Difficulty: Intermediate | Prerequisites: Supply, demand, and market equilibrium (Ch. 2.1–2.3)
Tags: price elasticity of demand, PED, price elasticity of supply, PES, income elasticity, cross-price elasticity, midpoint method, consumer surplus, producer surplus, total surplus, deadweight loss, DWL, price ceiling, price floor, rent control, minimum wage, ECO 101
You now know that demand slopes down and supply slopes up, and that equilibrium is where they cross. This chapter asks the next questions: how much do buyers and sellers respond to price changes (elasticity), who benefits from a market transaction and by how much (surplus), and what happens when the government steps in to control prices (price floors and ceilings).
These topics tie together. Elasticity determines how much a tax or price control actually shifts behaviour. Surplus gives you a way to measure welfare. Deadweight loss tells you the efficiency cost of intervening in a market. If you are behind, make sure you are comfortable with supply, demand, and equilibrium first.
Elasticity measures how responsive buyers or sellers are to price changes. When demand is elastic, a price increase loses you more customers than it gains you in revenue; when inelastic, the opposite. Consumer and producer surplus measure the gains from trade; together they form total surplus. Price controls (ceilings and floors) push the price away from equilibrium, creating shortages or surpluses and generating deadweight loss.
Price elasticity of demand (PED)
A measure of how responsive quantity demanded is to a change in price. Calculated as the percentage change in quantity demanded divided by the percentage change in price.
Think of it as: how much do buyers flinch when the price moves?
Elastic demand (PED > 1)
Consumers are highly responsive to price changes. A small price increase leads to a large drop in quantity demanded. Common for luxury goods and goods with many substitutes.
Inelastic demand (PED < 1)
Consumers are not very responsive to price changes. A price increase has a relatively small effect on quantity demanded. Common for necessities and goods with few substitutes.
Unit elastic demand (PED = 1)
The percentage change in quantity demanded exactly equals the percentage change in price. Total revenue does not change.
Midpoint method
A formula for calculating percentage changes that uses the average of the old and new values as the base, avoiding the directional bias of the standard method.
Price elasticity of supply (PES)
A measure of how responsive the quantity supplied is to a change in price. Supply tends to be more elastic in the long run because firms can adjust production capacity.
Income elasticity of demand (IED)
Measures how quantity demanded changes in response to changes in consumer income. Positive for normal goods; negative for inferior goods; greater than 1 for luxury goods.
Cross-price elasticity of demand (XED)
Measures how the demand for one good responds to a change in the price of another good. Positive for substitutes (Coke and Pepsi); negative for complements (coffee and creamer).
Consumer surplus
The difference between what consumers are willing to pay for a good and what they actually pay. On a graph, it is the area below the demand curve and above the market price.
Think of it as the "bonus" buyers get when the price is lower than their maximum willingness to pay.
Producer surplus
The difference between the price producers receive and the minimum they would accept. On a graph, it is the area above the supply curve and below the market price.
Think of it as the "bonus" sellers get when the price is higher than their minimum acceptable price.
Total surplus
Consumer surplus plus producer surplus. Measures the total welfare gains from trade in a market. Total surplus is maximised at equilibrium.
Deadweight loss (DWL)
The loss in total surplus that occurs when the market is not at equilibrium (due to taxes, subsidies, or price controls). Represents trades that would have been mutually beneficial but did not happen.
Think of it as the efficiency cost of interfering with the market.
Price ceiling
A maximum legal price set below the equilibrium price. Creates a shortage because quantity demanded exceeds quantity supplied at the controlled price.
In simple terms, this means the government says "you cannot charge more than this." Example: rent control.
Price floor
A minimum legal price set above the equilibrium price. Creates a surplus because quantity supplied exceeds quantity demanded at the controlled price.
In simple terms, this means the government says "you cannot charge less than this." Example: minimum wage.
PED = % change in quantity demanded / % change in price.
The result is typically negative (because demand slopes down), but economists use the absolute value when classifying.
Interpreting PED values
PED > 1: elastic. Quantity demanded is highly responsive. A price increase loses you significant volume.
PED < 1: inelastic. Quantity demanded is not very responsive. A price increase does not reduce volume much.
PED = 1: unit elastic. Percentage changes are equal.
Revenue implications
Elastic demand: raising prices decreases total revenue (you lose too many customers).
Inelastic demand: raising prices increases total revenue (customers keep buying).
Unit elastic: total revenue is unchanged.
Determinants of PED
Availability of substitutes: more substitutes means more elastic demand.
Necessities vs. luxuries: necessities tend to be inelastic; luxuries tend to be elastic.
Proportion of income spent: goods that take up a larger share of income tend to have more elastic demand.
Time horizon: demand is more elastic in the long run, because consumers have time to find alternatives.
Definition of the market: narrowly defined markets ("Pepsi") are more elastic than broadly defined ones ("soft drinks").
