chapter 4: elasticity or demand or incomethe price of some other commodity it measures the...
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Chapter 4: ElasticityChapter 4: Elasticity
It measures the responsiveness of quantity demanded (or demandor demand) with respect to changes in its own price (or incomeor income or the price of the price of some other commoditysome other commodity).
Elasticity of Demand:Elasticity of Demand:
Why is Elasticity Important?Why is Elasticity Important?
How does a firm go about determining the price at which they should sell their product in order to maximize total revenue?
Total Revenue = Price Total Revenue = Price Quantity Quantity
You are a marketing manager for Intel
A new computer chip has been developed
Decision to Be Made Do you sell the new chip at a high price Do you sell the new chip at a high price
($400)?($400)? Do you sell the new chip at a low price Do you sell the new chip at a low price
($200)?($200)?
Demand and Total RevenueDemand and Total Revenue
Quantity (millions of chips per year)
Pri
ce (
doll
ars
per
chip
)
40 80 120
100
200
300
400
Da
Demand and Total RevenueDemand and Total Revenue
Quantity (millions of chips per year)
Pri
ce (
doll
ars
per
chip
)
100
200
300
400
Db
40 60 80 120
Demand and Total RevenueDemand and Total Revenue
Quantity (millions of chips per year)
Pri
ce (
dolla
rs p
er c
hip)
Db
Pri
ce (
dolla
rs p
er c
hip)
Da
Quantity (millions of chips per year)
Slope Depends on Slope Depends on Units of MeasurementUnits of Measurement
In these two examples, we can compare the slopes of the demand curves
We cannot do so if we are dealing with different goods and services. Or whenever the unit of measurement has been changed.
Pri
ce
Quantity
0 1 2 3 4 5 6 7 8
9
1
2
34
5
6
7
8
Effect of a change of unit of measurement on SlopeEffect of a change of unit of measurement on Slope
10
9 10 11 12
Slope Depends on Slope Depends on Units of MeasurementUnits of Measurement
In these two examples, we can compare the slopes of the demand curves
We cannot do so if we are dealing with different goods and services. Or, whenever the unit of measurement has been changed.
ElasticityElasticity is independent of the units of measurement.
Price elasticity of demandPrice elasticity of demand
A measure of the responsiveness of the quantity demanded of a good to a change in its own price (ceteris paribus).
Elasticity: A Units-Free Elasticity: A Units-Free MeasureMeasure
avg
avg
d
P P
Q
Q
Price Elasticity of
Demand
Calculating ElasticityCalculating Elasticity
The changes in price and quantity are expressed as percentages of the average price and average quantity.
This way we avoid having two values for the This way we avoid having two values for the price elasticity of demand for the same range of price elasticity of demand for the same range of the demand curvethe demand curve
Example: Suppose, quantity demanded changes Example: Suppose, quantity demanded changes from 150 to 100 when Price increases from 5 to from 150 to 100 when Price increases from 5 to 10 dollars. Find out the price elasticity of demand 10 dollars. Find out the price elasticity of demand for this specific range of the demand curve.for this specific range of the demand curve.
