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Fall, 1998
Course: ECON 22060 Principles
of Microeconomics
Prof: Casper
Notes 2
Chapter 6: ELASTICITY: DEMAND AND SUPPLY
Few doubt that consumers respond to price changes. The question is,
how large is their response?
Economists have devised measures of how much consumers alter their
purchases in response to price changes. These measures are called
elasticities.
Elasticity is a measure of responsiveness.
Responsiveness to what?
price
income
prices of other goods
Elasticity measures the degree of responsiveness to changes in other
variables that affect demand (or supply).
PRICE ELASTICITY OF DEMAND
The price elasticity of demand is the percentage change in the
quantity demanded divided by the percentage change in the price of
that product.
The more price-elastic demand is, the more responsive consumers are
to a price change.
How do we measure price elasticity?
ed = % change in Q demanded/% change in P
Note: The price elasticity of demand is always negative. To avoid
confusion, economists use the absolute value of the price elasticity
of demand and thus ignore the negative sign.
How do we characterize elasticity?
Demand can be elastic, unit elastic, or inelastic.
If ed > 1, demand is elastic and the percentage change in quantity
demanded is greater than the percentage change in price.
If ed = 1, demand is unit elastic and the percentage change in
quantity demanded is equal to the percentage change in price.
If ed < 1, demand is inelastic and the percentage change in quantity
demanded is less than the percentage change in price.
Calculating the Arc Elasticity
Elasticity is a ratio of percentage changes.
The most popular way to calculate these percentage changes is to
average the starting and ending points of the changes.
The elasticity obtained when the midpoint--or average--price and
quantity is used is
called the arc elasticity.
ed = (Q2 - Q1)/[(Q1 + Q2)/2] /
(P2 - P1)/ [(P1 + P2)/2]
Example: Arc Elasticity
Kent Transit just increased its fares from $1.00 to $1.20. Ridership
has subsequently dropped off from 45,000 to 35,000. What is the
price elasticity of demand?
Demand Curve Shapes and Elasticity
A perfectly elastic demand curve is a horizontal line that shows
that consumers can purchase any quantity that they want at the
single prevailing price.
A perfectly inelastic demand curve is a vertical line illustrating
the idea that consumers cannot or will not change the quantity of a
good they purchase when the price of the product is changed.
In between the two extremes are the demand curves for most products.
[See figure 2 in your text for illustrations.]
DETERMINANTS OF THE PRICE ELASTICITY OF DEMAND
The degree to which the price elasticity of demand is inelastic or
elastic depends upon the following factors, which differ among
products or among consumers:
the existence of substitutes
the importance of the product in the consumer's total budget
the time period under consideration
Substitutes
Consumers who can switch from one product to another without losing
quality or some other attribute associated with the original product
will be very sensitive to a price change. Their demand will be
elastic.
The more substitutes that there are for a product, the greater the
price elasticity of demand.
Increasing the brand name recognition and customer loyalty toward
that brand means fewer close substitutes exist and thus the price
elasticity of demand is lower.
Importance
The greater the portion of a consumer's budget a good constitutes,
the more elastic is the demand for the good.
Time Period
The longer the time period under consideration, the more elastic is
the demand for any product.
Income Elasticity of Demand
The income elasticity of demand measures the percentage change in
demand caused by a percentage change in income.
Em = % change in demand for good j/
% change in income
If Em > 0, the good is a normal good.
If Em < 0, the good is an inferior good.
Example: Income Elasticity
If average household incomes in a community decrease from $20,000 to
$16,000 per year and the demand for White Castle hamburgers
increases from 1,000 to 2,000 burgers per month, what is the income
elasticity of demand?
Are White Castle hamburgers a normal good or an inferior good? How
did you know?
Cross-Price Elasticity of Demand
The cross-price elasticity of demand measures the percentage change
in demand for one good divided by the percentage change in the price
of a related good.
Ej = % change in demand for good j/
% change in price of good k
If Ej > 0, the goods are substitutes.
If Ej < 0, the goods are complements.
Example: Cross Price Elasticity
Kent has two motels-the Inn of Kent and the Holiday Inn. If the Inn
of Kent lowers its room rates from $70 to $60 and the Holiday Inn's
occupancy drops from 10,000 to 8,000 rooms per year, what is the
cross-price elasticity of demand?
Based upon your calculations, what can you conclude about the
relationship between the Inn of Kent and the Holiday Inn?
