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elasticity
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a measure of how sensitive one variable is to changes in another
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price elasticity of demand
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measures how much quantity demanded changes when the good's price changes
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price elasticity of demand equation
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% change in quantity demanded / % change in price
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elasitc
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describes demand that is sensitive to price changes
flat, lower slope
ED > 1
flat, lower slope
ED > 1
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inelastic
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describes demand that is not very sensitive to price changes
steep, higher slope
ED < 1
steep, higher slope
ED < 1
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unit elastic
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when the percentage change in price and quantity demanded are the same
a change in price will have no effect on total revenue
ED = 1
a change in price will have no effect on total revenue
ED = 1
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perfectly elastic
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horizontal demand curve
consumers are perfectly price sensitive
any change in price will result in 0 quantity
ED = infinity
consumers are perfectly price sensitive
any change in price will result in 0 quantity
ED = infinity
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perfectly inelastic
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vertical demand curve
quantity does not respond at all to changes in price
any change in price will keep the same quantity
consumers will continue buying regardless of price
ED = 0
quantity does not respond at all to changes in price
any change in price will keep the same quantity
consumers will continue buying regardless of price
ED = 0
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determinants of price elasticity of demand
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availability of close substitutes, passage of time, necessities vs luxuries, the share of a good in a consumer's budget, the definition of the market
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the availability of close substitutes
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more substitutes, more elastic the demand
the more specific a product is, the more substitutes it has
the more specific a product is, the more substitutes it has
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the passage of time
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the more time people have, the more decisions they can make and adjust
more time, more elastic
elasticity is larger with demand
more time, more elastic
elasticity is larger with demand
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luxury or necessity
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a luxury is more elastic than a necessity
a necessity people need, so they will pay for it no matter the price
a necessity people need, so they will pay for it no matter the price
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the share of a good in a consumer's budget
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the demand for a good will be more elastic the larger the share of the good in the consumer's budget
the smaller the portion in a budget, the less elastic the demand
ex: paying $3 instead of $2 vs paying $70 instead of $60
the smaller the portion in a budget, the less elastic the demand
ex: paying $3 instead of $2 vs paying $70 instead of $60
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the definition of the market
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the more narrowly defined the market, the more substitutes are available, and the more elastic the demand
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total revenue
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the total amount of money a firm receives by selling goods or services
TR = P x Q
TR = P x Q
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total revenue along a linear demand curve
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slope is constant along a linear demand curve, but elasticity is not constant
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elasticity is not constant along a linear demand curve
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use the mid-point formula to find where the graph is unit-elastic (TR maximized here)
above the midpoint, the demand is elastic
below the midpoint, the demand is inelastic
demand curves are always negative, so the lower the quantity, the more elastic
above the midpoint, the demand is elastic
below the midpoint, the demand is inelastic
demand curves are always negative, so the lower the quantity, the more elastic
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cross-price elasticity of demand
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measures the strength of the relationships between goods
how much does the quantity demanded of one good change when the price of another good changes
how much does the quantity demanded of one good change when the price of another good changes
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cross-price elasticity of demand equation
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% change in quantity of A demanded / % change in price of B
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cross-price elasticity of demand of substitutes is
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positive
increase in the price of a substitute leads to increase in quantity demanded
increase in the price of a substitute leads to increase in quantity demanded
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cross-price elasticity of demand of compliments is
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negative
increase in the price of a compliment leads to decrease in quantity demanded
increase in the price of a compliment leads to decrease in quantity demanded
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if products are unrelated, the cross-elasticity will be
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0
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income elasticity of demand
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measures the strength of the effect of income on quantity demanded
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normal goods
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higher one's income, higher the quantity
income elasticity is positive
income elasticity is positive
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normal goods: necessities
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0 < IED <- 1
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normal goods: luxuries
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IED > 1
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inferior goods
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higher one's income, lower the quantity
income elasticity is negative
IED < 0
income elasticity is negative
IED < 0
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income elasticity of demand equation
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% change in quantity demanded / % change in income
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price elasticity of supply
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measures how responsive producers are to changes in the market price
when the price increases, producers increase supply. this concept measures that increase
when the price increases, producers increase supply. this concept measures that increase
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price increases more when
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supply is inelastic
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price increases less when
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supply is elastic
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elasticity of supply will be greater
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the more inventory the firm has
the more easily the firm can hire workers / get machines
the longer the time horizon
the more easily the firm can hire workers / get machines
the longer the time horizon
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when both demand and supply are inelastic
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prices of that product will be unstable
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three problems to solve when sellers try to maximize profit