avg
avgd
P P
Q Q
ε
6.5
3
1
5.1
5
2
5.1152
7.55
12550
Calculating the Elasticity of DemandCalculating the Elasticity of Demand
Quantity (millions of chips per year)
Pri
ce (d
olla
rs p
er c
hip)
36 44
390
410
Da
Originalpoint
Quantity (millions of chips per year)
Pri
ce (d
olla
rs p
er c
hip)
36 44
390
410
Da
Originalpoint
Newpoint
Calculating the Elasticity of DemandCalculating the Elasticity of Demand
Quantity (millions of chips per year)
Pri
ce (d
olla
rs p
er c
hip)
36 44
390
410
Da
= -$20P
= 8Q
Originalpoint
Newpoint
Calculating the Elasticity of DemandCalculating the Elasticity of Demand
Quantity (millions of chips per year)
Pri
ce (d
olla
rs p
er c
hip)
36 44
390
400
410
Da
Originalpoint
Newpoint
Pave = $400
= -$20P
= 8Q
Quantity (millions of chips per year)
Pri
ce (d
olla
rs p
er c
hip)
36 40 44
390
400
410
Da
Originalpoint
Newpoint
Pave =$400
Qave = 40
= -$20P
= 8Q
Calculating the Elasticity of DemandCalculating the Elasticity of Demand
Calculating ElasticityCalculating Elasticity
PΔ%
QΔ% d
Pricein Change Percentage
DemandedQuantity in Change Percentage ε d
avg
avg
P P
Q
Q
400/20
40/8
= - 4
Inelastic and Elastic DemandInelastic and Elastic Demand
Three demand curves that cover the entire range of possible elasticities of demand:
Perfectly inelasticUnit elasticPerfectly elastic
Perfectly inelastic demandPerfectly inelastic demand Implies that quantity demanded remains constant when price changes occur.
Price elasticity of demand = 0
avg
avg
d
d
P P
Q Q
ε
6
12
Pri
ce
Quantity
D
Elasticity = 0
Perfectly Inelastic
10
Unit elastic demandUnit elastic demand Implies that the percentage change in quantity demanded equals the percentage change in price.
Price elasticity of demand = -1
avg
avg
d
d
P P
Q Q
ε
Unit Elastic DemandUnit Elastic Demand
6
12
Pri
ce
Quantity
D
1 2 3
Elasticity = -1
Unit Elasticity
Perfectly elastic demandPerfectly elastic demand Implies that if price increases by any
percentage, quantity demanded will fall to 0 and if price decreases by any percentage, quantity will rise to infinity.
Price elasticity of demand =
avg
avg
d
d
P P
Q Q
ε
6
12
Pri
ce
Quantity
D3
Elasticity =
Perfectly Elastic
Perfectly Elastic DemandPerfectly Elastic Demand
Inelastic and Elastic DemandInelastic and Elastic Demand
Inelastic demandInelastic demand Implies the percentage change in quantity demanded
is less than the percentage change in price. In absolute sense, price elasticity of demand > 0 and
< 1
Elastic demandElastic demand Implies the percentage change in quantity demanded
is greater than the percentage change in price. In absolute sense, price elasticity of demand > 1
avg
avg
d
d
P P
Q Q
ε
Elasticity Along a Straight-Line Elasticity Along a Straight-Line Demand CurveDemand Curve
0 40 80 100 120 160 200
250
100
200
300
400
500
Pri
ce (
dolla
rs p
er c
hip)
Quantity (millions of chips per year)
Elasticity Along a Straight-Line Elasticity Along a Straight-Line Demand CurveDemand Curve
Elasticity = -4
0 40 80 100 120 160 200
250
100
200
300
400
500 Lowering the pricefrom $500 to $300results in a price elasticity of demand of -4.
Elastic
Pri
ce (
dolla
rs p
er c
hip)
Quantity (millions of chips per year)
Elasticity Along a Straight-Line Elasticity Along a Straight-Line Demand CurveDemand Curve
Elasticity = -1/4
0 40 80 100 120 160 200
250
100
200
300
400
500 Lowering the pricefrom $200 to $0results in a price elasticity of demand of -1/ 4.
Inelastic
Pri
ce (
dolla
rs p
er c
hip)
Quantity (millions of chips per year)
Elasticity Along a Straight-Line Elasticity Along a Straight-Line Demand CurveDemand Curve
|Elasticity| = 1
0 40 80 100 120 160 200
250
100
200
300
400
500
Pri
ce (
dolla
rs p
er c
hip)
Quantity (millions of chips per year)
Lowering the pricefrom $500 to $0results in a price elasticity of demand of -1.
