Unit 7
THE FIRM AND ITS CUSTOMERS
Gains from Trade and Elasticity
Gains from Trade
• In previous chapters, you would have dealt with gains from trade. When two parties interact with
one another, they do so because it benefits them.
• We call the benefit they enjoy an economic rent. There are many forms of economic rent, but we
call his specific one gains form trade.
• With this in mind, we should consider the welfare of the buyer and the seller at equilibrium not just
the equilibrium price and quantity.
• Remember, the demand curve was a measure of WTP while the marginal cost curve showed the
lowest price the firm is willing to accept to produce a product. Therefore, if a price is negotiated at
a price below the WTP of the buyer but above the reservation price of the supplier, then both
parties will enjoy an economic rent.
• We call the economic rent that the consumer gets, consumer surplus. Similarly, we call the
equivalent economic rent for producers, producer surplus.
Gains from Trade – Consumer Surplus versus Producer Surplus
8 000
Marginal cost
Price, Marginal cost ($)
E
Isoprofit curve: $150,000
P* = $5,440
Isoprofit curve: $63,360
Demand curve
0
0 10 20 Q* = 32 100
Quantity of cars, Q
Is this allocation between the buyer and seller
Pareto Efficient
• Review – A Pareto-efficient outcome is one where no party can improve without the other party
losing something.
• Do you think this allocation, when the firm has power, is pareto efficient?
• Definitely not! If you return to the previous slide and consider hypothetical sale of the 33rd good
you will see that if the supplier were to sell this good for a price lower than $5440 but higher than
the production cost, both parties would be better off. This would be a pareto improvement
• If the firm were to operate instead at point F, where price equals the marginal cost on the next
slide, all the pareto-improving interactions in the point above would have taken place and the
maximum total surplus would have been achieved in the market.
• Why would the firm not want this? Well, total surplus is greater at F, consumer surplus is greater at
F, but producer surplus is lower, and given that the firm can choose, the firm would prefer the
larger producer surplus.
• This choice by the firm introduces a deadweight loss to society.
Figure 7.14. Deadweight loss.
8 000
Marginal cost
Price, Marginal cost ($)
E
Isoprofit curve: $150,000
P* = $5,440
Isoprofit curve: $63,360
P0
F
Demand curve
0
0 10 20 Q* = 32 Q0 100
Quantity of cars, Q
Price Elasticity of Demand
• What is “Elasticity” ?
• Understanding the definition of this word goes a long way in
understanding this entire chapter!
• In short…
“The responsiveness of demand”
– How does demand respond…
– Respond to what? A change in something…
PRICE ELASTICITY OF DEMAND
A firm’s pricing decision depends on the slope of the demand curve.
Price elasticity of demand = degree of responsiveness (of consumers) to a price change.
Elasticity helps us determine that if:
For example, If price decreases by 10%...
is the quantity going to increase by…
More than 10%? Less than 10%?
Price Price
D
D
80 80
price decreases
by 10% 72 72
100 120 Quantity Quantity
100 105
Price Elasticity of Demand (PED) formula
What is PED and what are we trying to determine?
PED: The degree to which a Q demanded reacts, to a change in price. We know
that as price changes, quantity changes too. Elasticity determines by how
much quantity changes, as price changes.
We use the following Formula:
PED is always negative (because P and Qd have a negative relationship), but we
quote PED in |absolute| terms so it’s quoted as positive
• If PED > 1 , the numerator must be larger. When PED > 1 it is called ELASTIC, it
means that the % change in price is smaller than the % change in quantity
or you can say it means that the % change in quantity is bigger than the %
change in price
• If PED is INELASTIC, PED < 1, the denominator is larger,
• It suggests that the % change in price is bigger than the % change in quantity
or you can say If If PED is INELASTIC, it suggests that the % change in
quantity is smaller than the % change in price
PED: formula
This is the most basic form of the formula.
We simply look at how much a % change in price will affect
the quantity demanded.
How do we find % change? New minus old, divided by old.
Why is it written
as (1/slope)
But the PED formula has the inverse!!!!!
PED = Perfectly Inelastic = 0
Perfectly inelastic
Vertical Demand curve = No matter how much price changes, Qd stays the same
Price
D (vertical) If we begin at P0
Whether we increase the price to P1
P1 or whether we decrease the price to P2
P0 the quantity remains unchanged
P2
PED = 0 = perfectly inelastic
Q0 Quantity
PED = Perfectly Elastic =
Perfectly elastic
If price changes by even a small amount, Qd changes by a massive amount
Price
If we begin at P0
P1
Whether we increase the price to P1
P0
whether we decrease the price to P2
D (horizontal)
P2 the quantity changes infinitely
Q0 Quantity
What makes a product elastic or inelastic?
1. Are there close substitutes to the product?
Consider smokers during the lockdown period. Given that smokers are addicted to Nicotine, they were willing to
pay seriously high prices for their cigarettes because there aren’t really substitutes to Nicotine. Buyers are
therefore not sensitive to the price and will buy the products even if they become expensive.
2. Is the product a complement in consumption?
If you really like coffee and consume it with sugar in a fixed ratio of 1 teaspoon of coffee for each teaspoon of
sugar, you will be less sensitive to increases in the price of sugar because it’s necessary for the consumption of
your cup of coffee.
3. Does purchasing the product use up a large share of my income?
If you are extremely wealthy and bread doubles in price, you couldn’t care less. You are therefore insensitive to
price changes because it uses only a small percentage of your income. In contrast, if you are poor and bread
doubles in price, you may be forced to find cheaper alternatives because you are sensitive to price changes that
make a large dent in your budget.
4. What’s the time frame we are discussing?
Both demand and supply are more elastic in the long-run. Right now, vehicle owners have no choice but to cough
up more money for fuel when petrol becomes more expensive. But as time goes by and alternate means of
powering our vehicles emerges, we become more sensitive to increases in the price of petrol.
Elasticity isn’t all about the slope though
Earlier in the slides, we said that elasticity depends on the slope.
While this is true, even really steep demand curves will have elastic
portions on them.
Price elasticity of demand = degree of responsiveness (of
consumers) to a price change.
The diagram alongside shows this. Notice how, for a given slope, as
we move down the demand curve, the elasticity decreases along
with the marginal revenue.
MR is always positive when demand is elastic.
Look what happens at point C. The change in price is 80 Dollars and
MR increases by the exact same amount. What does this mean for
total revenue?
Price Elasticity and Policy
• The effect of good-specific taxes
depends on the elasticity of
demand for those goods.
• Governments raise more tax
revenue by levying taxes on price-
inelastic goods.
• Several countries e.g. Denmark
and France have introduced taxes
on unhealthy foods – to reduce
consumption not to raise revenue.
Price Elasticity and Market Power
A firm’s profit margin depends on the elasticity of demand, which
is determined by competition:
• Demand is relatively inelastic (close to zero) if there are few
close substitutes
𝑃−𝑀𝐶 1
• Lerner Index is a measure of market power = =
𝑃 𝜀
• If there are no close substitutes, the RHS is going to be large.
This means that the numerator on the LHS is inversely related
to price elasticity of demand.
• Firms with market power have enough bargaining power to
Price Elasticity and Profit Margins
A firm’s markup (profit margin as a proportion of the price)
is inversely proportional to price elasticity of demand.
Elastic demand Inelastic demand