Examples
Petrol: relatively inelastic (few substitutes, a necessity for most drivers).
Airline tickets: relatively elastic (many substitutes, discretionary spending).
Insulin: highly inelastic (no substitutes, life-dependent necessity).
Price elasticity of supply (PES)
Measures how responsive quantity supplied is to a change in price.
Time is the critical determinant. Supply tends to be more elastic in the long run because firms can adjust capacity, build new factories, or enter/exit the market.
Example: agricultural products are often inelastic in the short run because crops take time to grow.
Income elasticity of demand (IED)
Measures how quantity demanded changes when consumer income changes.
IED > 0: normal good (demand rises with income).
IED < 0: inferior good (demand falls as income rises). Example: instant noodles.
IED > 1: luxury good (demand rises more than proportionally with income). Example: organic produce, overseas travel.
Cross-price elasticity of demand (XED)
Measures how demand for one good responds to a change in the price of another.
XED > 0: substitutes. If the price of Coke rises, demand for Pepsi increases.
XED < 0: complements. If the price of coffee rises, demand for creamer falls.
Helps firms understand competition and interdependence between markets.
Consumer surplus
The area below the demand curve and above the market price.
Example: if you would pay $100 for a concert ticket but only pay $70, your consumer surplus is $30.
Measures the net benefit consumers gain from participating in the market.
Producer surplus
The area above the supply curve and below the market price.
Example: if a firm would accept $40 for a product but sells it for $70, the producer surplus is $30.
Measures the net benefit producers earn from selling in the market.
Total surplus and efficiency
Total surplus = consumer surplus + producer surplus.
At equilibrium, total surplus is maximised. This is the efficient outcome.
Efficiency means maximising total surplus. Equity means fairness in how that surplus is distributed. Economists typically measure efficiency first, then debate how equity should reshape outcomes.
Deadweight loss (DWL)
DWL represents mutually beneficial trades that do not occur because the market has been pushed away from equilibrium.
On a graph, DWL is the triangle of lost surplus caused by taxes, subsidies, or price controls.
Formula: DWL = lost consumer surplus + lost producer surplus - tax revenue (when a tax is involved).
Economists focus on minimising DWL to keep markets as efficient as possible.
Tax revenue
Tax revenue = tax per unit multiplied by the quantity sold after the tax is imposed.
TR = Tax x Q sold.
On a graph, tax revenue is the rectangle between the supply and demand curves after the tax, with height equal to the tax and width equal to the post-tax quantity.
Price ceilings
A price ceiling is a maximum legal price, set below equilibrium.
Creates a shortage (quantity demanded exceeds quantity supplied at the ceiling price).
Unintended consequences: shortages, black markets, lower product quality, misallocation.
Example: rent control. Intended to keep housing affordable, but tends to reduce the supply of rental housing over time, discourage maintenance, and create long waiting lists.
Example: petrol price caps during the 1970s U.S. oil crisis led to long queues at filling stations.
Price floors
A price floor is a minimum legal price, set above equilibrium.
Creates a surplus (quantity supplied exceeds quantity demanded at the floor price).
Unintended consequences: surplus of goods or labour, wasted resources, government may have to purchase the excess.
Example: minimum wage. Set above the equilibrium wage, it can create a surplus of labour (unemployment), because more workers want jobs at the higher wage but employers hire fewer of them.
A price floor or ceiling that is not binding (set above equilibrium for a ceiling, or below equilibrium for a floor) has no effect on the market.
PED (general formula)
PED = (% change in quantity demanded) / (% change in price)
PED (midpoint method, preferred on exams)
% change in Qd = (Q2 - Q1) / ((Q2 + Q1) / 2) x 100
% change in P = (P2 - P1) / ((P2 + P1) / 2) x 100
PED = % change in Qd / % change in P
The midpoint method uses the average of the two values as the denominator, so the result is the same regardless of which direction you calculate.
Total surplus
TS = CS + PS
CS = area below the demand curve and above the price.
PS = area above the supply curve and below the price.
Tax revenue
TR = Tax x Q sold (after tax)
Deadweight loss
DWL = lost CS + lost PS - Tax Revenue
Visually, DWL is the triangle between the supply and demand curves, from the post-tax quantity to the equilibrium quantity.
Worked PED example
Price increases from $8 to $12. Quantity demanded decreases from 100 to 60.
% change in Qd = (60 - 100) / ((60 + 100) / 2) x 100 = -40 / 80 x 100 = -50%.
% change in P = (12 - 8) / ((12 + 8) / 2) x 100 = 4 / 10 x 100 = 40%.
PED = -50% / 40% = -1.25. The absolute value is 1.25, which is greater than 1, so demand is elastic.
Businesses use PED to set pricing strategy. If demand for your product is inelastic (petrol, insulin), you can raise prices without losing many customers. If elastic (airline tickets, designer handbags), a price increase hurts revenue.
