelastic (the absolute value of the price elasticity of demand for oranges
is less 1). In this case, the percentage decline in quantity of orangesdue to unfavorable weather in
California-- results in a larger percentage increase in the price of oranges. Therefore the total revenues of
the sellers/growers (i.e. the new PxQ) will rise.
3. Pat runs a sandwich shop (Pats Sandwiches) in a Seattle neighborhood. He decides to increase the
price of his sandwiches one day. At the end of that day, Pat finds that the shop indeed earned more
revenues. Pat is pleased and decides to keep the new higher price. At the end of the month, however, he
discovers that his revenues are way down. What is going on?
The difference between higher earnings in the short run and lower earnings in longer run has to do with
the differences in the price elasticity of demand in the short versus long run. In the short run (a day) the
demand for sandwiches at Pats Sandwiches is inelastic. Therefore as Pat raises the price of sandwiches,
his revenues rise. You can say that Pats regular customers are not able to find close substitutes to Pats
sandwiches in a day. However, given a month, the customers will find cheaper substitutes for Pats
sandwiches. Over time they may switch away from Pats shop to other restaurants. Therefore it is possible
that over a month Pat would lose a lot of customers (elastic demand). This implies that over a month, as he
increases his price, his revenues would fall.

Refer to the graph below. When market price is $2.00, how much is the
producer surplus obtained from selling all 50 cups?

$1.00

PS= ($2-$1)x(50) = $25