|Elasticity| < 1
|Elasticity| > 1
Elasticity, Total RevenueElasticity, Total Revenueand Expenditureand Expenditure
Elastic demandElastic demand — a 1 percent decrease in price will result in a greater than 1 percent increase in quantity demanded. Total revenue will increase
Unit elastic demandUnit elastic demand — a 1 percent decrease in price will result in a 1 percent increase in quantity demanded Total revenue will not change
avg
avg
d
d
P P
Q Q
ε
TR = P x Q
Elasticity, Total RevenueElasticity, Total Revenueand Expenditureand Expenditure
Inelastic demandInelastic demand — a 1 percent decrease in price will result in a less than 1 percent increase in quantity demanded. Total revenue will decrease
avg
avg
d
d
P P
Q Q
ε
Elasticity, Total RevenueElasticity, Total Revenueand Expenditureand Expenditure
Total Revenue TestTotal Revenue Test
Price elasticity of demand can be
estimated by observing the change
in total revenue that results from a
price change (ceteris paribus).
Elasticity, Total Revenue & ExpenditureElasticity, Total Revenue & Expenditure
Total Revenue TestTotal Revenue Test Price cut and total revenue increases
demand is elasticdemand is elastic. Price cut and total revenue decreases
demand is inelasticdemand is inelastic Price cut and total revenue does not
change demand is unit elasticdemand is unit elastic
0 100 200
250
100
200
300
400
500
Pri
ce (
doll
ars
per
chip
)
D
TR = P x Q
25
0 100 200
250
100
200
300
400
500
Pri
ce (
doll
ars
per
chip
)
0 100 200
5
10
15
20
Tot
al R
even
ue (
bill
ions
of
doll
ars)
Quantity (millions of chips per year)
D
TR
25
0 100 200
250
100
200
300
400
500
Pri
ce (
doll
ars
per
chip
)
0 100 200
5
10
15
20
Tot
al R
even
ue (
bill
ions
of
doll
ars)
Quantity (millions of chips per year)
Maximum total revenue
When demandis inelastic, price cut decreasestotal revenue
When demandis elastic, price cut increasestotal revenue
Inelastic demand
Unitelastic
Elasticdemand
More Elasticities of DemandMore Elasticities of Demand
Cross elasticity of demandCross elasticity of demand Measures the responsiveness of the
demand for a good to a change in the price of a substitute or complement good.
Cross elasticity of demand
= Percentage change in Demand
Percentage change in price of a substitutesubstitute or complementcomplement
Income Elasticity of DemandIncome Elasticity of Demand
Income elasticityIncome elasticity Measures the responsiveness of the demand to
a change in income.
Income elasticity of demand =
Percentage change In Demand
Percentage change in incomeincome
Income Elasticity of DemandIncome Elasticity of Demand
Income elasticity can be:1) Greater than 1 (normal good, income elastic)
luxury goodsluxury goods - ocean cruises, jewelry
2) Between zero and 1 (normal good, income inelastic)
necessitiesnecessities - food, clothing
3) Less than zero (inferior goodinferior good)potatoes, rice
Pri
ce
Quantity
0 1 2 3 4 5 6 7 8
9
1
2
34
5
6
7
8
Unit Tax and Tax Burden:Unit Tax and Tax Burden:
10
9 10 11
S1
S2
$2
Pri
ce
Quantity
0 1 2 3 4 5 6 7 8
9
1
2
34
5
6
7
8
Unit Tax and Tax Burden:Unit Tax and Tax Burden:
10
9 10 11
S1
S2
$2
Consumers’ part
Suppliers’ part
Pri
ce
Quantity
0 1 2 3 4 5 6 7 8
9
1
2
34
5
6
7
8
Elasticity and Tax Burden: Perfectly Inelastic DemandElasticity and Tax Burden: Perfectly Inelastic Demand
10
9 10 11
S1
S2
$2
Consumers’ part
Pri
ce
Quantity
0 1 2 3 4 5 6 7 8
9
1
2
34
5
6
7
8
Elasticity and Tax Burden: Perfectly Elastic DemandElasticity and Tax Burden: Perfectly Elastic Demand
10
9 10 11
S1
S2
$2
Producers’ part
Pri
ce
Quantity
0 1 2 3 4 5 6 7 8
9
1
2
34
5
6
7
8
Elasticity and Tax Burden: Perfectly Elastic SupplyElasticity and Tax Burden: Perfectly Elastic Supply
10
9 10 11
S1
S2
$2
Consumers’ part
Pri
ce
Quantity
0 1 2 3 4 5 6 7 8
9
1
2
34
5
6
7
8
Elasticity and Tax Burden: Perfectly inelastic SupplyElasticity and Tax Burden: Perfectly inelastic Supply
10
9 10 11
S1
$2
Producers’ part
Marginal Utility & Consumer Choice:
Chapter 5Chapter 5
Utility:Utility:
The satisfaction or enjoyment a person obtains from consuming a good.
