ec0 511_lecture notes on basic microeconomics

Microeconomics Primer

Dr. Sakib B. Amin

Department of Economics

North South University

ECO 511: Microeconomics Analysis

1

What is Economics?

o Economics is the Social Science that studies the choice that individuals, businesses, governments and the entire societies make as they cope with scarcity.

o Economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people.

2

Scarcity

o Economics deal with a central problem faced by all individuals and all societies: The Problem of Scarcity

Fundamental Reason:

o Our wants far exceed our resources. So, scarcity of resources is the key problem.

o The excess of Human needs over what can actually be produced.

o Our inability to satisfy all our wants is called scarcity.

3

Scarcity

The problem of scarcity means that every time we take an economic decision (for example, how much to consume or for a firm how much to produce of a given good) we face some constraints that affect our decision.

Scarcity arises because some resources that are used to produce goods are limited by physical space.

For example, to produce goods and services we need to use productive resources like Labour, Land and Raw Materials, Capital (machines, factories, equipment, etc.etc.).

4

Scarcity

The amount of Labour is limited both in number and in skills.

The worlds land area is limited and so are raw materials (think of petrol).

The stock of capital is limited since we have a limited amount of factories, machines, transportation and other equipment.

Labour, Raw Materials, Land and Capital are what we call Factors of Production (or productive Inputs).

5

Scarcity

Furthermore, scarcity arises from other resources, like time or income (normally we cannot consume more than what we earn, a firm may not be able to start a new factory if it not able to get a bank loan, etc. etc.).

Given the limited amount of resources we con only produce and consume a limited amount of goods and services.

6

Why is scarcity a problem?

If we know that we have limited resources we could just behave accordingly. The problem arises because in general human wants and needs are virtually unlimited. We all would like to have more money to be able to consume more goods and services. Thus, scarcity becomes a problem because it implies that the means of fulfilling human needs are limited.

Therefore economists tend to define scarcity in the following way:

the excess of human needs over what can actually be produced.

7

Scarcity

Scarcity implies that we cannot choose whatever we want when we decide about what and how much to consume (I cannot buy today a BMW that costs 50000 if my total income today is 10000, etc. etc.) or when we decide about what and how much to produce (I cannot produce a good that requires 1000 workers if only 100 are available, etc. etc.)..

8

Economic Categories

Four common Economic Categories are:

1. Microeconomics

2. Macroeconomics

3. Positive Economics

4. Normative Economics

9

Microeconomics

Adam Smith is usually considered the founder of the field of Microeconomics. This is the branch of Economics, which is concerned with the behaviour of individual entities such as markets, firms and households.

In The Wealth of Nations, Smith considered how individual prices are set, studied the determination of prices of Land, Labour and Capital, and inquired into the strengths and weaknesses of the market mechanism.

10

Microeconomics

Microeconomics studies the behaviour of individual decision-making units, the individual, the household ,the firm, the industry and how these agents interact in markets.

Microeconomics is the study of the economic behaviour of single units( a consumer, a household, a firm, a particular industries, etc.etc) and of the interrelationship between those units.

11

Microeconomics

A Micro economist might be interested in answering such questions as:

How does a Market work?

What level of output does a firm produce?

What price does a firm charge for the good it produces?

How does a consumer determine how much of a good he/she will buy?

Can Government policy affect business and consumer behaviour?

12

Microeconomics

Generally Microeconomics looks at the production, exchange and consumption of goods and services at the level of an individual producer of the good or the market in which a single good or service is exchanged or an individual consumer of the product.

The Key word is individual: Microeconomics deals with the behaviour of the individual entities that make up the economy.

13

Macroeconomics

Macroeconomics is the study of the entire economy in terms of the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the general behavior of prices. Macroeconomics can be used to analyze how best to influence policy goals such as economic growth, price stability, full employment and the attainment of a sustainable balance of payments.

Rather than worrying about why the price of gasoline has risen or fallen over the last several days Macroeconomics is concerned with the inflation rate, a measure of how the average price of all goods and services has changed.

14

Macroeconomics

A Macroeconomist might be interested in answering such questions as:

How does the Economy work?

Why is the unemployment rate sometimes high and sometimes low?

What causes inflation?

Why do some national economies grow faster than other national economies?

What might cause interest rates to be low one year and high the next?

How do the changes in the money supply affect the economy?

15

Micro vs. Macro

Macroeconomics and Microeconomics are obviously related and the distinction between them is not as sharp as it looks at first sight.

In ECO 101 we will deal with Microeconomic problems whereas in ECO 104 will study Macroeconomic problems.

16

Positive Economics

Positive economics involves ifthen statements: e.g. a tax on cigarettes will cause the price to rise and the quantity consumed to fall.

