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Price elasticity of demand
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How sensitive changes in quantity demanded are to changes in price
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Calculating elasticity
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At the most basic, it's percent change in quantity over percent change in price
Midpoints formula
(examples on notes)
Midpoints formula
(examples on notes)
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Classifications of elasticity
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Inelastic demand: < 1
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1. The percent change in quantity is less than the percent change in price. (Quantity changes less than price.)
2. Steeper (more vertical) demand curve
3. If the elasticity is less than 1, businesses can increase revenue by increasing price.
4. Governments tend to tax non-elastic products because the additional cost added by the tax will not greatly reduce sales.
2. Steeper (more vertical) demand curve
3. If the elasticity is less than 1, businesses can increase revenue by increasing price.
4. Governments tend to tax non-elastic products because the additional cost added by the tax will not greatly reduce sales.
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Elastic demand: > 1
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1. Quantity changes more than price.
2. Flatter (more horizontal) demand curve
3. If prices raised, quantity falls by a greater percentage and total revenue declines.
2. Flatter (more horizontal) demand curve
3. If prices raised, quantity falls by a greater percentage and total revenue declines.
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Unitary elastic: = 1
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1. Equal percentage changes in price and quantity
2. Revenue remains constant as move along the demand curve
3. This requires a non-linear demand curve
2. Revenue remains constant as move along the demand curve
3. This requires a non-linear demand curve
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Perfectly elastic: = infinity
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Quantity demanded falls to zero with even the slightest change in price. Demand curve is horizontal.
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Perfectly inelastic: = 0
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Quantity demanded does not respond at all to price changes. Demand curve is vertical.
The degree of elasticity changes as you move along a demand curve, even though the slope is constant.
The degree of elasticity changes as you move along a demand curve, even though the slope is constant.
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Determinants of elasticity
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Availability of substitutes
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Can depend on how specifically you define a market
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Necessity versus luxury
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Necessity less elastic: Think groceries versus restaurants
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Fraction of buyer's budget
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10% increase in a cup of coffee not the same as 10% increase in college tuition
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Short-term vs. long-term
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Can adjust how much driving you do more in the long-term than in the short-term if gas prices rice
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Production costs
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Basic assumption of economics:
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The motivation for business decisions is profit maximization.
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Profit maximization best explains why firms do what they do
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Particularly, why they choose a particular price and output.
In simple terms, why they choose to make certain things and how much to make.
In simple terms, why they choose to make certain things and how much to make.
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Explicit versus implicit costs
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Explicit costs:
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Payments to non-owners of a firm for their resources
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Implicit costs:
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The opportunity costs of using resources owned by the firm
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Economic and accounting profit
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Accounting profit:
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Total revenue minus total explicit cost
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Economic profit:
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Total revenue minus explicit and implicit costs
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Normal profit:
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Minimum profit needed to keep a firm in operation
- Equals zero economic profit
- Equals zero economic profit
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Short run versus long run
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Distinction depends on the ability to vary the quantity of inputs or resources used in production
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1. So in the short-run, for example, your factory machinery (capital) would be fixed; you could hire more workers, but they would only have the same amount of equipment to use.
2. In the long-run, you could build new factories and buy more equipment.
2. In the long-run, you could build new factories and buy more equipment.
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Fixed input
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Quantity cannot change during the short run
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Variable input
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Quantity can change during the short run
i. Could vary workers hired during a year, or change the amount of raw materials used in production
i. Could vary workers hired during a year, or change the amount of raw materials used in production
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Long run:
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Period of time when there is at least one fixed input
i. New factory built or new company enter the industry
i. New factory built or new company enter the industry
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Production function:
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The relationship between the maximum amounts of output a firm can produce and various quantities of inputs
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Marginal product
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Change in total output produced by adding one unit of input, ceteris paribus
i. So how much does production increase when you add one more worker?
ii. Initially the marginal product is increasing but then falls because of diminishing marginal returns
i. So how much does production increase when you add one more worker?