Util:Util:
A hypothetical unit used to measure how much utility a person obtains from consuming a good.
Marginal Utility:Marginal Utility:
The change in total utility a person derives from consuming an additional unit of a good.
Total Utility:Total Utility:The total number of utils a person derives from consuming a specific quantity of a good.
Law of Diminishing Marginal Law of Diminishing Marginal Utility:Utility:
The idea that as more of a good is consumed, the utility a person derives from each additional unit diminishes.
Total and Total and Marginal UtilityMarginal Utility
Water-Diamond Paradox:Water-Diamond Paradox:
How much people value a good depends upon the utils they derive from the last unit consumed or the Marginal Utility.
MU of Pears
MU of Apples
1 60 52 2 50 50 3 40 48 4 30 46
Making selection from a given budget:
MU/Pof Pears
MU/Pof Apples
1 60/2 =30 52/12 50/2 =25 50/13 40/2 =20 48/14 30/2 = 15 46/1
Clothes Utils Price MU/P
1 18 10 1.82 16 10 1.63 14 10 1.44 12 10 1.25 11 10 1.16 9 10 0.9
Amusement Utils Price MU/P
1 23 10 2.32 21 10 2.13 17 10 1.74 15 10 1.55 14 10 1.46 13 10 1.3
Making selection from a given budget:
Clothes Utils Price MU/P
1 18 8 2.252 16 8 2.003 14 8 1.754 12 8 1.505 11 8 1.386 9 8 1.13
20% Sale on Clothing:
Amusement Utils Price MU/P
1 23 10 2.32 21 10 2.13 17 10 1.74 15 10 1.55 14 10 1.46 13 10 1.3
MU/P Equalization Principle:
)(P
MU)(
P
MU)(
P
MUgoodotheranyamusementclothes
Consumer Surplus:Consumer Surplus:
The difference between the maximum amount a person would be willing to pay for a good or service and the amount the person actually pays.
1
10
3
2
8
6
3
D
Quantity
Price
0
3
D
Quantity
Price
0
Chapter 6:Chapter 6:
Price Ceilings and Price Floors
Defense Goods
Civilian Goods
10
4
10
Quantity (1,000)
Pri
ce (
$)
7
D
S1
S2
Price Ceiling
10
4
10
Quantity (1,000)
Pri
ce (
$)
7
D
S2
4
Excess Demand or Shortage
Price Ceiling
2
4
10
Quantity (1,000)
Pri
ce (
$)
12
D
S1
S2
14Ex
cess
Sup
ply
or S
urpl
us
Price Floor
2
4
10
Quantity (1,000)
Pri
ce (
$)
12
D
S2
14Ex
cess
Sup
ply
or S
urpl
us
Price Floor
Chapter 8Chapter 8
Costs of ProductionCosts of Production
What is a Fixed Cost?What is a Fixed Cost?
Cost to a firm that does not vary with the quantity of goods produced
What are examples of Fixed What are examples of Fixed Costs?Costs?
rent or mortgage a part of utilities
Fixed Costs are also known Fixed Costs are also known as…..as…..
Sunk Cost
What is a Variable Cost?What is a Variable Cost?