Positive Economics attempts to determine What is. It also attempts to describe how the economy functions. Generally, it relies on testable hypotheses.

Essentially Positive Economics deal with cause-effect relationships that can be tested.

17

Normative Economics

Normative economics makes recommendations about what should be based on value judgments: e.g. the government should put more tax on cigarettes to cut smoking.

Normative Economics deals with value judgments and opinions that can not be tested.

18

Positive and Normative Economics

Many topics in Economics can be discussed within both a positive framework and a normative framework.

Let us consider a propose cut in Income Taxes.

An economist practicing positive economics would want to know the effect of a cut in income taxes, whether it affect the unemployment rate, economic growth, inflation and so on.

An economist practicing normative economics would address issues that directly or indirectly relate to whether income tax should be cut.

He may mention that income tax should be cut because the burden is currently very high.

19

Rationality

Each individuals select the choices that make them happiest, given the information available at the time of a decision.

Every economic decisions have been made by rationality.

We assume that people act in their own rational self interest. People make the choices they believe leave them best off.

20

Three Basic Questions of Economics

All Economic systems must have some way of answering 3 basic questions:

1. What goods and services are produced and in what quantities?

2. How are the goods and services produced and who produces them?

3. Who gets the goods and services that are produced?

21


What goods and services are produced and in what quantities?

o A society must determine how much of each of the many possible goods and services it will make, and when they will be produced? Will we produce pizzas and or shirts today?

o A few high quality shirts or many cheap shirts?

o Will we use scarce resources to produce many consumption goods( like pizzas)?

22


How are the goods and services produced and who produces them?

o A society must determine who will do the production, with what resources, and what production techniques they will use.

o Whether we will apply the Labour Intensive Technology or Capital Intensive Technology?

23


Who gets the goods and services that are produced?

o Who gets to eat the fruit of economic activity?

o How is the national product divided among different households?

24


There are two extreme systems for answering these questions. In a Command Economy, the Government decides all the answers. In a Market Economy, the questions get answered through the interaction of buyers and sellers in the market

25

Market Economy

o A Market Economy is one in which individuals and private firms make the major decisions about production and consumption.

o A system of prices, of markets, of profits and losses, of incentives and rewards determine what, how and for whom.

o Firms produce the commodities that yield the highest profits ( the what) by the techniques of production that are least costly(the how).

o Consumption is determined by individuals decisions about how to spend the wages and property incomes generated by their labour and property ownership( the for whom)

26

Market Economy

A free-market economy is an economy where agents decide for themselves which product to produce or to buy. Another way to say the same thing: a free-market economy is an economy where property rights are voluntarily exchanged at a price arranged completely by the mutual consent of sellers a buyers.

The extreme case of a market economy, in which the government keeps it hands off economic decisions is called a laissez-faire economy.

27

Command Economy

By contrast, a command economy is one in which the government makes all important decisions about production and distribution through its ownership of resources and its power to enforce decisions.

A typical example of such an economy was the Soviet Union before the 1989, or nowadays, Cuba and North Korea.

28

Command Economy

In a Planned economy all the relevant economic decisions are made centrally, by an individual or a small number of individuals on behalf of a larger group of people. In general a central planner or government would establish the production target for the countrys factories, would develop master plan for how to achieve those targets and would set up guidelines for the distribution and use of the goods and services produced (in the ancient Soviet Union those targets were set up on a 5 year base.

All the productive sectors are nationalized (under the direct control of the government) and so individuals are not free to start their own businesses as they do in free-market economy.

29

Mixed Economies

The free market and the planned economies represent two extremes of how to organize economic activity in a given economy. In reality, most of the economies we see can be called mixed economies.

A mixed economy is an economy where not all the economic decisions are left to the private individuals but governments intervene as well.

There has never been a 100 percent market economy ( although nineteenth-century England came close).

30

Economic Resources

Economists divide resources into four broad categories:

1. Land

2. Labour

3. Capital and

4. Entrepreneurship

Sometimes Resources are referred to as inputs or factors of production

31

Economic Resources

Land Includes natural resources, such as minerals, forests, water, and unimproved land. For example, oil, wood and animals fall into this category.

Labour consists of the physical and mental talents people contribute to the production process. For example, a person building a house is using his or her own labor.

Capital consists of produced goods that can be used as inputs for further production. Factories, machinery, tools, computers and buildings are examples of capital.

Entrepreneurship refers to the particular talent that soe

32

Economic Resources

Entrepreneurship refers to the particular talent that some people have for organizing the resources of land, labor, and capital to produce goods, seek new business opportunities, and develop new ways of doing things.

