What do my students have to say about Economics?

ECONOMICS & DECISION MAKING

Dr. R. JAYARAJ, M.A., Ph.D.,COMES, UPES

What Is Economics? Economics is the study of how people choose to use resources.

Resources include the time and talent people have available, the land, buildings, equipment, and other tools on hand, and the knowledge of how to combine them to create useful products and services.

Important choices involve how much time to devote to work, to school, and to leisure, how many dollars to spend and how many to save, how to combine resources to produce goods and services, and how to vote and shape the level of taxes and the role of government.

Often, people appear to use their resources to improve their well-being. Well-being includes the satisfaction people gain from the products and services they choose to consume, from their time spent in leisure and with family and community as well as in jobs, and the security and services provided by effective governments. Sometimes, however, people appear to use their resources in ways that don't improve their well-being.

Definitions of Economics In short, economics includes the study of labor, land, and

investments, of money, income, and production, and of taxes and government expenditures. Economists seek to measure well-being, to learn how well-being may increase overtime, and to evaluate the well-being of the rich and the poor.

The most famous book in economics is the Inquiry into the Nature and Causes of The Wealth of Nations written by Adam Smith, and published in 1776 in Scotland.

The term “wealth” has a special meaning in Economics. In the ordinary language, by “wealth”, we mean money, but in economics, wealth refers to those goods which satisfy human wants. But we should remember all goods which satisfy human wants are not wealth. For example, air and sunlight are essential for us. We cannot live without them. But they are not regarded as wealth because they are available in abundance and unlimited in supply. We consider only those goods which are relatively scarce and have money value as wealth.

"Economics is the study of people in the ordinary business of life.”-- Alfred Marshall, Principles of economics; an introductory volume (London: Macmillan, 1890)

"Economics is the science which studies human behaviour as a relationship between given ends and scarce means which have alternative uses.”-- Lionel Robbins, An Essay on the Nature and Significance of Economic Science (London: MacMillan, 1932)

Economics is the "study of how societies use scarce resources to produce valuable commodities and distribute them among different people.”-- Paul A. Samuelson, Economics (New York: McGraw-Hill, 1948)

What do my students have to say about Economics?

Economics is studying how people choose to spend their limited incomes on unlimited wants.

Economics is about the world around us, how people spend their money to benefit themselves. However, its complicated and makes life very difficult for us.

Economics is about the economy and how it works. It seems to be purely about efficiency.

Economics is about the relationship between producers & consumers and the way in which the forces of supply & demand affect prices & products in the economy.

Economics is the study of how a country runs globally and within itself. How we use our limited resources ( in our country & globally ) to satisfy the infinite wants of people living within the country.

Economics is the rotation, management and analysis of money.

Economics does require a brain! Don’t be fooled.

Economics is an interesting social science that is relevant to our everyday lives. As you start learning more about it, you will realise how it does apply to our lives.

Economics is awesome because of the deeper understanding it helps us to reach the way we function in our daily lives.

Economics is about discovering new things, understanding them and challenging those we believe in as a global economy.

Economics is everywhere.

Economics is a way of looking at how societies organise

And finally, If your demand for the best quality education is inelastic, UPES has the supply. Make the right decision.

Difference between Micro and Macroeconomics

Macro and microeconomics are the two vantage points from which the economy is observed.

Macroeconomics looks at the total output of a nation and the way the nation allocates its limited resources of land, labor and capital in an attempt to maximize production levels and promote trade and growth for future generations. After observing the society as a whole, Adam Smith noted that there was an "invisible hand" turning the wheels of the economy: a market force that keeps the economy functioning.

Microeconomics looks into similar issues, but on the level of the individual people and firms within the economy. It tends to be more scientific in its approach, and studies the parts that make up the whole economy. Analyzing certain aspects of human behaviour, microeconomics shows us how individuals and firms respond to changes in price and why they demand what they do at particular price levels.

Managerial Economics vs. Microeconomics: Common and Different

Microeconomics Managerial Economics

How should the prices be set?In which way were the prices set?