As consumer incomes rise over time, a firm whose products have a low
income elasticity of demand will not experience the sales growth of
a firm whose products have a higher income elasticity of demand.
In general, one can calculate a variety of other elasticities--e.g.,
the advertising elasticity of demand caused by a change in tastes
due to advertising expenditures.
SUPPLY ELASTICITIES
The price elasticity of supply is a measure of how sellers adjust
the quantity of a good they offer for sale when the price of that
good changes.
The price elasticity of supply is usually a positive number because
the quantity supplied typically rises when the price rises (and vice
versa).
Es = % change in Q supplied/
% change in P
[See Figure 5 in your text.]
There are some special types of goods for which supply cannot change
no matter the length of time allowed for change. For such goods, the
price elasticity of supply is zero or perfectly inelastic and supply
is vertical.
A perfectly elastic supply curve suggests that the quantity supplied
is unlimited at the given price.
For most goods, the supply curve lies between the extremes of being
perfectly inelastic and perfectly elastic.
The shape of the supply depends primarily on the length of time
being considered.
The short run is a period of time long enough for existing firms to
change the quantity of output they produce by changing some of the
resources used to produce their output, but not long enough for
firms to change all of the resources.
The long run is a period of time long enough for existing firms to
change the quantities of all the resources they use and for new
firms to begin producing the product.
Supply curves applicable to shorter periods of time tend to be more
elastic than supply curves that apply to longer periods of time.
Impact of a tax
Who pays a tax levied upon some item or business? Who pays the tax
depends upon the price elasticities of demand and supply.
Tax incidence is a measure of who pays the tax.
In general, the elastic the demand and the less elastic the supply,
everything else held constant, the more the incidence falls on
businesses and the less on consumers.
Elasticity Along a Straight Line Demand Curve
The price elasticity of demand varies along a straight line downward
sloping demand curve, declining as one moves down the curve.
Even though the slope of a straight line is constant, the percentage
changes vary as one moves along the curve.
As we move down the curve from higher to lower prices, a given
dollar change becomes a larger and larger percentage change in
price. The opposite is true as quantity changes.
[See Figure 3 in your text.]
As we move down the straight line demand curve, the percentage
change in quantity demanded declines while the percentage change in
price increases. The price elasticity of demand moves close to zero
as we move down the straight-line demand curve.
A downward sloping demand curve can be divided into three parts by
the price elasticity of demand: the elastic region, the unit-elastic
point, and the inelastic region.
USE OF PRICE ELASTICITY OF DEMAND
The price elasticity of demand is useful to business managers.
It suggests whether one should raise or lower prices, whether to
charge different consumers different prices, whether to charge
different prices at different times of the day, and whether it is
better to focus on prices, to advertise, or to carry out business
strategies that do not focus on prices.
Price Elasticity and Total Revenue
There is a close relationship between price elasticity of demand and
total revenue.
Total Revenue (TR) equals the price of a product multiplied by the
quantity sold.
TR = P x Q
Elasticity
Price Increases ()
Price Decreases ()
Elastic
(Ed > 1)
TR decreases
TR increases
Unit elastic
(Ed = 1)
TR unchanged
TR unchanged
Inelastic
(Ed < 1)
TR increases
TR decreases
Total revenue increases as price increases if demand is inelastic,
decreases as price increases if demand is elastic, and stays the
same if demand is unit-elastic.
As long as the price elasticity of demand exceeds 1, total revenue
is decreased if the price is increased.
Total revenue is maximized by setting the price where the demand is
unit-elastic.
To increase revenue:
1. if in the elastic region of demand, lower price;
2. if in the inelastic region of demand, raise price.
What explains why firms charge different consumers different prices
for the same product?
If different groups of consumers have different price elasticities
of demand for the same product--and if the groups are easily
identificable and can be kept from trading with each other--then a
seller can increase total revenue by charging each group a different
price.
Charging different prices to different consumers for the same
produce is called price discrimination.
Example, price discrimination occurs when senior citizens are
offered special discounts.... what does that suggest about their
price elasticity of demand?
CHAPTER 7: CONSUMER CHOICE
Not unless scarcity disappears, will we be freed of having to make
choices. Although scarcity and choice are pervasive, how people make
decisions is a question that has eluded scientific explanation.
Economists assume: People tend to compare perceived costs and
benefits of alternatives and select those that they believe give
them the greatest relative benefits.
To explain how comparisons are made, philosophers and economists of
the nineteenth century developed a concept called utility. That
concept forms the basis of understanding consumer decision-making
today.