33

Economic Resources

Economic Resource Resource payment

land rent

labor wages

capital interest

entrepreneurial ability profit

34

Market Mechanism

The main mechanism for the allocation of resources is the market. We study the way in which markets work and the outcomes that the market mechanism produces.

A Market is defined as any place where the sellers of a particular good or service can meet with the buyers of that goods and service.

35

Market Mechanism

The main economic actors (or agents) are:

Households, who consume goods and supply labour and capital.

Firms, which employ workers and capital to produce goods.

There is also an important role for the government in:

Creating and enforcing the conditions for markets to work.

Intervening to correct situations where markets fail.

Redistributing income and wealth in the interest of equity.

Stabilizing economy wide fluctuations.

36

Logical Fallacies

The following are some of the common fallacies encountered in Economics reasoning:

1. The Post hoc Fallacy

2. Failure to hold other things constant

3. The Fallacy of Composition

37

Logical Fallacies

The post hoc fallacy occurs when we assume that, because one event occurred before another event, the first event caused the second event.

A Post Hoc is a fallacy with the following form:

1.A occurs before B

2. Therefore A is the cause of B

Remember to hold other things constant when you are analyzing the impact of a variable on the economic system.

When you assume that what is true for the part is also true for the whole, you are committing the fallacy of composition.

38

Logical Fallacies

Some popular fallacies about economics and economists:

Economists always disagree

Economics is mainly about predicting the future

Economic models are too simple to capture reality.

Economics views individuals as caring only about money

39

Opportunity Cost

Opportunity cost of any action: is the best or next highest ranked alternative foregone because of choosing the given action.

Another way to say the same thing: an opportunity cost is the cost of any activity measured in terms of the best alternative foregone.

Opportunity Costs arise because time and resources are scarce. Nearly all decisions involve Teade-offs.

40

Opportunity Cost

For example, the opportunity cost for a student that buys the textbook for Eco 101 may be a new pair of jeans that he could have bought instead. Obviously we should consider only the best alternative in evaluating the opportunity cost.

For example, if the best alternative was to go to a restaurant and buy a dinner with the money spent for the book, then the opportunity cost I represented by the dinner and NOT by the pair of jeans.

41

Marginalism

In weighing the costs and benefits of a decision, it is important to weigh only the costs and benefits that arise from the decision.

For example, when deciding whether to produce additional output, a firm considers only the additional cost (or marginal cost) with the additional benefit.

42

Marginalism

Marginal benefit = additional benefit resulting from a one-unit increase in the level of an activity

Marginal cost = additional cost associated with one-unit increase in the level of an activity

According to Economists, when individual make decisions by comparing marginal benefits to marginal costs, they are making decisions at the margin.

MB > MC expand the activity

MB < MC contract the activity

43

Efficiency

Optimal level of activity: MB = MC (Net benefit is maximized at this point).This is the Efficient amount of output.

Suppose we are studying for an economist test:

If MB Studying first hour> MC studying first hour; Keep Studying.

If MB Studying second hour> MC studying second hour; Keep Studying.

You should stop reading when MB=MC. This is where Efficiency is achieved.

44

Figure: Efficiency

MB>MC

MC>MB

MC of Studying

MB of Studying

MB, MC

Time Spent Studying (Hrs)

MB=MC

3 Hrs

45

Working with Diagrams and Slope: Positive and Negative Relationships

An upward-sloping line describes a

positive relationship between X and Y

A downward sloping line describes a

negative relationship between X and Y

46

Working with Diagrams and Slope:

The Component of a Line

b =

Y

X

Y Y

X X

1 0

1 0

The algebraic expression of this line is as follows:

a = Y-intercept, or value of Y when X = 0.

Y = a + bX

where:

Y = dependent variable X = independent variable

+ = positive relationship between X and Y

b = slope of the line, or the rate of change in Y given a change in X.

47

Working with Diagrams and Slope: Strength of the Relationship Between

X and Y

This line is relatively flat. Changes in the value of X have

only a small influence on the

value of Y.

This line is relatively steep. Changes in the value of X have a

greater influence on the value of

Y.

48

Working with Diagrams and Slope:

Different Slope Values

b 5

1005. b

7

100 7.

b 0

100

b 10

0

49

50

The Market Forces of Supply and

Demand

51

Demand

Demand refers to how much (quantity) of a product or service is desired by buyers.

The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship.

Economists have a very precise definition of demand. For them demand is the relationship between the quantity of a good or service consumers will purchase and the price charged for that good.

52

Demand

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

A relationship between price and quantity demanded in a given time period, ceteris paribus.