Computer Manufacturer (e.g.: IBM)

Similar concepts

The nature of managerial economic decision makingThe nature of managerial economic decision making

The role of managerial economics in managerial decision making The role of managerial economics in managerial decision making

Managerial decision problems

Product price and output

Make or buy

Production technique

Internet strategy

Advertising media and intensity

Investment and financing

Managerial decision problems

Product price and output

Make or buy

Production technique

Internet strategy

Advertising media and intensity

Investment and financing

Economic concepts

Theory of consumer behaviour

Theory of firm

Theory of market structures and pricing

Economic concepts

Theory of consumer behaviour

Theory of firm

Theory of market structures and pricing

Decision making tools

Numerical analysis

Statistical analysis

Forecasting

Game theory

Optimisation

Decision making tools

Numerical analysis

Statistical analysis

Forecasting

Game theory

Optimisation

Managerial Economics

Use of economics concepts and decision making tools to

solve managerial decision problems

Managerial Economics

Use of economics concepts and decision making tools to

solve managerial decision problems

Optimal solutions Optimal solutions

Managerial Economics Is a Tool for Improving Management Decision

Making

Categories of Basic Principles of Economics

How do people make decisions?

How do people interact?

How does the economy work overall?

How Do People Make Decisions?

Principle #1 - People face tradeoffs

Time allocation – an example of tradeoffs

Efficiency versus equity

Production Possibilities Frontier

Principle #2 - The cost of something is what you have to give up to get it

Opportunity costs come from Von Weiser, a German economist late 1800s

Opportunity costs are independent of monetary units

The real costs of going to college

Principle #3 - Rational people think at the margin

Rational or irrational decision-making

Marginal benefits and costs versus total benefits and costs

Weighing marginal costs and benefits leads to maximizing net benefits (total welfare)

Principle #4 –People respond to incentives

Reactions to changes in marginal benefits and costs

Increases (decreases) in marginal benefits mean more (less) of an activity

Increases (decreases) in marginal costs mean less (more) of an activity

How Do People Interact?

Principle #5 - Trade can make everybody better off

Adam Smith author of the “An Inquiry into the Causes and Consequences of the Wealth of Nations” 1776

Gains from the division of labor and specialization

Mercantilists perspectives

Markets

Principles 1-5 combine with markets to turn the pursuit of self-interest into promoting the interests of society

Adam Smith and the “invisible hand”

creativity and productivity are stimulated by the pursuit of self-interest into improving resource allocations

in some cases markets fail to allocate resources effectively

Principle #6 - Markets are usually a good way of organizing economic activity

Feudal (military security) times where feudal states were self-supporting, also haciendas (domestic factory) in the new world

the benefits of trade are so powerful that people began to trade

markets for economists are more abstract than the notion of a middle eastern bazaar or a flea market and simply determine the prices and quantities traded of different goods and services

Principle #7 Governments can sometimes improve interaction that occurs in markets

there are circumstances when market signals fail to allocate resources efficiently or equitably

Public Goods, Externalities and Income Distribution

Some goods or services that people desire will not be produced by markets (e.g. light houses).

Some goods or services will either be under produced (vaccines) or overproduced (pollution) because markets fails to register certain benefits or costs.

How Does the Economy Work as a Whole?

Principle # 8 – A country’s standard of living depends upon its ability to produce goods and services

Adam Smith’s “An Inquiry into the Nature and the Consequences of the Wealth of Nations”

wealth: a necessary or sufficient condition for happiness (are rich people happier, children with lots of toys)

productivity

Principle #9 – The general level of prices rises when the government prints and distributes too much money

definition of money, the concept of inflation, and economic language

inflation is an increase in the general or average level of prices in an economy

the establish of the Federal Reserve and the introduction of sustained inflation in the US

Principle #10 – Society faces a short-run tradeoff between inflation and unemployment

Short-run and the long-run

demand and supply shocks

short-run increases (decreases) in output above (below) long-run potential output lead to adjustments

countercyclical stabilization versus pro-cyclical destabilization

Markets

In economics, a market is not a place but rather a group of buyers and sellers with the potential to trade with each other

Market is defined not by its location but by its participants

First step in an economic analysis is to define and characterize the market or collection of markets to analyze

Economists think of the economy as a collection of individual markets

How Broadly Should We Define The Market

Defining the market often requires economists to group things together

Aggregation is the combining of a group of distinct things into a single whole

Markets can be defined broadly or narrowly, depending on our purpose

How broadly or narrowly markets are defined is one of the most important differences between Macroeconomics and Microeconomics