Cost that varies with the quantity of goods produced
What are examples of What are examples of Variable Costs?Variable Costs?
worker’s wages raw materials some utilities some taxes
What is Labor Productivity?What is Labor Productivity?
The output per laborer per hour
Under what condition is it Under what condition is it cheaper to pay $10 an hr. to a cheaper to pay $10 an hr. to a U.S. worker than $1 an hour to U.S. worker than $1 an hour to a foreign worker?a foreign worker?
If the U.S. worker is more than 10 times as productive as the foreign worker
Why do labor costs per Why do labor costs per unit of output changes as unit of output changes as more units of labor are more units of labor are hired?hired?
Price of labor increases Quality of labor decreases Labor productivity Changes
Why do non-labor, variable Why do non-labor, variable costs per unit of output costs per unit of output increase as output increases?increase as output increases?
Resources become more scarce
Does the cost of all resources Does the cost of all resources increase more than production increase more than production increases?increases?
No, the costs of some resources may vary proportionately with the level of production
What is Total Variable Cost?What is Total Variable Cost?
The sum of specific variable costs in the firm’s cost structure
Total Variable Costs$
Q
What are Total Costs?What are Total Costs?
Cost to the firm that includes both fixed and variable costs
Total Costs
$
Q
TFC
TC
TVC
What isWhat isAverage Total Cost?Average Total Cost?
Total cost divided by the quantity of goods produced
1 2 3 4 5 6 7 8 9 10
1
2
3
4
5
7
89
10
6
5
ATC =
5/2 = 2.5
ATC =
6/5 = 1.2
TC
6
Q
$
0
TVC
1 2 3 4 5 6 7 8 9 10
1
2
3
4
5
7
89
10
6ATC
Q
$
0
What isWhat isAverage Variable Cost?Average Variable Cost?
Total variable cost divided by the quantity of goods produced
1 2 3 4 5 6 7 8 9 10
1
2
3
4
5
7
89
10
6
TVC
Q
$
0
1 2 3 4 5 6 7 8 9 10
1
2
3
4
5
7
89
10
6ATC
AVC
Q
$
0
What isWhat isAverage Fixed Cost?Average Fixed Cost?
Total fixed cost divided by the quantity of goods produced
Quantity
AFC
90
Cos
ts
What is Marginal Cost?What is Marginal Cost?
The change in total costThe change in total cost associated with one more one more unit of productionunit of production
MC = Q
TC
If the only thing we observe is a If the only thing we observe is a change in total cost associated with a change in total cost associated with a small change in output produced then small change in output produced then MC is computed in the following way.MC is computed in the following way.
1 2 3 4 5 6 7 8 9 10
1
2
3
4
5
7
89
10
6
MC =
3/3 = 1
TC
3
3
Q
$
0
1 2 3 4 5 6 7 8 9 10
1
2
3
4
5
7
89
10
6
TC
Q
$
0
TC,
TVC,
TFC
TFC
Q
Q
Q2 Q3
ATCMC
AVC
AFC0
0 Q1
1 2 3 4 5 6 7 8 9 10
1
2
3
4
5
7
89
10
6
MC
ATC
AVC
Q
$
0
1 2 3 4 5 6 7 8 9 10
1
2
3
4
5
7
89
10
6
MCATC
AVC
Q
$
0
What is the Short Run?What is the Short Run?
A time period in which producers can change some, but not all of its resources
What is the Long Run?What is the Long Run?
The time period in which producers can change quantities of all resources
Short-run Vs. Long-run Average CostShort-run Vs. Long-run Average CostShort-run Vs. Long-run Average CostShort-run Vs. Long-run Average Cost
Q
$ per unit of Output
SRA
C ASR
AC B
SRA
CC
SRA
CD
Q1Q2 Q30
LRAC
What are Economies of Scale?What are Economies of Scale?
When a firm increases resources in the long run and ATC decreases
What are Diseconomies of Scale?What are Diseconomies of Scale?
When a company increases resources in the long run and ATC increases