ii. Initially the marginal product is increasing but then falls because of diminishing marginal returns
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Law of diminishing marginal returns:
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Marginal product decreases as additional units of a variable factor are added to a fixed factor
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Total cost curves
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Total fixed cost:
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Cost that do not change as output changes
i. Must be paid even if output is zero
i. Must be paid even if output is zero
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Total variable cost:
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Cost that are zero when output is zero and increase as output changes
Example: Hourly wages, electricity, fuel, raw materials
Example: Hourly wages, electricity, fuel, raw materials
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Total cost =
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Total fixed cost plus total variable cost
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Average cost curves
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Average fixed cost:
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Total fixed cost divided by output
i. TFC/Q
ii. Fixed numerator divided by an ever-increasing denominator, so it's constantly falling as production increases
i. TFC/Q
ii. Fixed numerator divided by an ever-increasing denominator, so it's constantly falling as production increases
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Average variable cost:
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Total variable cost divided by output
i. TVC/Q
ii. U-shaped: falls at first, then rises
i. TVC/Q
ii. U-shaped: falls at first, then rises
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Average total cost:
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Total cost divided by output
i. TC/Q
ii. Or AFC + AVC
i. TC/Q
ii. Or AFC + AVC
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Marginal cost curve
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a. Change in total cost when one additional unit of output is produced Or Change in TC/ Change in Q
b. The marginal cost curve intersects both the AVC and ATC curves at their minimums.
b. The marginal cost curve intersects both the AVC and ATC curves at their minimums.
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Long-run average costs
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Least cost rule
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To produce any given level of output, a firm will choose the input mix with the lowest cost.
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Not pick the least possible cost:
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That's always to not produce anything and go out of business!
Rather any given level of output should be produced at the lowest cost you can do it
Rather any given level of output should be produced at the lowest cost you can do it
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In the long run, companies consider the mix of capital and labor that allows them to produce what they want at the lowest possible price:
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i. The relative price of capital and labor is the deciding factor on which to use.
ii. As labor costs increase, capital like robotics are more attractive to a business.
ii. As labor costs increase, capital like robotics are more attractive to a business.
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Economies of scale: LRAC declines as the firm increases output
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So cost per unit is going down as produce more units
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Better division of labor and specialization
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i. As a firm expands, having more workers allows managers to break a job into small tasks
ii. Each worker, including managers, can specialize by mastering narrowly defined tasks
ii. Each worker, including managers, can specialize by mastering narrowly defined tasks
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Flat portion of LRAC
i. Constant returns to scale
i. Constant returns to scale
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i. Believed to be shape of many real-world industries
ii. Same average cost per unit as you produce more
ii. Same average cost per unit as you produce more
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Upward-sloping portion of LRAC
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Diseconomies of scale
viii.Costs more per unit as make more units
As the firm grows, the chain of command lengthens, communication becomes more complex, too bureaucratic and operations bog down
viii.Costs more per unit as make more units
As the firm grows, the chain of command lengthens, communication becomes more complex, too bureaucratic and operations bog down
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Three characteristics of perfect competition
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Large number of small firms
Homogenous product
Easy entry and exist
Although few markets have exactly these characteristics, many markets generally have these attributes to some degree.
Homogenous product
Easy entry and exist
Although few markets have exactly these characteristics, many markets generally have these attributes to some degree.
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Short-run profit maximization for a perfectly competitive firm
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Because the firm is a price taker, the firm only has control over how much to produce.
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Specifically, what output maximizes profit at the going price?