Defining Macroeconomic Markets

Goods and services are aggregated to the highest levels

Macro models lump all consumer goods into the single category “consumption goods”

Macro models will also analyze all capital goods as one market

Macroeconomists take an overall view of the economy without getting bogged down in details

Defining Microeconomic Markets

Markets are defined narrowly

Focus on models that define much more specific commodities

Always involves some aggregation

But stops it reaches the highest level of generality that macroeconomics investigates

Buyers and Sellers Buyers and sellers in a market can be

Households

Business firms

Government agencies

All three can be both buyers and sellers in the same market, but are not always

For purposes of simplification this text will usually follow these guidelines

In markets for consumer goods, we’ll view business firms as the only sellers, and households as only buyers

In most of our discussions, we’ll be leaving out the “middleman”

Demand

Demand is: the willingness and ability of buyers to purchase different quantities of a good at different prices during a specific period of time.

The Law of Demand: as the price of a good rises, quantity demanded of that good falls; as the price of a good falls, quantity demanded of that good rises.

Demand

A household’s quantity demanded of a good

Specific amount household would choose to buy over some time period, given

A particular price that must be paid for the good

All other constraints on the household

Market quantity demanded (or quantity demanded) is the specific amount of a good that all buyers in the market would choose to buy over some time period, given

A particular price they must pay for the good

All other constraints on households

Quantity Demanded

Implies a choice

How much households would like to buy when they take into account the opportunity cost of their decisions?

Is hypothetical

Makes no assumptions about availability of the good

How much would households want to buy, at a specific price, given real-world limits on their spending power?

Stresses price

Price of the good is one variable among many that influences quantity demanded

We’ll assume that all other influences on demand are held constant, so we can explore the relationship between price and quantity demanded

The Law of Demand

The price of a good rises and everything else remains the same, the quantity of the good demanded will fall

The words, “everything else remains the same” are important

In the real world many variables change simultaneously

However, in order to understand the economy we must first understand each variable separately

Thus we assume that, “everything else remains the same,” in order to understand how demand reacts to price

The Demand Schedule

Demand schedule

A list showing the quantity of a good that consumers would choose to purchase at different prices, with all other variables held constant

Demand V.S. Quantities demanded

- demand is the entire relationship between price and quantity

- quantities demanded are specific amount of goods buyers want to buy

The Demand Curve

The market demand curve (or just demand curve) shows the relationship between the price of a good and the quantity demanded , holding constant all other variables that influence demand

Each point on the curve shows the total buyers would choose to buy at a specific price

Law of demand tells us that demand curves virtually always slope downward

Figure 1: The Demand Curve

Number of Bottles per Month

Price per Bottle

A

B

$4.00

2.00

D

40,000 60,000

At $2.00 per bottle, 60,000 bottles are demanded (point B).

When the price is $4.00 per bottle, 40,000 bottles are demanded (point A).

“Shifts” vs. “Movements Along” The Demand Curve

Move along the demand curve

From a change in the price of the good we analyze

In maple syrup example, Figure 1

A fall in price would cause a movement to the right along the demand curve (point A to B)

Figure 3(a): Movements Along and Shifts of The Demand Curve

Quantity

Price

P2

Q2 Q1 Q3

P1

P3

Price increase moves us leftward along demand curve

Price increase moves us rightward along demand curve

“Shifts” vs. “Movements Along” The Demand Curve

Shift of demand curve a change in other things than price of the good

causes a shift in the demand curve itself, for example, income

In Figure 2 Demand curve has shifted to the right of the old

curve (from Figure 1) as income has risen

A change in any variable that affects demand—except for the good’s price—causes the demand curve to shift

Figure 2: A Shift of The Demand Curve

B C$2.00

60,000 80,000

D1D2

An increase in income shifts the demand curve for maple syrup from D1 to D2.