Ceteris paribus is a Latin phrase that means all variables other than the ones being studied are assumed to be constant. Literally, ceteris paribus means other things being equal.

53

Demand

A households decision about what quantity of a particular output, or product to demand depends on a number of factors including:

The Price of the product in question.

The Income available to the Household (HH).

The Households amount of accumulated wealth.

The prices of other products available to the HH.

The Households Tastes and Preferences.

The Households Expectations about Future Income, Wealth and Prices.

54

Demand schedule

55

Demand curve

56

Law of Downward-Sloping Demand

When the price of a commodity is raised ( and other things are held constant), buyers tend to buy less of the commodity and vice versa.

Why does quantity demanded tend to fall as price increases?

Substitution Effect: When the price of a good rises, we will substitute other similar goods for it.

Income Effect: The depressing effect of price increases on purchases. When a price goes up, We find ourselves somewhat poorer than we were before. Example: When Gasoline prices double, we have to curb our consumptions.

57

Market Demand

Market demand refers to the sum of all individual demands for a particular good or service.

Graphically, individual demand curves are summed horizontally to obtain the market demand curve.

Market demand is the horizontal summation of individual consumer demand curves.

58

Market demand curve

59

Two Simple Rules for Movements vs. Shifts

Rule One

When an independent variable changes and that variable does not appear on the graph, the curve on the graph will shift.

Rule Two

When an independent variable does appear on the graph, the curve on the graph will not shift, instead a movement along the existing curve will occur.

60

Change in Quantity Demanded versus Change in

Demand

Change in Quantity Demanded

Movement along the demand curve.

Caused by a change in the price of the product.

61

Changes in Quantity Demanded

0

D1

Price of Cigarettes per Pack

Number of Cigarettes Smoked per Day

A tax that raises the price of cigarettes results in a movement along the demand curve.

A

C

20

2.00

$4.00

12

62

Change in Quantity Demanded versus Change in

Demand

Change in Demand

A shift in the demand curve, either to the left or right.

Caused by a change in a determinant other than the price.

63

Shift in Demand Curve

64

Determinants of Demand

Market price

Consumer income

Prices of related goods

Tastes

Expectations of Future Price and Income

65

Consumer Income Normal Good

$3.00

2.50

2.00

1.50

1.00

0.50

2 1 3 4 5 6 7 8 9 10 12 11

Price of Ice-Cream Cone

Quantity of Ice-Cream Cones

0

Increase in demand

An increase in income...

D1

D2

66

Consumer Income Inferior Good

$3.00

2.50

2.00

1.50

1.00

0.50

2 1 3 4 5 6 7 8 9 10 12 11



0

Decrease in demand

An increase in income...

D1 D2

67

Prices of Related Goods

Substitutes & Complements

When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes. On the other hands an increase in the price of one results in an increase in the demand for the other.

When a fall in the price of one good increases the demand for another good, the two goods are called complements. an increase in the price of one results in a decrease in the demand for the other.

68

Change in the price of a substitute good

Price of coffee rises:

69

Change in the price of a

complementary good

Price of DVDs rises:

70

Demand and the # of buyers

An increase in the number of buyers results in an increase in demand.

71

Expectations

A higher expected future price will increase current demand.

A lower expected future price will decrease current demand.

A higher expected future income will increase the demand for all normal goods.

A lower expected future income will reduce the demand for all normal goods.

72

Change in Quantity Demanded

versus Change in Demand

Variables that Affect Quantity Demanded

A Change in This Variable . . .

Price Represents a movement along the demand curve

Income Shifts the demand curve

Prices of related goods

Shifts the demand curve

Tastes Shifts the demand curve

Expectations Shifts the demand curve

Number of buyers

Shifts the demand curve

73

Supply

the relationship that exists between the price of a good and the quantity supplied in a given time period, ceteris paribus.

74

Supply

Quantity supplied is the amount of a good that sellers are willing and able to sell.

75

Supply schedule

76

Law of Supply

The law of supply states that there is a direct (positive) relationship between price and quantity supplied.

77

Change in Quantity Supplied

1 5



0

S

1.00 A

C $3.00 A rise in the

price of ice

cream cones

results in a

movement along

the supply

curve.

78

Change in Supply Price of Ice-Cream Cone


0

S1 S2

S3

Increase in Supply

Decrease in Supply

79

Market Supply

Market supply refers to the sum of all individual supplies for all sellers of a particular good or service.

Graphically, individual supply curves are summed horizontally to obtain the market supply curve.

80

Determinants of Supply

Market price

Input prices

Technology

Expectations

Number of producers

81

Change in Quantity Supplied

versus Change in Supply

Variables that Affect Quantity Supplied

A Change in This Variable . . .

