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Chapter 6: Elasticity (LSCS) Chapter 4: Elasticity (Hand-outs) (HCCS) Chapter 6: Elasticity Price elasticity of demand (PED, Ed or E p) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price (holding constant all the other determinants of demand, such as income or preferences.) The value Ed of is computed by using the following formula. The above formula can result in different values of Ed’s when prices move up or down at the same magnitute (i.e. $2 $3 or $3 $2) –depending on which price is the original (or base) point. Thus, economists revised the formula and evaluate the price changes in either direction by using the midpoint formula as shown below. D The Relationship between E D , the Q Curve and the Total Revenue Function Values of Ed are interpreted as follows: Source: http://en.wikipedia.org/wiki/Price_elasticity_of_demand , 2010. Income elasticity of demand ( EM or EI) measures the responsiveness of the demand for a good to a change in the income of the people demanding the good. It is calculated as the ratio of the percentage change in demand to the percentage change in income. For example, if, in response to a 10% increase in income, the demand for a good increased by 20%, the income elasticity of demand would be 20%/10% = 2. a) A negative income elasticity of demand is associated with inferior goods; an increase in income will lead to a fall in the demand and may lead to changes to more luxurious substitutes. b) A positive income elasticity of demand is associated with normal goods; an increase in income will lead to a rise in demand. If income elasticity of demand of a commodity is less than 1, it is a necessity good. If the elasticity of demand is greater than 1, it is a luxury good or a superior good. c) A zero income elasticity (or inelastic) demand occurs when an increase in income is not associated with a change in the demand of a good. These would be sticky goods. Source: http://en.wikipedia.org/wiki/Income_elasticity_of_demand , 2010. “ Cross elasticity of demand or cross-price elasticity of demand (E xy ) measures the responsiveness of the demand for a good (X) to a change in the price of another good (Y.) It is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For example, if, in response to a 10% increase in the price of fuel, the demand of new cars that are fuel inefficient decreased by 20%, the cross elasticity of demand would be [−20% / 10%] = −2. a) When two goods, fuel and cars(consists of fuel consumption), are complements; that is, one is used with the other. In these cases the cross elasticity of demand will be negative, as shown by the decrease in demand for cars when the price of fuel increased E xy < 0. b) Where the two goods are substitutes, E xy will be positive, so that as the price of one goes up the demand of the other will increase. For example, in response to an increase in the price of carbonated soft drinks, the demand for non- carbonated soft drinks will rise. In the case of perfect substitutes, E xy is equal to positive infinity. c) Where the two goods are independent, E xy will be zero: as the price of one good changes, there will be no change in demand for the other good.” Source: http://en.wikipedia.org/wiki/Cross_elasticity_of_demand , 2010. “ Price elasticity of supply (ES) is a measure of the sensitivity of the quantity of a good supplied in a market to changes in the market price for that good, ceteris paribus . Per the law of supply, it is posited that at a given price and corresponding quantity supplied in a market, a price increase will also increase the quantity supplied. E S is a numerical measure (coefficient) of by how much that supply is affected. Mathematically: In other words, E S is the percentage change in quantity supplied one that would occur would expect after a 1% change in price. For example, if, in response to a 10% rise in the price of a good, the quantity supplied increases by 20%, the price elasticity of supply would be 20%/10% = 2.” Source: http://en.wikipedia.org/wiki/Price_elasticity_of_supply , 2010. (LSCS) Chapter 7: Business and the Costs of Production (HAND-OUTS) (HCCS) Chapter 8: Production and Costs - In microeconomics, production is simply the conversion of (factor) inputs (or resources) into products that can be traded or sold commercially. In mathematical terms, outputs (Q) = total product (TP) = function (L, K) = f(L, K) in the short-run (SR) where labor (L) and capital (K) can be substitute or complementary factor inputs used in production. - Production decisions are based on the following criteria a) What goods to produce b) How to produce them c) The optimum mix of factor inputs (i.e. land, labor, capital and entrepreneurship) used