The Concept of Utility
Utility
Is a term used to describe the satisfaction or happiness received
from the consumption of goods or services.
Utils
A measure of the satisfaction or happiness received.
We assume: Given their available income, consumers make choices that
give them the greatest satisfaction--that is, they maximize their
utility.
Diminishing Marginal Utility
What is marginal utility?
Marginal utility is the change in total utility that occurs when an
additional unit of a good or service is consumed.
MU = Change in total utility/Change in quantity
As we consume more of a good or service, we note that each
additional unit of a good or service yields fewer additional units
of satisfaction. This relationship is called diminishing marginal
utility.
It might be possible to reach a point where an additional unit
creates disutility.
Relationship between Total Utility and Marginal Utility
Total utility is the measure of the total satisfaction derived from
consuming a quantity of some good or service.
As soon as the marginal utility starts to decrease, the increase in
total utility will also decrease.
Marginal utility declines with each successive unit, reaches zero,
and then turns negative. As long as marginal utility is positive,
total utility rises.
[See figure 1 a,b in your text]
The concept of diminishing marginal utility makes sense only if we
define a period of time during which consumption is occurring.
Usually, the shorter the time period, the more quickly marginal
utility diminishes.
The rate at which marginal utility diminishes depends upon an
individual's tastes and preferences.
Utility and Choice
No one has enough income to purchase everything until the marginal
utility of each item is zero.
How do consumers go about allocating their limited incomes among
various goods and services?
We assume that they compare ratios of the marginal utility per
dollar of expenditure (MU/P), not the marginal utility of each good
(MU).
Equimarginal Principle
The general rule is
MUa / Pa = MUb / Pb = .... MUn / Pn
The ratio of the marginal utility to price puts all goods on the
same basis, and allows us to make comparisons.
A utility-maximizing consumer always chooses the purchase that
yields the greatest marginal utility per dollar of expenditure. If
two goods offer the same marginal utility per dollar of expenditure,
the consumer will be indifferent between the two.
In order to maximize utility, consumers must allocate their limited
incomes among goods and services in such a way that the marginal
utilities per dollar of expenditure on the last unit of each good
purchases will be nearly as equal as possible. This is called the
equimarginal principle and also represents consumer equilibrium.
Consumers are in equilibrium when they have no incentive to
reallocate their limited budget or income.
We have shown how consumers make choices--by allocating their scarce
incomes among goods and services to maximize their utility. The next
step is to relate consumer choices to the demand curve.
Recall from the law of demand that as the price of a good falls, the
quantity demanded increases (and vice versa).
Demand Curve Revisited
A change in the price of a good will disturb the consumer's
equilibrium. The ratios of the marginal utility per dollar spent for
each good will no longer be equal.
The consumer will then reallocate income among goods in order to
increase total utility.
When the price of one good falls while everything else is held
constant, two things occur:
substitution effect
Other goods become relatively more expensive so consumers buy more
of the less expensive good and less of the more expensive good
income effect
The good purchased prior to the price change now costs less so the
consumer can buy more of all goods
Consumer Surplus
An individual's demand curve measures the value that the individual
places on each unit of the good being considered.
Consumer surplus
Is a measure of the difference between what a consumer is willing
and able to pay and the market price of a good.
CHAPTER 8: SUPPLY: THE COSTS OF DOING BUSINESS
In this chapter, we will look at
relationship between output and inputs
relationship between output and cost
distinction between the short-run vs. the long-run
In the previous chapter, we discussed consumer behavior and the
theory of consumer choice that underlies demand.
In this chapter, we will shift to the supply side and focus on the
firm. The term "firm" will be used to refer to all types of
businesses--sole proprietorships, partnerships, and corporations.
ASSUMPTIONS ABOUT ECONOMIC BEHAVIOR
Households Maximize utility, or satisfaction, subject to limited
income.
Firms Maximize profits.
PROFITS = TOTAL REVENUE- TOTAL COST
The manager of a firm must figure out how best to increase the
difference between revenues and costs.
In this chapter, we will examine costs. In the following chapters,
we will put cost and demand together and discuss the strategies of
the firm to maximize profits.
Firms must have an understanding of both revenue and costs in order
to be successful.
We examine the relationship between output and costs in both the
short run and the long run.
Relationship between Inputs and Outputs
Total product (also called total physical product) shows the
relationship between output produced and the quantity of a variable
resource.
