Microeconomics: Consumer demand & Elasticity

Satisfaction. The benefit or satisfaction a consumer receives upon consuming a good. It is hard to measure, being a subjective concept.

Maximum. Marginal utility is the extra utility (benefit or satisfaction) derived from consuming one more unit of a good or service. If marginal utility is zero, that means you are at your maximum utility--consuming more of a product will not increase the utility.

Substitution. It is the tendency of people to purchase less expensive goods that serve the same purpose as a good whose price has risen.

Summing or adding. The market demand curve would be the demand curve for an entire market--i.e. the entire market for computers. To get the market demand curve, naturally you would add up the individual demand curves. For example, to find the market demand curve for the United States market for computers, you might add up the demand curves for the different regions of the United States.

Zero. In the long run, economic profit is zero. Zero economic profit is also known as normal profit. It is important that you understand the reason for this: In competitive markets, as long as firms are making an economic profit, new firms will enter. New firms will keep on entering the market until it is so competitive that economic profit is zero. The only way a firm will have economic profit in the long run is if there are barriers to entry to protect economic profits. That is why a monopoly actually makes economic profits in the long run--no firms can enter the market!

Three times. If the MU for burgers is 3 times that of fries, that means the consumer gets 3 times the satisfaction or benefit from eating burgers that he does from eating fries. In economic terms, if the MU is 3 times bigger, the consumer would be willing to pay 3 times more.

Income. The change in quantity demanded that occurs when the purchasing power of income is altered as a result of a price change. In other words, when a good becomes less expensive, a consumer's purchasing power goes up--he can buy more goods with the same amount of money. The opposite happens when the price goes up. This is the income effect of a price change--it has a direct effect on demand, since when price goes down, demand goes up.

Consumer equilibrium. To reach consumer equilibrium, the marginal utility divided by the price (MU / P) for each good should be the same. For example, in a previous problem, we stated that one consumer gets three times the MU from hamburgers as he does from fries. If hamburger's MU is 3, and the fries MU is 1, then when the fries cost $0.50, each burger must cost $1.50 (3 x 0.50). 3 / $1.50 is equal to 1 / $0.50, so consumer equilibrium is established.<br />

Marginal utility. If the marginal utility per dollar is higher for one good than the other, that means for every dollar you spend on that one good, you are getting more utility (benefit or satisfaction). For example, let's say you get 3 MU from one burger, and 1 MU from an order of fries, and the burger costs $6 and the fries costs $1. MU / P is the equation that tells you marginal utility per dollar, so 3 / $6 = 0.5, and 1 / $1 = 1. The fries are the better buy because their marginal utility per dollar is twice as high as the hamburger's.

Marginal. When the price of pies increases, the marginal utility per dollar of pies decreases, because MU per dollar is MU / P. As P gets bigger, MU per dollar gets smaller. Also, as you keep eating more and more slices of pie, eventually marginal utility drops to zero. In other words, there comes a point where eating another piece of pie will not give you any additional satisfaction.

Muffin. Remember, to calculate marginal utility per dollar, divide the marginal utility by the price (MU / P). For the doughnut, MU / P = 30 / $2. For the muffin, MU / P = 20 / $1. The muffin has a marginal utility per dollar of 20, which is higher than the doughnut's MU per dollar of 15, making the muffin the better buy.

Consumer surplus. A person who has been working in the hot sun may be willing to pay as much as $2.00 for a can of cold soda, but if he can buy it for only $.50, he thinks he has found a good deal and may buy two or three. The difference between the maximum a person would pay and the actual amount that he does pay is consumers' surplus.

Peanuts. Because he is in equilibrium, we know that the marginal utility per dollar he got for both the peanuts and the soft drinks must be the same. In that case, if he is paying twice as much for the peanuts as the soft drinks, he must be getting twice as much marginal utility (satisfaction) from the peanuts.

