Chapter 4: Elasticity Elasticity of Demand: It measures the responsiveness of quantity demanded (or demand) with respect to changes in its own price (or income or the price of some other commodity).

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 ´ 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 ($400)? Do you sell the new chip at a low price ($200)?

Demand and Total Revenue 400 Price (dollars per chip) 300 200 Da 100 40 80 120 Quantity (millions of chips per year)

Demand and Total Revenue 400 Price (dollars per chip) 300 200 100 Db 40 60 80 120 Quantity (millions of chips per year)

Demand and Total Revenue Price (dollars per chip) Price (dollars per chip) Da Db Quantity (millions of chips per year) Quantity (millions of chips per year)

Slope Depends on Units 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.

Effect of a change of unit of measurement on Slope Price 10 9 8 7 6 5 4 3 2 1 1 2 3 4 5 6 7 8 9 10 11 12 Quantity

Slope Depends on Units 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. Elasticity is independent of the units of measurement.

Price 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 Measure Price Elasticity of Demand

Calculating 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 price elasticity of demand for the same range of the demand curve

Example: Suppose, quantity demanded changes from 150 to 100 when Price increases from 5 to 10 dollars. Find out the price elasticity of demand for this specific range of the demand curve.

Calculating the Elasticity of Demand Original point 410 Price (dollars per chip) 390 Da 36 44 Quantity (millions of chips per year)

Calculating the Elasticity of Demand Original point 410 Price (dollars per chip) New point 390 Da 36 44 Quantity (millions of chips per year)

Calculating the Elasticity of Demand Original point 410 Price (dollars per chip) = -$20 New point 390 Da = 8 36 44 Quantity (millions of chips per year)

Price (dollars per chip) Original point 410 Price (dollars per chip) = -$20 400 Pave = $400 New point 390 Da = 8 36 44 Quantity (millions of chips per year)

Calculating the Elasticity of Demand Original point 410 Price (dollars per chip) = -$20 400 Pave =$400 New point Qave = 40 390 Da = 8 36 40 44 Quantity (millions of chips per year)

Calculating Elasticity = - 4

Inelastic and Elastic Demand Three demand curves that cover the entire range of possible elasticities of demand: Perfectly inelastic Unit elastic Perfectly elastic

Perfectly inelastic demand Implies that quantity demanded remains constant when price changes occur. Price elasticity of demand = 0

Price D Elasticity = 0 12 Perfectly Inelastic 6 1 Quantity

Unit elastic demand Implies that the percentage change in quantity demanded equals the percentage change in price. Price elasticity of demand = -1

Unit Elastic Demand Price Elasticity = -1 12 Unit Elasticity 6 D 1 2 3 1 2 3 Quantity

Perfectly 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 =

Perfectly Elastic Demand Price Elasticity = 12 D3 6 Perfectly Elastic Quantity

Inelastic and Elastic Demand Inelastic 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 demand Implies the percentage change in quantity demanded is greater than the percentage change in price. In absolute sense, price elasticity of demand > 1

Elasticity Along a Straight-Line Demand Curve 500 Price (dollars per chip) 400 300 250 200 100 0 40 80 100 120 160 200 Quantity (millions of chips per year)

Elasticity Along a Straight-Line Demand Curve 500 Lowering the price from $500 to $300 results in a price elasticity of demand of -4. Elastic Price (dollars per chip) 400 300 250 200 100 0 40 80 100 120 160 200 Quantity (millions of chips per year)

Elasticity Along a Straight-Line Demand Curve 500 Lowering the price from $200 to $0 results in a price elasticity of demand of -1/ 4. Price (dollars per chip) 400 Inelastic 300 250 200 Elasticity = -1/4 100 0 40 80 100 120 160 200 Quantity (millions of chips per year)

