(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.
In many sectors of the economy markets are best described by the term oligopoly - where a few producers dominate the majority of the market and the industry is highly concentrated. In a duopoly two firms dominate the market although there may be many smaller players in the industry.
Competitive markets operate on the basis of a number of assumptions. When these assumptions are dropped - we move into the world of imperfect competition. These assumptions are discussed below
Assumptions behind a Perfectly Competitive Market
1. Many suppliers each with an insignificant share of the market – this means that each firm is too small relative to the overall market to affect price via a change in its own supply – each individual firm is assumed to be a price taker
2. An identical output produced by each firm – in other words, the market supplies homogeneous or standardised products that are perfect substitutes for each other. Consumers perceive the products to be identical
3. Consumers have perfect information about the prices all sellers in the market charge – so if some firms decide to charge a price higher than the ruling market price, there will be a large substitution effect away from this firm
4. All firms (industry participants and new entrants) are assumed to have equal access to resources (technology, other factor inputs) and improvements in production technologies achieved by one firm can spill-over to all the other suppliers in the market
5. There are assumed to be no barriers to entry & exit of firms in long run – which means that the market is open to competition from new suppliers – this affects the long run profits made by each firm in the industry. The long run equilibrium for a perfectly competitive market occurs when the marginal firm makes normal profit only in the long term
6. No externalities in production and consumption so that there is no divergence between private and social costs and benefits
Short Run Price and Output for the Competitive Industry and Firm
In the short run the equilibrium market price is determined by the interaction between market demand and market supply. In the diagram shown above, price P1 is the market-clearing price and this price is then taken by each of the firms. Because the market price is constant for each unit sold, the AR curve also becomes the Marginal Revenue curve (MR). A firm maximises profits when marginal revenue = marginal cost. In the diagram above, the profit-maximising output is Q1. The firm sells Q1 at price P1. The area shaded is the economic (supernormal profit) made in the short run because the ruling market price P1 is greater than average total cost.
Not all firms make supernormal profits in the short run. Their profits depend on the position of their short run cost curves. Some firms may be experiencing sub-normal profits because their average total costs exceed the current market price. Other firms may be making normal profits where total revenue equals total cost (i.e. they are at the break-even output). In the diagram below, the firm shown has high short run costs such that the ruling market price is below the average total cost curve. At the profit maximising level of output, the firm is making an economic loss (or sub-normal profits)
The Effects of a change in Market Demand
In the diagram below there has been an increase in market demand (ceteris paribus). This causes an increase in market price and quantity traded. The firm's average revenue curve shifts up to AR2 (=MR2) and the profit maximising output expands to Q2. Notice that the MC curve is the firm's supply curve. Higher prices cause an expansion along the supply curve. Following the increase in demand, total profits have increased. An inward shift in market demand would have the opposite effect. Think also about the effect of a change in market supply - perhaps arising from a cost-reducing technological innovation available to all firms in a competitive market.
long run price and output under perfect competition
The Long Run Adjustment Process
If most firms are making abnormal profits in the short run there will be an expansion of the output of existing firms and we expect to see the entry of new firms into the industry. Firms are responding to the profit motive and supernormal profits act as a signal for a reallocation of resources within the market. The addition of new suppliers causes an outward shift in the market supply curve. This is shown in the diagram below.
Making the assumption that the market demand curve remains unchanged, higher market supply will reduce the equilibrium market price until the price = long run average cost. At this point each firm is making normal profits only. There is no further incentive for movement of firms in and out of the industry and a long-run equilibrium has been established. The entry of new firms shifts the market supply curve to MS2 and drives down the market price to P2. At the profit- maximising output level Q3 only normal profits are being made. There is no incentive for firms to enter or leave the industry. Thus a long-run equilibrium is established.
Does perfect competition lead to economic efficiency?
Perfect competition is used as a yardstick to compare with other market structures (such a monopoly and oligopoly) because it displays high levels of economic efficiency. In both the short and long run, price is equal to marginal cost (P=MC) and therefore allocative efficiency is achieved – the price that consumers are paying in the market reflects the factor cost of resources used up in producing / providing the good or service.
Productive efficiency occurs when price is equal to average cost at its minimum point. This is not achieved in the short run – firms can be operating at any point on their short run average total cost curve, but productive efficiency is attained in the long run because the profit maximising output is achieved at a level where average (and marginal) revenue is tangential to the average total cost curve. The long run of perfect competition, therefore, exhibits optimal levels of static economic efficiency.
There is of course another form of economic efficiency – dynamic efficiency – which relates to aspects of market competition such as the rate of innovation in a market, the quality of output provided over time.
Class: Microeconomics (ECON 2302) *** SAMPLES *** *** SAMPLES *** Subject: Take-home Assignment #2 Due Date: On the Date of Exam #2
Instructions : Please follow the instructions and show the steps to your answer . Written explanation is expected to be free of grammatical and syntax errors (as much as possible) and NO plagiarism. Arithmetical steps should follow college standards. Graphs, tables, flows and other visual representations should be of good quality and with clear details. It is also important that you show the formula first before deriving any arithmetical results –if applicable.
Try your BEST in doing school work –AS ALWAYS! Late homework will not be accepted.
IMPORTANT : Write your answers on separate sheets of paper and turn them in with your name and section number on the first page. DO NOT turn in the handout .
