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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