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how to make the product
what is the cost of making the product
how much can the seller get for the product in the market
what is the cost of making the product
how much can the seller get for the product in the market
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how to make the product
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turning inputs into outputs
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variable factor of production
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input that changes in a certain period of time and that changes if the level of output changes
eventually in the long-term, every factor becomes variable
eventually in the long-term, every factor becomes variable
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fixed factor of production
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input that cannot be changed in a certain period of time, regardless of how much output is produced
only exist in short-term
only exist in short-term
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technology
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the process by which a firm uses inputs to produce outputs
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technological change
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a change in the ability of a firm to produce a given level of output with a given quantity of input
ex: increased output with the same input or the same output with decreased input
ex: increased output with the same input or the same output with decreased input
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production function
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the relationship between the inputs employed and the maximum output of the firm
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marginal product of labor (MPl)
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the additional output a firm produces as a result of hiring one more worker
increases, reaches a maximum, decreases
increases, reaches a maximum, decreases
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MPl equation
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Q2-Q1 / L2-L1
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three stages of MPl
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increases, reaches a maximum, decreases
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increases
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specialized workers and division of labor
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reaches a maximum
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at the point of diminishing returns
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decreases
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law of diminishing returns: at some point, each additional worker will contribute less output than the worker before
total output increasing, but at a lower rate
total output maximized when MPl hits the x-axis (MPl=0)
total output increasing, but at a lower rate
total output maximized when MPl hits the x-axis (MPl=0)
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decreases past 0
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MPl < 0
hiring another worker will decrease the total output
hiring another worker will decrease the total output
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average product of labor (APl)
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the total output produced by a firm divided by the quantity of workers
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if MPl > APl then
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APl is increasing
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if MPl < APl then
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APl is decreasing
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variable costs
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costs that change as output changes
ex: cost of labor (wages), ingredients, electricity, plumbing, shipping costs, etc
ex: cost of labor (wages), ingredients, electricity, plumbing, shipping costs, etc
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fixed costs
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costs that do not change as the output changes
ex: rent, insurance, etc
ex: rent, insurance, etc
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variable costs vs fixed costs
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in the long-run, all of the firm's costs are variable costs
fixed costs only occur in the short term
only variable costs should be considered when contemplating shutting down
fixed costs only occur in the short term
only variable costs should be considered when contemplating shutting down
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total cost equation
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TC = FC + VC
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explicit costs
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a cost that involves spending money
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implicit costs
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a non-monetary opportunity cost
ex: time
ex: time
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average fixed cost (AFC) equation
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FC/Q
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average variable cost (AVC) equation
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VC/Q
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average total cost (ATC) equation
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TC/Q
AFC + AVC
AFC + AVC
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the ATC curve is
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U-shaped
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marginal cost (MC)
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the change in total costs resulting from a one-unit increase in output
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since fixed cost does not change when output changes,
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MC is also the change in a firm's variable cost from producing one more unit
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MC equation
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change in TC / change in output or Q or
change in VC / change in Q
change in VC / change in Q
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if the marginal cost curve is negatively sloped
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labor specialization
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if the marginal cost curve is positively sloped
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diminishing returns
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MC > ATC
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ATC increases
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MC < ATC
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ATC decreases
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MPl increases
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MC decreases
inverse
(MPl increases because of specialization & division of labor, decreases because of diminishing returns)
inverse
(MPl increases because of specialization & division of labor, decreases because of diminishing returns)
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above all short-run
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below long-run
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all costs are
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variable in the long-run
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a long-run average cost curve
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a curve that shows the lowest cost at which a firm is able to produce a given quantity of output in the long run, when no inputs are fixed
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MC, ATC, AFC, & AVC on a graph
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those curves are decreasing
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when MC is below ATC & AVC
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those curves are increasing
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when MC is above ATC & AVC
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their minimum points
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MC intersects the ATC & AVC curves at
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ATC decreases as output increases
inverse relationship
inverse relationship
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economies of scale