Governments use PED to predict the effects of taxes and subsidies. A tax on an inelastic good (cigarettes) raises substantial revenue because consumers keep buying; a tax on an elastic good shifts consumption sharply.
Rent control in cities like New York and San Francisco is a textbook price ceiling. It keeps some rents affordable but reduces the incentive to build or maintain rental housing.
Minimum wage is a textbook price floor in the labour market. It protects low-wage workers but can create unemployment if set significantly above equilibrium.
Students often confuse elastic and inelastic with the direction of the demand curve. All normal demand curves slope downward. Elasticity is about the degree of responsiveness, not the direction.
Students sometimes report PED as a negative number and then classify it incorrectly. Use the absolute value. A PED of -1.5 means |1.5|, which is elastic.
Students confuse a non-binding price control with a binding one. A price ceiling set above equilibrium has no effect. A price floor set below equilibrium has no effect. Only binding controls (ceiling below equilibrium, floor above equilibrium) distort the market.
Students sometimes think deadweight loss goes to someone. It does not. DWL is surplus that simply disappears, representing trades that never happen.
Be able to calculate PED using the midpoint method and classify the result as elastic, inelastic, or unit elastic.
Know the revenue implications: elastic means a price increase reduces total revenue; inelastic means it increases total revenue.
Be able to identify and shade consumer surplus, producer surplus, tax revenue, and deadweight loss on a supply-and-demand graph.
Understand the difference between efficiency (maximising total surplus) and equity (fairness).
Know the effects of price ceilings (shortages) and price floors (surpluses), and be able to give real-world examples of each.
Expect questions combining elasticity and price controls: "If the government imposes a tax on a good with inelastic demand, who bears most of the tax burden?" (Consumers, because they keep buying.)
True or false: If PED = 0.6, demand is elastic. (False. PED < 1 means inelastic.)
Fill in the blank: Consumer surplus is the area below the ______ curve and above the ______. (Demand; market price.)
True or false: A price ceiling set above equilibrium creates a shortage. (False. A ceiling above equilibrium is non-binding and has no effect.)
Fill in the blank: Deadweight loss represents trades that ______. (Would have been mutually beneficial but did not happen.)
True or false: If income elasticity of demand is negative, the good is an inferior good. (True.)
Q: The price of a good rises from $10 to $14, and quantity demanded falls from 200 to 160. Using the midpoint method, calculate PED and classify the demand.
A: % change in Qd = (160 - 200) / ((160 + 200) / 2) x 100 = -40/180 x 100 = -22.2%. % change in P = (14 - 10) / ((14 + 10) / 2) x 100 = 4/12 x 100 = 33.3%. PED = 22.2 / 33.3 = 0.67 (absolute value). Since 0.67 < 1, demand is inelastic.
Q: A concert ticket is worth $120 to you, and you buy it for $85. What is your consumer surplus?
A: $120 - $85 = $35.
Q: The government sets a price ceiling on bread at $2, but the equilibrium price is $1.50. What happens?
A: Nothing. The ceiling ($2) is above the equilibrium price ($1.50), so it is non-binding. The market continues to operate at the equilibrium price.
Q: Explain why a minimum wage set above the equilibrium wage can lead to unemployment.
A: At a wage above equilibrium, the quantity of labour supplied (workers wanting jobs) exceeds the quantity of labour demanded (employers willing to hire). The surplus of labour is unemployment.
Q: A tax is imposed on a good with very inelastic demand. Who bears most of the tax burden, and why?
A: Consumers bear most of the burden. Because demand is inelastic, consumers are not very responsive to the price increase, so they continue buying at nearly the same quantity. The price they pay rises by close to the full amount of the tax.
Elasticity connects back to the demand and supply curves from Ch. 2.1-2.3. Elasticity tells you the steepness of those curves and how much quantity responds to a price change.
Consumer and producer surplus are the welfare measures that underpin nearly every policy analysis in the rest of the course. Any time the government intervenes (taxes, subsidies, trade restrictions), the first question is: what happens to surplus?
Price controls connect forward to discussions of market failure, public goods, and externalities. If the market itself produces an inefficient outcome (pollution, for example), price controls or taxes can sometimes improve total surplus, even though they create DWL in a perfectly competitive market.
Price elasticity of demand, PED, elastic, inelastic, unit elastic, midpoint method, arc elasticity, price elasticity of supply, PES, income elasticity of demand, IED, normal good, inferior good, luxury good, cross-price elasticity, XED, substitutes, complements, consumer surplus, producer surplus, total surplus, deadweight loss, DWL, tax incidence, tax burden, price ceiling, price floor, rent control, minimum wage, binding, non-binding, shortage, surplus, market efficiency, equity, welfare economics, ECO 101, intro to microeconomics