Price Represents a movement along the supply curve

Input prices Shifts the supply curve

Technology Shifts the supply curve

Expectations Shifts the supply curve

Number of sellers Shifts the supply curve

82

Price of inputs

As the price of a inputs rises, profitability declines, leading to a reduction in the quantity supplied at any price.

83

Technological improvements

Technological improvements (and any changes that raise the productivity of labor) lower production costs and increase profitability.

84

Expectations and supply

An increase in the expected future price of a good or service results in a reduction in current supply.

85

Increase in # of sellers

86

Supply

Demand



Equilibrium of

Supply and Demand

2 1 3 4 5 6 7 8 9 10 12 11 0

$3.00

2.50

2.00

1.50

1.00

0.50

Equilibrium

87



2 1 3 4 5 6 7 8 9 10 12 11 0

$3.00

2.50

2.00

1.50

1.00

0.50

Supply

Demand

Surplus

Excess Supply

If the price exceeds the equilibrium price,

a surplus occurs:

88

Excess Demand


Price of Ice-Cream

Cone

$2.00

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Supply

Demand

$1.50

Shortage

If the price is below the equilibrium a shortage

occurs:

89

Three Steps To Analyzing

Changes in Equilibrium

Decide whether the event shifts the supply or demand curve (or both).

Decide whether the curve(s) shift(s) to the left or to the right.

Examine how the shift affects equilibrium price and quantity.

90

Demand rises

91

Demand falls

92

Supply rises

93

Supply falls

94

How an Increase in Demand Affects the

Equilibrium

Price of Ice-Cream

Cone

2.00

0 7 Quantity of Ice-Cream Cones

Supply

Initial equilibrium

D1

1. Hot weather increases the demand for ice cream...

D2

2. ...resulting in a higher price...

$2.50

10 3. ...and a higher quantity sold.

New equilibrium

Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.

95

S2

How a Decrease in Supply Affects

the Equilibrium

Price of Ice-Cream

Cone

2.00

0 1 2 3 4 7 8 9 11 12 Quantity of Ice-Cream Cones

13

Demand

Initial equilibrium

S1

10

1. An earthquake reduces the supply of ice cream...

New equilibrium

2. ...resulting in a higher price...

$2.50

3. ...and a lower quantity sold.

96

Price ceiling

Price ceiling - legally mandated maximum price

Purpose: keep price below the market equilibrium price

Examples:

rent controls

price controls during wartime

gas price rationing in 1970s

97

Price ceiling (continued)

98

Price floor

price floor - legally mandated minimum price

designed to maintain a price above the equilibrium level

examples:

agricultural price supports

minimum wage laws

99

Price floor (continued)

Elasticity and its Application

What is an Elasticity?

Measurement of the percentage change in one variable that results from a 1% change in another variable.

When the price rises by 1%, quantity demanded might fall by 5%.

The price elasticity of demand is -5 in this example.

Types of Elasticity

1.Elasticity of Demand

i) Price Elasticity of Demand

ii) Income Elasticity of Demand

iii) Cross Price Elasticity of Demand

2.Elasticity of Supply

Price Elasticity of Demand Price elasticity of demand is the percentage change

in quantity demanded given a percent change in the price.

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

Price Elasticity of Demand

Q

P

P

Q

PP

QQ

/

/

The price elasticity of demand is always negative.

Economists usually refer to the price elasticity of demand by its absolute value (ignore the

negative sign).

Computing the Price Elasticity

of Demand

price inchange Percentage

demandedquatity inchange Percentagedemand of elasticityPrice

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:

2percent10

percent20

100002

002202

10010

810

.

)..(

)(

Example:

P0 = 8 P1 = 7

Q0 = 40 Q1 = 48

Step 1: Q = 48 - 40 = 8

P = 7 - 8 = -1

Step 2: Use the formula for Ed.

Example:

Step 3:

Ed = (Qd / P) * P0 / Q0

= (8 /-1) * (8/40) = - 1.6

Step 4:

This means that for every 1 % change in price that there is a 1.6

% change in quantity demanded in the opposite direction.

0 1 2 3 4 5 6

Inelastic

Unit elastic

Elastic

Price elasticity of demand

Demand is said to be: elastic when Ed > 1,

unit elastic when Ed = 1, and

inelastic when Ed < 1.

Inelastic Demand

Inelastic demand

The percentage change in quantity is less than the percentage change in price.

Price elasticity of demand < 1

Inelastic Demand

- Elasticity is less than 1

Quantity

Price

4

$5 1. A 25% increase in price...

Demand

100 90 2. ...leads to a 10% decrease in quantity.

Elastic Demand

Elastic demand

The percentage change in quantity is greater than the percentage change in price.