Number of Bottles per Month

Price per Bottle

At each price, more bottles are demanded after the shift

Income: Factors That Shift The Demand Curve

An increase in income has effect of shifting demand for normal goods to the right

However, a rise in income shifts demand for inferior goods to the left

A rise in income will increase the demand for a normal good, and decrease the demand for an inferior good

Normal good and inferior good are defined by the relation between demand and income

Wealth: Factors That Shift The Demand Curve

Your wealth—at any point in time—is the total value of everything you own minus the total dollar amount you owe

- Example

An increase in wealth will

Increase demand (shift the curve rightward) for a normal good

Decrease demand (shift the curve leftward) for an inferior good

Prices of Related Goods: Factors that Shift the Demand Curve

Substitute—good that can be used in place of some other good and that fulfills more or less the same purpose

Example

A rise in the price of a substitute increases the demand for a good, shifting the demand curve to the right

Complement—used together with the good we are interested in

Example

A rise in the price of a complement decreases the demand for a good, shifting the demand curve to the left

Other Factors That Shift the Demand Curve

Population

As the population increases in an area

Number of buyers will ordinarily increase

Demand for a good will increase

Expected Price

An expectation that price will rise (fall) in the future shifts the current demand curve rightward (leftward)

Tastes

Combination of all the personal factors that go into determining how a buyer feels about a good

When tastes change toward a good, demand increases, and the demand curve shifts to the right

When tastes change away from a good, demand decreases, and the demand curve shifts to the left

Small Summary-- Factors Affecting Demand

Income (depends on good’s nature: normal or inferior)

Wealth (depends on good’s nature)

Prices of substitutes (positively related)

Prices of complements (negatively related)

Population (positively related)

Expected price (positively related)

Tastes (positively related)

Figure 3(b): Movements Along and Shifts of The Demand Curve

Quantity

Price

D2

D1

Entire demand curve shifts rightward when:• income or wealth ↑• price of substitute ↑• price of complement ↓• population ↑• expected price ↑• tastes shift toward good

Figure 3(c): Movements Along and Shifts of The Demand Curve

Quantity

Price

D1

D2

Entire demand curve shifts leftward when:• income or wealth ↓• price of substitute ↓• price of complement ↑• population ↓• expected price ↓• tastes shift toward good

Supply

Supply is the willingness and ability of sellers to produce and offer to sell different quantities of a good at different prices during a specific period of time

Law of Supply: As the price of a good rises, the quantity supplied of the good rises; and as the price of a good falls, the quantity supplied of the good falls.

Supply A firm’s quantity supplied of a good is the

specific amount its managers would choose to sell over some time period, given

A particular price for the good

All other constraints on the firm

Market quantity supplied (or quantity supplied) is the specific amount of a good that all sellers in the market would choose to sell over some time period, given

A particular price for the good

All other constraints on firms

The Law of Supply

States that when the price of a good rises and everything else remains the same, the quantity of the good supplied will rise

The words, “everything else remains the same” are important

In the real world many variables change simultaneously

However, in order to understand the economy we must first understand each variable separately

We assume “everything else remains the same” in order to understand how supply reacts to price

The Supply Schedule and The Supply Curve

Supply schedule—shows quantities of a good or service firms would choose to produce and sell at different prices, with all other variables held constant

Supply curve—graphical depiction of a supply schedule

Shows quantity of a good or service supplied at various prices, with all other variables held constant

Figure 4: The Supply Curve

F

G

2.00

S

40,000 60,000

$4.00

At $4.00 per bottle, quantity supplied is 60,000 bottles (point G).

When the price is $2.00 per bottle, 40,000 bottles are supplied (point F).

Number of Bottles per Month

Price per Bottle

Shifts vs. Movements Along the Supply Curve

A change in the price of a good causes a movement along the supply curve

In Figure 4

A rise (fall) in price would cause a rightward (leftward) movement along the supply curve

A drop in transportation costs will cause a shift in the supply curve itself

In Figure 5

Supply curve has shifted to the right of the old curve (from Figure 4) as transportation costs have dropped

A change in any variable that affects supply—except for the good’s price—causes the supply curve to shift

Figure 5: A Shift of The Supply Curve

S2

GJ

S1

60,000

$4.00

80,000

A decrease in transportation costs shifts the supply curve for maple syrup from S1 to S2.

