Introduction to Economics

Seminar 5 - Friday 26 May 2023

Please submit one set of answers per group, specifying the group members and their NIS (u... num-
ber). You can submit scanned handwritten solutions to Aula Global, as long as the scanned version
is easily readable.

Discussion points on elasticity and welfare

Answer the following questions intuitively, mathematically or graphically:
1. How does the elasticity of demand affect the size of the consumer surplus?
Consumer surplus is lowest in markets where demand is highly elastic. Graphically it is very
clear. Price-sensitive consumers do not tend to value items much more than the price they
pay for them.
Note: do not confuse this with the monopoly situation where the lower the elasticity of the
demand (the steeper the slope of the demand curve), the more consumer surplus the monop-
olist can extract.
2. Define social welfare to be the sum of consumer and producer surplus. Is a competitive equi-
librium the only way to maximize welfare? Discuss.
We have seen in class that social welfare is maximized under competitive equilibrium condi-
tions. We have also seen that interventions that try to control supply, demand, or prices are
typically welfare reducing.

However, there is a case to be made to avoid measuring welfare with monetary surplus. Fur-
thermore, in the case of taxation, government revenue can be used for welfare improvements
beyond market surplus.
3. All else being equal, what would be the effect of higher supply elasticity (a flatter slope of the
supply curve) for total, consumer, and producer surplus?
It implies a transfer of surplus from the producer to the consumer. Total surplus depends on
where the equilibrium price stands, but most likely it will mean an overall welfare improve-
ment.

Computing elasticities and surplus

Consider a competitive market for which the quantities demanded and supplied (per year) at vari-
ous prices are given as follows:

Price ($) Demand (units) Supply (units)

60 22 14
80 20 16
100 18 18
120 16 20

1. Compute the elasticity of demand at a price of $100. Compare it to that of the elasticity at a
price of $80. Why isn’t it constant? Does this make sense?
Using the formula seen in class, the elasticity at 100 is (2/18)/(20/100) = 0.56 and 0.4 at 80.
It makes sense that the elasticity increases at the price goes up, since the change in demand

1
 (2 for each price increment) represents a larger fraction of the demand. It is consistent with
what was seen in class.

2. Find the equilibrium price and quantities and compute the consumer and producer surplus.
(Assume that supply is zero below a price of $60 and demand is zero above a price of $120.)
From the table, equilibrium price is 100 and quantity 18. The consumer surplus will be equal
to 20 × 16 + 0 × 2 = 320 and the producer surplus 40 × 14 + 20 × 2 + 0 × 2 = 600

3. Suppose the government sets a price ceiling of $80. Will there be a shortage, and, if so, how
large will it be?
With a price ceiling of $80, consumers would like to buy 20 million, but producers will supply
only 16 million. This will result in a shortage of 4 million.

Partial equilibrium and surplus maximization

Consider a market for a homogenous good with demand for a price p: q = D(p) and aggregate supply
q = Q(p). The inverse demand function is denoted ∆(q) such that ∆(D(p)) = p and the inverse supply
function Ξ(Q(p)) = p.

1. Use the inverse demand and supply functions to show that the consumer and producer surplus
as a function of quantity and price (p, q) are given by:
Z q
SC (p, q) = ∆(q)dq − pq;
0

and the producer surplus:

Z q
SP (p, q) = pq − Ξ(q)dq.
0

The consumer surplus is given by:

Z q
SC (p, q) = (∆(q) − p)dq =;
0

and the producer surplus:

Z q
SP (p, q) = (p − Ξ(q))dq.
0

The desired result is immediate.

2. Show that the first order condition for total surplus to be maximized is ∆(q) = Ξ(q).
First, notice that total surplus only depends on the quantity. It is maximal when:

d

SC (p, q) + SP (p, q) = 0
dq

Using the fundamental theorem of calculus to differentiate the integrals with respect to q, we
get the desired FOC.