in production d) Market information (i.e. market quantity demanded (Q D) and the market price (P*) for the firm’s products) - Facing a competitive market with many sellers of similar or identical products, most firms (except monopolists) organize production in such a way so that the firm’s economic profit is maximized. Most common methods include product specialization, internal division of labor (L) , mass (or volume) production by utilizing a large quantity of capital (K), risk reduction from diversification in products or the minimization of transaction costs, etc. EXAMPLES OF ECONOMIC COSTS Notes about Costs 1) TC = TFC + TVC = (total sunk costs + total periodic costs) + total costs (of labor and capital) in the SR 2) ATC (or AC) = AFC + AVC (or Average Total Cost = Average Fixed Cost + Average Variable Cost) 3) Sunk and periodic costs are expenses whose total does not change even with no production (i.e. Q = 0.) 4) Variable costs are paid to workers and owners of capital in production in the short run when Q > 0. Notes : (a) MPL = Marginal Product of Labor = the additional output of one more worker in total production = ∆Q/ ∆L (b) Wages (W) are labor’s opportunity costs for NOT foregoing taking time off working AND monetary compensations for their accumulation of human capital -up to the time of their employment. (LSCS) Chapters 8, 9: Pure Competition in the Short and Long Runs (HAND-OUTS) (HCCS) Chapter 9: Perfect Competition There are two definitions of profits: Accounting Profits and Economic Profits a) Accounting profit = Total revenue – Accounting costs b) Economic profit ( Π) = Total revenue (TR) – All costs of production (TC) = TR – TC = TR – (Explicit costs + Implicit costs) Accounting (or explicit) costs include monetary wages (paid to labor), rents (to landowners), interest payments (to capital owners) and capital depreciation. Those costs are recorded on the firm’s accounting balance sheets and are reported to the IRS for year-end tax purposes. Implicit (or opportunity) costs include wages earned by the firm’s owner elsewhere, foregone monetary earnings for factor inputs (i.e. workers or capital) somewhere else or imputed market values of alternative uses of resources, etc. - In Economics, we only concern with economic profit where profits = total revenue – total costs or Π = TR – TC = P.Q – ATC.Q = (P – ATC) Q - Examples - If a typical competitive firm is a strict profit-maximizer, the manager (or owner) will sell the product as long as the marginal cost (where MC = ∆TC/ ∆Q) is less than or equal to the product’s marginal revenue (where MR = ∆TR/ ∆Q.) - All firms aim to maximize their economic profit. For all firms in all market structures (i.e. perfect competition, monopolistic competition, oligopoly or monopoly,) a maximum economic profit is obtained when MR = MC. Therefore, if MR > MC, the firm should increase outputs. If MR < MC, the firm should cut back production. - In perfect competition with extremely low entry and exit costs, the market is not in equilibrium when a representative firm does not earn a normal profit (i.e. Π ≠ 0.) In the short run, new firms will enter the market when Π > 0 or a few existing firms will exit the market when Π < 0 until all representative firms earn a normal profit ( Π = 0) in the LR. - “Market disciplines” will provide profit and survival incentives for firms to produce the Good at their least possible costs since there are competitors which are willing to sell the same product at a market-setting price. Simultaneously, consumers only purchase the Good at the market price which matches their additional willingness to pay for another unit of the Good –in order to maximize their total satisfaction within income budget constraints. Therefore, competition arises. Notes: The following essays, illustrations and contents are copied directly from the Internet address http://tutor2u.net/economics/content/topics/competition/competition.htm for general educational purposes ONLY. Date: 3/17/2012 Perfect competition - The economics of competitive m a r k e t s Introduction The degree to which a market or industry can be described as competitive depends in part on how many suppliers are seeking the demand of consumers and the ease with which new businesses can enter and exit a particular market in the long run. The spectrum of competition ranges from highly competitive markets where there are many sellers, each of whom has little or no control over the market price - to a situation of pure monopoly where a market or an industry is dominated by one single supplier who enjoys considerable discretion in setting prices, unless subject to some form of direct regulation by the government.
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