Elasticity Along a Straight-Line Demand Curve 500 Lowering the price from $500 to $0 results in a price elasticity of demand of -1. |Elasticity| > 1 Price (dollars per chip) 400 |Elasticity| = 1 300 250 200 |Elasticity| < 1 100 0 40 80 100 120 160 200 Quantity (millions of chips per year)

Elasticity, Total Revenue and Expenditure TR = P x Q Elasticity, Total Revenue and Expenditure Elastic 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 demand — a 1 percent decrease in price will result in a 1 percent increase in quantity demanded Total revenue will not change

Elasticity, Total Revenue and Expenditure Inelastic demand — a 1 percent decrease in price will result in a less than 1 percent increase in quantity demanded. Total revenue will decrease

Elasticity, Total Revenue and Expenditure Total 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 & Expenditure Total Revenue Test Price cut and total revenue increases demand is elastic. Price cut and total revenue decreases demand is inelastic Price cut and total revenue does not change demand is unit elastic

500 Price (dollars per chip) 400 300 250 200 100 D 0 100 200 TR = P x Q

500 Price (dollars per chip) 400 300 250 200 100 D 0 100 200 25 20 Total Revenue (billions of dollars) 15 10 TR 5 0 100 200 Quantity (millions of chips per year)

Elastic demand 500 Price (dollars per chip) 400 Unit elastic 300 250 200 Inelastic demand 100 0 100 200 25 Maximum total revenue 20 Total Revenue (billions of dollars) 15 When demand is inelastic, price cut decreases total revenue When demand is elastic, price cut increases total revenue 10 5 0 100 200 Quantity (millions of chips per year)

More Elasticities of Demand Cross 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 substitute or complement

Income Elasticity of Demand Measures the responsiveness of the demand to a change in income. Income elasticity of demand = Percentage change In Demand Percentage change in income

Income Elasticity of Demand Income elasticity can be: 1) Greater than 1 (normal good, income elastic) luxury goods - ocean cruises, jewelry 2) Between zero and 1 (normal good, income inelastic) necessities - food, clothing 3) Less than zero (inferior good) potatoes, rice

Unit Tax and Tax Burden: Price 10 S2 9 S1 8 7 6 5 $2 4 3 2 1 1 2 3 4 5 6 7 8 9 10 11 Quantity

Unit Tax and Tax Burden: Price 10 S2 Consumers’ part 9 S1 8 7 6 $2 5 4 3 2 1 Suppliers’ part 1 2 3 4 5 6 7 8 9 10 11 Quantity

Elasticity and Tax Burden: Perfectly Inelastic Demand Price 10 S2 Consumers’ part 9 S1 8 7 6 $2 5 4 3 2 1 1 2 3 4 5 6 7 8 9 10 11 Quantity

Elasticity and Tax Burden: Perfectly Elastic Demand Price 10 S2 9 Producers’ part S1 8 7 6 5 4 $2 3 2 1 1 2 3 4 5 6 7 8 9 10 11 Quantity

Elasticity and Tax Burden: Perfectly Elastic Supply Price 10 Consumers’ part 9 8 7 6 S2 $2 5 S1 4 3 2 1 1 2 3 4 5 6 7 8 9 10 11 Quantity

Elasticity and Tax Burden: Perfectly inelastic Supply Price S1 10 9 Producers’ part 8 7 6 5 4 3 $2 2 1 1 2 3 4 5 6 7 8 9 10 11 Quantity

Chapter 5 Marginal Utility & Consumer Choice:

Utility: The satisfaction or enjoyment a person obtains from consuming a good. Util: A hypothetical unit used to measure how much utility a person obtains from consuming a good.

Marginal Utility: Total Utility: The change in total utility a person derives from consuming an additional unit of a good. Total Utility: The total number of utils a person derives from consuming a specific quantity of a good.

Law of Diminishing Marginal Utility: The idea that as more of a good is consumed, the utility a person derives from each additional unit diminishes.

Total and Marginal Utility

Water-Diamond Paradox: How much people value a good depends upon the utils they derive from the last unit consumed or the Marginal Utility.