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advancing / more efficient technology
workers & managers becoming more specialized with time & experience
large firms may be able to purchase inputs at lower costs than smaller competitors
as a firm expands, it may be able to borrow money less expensively (ex: lower interest rate) than before
workers & managers becoming more specialized with time & experience
large firms may be able to purchase inputs at lower costs than smaller competitors
as a firm expands, it may be able to borrow money less expensively (ex: lower interest rate) than before
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causes of economies of scale
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ATC increases as output increases
direct relationship
direct relationship
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diseconomies of scale
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the lowest output at which all economies of scale are exhausted
ATC remains constant as output increases
ATC remains constant as output increases
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minimum efficient scale
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total revenue - total cost
(P - ATC)Q
(P - ATC)Q
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profit =
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price x quantity
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total revenue =
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P - ATC
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profit per unit (profit / Q) =
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0
P = ATC
P = ATC
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firm breaks even when profits =
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MR = MC
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demand = price =
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profit per unit maximized
don't stop here
don't stop here
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where MC and ATC intersect
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total profits maximized
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where MC and MR intersect
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profit
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P > ATC
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break even
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P = ATC
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loss
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P < ATC
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pay both variable & fixed costs
ex: wages, lease, insurance, etc
ex: wages, lease, insurance, etc
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staying open
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only pay fixed costs
ex: fire workers (no wages), still pay lease
ex: fire workers (no wages), still pay lease
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shutting down
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fixed costs / sunk costs
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when deciding to shut down or not, a firm should not consider
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costs that have already been paid and cannot be recovered, irrelevant to decision making
ex: rent & insurance for the month
ex: rent & insurance for the month
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sunk costs
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produce nothing if total revenue < variable cost
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decision based on variable costs
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P<AVC
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a firm should shut down when
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P<ATC
don't need to shut down here
don't need to shut down here
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a firm has loss when
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perfectly competitive market, monopolistically competitive market, oligopolies, monopolies
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most competitive to least competitive
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many buyers and sellers
all firms sell identical products (no branding/marketing)
no barriers to new firms for entering the market
sellers are price takers: unable to affect the market price
all firms sell identical products (no branding/marketing)
no barriers to new firms for entering the market
sellers are price takers: unable to affect the market price
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perfect competition
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the other firms will follow to keep demand
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if one firm decreases price
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it will lose all demand
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if one firm increases price
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change in TR / change in Q
TR2 - TR1 / Q2 - Q1
TR2 - TR1 / Q2 - Q1
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marginal revenue equation
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MR = MC
the additional revenue should equal the additional cost for profit maximization
the additional revenue should equal the additional cost for profit maximization
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MR = P = AR
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TR / Q
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average revenue equation
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the difference between total revenue and total cost is greatest
TR - TC
TR - TC
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maximum profit when
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marginal revenue equals marginal cost
MR = MC = P
MR = MC = P
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the profit maximizing level of output
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the number of firms increases, supply increases, price decreases, profits fall, firm breaks even
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long run in a perfectly competitive market - profit
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firms exit the market, supply decreases, price increases, profits increase, break even
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long run in a perfectly competitive market - loss
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in real life, firms would use branding, marketing, and innovation to continue making profits
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in a hypothetical situation, all firms will break even in the long run
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average costs do not change as firms enter/exit a market
horizontal LR supply curve
horizontal LR supply curve
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constant cost industry
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costs of inputs increases as more firms enter the market
upward sloping LR supply curve
increasing number of firms, more competition, higher wages, higher input costs, higher break even point
upward sloping LR supply curve
increasing number of firms, more competition, higher wages, higher input costs, higher break even point
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increasing cost industry
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costs of inputs decreases as more firms enter the market
additional firms might generate benefits for other firms in the market, leading additional firms to have lower costs of production
downward sloping LR supply curve
additional firms might generate benefits for other firms in the market, leading additional firms to have lower costs of production
downward sloping LR supply curve
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decreasing cost industry
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goods/services produced at the lowest possible cost
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productive efficiency
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MC = supply
supply curve is the firm's MC curve at or above AVC
the firms will shut down below AVC
supply curve is the firm's MC curve at or above AVC
the firms will shut down below AVC
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supply curve in perfect competition
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the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it
exam 1: production is consistent with consumer preferences
exam 1: production is consistent with consumer preferences
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allocative efficiency
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