Number of Bottles per Month

Price per Bottle

At each price, more bottles are supplied after the shift

Factors That Shift the Supply Curve

Input prices

A fall (rise) in the price of an input causes an increase (decrease) in supply, shifting the supply curve to the right (left)

Price of Related Goods

When the price of an alternate good rises (falls), the supply curve for the good in question shifts leftward (rightward)

If a producer sees more profit in another good, and if the producer is easily able to switch, it will start making the other good, thereby reducing the supply for the good in question.Eg: If a farmer is currently growing wheat and he calculates more profit in growing barley, next year he will plant barley, thereby reducing supply of wheat.

For purposes of supply analysis related goods refer to goods from which inputs are derived to be used in the production of the primary good. For example, Spam (tinned meat) is made from pork shoulders and ham. Both are derived from Pigs. Therefore pigs would be considered a related good to Spam. In this case the relationship would be negative or inverse. If the price of pigs goes up the supply of Spam would decrease (supply curve shifts left) because the cost of production would have increased.

A related good may also be a good that can be produced with the firm's existing factors of production. For example, a firm produces leather belts. The firm's managers learn that leather pouches for smart phones are more profitable than belts. The firm might reduce its production of belts and begin production of cell phone pouches based on this information. Finally, a change in the price of a joint product will affect supply.

For example beef products and leather are joint products

Factors That Shift the Supply Curve

Number of Firms

An increase (decrease) in the number of sellers—with no other changes—shifts the supply curve to the right (left)

Technology

Cost-saving technological advances increase the supply of a good, shifting the supply curve to the right

Expected Price

An expectation of a future price increase (decrease) shifts the current supply curve to the left (right)

Factors That Shift the Supply Curve Changes in weather

Favorable weather

Increases crop yields

Causes a rightward shift of the supply curve for that crop

Unfavorable weather

Destroys crops

Shrinks yields

Shifts the supply curve leftward

Other unfavorable natural events may effect all firms in an area

Causing a leftward shift in the supply curve

Figure 6(a): Changes in Supply and in Quantity Supplied

P2

Q3 Q1 Q2

P1

P3

Quantity

Price Price increase moves us rightward along supply curve

S

Price increase moves us leftward along supply curve

Figure 6(b): Changes in Supply and in Quantity Supplied

Quantity

Price

S2

S1Entire supply curve shifts rightward when:• price of input ↓• price of alternate good ↓• number of firms ↑• expected price ↑• technological advance• favorable weather

Figure 6(c): Changes in Supply and in Quantity Supplied

Quantity

Price

S1

S2Entire supply curve shifts rightward when:• price of input ↑• price of alternate good ↑• number of firms ↓• expected price ↑• unfavorable weather

Summary: Factors That Shift The Supply Curve

The short list of shift-variables for supply that we have discussed is far from exhaustive

In some cases, even the threat of such events can cause serious effects on production

Basic principle is always the same

Anything that makes sellers want to sell more or less of a good at any given price will shift supply curve

Equilibrium: Putting Supply and Demand Together

When a market is in equilibrium

Both price of good and quantity bought and sold have settled into a state of rest

The equilibrium price and equilibrium quantity are values for price and quantity in the market but, once achieved, will remain constant

Unless and until supply curve or demand curve shifts

The equilibrium price and equilibrium quantity can be found on the vertical and horizontal axes, respectively

At point where supply and demand curves cross

Figure 7: Market Equilibrium

E

HJ1.00

$3.00

D

S

50,000 75,00025,000

Excess Demand

4. until price reaches its equilibrium value of $3.00

.

2. causes the price to rise . . .

3. shrinking the excess demand . . .

1. At a price of $1.00 per bottle an excess demand of 50,000 bottles . . .

Number of Bottles per Month

Price per Bottle

Excess Demand

Excess demand

At a given price, the excess of quantity demanded over quantity supplied

Price of the good will rise as buyers compete with each other to get more of the good than is available

Figure 8: Excess Supply and Price Adjustment

3. shrinking the excess supply . . .

K L

E3.00

D

S

$5.00

50,00035,000 65,000

Excess Supply at $5.00

2. causes the price to drop,

4. until price reaches its equilibrium value of $3.00.