Price elasticity of demand > 1

Elastic Demand

- Elasticity is greater than 1

Quantity

Price

4


Demand


Unit Elastic Demand

Unit elasticity

The percentage change in quantity equals the percentage change in price.

Price elasticity of demand = 1

Unit Elastic Demand

- Elasticity equals 1

Quantity

Price

4


Demand


The flatter the demand curve, the more price elastic is the

demand.

P

Qd

P

Qd

flatter steeper

The flatter the demand

curve, the more room

there is for the quantity

to adjustment.

Hence, the flatter the

demand curve, the more

responsive is the quantity

to a price change.

Perfectly Elastic Demand

- Elasticity equals infinity

Quantity

Price

Demand $4

1. At any price above $4, quantity demanded is zero.

2. At exactly $4, consumers will buy any quantity.

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

Perfectly Inelastic Demand

- Elasticity equals 0

Quantity

Price

4

$5

Demand

100 2. ...leaves the quantity demanded unchanged.

1. An increase in price...

Examples of Demand Elasticity

When the price of gasoline rises by 1% the quantity demanded falls by 0.2%, so gasoline demand is not very price sensitive.

Price elasticity of demand is -0.2 .

When the price of gold jewelry rises by 1% the quantity demanded falls by 2.6%, so jewelry demand is very price sensitive.

Price elasticity of demand is -2.6 .

Determinants of


Necessities versus

Luxuries

Availability of Close

Substitutes

Time Horizon

Factors That Influence Elasticity

The Closeness of Substitutes.

The closer the substitutes, the more elastic the demand

more elastic means a higher price elasticity (but not necessarily > 1)


Proportion of Income Spent on the Good

The greater the proportion of income spent on food, the more elastic the demand

Because of Income Effect of a price change


Time Elapsed Since Price Change

The longer the time, the more elastic the demand

Short-run demand

Long-run demand

Determinants of


Demand tends to be more elastic :

if the good is a luxury.

the longer the time period.

the larger the number of close substitutes.

Determinants of Price Elasticity of

Demand

Demand tends to be more inelastic

If the good is a necessity.

If the time period is shorter.

The smaller the number of close substitutes.

Elasticity along a linear

demand curve

Computing the Price Elasticity of

Demand Using the Midpoint Formula

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

)/2]P)/[(PP(P

)/2]Q)/[(QQ(Q=Demand of Elasticity Price

1212

1212

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 the your

elasticity of demand, using the midpoint formula, would be

calculated as:

32.25.9

22

2/)20.200.2(

)00.220.2(

2/)810(

)810(

percent

percent

)/2]P)/[(PP(P

)/2]Q)/[(QQ(Q=Demand of Elasticity Price

1212

1212

Arc elasticity measure

where

:

Example

Suppose that quantity demanded falls from 60 to 40 when the price rises from $3 to $5. The arc elasticity measure is given by:

In this interval, demand is inelastic (since elasticity < 1).

Slope Compared to Elasticity

The slope measures the rate of change of one variable (P, say) in terms of another (Q, say).

The elasticity measures the percentage change of one variable (Q, say) in terms of another (P, say).

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.

Elasticity: Mathematical Definition

slopeP

Q

1

slope

Q

P

elasticityP

Q slope

1

Exercise -- Linear Demand

Quantity Price

10 40

11 38

12 36

13 34

14 32

15 30

16 28

17 26

18 24

19 22

20 20

Compute the elasticity at the point indicated in red on the table (Q=18,P=24).

Slope = -2

1/Slope = -1/2

P/Q = 24/18 = 4/3

Elasticity = -2/3

Elasticity and Total Revenue

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.

TR = P x Q

$4

Demand

Quantity

P

0

Price

P x Q = $400

(total revenue)

100 Q



If demand is elastic in the relevant range of prices, price and total revenue vary inversely.

That is, a price increase will decrease total revenue.

An elastic demand means that the percentage change in quantity demanded is greater than the percentage change in price.

Hence, an increase in price will result in a more than offsetting percentage decrease in quantity taken.

Elastic: p q TR


If demand is inelastic in the relevant range of prices, price and total revenue vary directly.

That is, a price increase will increase total revenue.

An inelastic demand means that the percentage change in quantity demanded is less than the percentage change in price.

Hence, an increase in price will result in a less than offsetting percentage decrease in quantity taken.

Inelastic:

p q TR


If demand is unitary in the relevant range of prices, total revenue does not change in response to price changes.

A unitary own-price elasticity of demand means that the percentage change in quantity demanded is equal to the percentage change in price.

Hence, an increase in price will result in an offsetting percentage decrease in quantity taken.