3. Stephanie was willing to pay a total of $7.50 for all three orders of chips and salsa, but she was able to purchase them for a total of $4.50. This difference in what she was willing to pay, and what she actually ended up paying, equals the consumer surplus.

Inelastic. If demand is price inelastic, that means quantity demanded changes slowly compared to the price. This is good if you're raising the price, because a fairly large increase in price results in a relatively small decrease in quantity--which means the revenue grows. On the other hand, a fairly large decrease in price results in a relatively small increase in quantity--which means that revenue shrinks. Basically, with inelastic demand, quantity changes slowly relative to the price, so increased price means increased total revenue.

Negative. A negative marginal utility means that consuming an additional unit lowers your satisfaction or benefit. For example, if you eat enough slices of pie, your marginal utility may hit zero, or it may even go negative as you suffer from each agonizing additional piece of pie you consume.

Diminishing. The Principle of Diminishing Marginal Utility states that the more of a good that one obtains in a specific period of time, the less additional utility yielded by each additional unit of that good. For example, the first slice of pie will have a high marginal utility. The second will have less, and the third will have even less, until eventually you hit a number of slices of pie where you're getting zero, or negative marginal utility. In other words, the more units of a product consumed in a period of time, the lower and lower marginal utility gets for additional units.

Price elasticity. In other words, how big of an effect does changing the price of a product have on its demand? One factor price elasticity of demand depends on is how readily consumers can switch their purchases from one product to another. For example, for concert tickets for U2, the price elasticity is low--consumers will not switch to another product. The band could jack up the price, and it would have a relatively small effect on demand. On the other hand, if Burger King doubled the price of its burgers, a lot of customers would go to MacDonalds instead--price elasticity is high, because there is a lot of competitio

Straight line. When the price elasticity of demand is less than 1, demand is said to be inelastic--meaning that a price change will cause less of a change in quantity demanded. If elasticity is greater than 1, the quantity demanded is relatively elastic, meaning that a price change will cause an even larger change in quantity demanded.

Complements. Goods that are used together (as the price of one rises, the demand for the other falls). This is the opposite of substitutes, where a rise in price of one, results in a rise in demand for the other. An example of complements are milk and corn-flakes. As the price of milk rises, the demand for corn-flakes will fall. On the other hand, corn flakes and cheerios would be substitutes--as the price of corn flakes goes up, the demand for cheerios rises as people switch to cheerios.

Output. In a cartel, the firms agree to limit output. By artificially limiting the quantity supplied, they can raise the price. This price would be above the MC (Marginal Cost). Firms would have the incentive to increase quantity up to the point where MR=MC (the profit-maximizing point) and make more money. Look at the graph below: The cartel restricts output to quantity M. To make the maximum possible profit, a company should produce where MC=MR, which is at quantity CHEAT. An individual firm in a cartel has incentive to cheat on its agreement and increase from qM to qcheat.

Necessities. A larger price elasticity of demand means that when the price of luxuries change, it has a large effect on demand. On the other hand, necessities have a low price elasticity--whether the price changes or not, demand will not be affected as much because people still need to buy it.

Perfect Competition. In perfect competition, the product is homogeneous, or undifferentiated. Products such as cabbages and carrots are homogeneous--one company's carrots are not going to differ much from the next company's carrots.

1.25. The formula for calculating price elasticity of demand is the proportional change in quantity divided by the proportional change in price: It is not as complicated as it looks, just take one piece at a time. Make sure you can arrive at the same answer as provided above, using a separate piece of paper, and a calculator if necessary. Also, elasticity is always a positive number, so drop the negative sign off of your answer.

Discrimination. In this case some buyers pay a different price for the same product.

More,higher. The more elastic a customer's demand is, the more fickle he is to a change in price. A customer with a less elastic demand is more tolerant of a change in price or a higher price, so naturally you would charge a lower price to the more elastic customer, and a higher price to the less elastic customer.