Number of Bottles per Month

Price per Bottle

1. At a price of $5.00 per bottle an excess supply of 30,000 bottles . . .

Excess Supply

Excess Supply

At a given price, the excess of quantity supplied over quantity demanded

Price of the good will fall as sellers compete with each other to sell more of the good than buyers want

Income Rises: What Happens When Things Change

Income rises, causing an increase in demand

Rightward shift in the demand curve causes rightward movement along the supply curve

Equilibrium price and equilibrium quantity both rise

Shift of one curve causes a movement along the other curve to new equilibrium point

Figure 9

1. An increase in demand . . .E

F'

3.00

D1

D2

S

$4.00

50,000 60,000

3. to a new equilibrium.

5. and equilibrium quantity increases too.

2. moves us along the supply curve . . .

Number of Bottles of Maple Syrup per Period

Price per Bottle

4. Equilibrium price increases

An Ice Storm Hits: What Happens When Things Change

An ice storm causes a decrease in supply

Weather is a shift variable for supply curve

Any change that shifts the supply curve leftward in a market will increase the equilibrium price

And decrease the equilibrium quantity in that market

Figure 10: A Shift of Supply and A New Equilibrium

E'

E3.00

D

$5.00

50,00035,000

S2 S1

Number of Bottles

Price per Bottle

Using Supply and Demand: The Invasion of Kuwait

Why did Iraq’s invasion of Kuwait cause the price of oil to rise?

Immediately after the invasion, United States led a worldwide embargo on oil from both Iraq and Kuwait

A significant decrease in the oil industry’s productive capacity caused a shift in the supply curve to the left

Price of oil increased

Figure 12: The Market For Oil

P2

D

E'

P1E

Q2 Q1

S2

S1

Barrels of Oil

Price per Barrel of Oil

Using Supply and Demand: The Invasion of Kuwait

Why did the price of natural gas rise as well?

Oil is a substitute for natural gas

Rise in the price of a substitute increases demand for a good

Rise in price of oil caused demand curve for natural gas to shift to the right

Thus, the price of natural gas rose

Figure 13: The Market For Natural Gas

Cubic Feet of Natural Gas

Price per Cubic Foot of Natural

Gas

P4

P3

F

Q3 Q4

S

D2

F'

D1

Figure 11: Changes in the Market for Handheld PCs

1. An increase in supply . . .

2. and a decrease in demand . . .

5. and quantity decreased as well.

A

B$400

D2003

S2002

S2003

D2002

$500

2.45 3.33 Millions of Handheld PCs per Quarter

Price per Handheld

PC

4. Price decreased . . .

3. moved the market to a new equilibrium.

Both Curves Shift

When just one curve shifts (and we know the direction of the shift) we can determine the direction that both equilibrium price and quantity will move

When both curves shift (and we know the direction of the shifts) we can determine the direction for either price or quantity—but not both

Direction of the other will depend on which curve shifts by more

The Three Step Process

Key Step 1—Characterize the Market

Decide which market or markets best suit problem being analyzed and identify decision makers (buyers and sellers) who interact there

Key Step 2—Find the Equilibrium

Describe conditions necessary for equilibrium in the market, and a method for determining that equilibrium

Key Step 3—What Happens When Things Change

Explore how events or government polices change market equilibrium

Example: rental apartment

Example: problem 4, chapter 3 in textbook.

Demand & Supply Diagram

Equilibrium P & Q

Why $1000 can not be equilibrium?

Effects from a tornado destroying some apartments.

rent($)quantity demanded

quantity supplied

800 30 10

1000 25 14

1200 22 17

1400 19 19

1600 17 21

1800 15 22

Demand for two bedroom rental apartment

Summaries

Through the study of the chapter, you will be able to

Characterize a market.

Use a demand schedule and a demand curve to demonstrate the law of demand.

Explain the difference between a change in demand (shift of the curve) and a change in quantity demanded (movement along the curve).

List the factors that will lead to a change in demand, and give examples of each.

Similar analysis for supply side.

Explain how equilibrium price and quantity are determined in a competitive market.

Explain what will happen in a competitive market after a shift in the supply curve, the demand curve, or both.

Describe the three steps economists take to answer almost any question about the economy.

Demand and Supply Elasticities

THE ELASTICITY OF DEMAND

The price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

When we talk about elasticity, that responsiveness is always measured in percentage terms.

Specifically, the price elasticity of demand is the percentage change in quantity demanded due to a percentage change in the price.