Unitary: p q

TR

STAYS

The Total Revenue Test for Elasticity

INELASTIC

DEMAND

ELASTIC

DEMAND

Decrease in

Price

ELASTIC

DEMAND

INELASTIC

DEMAND

Increase in

Price

Decrease in

Total

Revenue

Increase in

Total

Revenue

Price

Quantity

D

P2

Q2

P1

Q1

P1 x Q1 = A + B

P2 x Q2 = A + C

(P2 x Q2) - (P1 x Q1) =

(A + C) - (A + B) =

C - B

C

A B

Expenditure = Price x Quantity

Price

Quantity

D

P 2

Q1

Inelastic Demand: Area C > Area B

P1

Q2

C

A B

Price

Quantity

D

P

Q

2

2

P1

Elastic Demand: Area B > Area C

Q1

C

A B

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.

Computing Income Elasticity

Income Elasticity of Demand

Percentage Change in Quantity Demanded

Percentage Change in Income

=

Income Elasticity - Types of Goods -

Normal Goods

Income Elasticity is positive.

Inferior Goods

Income Elasticity is negative.

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

Income elasticity of demand

A good is a luxury good if income elasticity > 1.

A good is a necessity good if income elasticity < 1.

A good is a normal good if income elasticity > 0.

A good is an inferior good if income elasticity < 0.

Cross Price Elasticity of Demand

Elasticity measure that looks at the impact a change in the price of one good has on the demand of another good.

% change in demand Q1/% change in price of Q2.

Positive-Substitutes

Negative-Complements.

Cross-Price elasticity of demand

The cross-price elasticity of demand between two goods j and k is defined as:

Cross-Price elasticity (cont.)

Cross-price elasticity is positive if and only if the goods are

substitutes

Cross-price elasticity is negative if and only if the goods are

complements.

THE THEORY OF CONSUMER CHOICE

Sakib-Bin-Amin, Lecturer, Department of Economics, NSU.

Utility

There are many goods and the consumer chooses a bundle (or combination) of quantities. Here we simplify to two goods, good X and good Y.

Goods yield satisfaction to the consumer; we shall call it utility.

Utility is the benefit or satisfaction that a person gets from the consumption of a good or service.


Cardinal vs. Ordinal Utility

In economics utility can Cardinal or Ordinal.

Utility is a subjective quantity that can not be measured in an obvious way. People usually attempt to maximize welfare or utility, the enjoyment or satisfaction that they derive from the consumption of a commodity or service.

A utility is a cardinal measure if we can give numbers to different levels of utility AND if we can make absolute comparisons between those different numbers.



For example, if the utility you get from a bundle is 100 while the utility you get from another bundle is 50, you can say that the first bundle gives you more utility than the second AND you can also say that the first bundle gives you double utility compared to the second.

A utility is an ordinal measure if only the ranking between different bundle matters. We cannot make absolute comparisons. From previous example, we can only say that the first bundle is preferred to the second because the utility associated with the first bundle is higher than the utility associated with the second bundle. And thats all. The differences in utilities (100 50) has no other meaning.



We normally consider utility to be ordinal. The main reason is that to have a cardinal utility we must have a unit of measure that we can use to measure utility. However, as you may guess is not very easy to find such a unit of measure (for example, how do we measure happiness? We can say if we are happier in some cases than in others, but we cannot really say more than that).

According to Bentham and Marshall, utility can be measured- if not in practice, at least in principle- with cardinal numbers ( such as 1,2,3 and so on). This cardinal measure of utility is commonly known as UTIL.


Utility Function

The Important concept is that any consumer can rationally compare and rank different combinations in terms of utility. (This is what we mean by preference).

Utility function can be written as: U(x, y)

Consider two different bundles (x1, y1) and (x2, y2), and assume that our consumer prefers (x2, y2) to (x1, y1) then we must have that: U(x1, y1) U(x2, y2)


Total Utility

Total utility is the total benefit that a person gets from the consumption of a good or service.

Total utility generally increases as the quantity consumed of a good increases.

Total Utility Increases at a decreasing rate.


Marginal Utility

Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed.

To calculate marginal utility, we use the total utility numbers in Table.

Suppose that you can consume 30 units of good A and 20 units of good B. You get some utility in doing that. Now assume that you can consume 31 units of good A and 20 units of good B. Your utility will probably change. This change in utility is the marginal utility of good A.


Total and Marginal Utility


Total and Marginal Utility

The marginal utility of

the 3rd bottle of water

= 36 units 27 units =

9 units.

Part (b) shows how Tinas marginal utility from bottled

water diminishes by placing

the bars shown in part (a)

side by side as a series of

declining steps.