As additional units of the variable resource are used, total output
at first increases quite rapidly and then increases more slowly, and
then levels off and declines.
Why?
Law of Diminishing Marginal Returns
When successive equal amounts of a variable resource are combined
with a fixed amount of another resource, output will initially
increase at an increasing rate, then increase at a decreasing rate,
and then decrease.
Why do diminishing marginal returns occur?
The limited capacity of the firm's fixed resources causes the
efficiency of the added variable resource to eventually decline.
Relationship between average physical product and marginal physical
product
Average physical product (APP)
APP = Total Output/Input
APP = TP/ R where R= amount of input
Marginal physical product (MPP)
MPP=Change Total Output/
Change in Input
See Figure 3 a,b,c in your text.
Note the average product curve increases quite rapidly, and then
slowly declines. The marginal product curve initially rises more
rapidly than the APP, then falls more rapidly, and eventually
reaches zero. When the MPP is zero or negative, the additional
variable resources are actually decreasing output and causing it to
decline.
Average and marginal relationships behave in the same way with
respect to each other no matter whether they refer to physical
product--or cost or revenue, etc.
A easy way to understand this relationship is to think about grades
during the course of a semester.....
As long as the marginal is less than the average, the average falls.
As long as the marginal is greater than the average, the average
rises.
If the average is falling when the marginal in below the average and
rising when the marginal is above the average, then marginal and
average can be the same only when average is neither rising or
falling--at the maximum value of the average.
To examine the costs of doing business--rather than the physical
production relationships--we must define the costs of each unit of
resources.
As additional amounts of a resource are added, total product
increases first at an increasing rate and then increases at a
decreasing rate; then total product starts to decrease.
In response, total cost increases first at a decreasing rate and
then increases at an increasing rate.
Both of these patterns are caused by the Law of Diminishing Returns.
The total cost curve and the total physical product curve are
"mirror images" of each other, each shaped by the law of diminishing
marginal returns.
Relationship between
average cost and marginal cost
Average Total Cost (ATC)
ATC = TOTAL COST / TOTAL OUTPUT
Marginal Cost (MC)
MC = CHANGE IN TOTAL COST /
CHANGE IN OUTPUT
Every firm will face U-shaped average and marginal cost curves in
the short run because of the law of diminishing marginal returns.
Short-run vs. Long-run
The short-run is a period of time where some of the firm's costs are
fixed and some vary with the level of output
In the short-run,
TOTAL COST= TOTAL FIXED COST + TOTAL VARIABLE COST
The long-run is a period of time where all of the firm's costs are
variable-i.e., they
vary with output. In the long-run, a firm can change its scale of
production or even
go out of business.
In the long-run,
TOTAL COST = TOTAL VARIABLE COST
Cost Curves in the Short-run
By definition,
TC = TFC + TVC
If we divide each of these costs by output,
ATC = AFC + AVC
The average total cost (ATC) equals average fixed cost (AFC) plus
average variable cost (AVC). Average fixed costs decline as output
rises because the fixed cost is divided by a larger and larger
number of units of output.
Average variable costs and average total costs first decrease and
then increase because of the law of diminishing marginal returns.
Marginal costs initially fall and then rise as output increases.
Use the above information to derive Bob's cost information.
Bob is operating in the short run. How can you tell?
What is happening to Bob's marginal physical product? At what output
level is marginal physical product greatest?
Use the above figures to graph the average cost curves and marginal
cost.
Cost Curves in the Long-Run
In the long run, the firm faces no fixed costs--everything is
variable.
The law of diminishing marginal returns does not apply when all
resources are variable. Diminishing returns applies only when
quantities of variable resources are combined with a fixed resource.
In the long run, when all resources are changed, the scale of the
firm has changed. Scale means size.
For each size of plant, there is a distinct set of short-run cost
functions.
Long-run Average Total Cost
The long-run average total cost (LRATC) curve shows the lowest cost
per unit of output for every level of output when all resources are
variable.
There are 3 possibilities:
If producing each unit of output becomes less costly as the amount
of output increases, there are economies of scale--unit costs
decrease as the quantity of production increases and all resources
are variable.
If the cost per unit increases, there are diseconomies of
scale--unit costs increase as the quantity of production increases
and all resources are variable.
If the cost per unit of output is constant, there are constant
returns to scale.
Most industries experience both economies and diseconomies of scale.
If the long-run average total cost curve reaches a minimum, the
level of output at which the minimum occurs is called the minimum
efficient scale. This varies from industry to industry.
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