Price Elasticity of Demand

• The midpoint method:

12

12

12

12

PPPP

QQQQ

ep

Price elasticity of demand: the percentage change in the quantity demanded that results from a 1 percent change in the price

Special Cases of Demand Elasticities

1. Perfectly inelastic demand: ep = 0

2. Inelastic demand: ep < 1

3. Unit elastic demand: ep = 1

4. Elastic demand: ep > 1

5. Perfectly elastic demand: ep = infinity

Determinants of Price Elasticity of Demand

Substitutability

More substitutable more elastic

Less substitutable less elastic

Proportion of Income

Greater proportion of income more elastic

Lesser proportion of income less elastic

Examples: Autos vs. Salt

Luxuriousness

More luxurious more elastic

Less luxurious less elastic

Examples: Cruise vs. Surgery

Time (More time greater elasticity, vice versa.)

Total Revenue and Demand Elasticity

Total revenue: TR = P x Q

If ep < 1, then an increase (decrease) in P will increase (decrease) TR

If ep = 1, then a change in P will not change TR

If ep > 1, then an increase (decrease) in P will decrease (increase) TR

The Price Elasticity of Demand and Its Determinants

Availability of Close Substitutes

Necessities versus Luxuries

Definition of the Market

Time Horizon

The Price Elasticity of Demand and Its Determinants

Demand tends to be more elastic:

the larger the number of close substitutes.

if the good is a luxury.

the more narrowly defined the market.

the longer the time period.

Computing the Price Elasticity of Demand

The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.

P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in p rice

Computing the Price Elasticity of Demand

Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:

( )

( . . ).

1 0 81 0

1 0 0

2 2 0 2 0 02 0 0

1 0 0

2 0 %

1 0 %2

P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in p rice

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the price change.

2 1 2 1

2 1 2 1

( ) /[( ) / 2]Price elasticity of demand =

( ) /[( ) / 2]

Q Q Q Q

P P P P

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:

(10 8)22%(10 8) / 2

2.32(2.20 2.00) 9.5%

(2.00 2.20) / 2

The Variety of Demand Curves

Inelastic Demand

Quantity demanded does not respond strongly to price changes.

Price elasticity of demand is less than one.

Elastic Demand

Quantity demanded responds strongly to changes in price.

Price elasticity of demand is greater than one.

Computing the Price Elasticity of Demand

Demand is price elastic.

$5

4Demand

Quantity1000 50

3percent 22

percent 67

5.00)/2(4.005.00)(4.00

50)/2(10050)(100

ED

Price

The Variety of Demand Curves

Perfectly Inelastic

Quantity demanded does not respond to price changes.

Perfectly Elastic

Quantity demanded changes infinitely with any change in price.

Unit Elastic

Quantity demanded changes by the same percentage as the price.

The Variety of Demand Curves

Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.

But it is not the same thing as the slope!

Figure 1 The Price Elasticity of Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0

$5

4

Quantity

Demand

1000

1. Anincreasein price . . .

2. . . . leaves the quantity demanded unchanged.

Price

Figure 1 The Price Elasticity of Demand

(b) Inelastic Demand: Elasticity Is Less Than 1

Quantity0

$5

90

Demand1. A 25%increasein price . . .

Price

2. . . . leads to an 10% decrease in quantity demanded.

4

100

Figure 1 The Price Elasticity of Demand

2. . . . leads to a 25% decrease in quantity demanded.

(c) Unit Elastic Demand: Elasticity Equals 1

Quantity

4

1000

Price

$5

80

1. A 25%increasein price . . .

Demand

Figure 1 The Price Elasticity of Demand

(d) Elastic Demand: Elasticity Is Greater Than 1

Demand

Quantity

4

1000

Price

$5

50

1. A 25%increasein price . . .

2. . . . leads to a 50% decrease in quantity demanded.

Figure 1 The Price Elasticity of Demand

(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Quantity0

Price

$4 Demand

2. At exactly $4,consumers willbuy any quantity.

1. At any priceabove $4, quantitydemanded is zero.

3. At a price below $4,quantity demanded is infinite.

Total Revenue and the Price Elasticity of Demand

Total revenue is the amount paid by buyers and received by sellers of a good.

Computed as the price of the good times the quantity sold.