The downward sloping blue

line is Tinas marginal utility curve.


Diminishing Marginal Utility

The law of diminishing Marginal Utility states that for a given time period, the marginal utility gained by consuming equal successive units of a good will decline as the amount consumed increases.

Even though marginal utility declines, total utility still increases as long as marginal utility is positive. Total utility will decline only if marginal utility is negative.


Diamond-water paradox

As noted by Adam Smith, water is essential for life and has a low market price (often a price of zero) while diamonds are not as essential yet have a very high market price.

Smiths observation came to be known as the Diamond- Water Paradox.



If a product is very useful then Total Utility of the product is very high compared to a less useful product. That Means value in use is related to total utility.

The total utility of water is high because water is extremely useful but we would expect its marginal utility to be low because water is relatively plentiful.

Water is immensely useful, but there is so much of it that individuals place relatively little value on another unit of it.



In contrast, diamonds are not as useful as water. We would expect the total utility of diamonds to be lower than the total utility of water. However, we would expect the marginal utility of diamonds to be high because there are relatively few diamonds in the world. So the consumption of diamonds takes place at relatively high marginal utility.

Generally, Value in exchange is related to marginal utility that means Market price is based on the Marginal Utility concept.

If Marginal Utility is high, the Market Price is also high and vice versa.

TU of water and diamonds


MU of water and diamonds



Equimarginal Principle

Equimarginal principle states that a consumer having a fixed income and facing given market prices of goods will achieve maximum satisfaction or utility when the marginal Utility of the last dollar spent on each good is exactly the same as the Marginal Utility of the last dollar spent on any other good.

MU Good1/P1 = MU Good2/P2= MU Good3/P3=

In other words, MUX/PX=MUY/PY

If any one good gave more MU/Dollar, utility would be increased by taking more money away from other goods and spending more on that good- until the law of diminishing MU/Dollar down to equality with that of other goods.


Equimarginal Principle

Case 1: MUX/PX>MUY/PY

In this case equilibrium will be achieved by increasing the amount of Product X.

Case 2: MUX/PX


Why Demand Curves Slope Downward?

Using the fundamental rule for consumer behaviour, we can easily see why demand curves slope downward.

Let us assume, The price of X falls. The situation now becomes: MUX/PX>MUY/PY

The consumer will attempt to restore equilibrium by buying more X. This behaviour- buying more X when the price of X falls- is consistent with the law of demand.


Indifference Curve

Indifference Curve is a curve which shows the different combinations of two commodities that gives the consumer same level of utility.

Features:

1. Utility is same on each point of indifference curve.

2. Indifference curve shows consumers preference.


Indifference Curve

INDIFFERENCE SCHEDULE

Combinations Apples Mangoes

1 15 1

2 11 2

3 8 3

4 6 4

5 5 5


Indifference Curve

In the above schedule, the consumer obtains as much total satisfaction from 11 apples and 2 mangoes as from 8 apples and 3 mangoes as well as from other combinations.

In other words, consumer feels indifferent whether he gets the 1st combination (15A+1M), 2nd combination (11A+2M), the 3rd combination (8A+3M), the 4th combination (6A+4M), or the 5th combination (5A+5M)


Indifference Curve


Indifference Map

A set of indifference curve is called an indifference map.

A higher indifference curve give higher utility but we cant say how much more utility the higher indifference curve represents.

Aggregate Utilities are remarkable but not measurable.


Indifference Map


Marginal Rate of Substitution

The Marginal rate of substitution shows how much of one commodity is substituted for how much of another or at what rate a consumer is willing to substitute one commodity for another in his consumption pattern to maintain the same level of utility.

The concept of MRS is a tool of Indifference Curve technique and MRS is the slope of Indifference Curve.

In the previous example, we have noticed that when a consumer has 15 Apples and 1 mango, he will be prepared to forgo 4 apples for 1 mango and yet remain at the same level of utility.

Here the MRS of Mango for apple is 4:1

MRS=Y/ X= Slope of Indifference Curve


Consumer Equilibrium

A consumer attempts to allocate its limited income among available goods and services so that he can maximize his satisfaction or utility.

Consumer equilibrium comes at the point where consumer utility is maximum. This occurs at a point where the budget line is tangent to the indifference curve. At this point of tangency:

Slope of Indifference Curve = Slope of Budget Line

MRSXY=PX/PY

MUX/MUY=PX/PY

MUX/PX=MUY/PY

This is the Consumer Equilibrium Condition



If MUX/PX>MUY/PY, it indicates that we have to purchase more X commodity. It will cause the MU to fall and over time equilibrium condition will be restored.

If MUX/PX

ec0 511_lecture notes on basic microeconomics

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