Elasticities of Demand and Supply 07 25 2011 Consumer Choice Limited income necessitates choice Consumers make decisions purposefully One good can be substituted for another Consumers must make decisions without perfect information The Law of Diminishing Marginal Utility applies to consumption Marginal Utility o The benefit derived from consuming an additional unit of the good Law of Diminishing Marginal Utility o As the consumption of a product increases the marginal utility derived from an additional consumption will eventually decline Eg One Banana good Two Bananas okay Three Bananas sick Marginal Benefit o The maximum price a consumer will be willing to pay for an additional unit of the product Consumer Equilibrium o Consumers will maximize utility by ensuring that the last dollar spent on each commodity yields an equal degree of marginal utility MUa Pa MUb Pb MUn Pn Responding to Price Changes o People will be more less of a good as the price of the good decreases increases for two reasons o When the price of a good decreases 1 Substitution effect The good has become cheaper relative to other goods Income effect it is as if your real income has increased The cost of time is different for different individuals o Those who earn a higher wage will face a high time cost Eg Lebron doesn t mow his own lawn The Market Demand Curve o The market demand curve is the horizontal sum of the individual demand curves Price Elasticity of Demand What is the Price Elasticity of Demand o Indicated how responsive consumers are to a change in the products price Price elasticity of demand change in Quantity demanded change in Price o ALWAYS NEGATIVE so we use the absolute value Calculations o change in Quantity Demanded new Q old Q new Q Old Q o change in Price new P old P new P old P o Price Elasticity change in QD change in P If Price elasticity of demand is o 1 elastic o 1 unitary elastic o 1 inelastic Elasticity will decrease as you move down a straight line demand curve Percent change in quantity decreases Percent change in price increases Determinant of Price Elasticity of Demand o 1 The most important determinant of the price elasticity of demand is the availability of substitutes good substitutes higher elasticity The more narrowly defined the product is the more elastic it is o 2 Products share of the consumers total budget The larger the share of the consumer s budget the higher the elasticity o 3 Second Law of Demand when the price of a product increases consumers will reduce their consumption by a larger amount in the long run that the short run TIME Elasticity and Totally Revenue o Total Revenue Expenditures Price x Quantity As price increases Quantity sold decreases o Increase Total Revenue Depends on Elasticity 1 Inelastic The PRICE effect dominates 2 Elastic The QUANTITY effect dominates 3 Unitary Elastic the effects are the same No change in total revenue Elasticity is not slope of demand Curve o A straight line demand curve will have constant slope but a different elasticity at every point Totally quantity increases as you move down the demand curve thus change in quantity changes Price works sort of the same way Income Elasticity Defn o Income elasticity measures the responsiveness of the demand for a good to a change in income o Income Elasticity change in Quantity change in Income o In this case the sign does matter Income Elasticity determine the type of good o 1 Normal Good positive income elasticity a Necessity income elasticity is between 0 and 1 b Luxury income elasticity is greater that 1 o 2 Inferior Good negative income elasticity Price Elasticity of Supply Measures how responsive suppliers are to a change in price o Price Elasticity of Supply change in Quantity Supplied change in Price ALWAYS positive Similar to the price elasticity of demand the price elasticity of supply will be greater in the long run Cost and Profit Incentives and Cooperation 07 25 2011 Residual Claimants over costs o Individuals who personally receive the excess of revenues o They have the incentive to increase revenues or reduce costs There are TWO ways to organize productive activity o 1 Contracting using outside producers for specific tasks o 2 Team Production Where employees work together under the supervision of the owner or owner s representative o Working at less than the expected rate of productivity which Shirking reduces output Principle Agent Problem o The incentive prolem that occurs when the purchaser of services lacks full information about the circumstances faced by the seller and therefore cannot know how well the seller performs the service Types of Business 1 Sole Proprietorship o a business firm owned by a single individual o gets all the profits but accepts all the risk 2 Partnership o a business firm owned by two or more individuals o they share in the profits and the risks 3 Corporation o a business owned by shareholders they have the right to the firm s profits but their liability is limited to the amount of their investment Short Run and Long Run Short Run o Defn Period of time during which some reasources or inputs are fixed A seller in the short run has some FIXED INPUTS that cannot be increased and the costs of which are UNAVOIDABLE even if the seller shuts down FIXED COSTS do not change when quantity changes VARIABLE INPUTS Resources that are not fixed in the short run The amount of the input used and its cost changes when the quantity of output changes The costs of the variable inputs are AVOIDABLE If the seller shuts down it doesn t have to bear any costs for the variable inputs o Examples of fixed resources and unavoidable costs A lease The capacity of a plant of facility The opportunity cost of equipment that cannot be quickly liquidated or converted to alternative uses Specialized skills training or education needed to serve a market Long Run o Defn A point in time when the seller is no longer committed At certain points in time a seller is no longer committed to a market and has the opportunity to either expand in the market or exit the market and enter a new market There are no fixed inputs and no unavoidable costs in the long run All inputs are variable in the long run and all long run costs are variable Explicit Costs Implicit Costs o The payments a firms makes to purchase the goods and services of productive resources o The opportunity costs associated with the firm s use of resources that it owns Total Costs TC o The costs both explicit and implicit of
View Full Document
Unlocking...