QPTR

Figure 2 Total Revenue

Demand

Quantity

Q

P

0

Price

P × Q = $400(revenue)

$4

100

When the price is $4, consumers will demand 100 units, and spend $400 on this good.

Elasticity and Total Revenue along a Linear Demand Curve

With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.

Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand

Demand

Quantity0

Price

Revenue = $100

Quantity0

Price

Revenue = $240

Demand$1

100

$3

80

An Increase in price from $1 to $3 …

… leads to an Increase in total revenue from $100 to $240

Elasticity and Total Revenue along a Linear Demand Curve

With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

Figure 3 How Total Revenue Changes When Price Changes: Elastic Demand

Demand

Quantity0

Price

Revenue = $200

$4

50

Demand

Quantity0

Price

Revenue = $100

$5

20

An Increase in price from $4 to $5 …

… leads to an decrease in total revenue from $200 to $100

Note that with each price increase, the Law of Demand still holds – an increase in price leads to a decrease in the quantity demanded. It is the change in TR that varies!

Elasticity of a Linear Demand Curve

0 2 64 10

8 12

14

2

1

4

3

5

6

$7

Demand is elastic; demand is responsive to changes in price.

Demand is inelastic; demand is not very responsive to changes in price.

When price increases from $4 to $5, TR declines from $24 to $20.

When price increases from $2 to $3, TR increases from $20 to $24.

Elasticity is > 1 in this range.

Elasticity is < 1 in this range.

Price

Quantity

Figure 4 Elasticity of a Linear Demand Curve

Other Demand Elasticities

Income Elasticity of Demand

Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income.

It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

Other Demand Elasticities

Computing Income Elasticity

In co m e e la stic ity o f d em an d =

P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in in co m e

Remember, all elasticities are measured by dividing one percentage change by another

Other Demand Elasticities

Income Elasticity Types of Goods

Normal Goods

Inferior Goods

Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.

Other Demand Elasticities

Income Elasticity

Goods consumers regard as necessities tend to be income inelastic

Examples include food, fuel, clothing, utilities, and medical services.

Goods consumers regard as luxuries tend to be income elastic.

Examples include sports cars, furs, and expensive foods.

Other Demand Elasticities

Cross-price elasticity of demand

A measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good

2 good of pricein %change

1 good of demandedquantity in %changedemand of elasticity price-Cross

THE ELASTICITY OF SUPPLY

Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good.

Price elasticity of supply is the percentage change in quantity supplied resulting from a percentage change in price.

Figure 5 The Price Elasticity of Supply

(a) Perfectly Inelastic Supply: Elasticity Equals 0

$5

4

Supply

Quantity1000

1. Anincreasein price . . .

2. . . . leaves the quantity supplied unchanged.

Price

Figure 5 The Price Elasticity of Supply

(b) Inelastic Supply: Elasticity Is Less Than 1

110

$5

100

4

Quantity0

1. A 25%increasein price . . .

Price

2. . . . leads to a 10% increase in quantity supplied.

Supply

Figure 5 The Price Elasticity of Supply

(c) Unit Elastic Supply: Elasticity Equals 1

125

$5

100

4

Quantity0

Price

2. . . . leads to a 25% increase in quantity supplied.

1. A 25%increasein price . . .

Supply

(If SUPPLY is unit elastic and linear, it will begin at the origin.)

Figure 5 The Price Elasticity of Supply

(d) Elastic Supply: Elasticity Is Greater Than 1

Quantity0

Price

1. A 25%increasein price . . .

2. . . . leads to a 100% increase in quantity supplied.

4

100

$5

200

Supply

Figure 5 The Price Elasticity of Supply

(e) Perfectly Elastic Supply: Elasticity Equals Infinity

Quantity0

Price

$4 Supply

3. At a price below $4,quantity supplied is zero.

2. At exactly $4,producers willsupply any quantity.

1. At any priceabove $4, quantitysupplied is infinite.

The Price Elasticity of Supply and Its Determinants

Ability of sellers to change the amount of the good they produce.

Beach-front land is inelastic.

Books, cars, or manufactured goods are elastic.

Time period

Supply is more elastic in the long run.

Computing the Price Elasticity of Supply

The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price.

P rice e las tic ity o f su p p ly =

P ercen tag e ch an g e in q u an tity su p p lied

P ercen tag e ch an g e in p rice