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Total revenue minus total cost is maximized
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Profits are maximized when the gap between total revenues and total costs is largest
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Marginal revenue equals marginal cost
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Profits are also maximized when the cost of producing one more unit is equal to what money you'll get for selling one more unit
Marginal revenue is a horizontal line at the market price for a perfectly competitive firm
Marginal revenue is a horizontal line at the market price for a perfectly competitive firm
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Short-run supply curves
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i. Perfectly competitive firm's short-run supply curve: A firm's marginal cost curve above the minimum point on its average variable cost curve
ii. Firm can earn an economic profit in the short run at equilibrium
ii. Firm can earn an economic profit in the short run at equilibrium
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Long-run supply curves
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In the long run, firms can change any input like plant size, can leave an industry if there are losses, or enter an industry if there are profits
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Entry and exit of firms is the key to long-run equilibrium
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New firms shifts the short-run supply curve to the right
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This causes the price to fall
Economic profits equal zero in the long run
Economic profits equal zero in the long run
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If firms exit because of losses, this shifts the short-run supply curve to the left
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This causes prices to rise
The economic loss turns into zero economic profit
The economic loss turns into zero economic profit
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In summary, in the long-run equilibrium is P = MR = SRMC = SRATC = LRAC
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Neither positive economic profits to attract new entrants nor negative economic profits (losses) to cause firms to shut down
Maximum efficiency is achieved
Lowest price is available to consumers
Maximum efficiency is achieved
Lowest price is available to consumers
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Market structure: Classification structure for key traits of a market
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Characteristics of perfect competition
Large number of firms
Homogenous product
Ease of entry and exit
Large number of firms
Homogenous product
Ease of entry and exit
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Explain short-run profit maximization
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Goal: Maximize profits: TR-TC
Price taker: Must take market price because homogenous product
Production decision: So deciding how much to produce is the key
Marginal choice: If can make more profit from producing one more unit, will do so
MR = MC If will make less if produce one more unit, won't do so
Price taker: Must take market price because homogenous product
Production decision: So deciding how much to produce is the key
Marginal choice: If can make more profit from producing one more unit, will do so
MR = MC If will make less if produce one more unit, won't do so
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Explain long-run competitive equilibrium
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No barriers: If profits being made, there's nothing stopping new companies from coming in and getting a slice.
Supply jumps: This increases the supply, causing the price to fall.
Equilibrium at zero economic profits.
Opposite if losing money: Firms close, supply falls, prices increase, erasing losses, and finally stop at zero economic profits.
Supply jumps: This increases the supply, causing the price to fall.
Equilibrium at zero economic profits.
Opposite if losing money: Firms close, supply falls, prices increase, erasing losses, and finally stop at zero economic profits.
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Why do competitive firms stay in business if they make zero profit?
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Profit = TR - TC
Total cost includes all opportunity costs
Zero-profit equilibrium is where there is zero economic profit but positive accounting profit
i. Make just enough money where it's not worth it for you to quit and get into another line of work
Total cost includes all opportunity costs
Zero-profit equilibrium is where there is zero economic profit but positive accounting profit
i. Make just enough money where it's not worth it for you to quit and get into another line of work
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Perfect competition from society's perspective:
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pros
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1. Firms produce in long-run at zero economic profits, where price equals average total cost. That is, prices are at the lowest possible level for consumers.
2. P = MC implies an efficient allocation of resources: You wouldn't be better off using your resources in any other way; you're getting the most out of them that you can.
i. Output produced at the lowest possible cost to society.
ii. This is efficiency.
2. P = MC implies an efficient allocation of resources: You wouldn't be better off using your resources in any other way; you're getting the most out of them that you can.
i. Output produced at the lowest possible cost to society.
ii. This is efficiency.
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Con
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Competitive markets rarely promote technological process because there are no barriers from competitors using what you do, giving little profit incentive to innovate.
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Four-step procedure for analyzing each of the four market types. First, perfect competition:
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1. What does demand look like from a business's perspective?
i. Horizontal line: Price taker.
2. What is profit-maximizing quantity of output?
ii. MR=MC at lowest possible point of average total cost
3. Given profits (or losses) in the short-term, what is the long-run equilibrium?
iii. Firms enter (or exit), leading to zero economic profit.
4. Pros and cons from society's perspective?
iiii. Low cost and efficient but not innovative.
i. Horizontal line: Price taker.
2. What is profit-maximizing quantity of output?
ii. MR=MC at lowest possible point of average total cost
3. Given profits (or losses) in the short-term, what is the long-run equilibrium?
iii. Firms enter (or exit), leading to zero economic profit.
4. Pros and cons from society's perspective?
iiii. Low cost and efficient but not innovative.
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