Making selection from a given budget:

Making selection from a given budget:

20% Sale on Clothing:

MU/P Equalization Principle:

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.

Price 10 8 6 3 D 1 2 3 Quantity

Price 3 D Quantity

Chapter 6: Price Ceilings and Price Floors

Civilian Goods Defense Goods

S2 Price ($) S1 10 Price Ceiling 4 D 7 10 Quantity (1,000)

S2 Price ($) 10 Price Ceiling 4 D 4 7 10 Excess Demand or Shortage Quantity (1,000)

Price ($) S1 Excess Supply or Surplus S2 Price Floor 4 2 D 10 12 14 Quantity (1,000)

Price ($) Excess Supply or Surplus S2 Price Floor 4 2 D 10 12 14 Quantity (1,000)

Chapter 8 Costs of Production

What is a Fixed Cost? Cost to a firm that does not vary with the quantity of goods produced

What are examples of Fixed Costs? rent or mortgage a part of utilities

Fixed Costs are also known as….. Sunk Cost

What is a Variable Cost? Cost that varies with the quantity of goods produced

What are examples of Variable Costs? worker’s wages raw materials some utilities some taxes

What is Labor Productivity? The output per laborer per hour

Under what condition is it cheaper to pay $10 an hr. to a U. S Under what condition is it cheaper to pay $10 an hr. to a U.S. worker than $1 an hour to a foreign worker?

If the U.S. worker is more than 10 times as productive as the foreign worker

Why do labor costs per unit of output changes as more units of labor are hired? Price of labor increases Quality of labor decreases Labor productivity Changes

Why do non-labor, variable costs per unit of output increase as output increases? Resources become more scarce

Does the cost of all resources increase more than production increases? No, the costs of some resources may vary proportionately with the level of production

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? Cost to the firm that includes both fixed and variable costs

Total Costs TC $ TVC TFC Q

What is Average Total Cost? Total cost divided by the quantity of goods produced

$ TC TVC 10 ATC = 9 5/2 = 2.5 8 7 6 5 ATC = 4 6/5 = 1.2 3 6 5 2 1 Q 1 2 3 4 5 6 7 8 9 10

$ 10 9 8 7 ATC 6 5 4 3 2 1 Q 1 2 3 4 5 6 7 8 9 10

What is Average Variable Cost? Total variable cost divided by the quantity of goods produced

$ 10 9 TVC 8 7 6 5 4 3 2 1 Q 1 2 3 4 5 6 7 8 9 10

$ 10 9 8 7 ATC 6 5 AVC 4 3 2 1 Q 1 2 3 4 5 6 7 8 9 10

What is Average Fixed Cost? Total fixed cost divided by the quantity of goods produced

Costs AFC Quantity 9090

What is Marginal Cost? The change in total cost associated with one more unit of production

If the only thing we observe is a change in total cost associated with a small change in output produced then MC is computed in the following way. MC = Q TC

$ TC 10 MC = 9 3/3 = 1 8 3 7 6 5 3 4 3 2 1 Q 1 2 3 4 5 6 7 8 9 10

$ TC 10 9 8 7 6 5 4 3 2 1 Q 1 2 3 4 5 6 7 8 9 10

TC, TVC, TFC TFC Q1 Q2 Q3 Q MC ATC AVC AFC Q

$ 10 MC 9 ATC 8 7 AVC 6 5 4 3 2 1 Q 1 2 3 4 5 6 7 8 9 10

$ 10 MC 9 ATC 8 7 AVC 6 5 4 3 2 1 Q 1 2 3 4 5 6 7 8 9 10

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? The time period in which producers can change quantities of all resources

Short-run Vs. Long-run Average Cost $ per unit of Output SRACD SRACC SRACA SRACB LRAC Q1 Q2 Q3 Q

What are Economies of Scale? When a firm increases resources in the long run and ATC decreases What are Diseconomies of Scale? When a company increases resources in the long run and ATC increases