Problem #1 (10 points) *** SAMPLES ***
For this problem, please use the midpoint formulas for computing ALL values of elasticity. You also need to write out detailed midpoint formulas with your ending and beginning points. Please show your works.
(3 Points) (A) Suppose the price of good X increases from observations #1 to #4. What is X’s price elasticity of demand? (3 Points) (B) Suppose the price of good Z increases from observations #1 to #3. What is Z’s price elasticity of supply? (4 Points) (C) Suppose the price of good X increases from observations #4 to #5. What is the coefficient of cross-price elasticity of demand of goods X and Z? Using the numeric values in the above table, prove that X and Z are substitutes.
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Problem #2 (10 points) *** SAMPLES ***
Please fill in the cells with appropriate values and show a few steps of calculations –along with the formulas.
Problem #3 (10 points) *** SAMPLES ***
100 MC 90 80 70 Cost ATC per 60 unit 50 AVC (dollars) 40 30 20 10
0 1 2 3 4 5 6 7 8 Quantity of output
(units per hour)
(4 Points) (A) Refer to the above diagram. When the market price is $70.00, what are the estimated values of the firm’s output, AFC, AVC, ATC, TFC, TVC, TC, TR and profits (or losses?) Please mark the profit (or loss) box on YOUR OWN graph also –with great CARE! How did you get your answer? Show your work.
(4 Points) (B) Refer to the above diagram. When the market price is $40.00, What are the estimated values of the firm’s output, AFC, AVC, ATC, TFC, TVC, TC, TR and profits (or losses?) Please mark the profit (or loss) box on YOUR OWN graph also –with great CARE! How did you get your answer? Show your work.
(2 Points) (C) If the market price is $28.00, should the firm remain in the market or shut down? Explain your reason!
======Problem #4 (10 points) *** SAMPLES ***
Notes: (All estimated prices and quantities correspond to their respective labels on the graph) WHERE TFC = $200 Q X = 900; Q B = 1,000; Q W = 1,100; Q A = 1,200; Q C = 1,300; Q Z = 1,400
$ X = $500; $’ X = $520; $ B = $600; $’ W = $620; $ A = $700;
$ W = $700; $’ A = $900; $ C = $1,000; $ Z = $1,060; $’ Z = $1,400
(5 Points) (A) Refer to the above diagram. When the firm chose an output level of Q W, please compute the values of P, AFC, AVC, ATC, TFC, TVC, TC, TR and profits (or losses.) Remember to show steps to your answers and formulas too.
(5 Points) (B) Refer to the above diagram. Suppose each typical firm in the market produces Q W units. Is this market (of a competitive and normal product) stable? How so? If not stable, how the firm and the market adjust toward their respective equilibria? Assumptions (for #4B): Let subscripts A = SR equilibrium and B = LR equilibrium WHERE
qA= 1100, Number of firms (N) = 200 firms (at the beginning state in the SR)
qB = 1000, Number of firms (N) = 300 firms (at the ending state in the LR)
In the context of “The Market” and “A Typical Firm” diagram, please graphically and verbally demonstrate your explanations of adjustment toward equilibrium (in the long run) –by using the “Cause Effect Evidence” method
Hints : For #4B, you should have the market quantities and prices BEFORE and AFTER the long-run market adjustments –with their respective values of P’s, Q’s, and q’s along with proper labels, directional changes and details. Try to be consistent with given labels in this diagram and use them in your own two graphs. ======
Question #5 (10 points) *** SAMPLES ***
Notes: (All estimated prices and quantities correspond to their respective labels on the graphs) WHERE P B = $5.00; P’’ B = $4.20; P’ B = $3.40; q B = 600; Q B = 36,000 P A = $4.00; q A = 500; Q A = 50,000
P C = $3.00; P’’ C = $4.40; P’ C = $3.20; q C = 400; Q C = 60,000
The following panels describe the relationship between a representative firm and a competitive market for a normal good. The market is currently in its short-run equilibrium at Point C on the market demanded curve.
(2 Points) (A) What are the representative firm’s TC, TR and profits (or losses?)
(4 Points) (B) The market is currently in its short-run equilibrium at Point C on the market demanded curve. Please modify your own diagrams with proper notations, labels, directions of changes to indicate the typical firm’s and the industry’s adjustments toward their respective long-run equilibrium at points A’s.
(4 Points) (C) You are also required to use the “cause effect” method to describe the transitions from the initial to ending states (at the levels of the firm and the market.) Your expositions should EXPLAIN all the modifications and changes that you have made in #5B.
HINTS :
(A) All firms are assumed to be identical and the market quantity supply is the sum of all firms’ outputs Q = Nq (where N represents the number of firms in the industry)
(B) The firm’s economic profit is zero in the long run -because new firms will enter the market -if there is a profit or exit if losses occur. In the long-run, market forces will discipline all firms. Consumers will also make full adjustments –if necessary.
(C) For Questions #4 and #5, it’s best that you study the lecture notes for Perfect Competition where the interactions between “A Representative Firm” and “The Market” are illustrated by your instructor in class. Try to follow detailed explanations in the lecture –as much as you could.
______**** DO NOT COPY THE FOLLOWING SAMPLE SOLUTIONS AS YOUR ANSWERS FOR YOUR TAKE-HOME ASSIGNMENT (or Homework) #2. ** STUDY AND USE THEM AS A GUIDE TO YOUR OWN WORK. ***
**** THEY ARE SAMPLE ANSWERS ****
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PROBLEM #2 : Please see the last page for solutions.