Elastic. When demand is elastic, it changes quickly relative to price. When you raise the price a little, your quantity drops a lot, meaning less total revenue. When you lower the price a little, your quantity sold increases a lot, meaning more total revenue. When demand is elastic, you're better off decreasing the price, because that increases total revenue.

Cross-price. Normally, when you calculate price elasticity of demand, you are just dealing with one good, and you divide percentage change in quantity by percentage change in price for that one good. However, with related goods, you may want to know the Cross-Price elasticity of demand, in which you divide the percentage change in quantity for Item1 by the percentage change in price for Item2.

Normal. A normal good is a commodity for which consumption increases when income increases; in other words, if your income goes up, consumption of that good goes up. On the other hand, an inferior good is a commodity for which consumption decreases when income goes up--i.e. when income goes up, intercity railway transportation goes down as people use automobiles and airplanes instead.

5. There are several economic principles to keep in mind here--first of all, we know that when price increases, quantity supplied increases. Secondly, we know that when price elasticity of supply is less than 1, it is inelastic. If supply is inelastic, that means that it changes at a slower rate than price, so if price changes by 10%, then supply changes by less than 10%. The formula for price elasticity of supply is

Complement. Complement goods are goods that are used together (as the price of one rises, the demand for the other falls). That means, when the price of the bicycle is raised, the demand for the complement goods will go down. If they want to prevent that, they need to lower the prices of the complement goods, because when prices go down, demand goes up.

Fixed. The AFC (average fixed cost) gets lower as you increase output, because you are dividing the fixed cost, which does not change, over a larger quantity of production. For example, a huge law firm with hundreds of lawyers might save clients money over a smaller law firm because they have low overhead due to a low AFC.

Substitute. Goods that can be used in place of each other (as the price of one rises, the demand for the other rises). As the price of beef rises, more people are substituting chicken for beef, making chicken a substitute good.

Inelastic. If the demand curve is price inelastic, that means that the demand changes at a slower rate than the price. As long as demand isn't dropping as fast as the price is rising, your total revenue is going up. In terms of a graph, a very steeply sloping demand curve (that is, almost straight up and down) indicates that a given percentage increase in price will induce only a comparatively smaller percentage decrease in the quantity of the commodity that potential consumers wish to buy ("relatively inelastic demand"); while a very gently sloping demand curve shows that a given percentage increase in price will produce a still larger percentage decrease in quantity demanded

Monopoly. Monopoly will have the highest price in the long run. Perfect competition will have the lowest price, and the highest quantity in the long run.

Elastic. Ignoring the plus or minus sign, an elasticity greater than 1 is referred to as relatively elastic and an elasticity less than 1 is referred to as relatively inelastic. (An elasticity precisely equal to 1 is termed unit elasticity.) Remember, to determine price elasticity of demand, just divide percentage change in quantity by percentage change in price, so 20 / 10 = 2. 2 is greater than 1, so demand is elastic--demand changes at a greater rate than price.

Inelastic. If demand is inelastic, that means that demand changes at a slower rate than price. Demand would have to be inelastic for an increase in tuition to mean an increase in total revenue. If it was elastic, then demand would drop so fast when they increase the price that they would lose money, not gain money.

Decrease. The price floor sets a minimum price. Assuming this price floor is above the equilibrium price, the price will decrease to the equilibrium price as soon as the price floor is removed. In the graph below, the price would drop from Pm to Po.

Increase. If demand is elastic, demand changes at a faster rate than price, so if you drop the price, demand rises so much that you come out ahead in terms of total revenue. On the other hand, if demand is inelastic, that means that even if you drop the price, demand does not change that much, so you end up losing money. Elasticity basically tells you how much does demand change in response to a price change.

Inelastic. If demand is inelastic, demand is affected relatively little when the price is increased. An example is a U2 concert, where demand is so inelastic that they could increase the cost of a ticket by ten or twenty dollars, and still sell out.

Increase. Total revenue is simply asking how much money total comes in from sales. It does not take into account expenses, costs, etc.. In this case, all you have to do is figure out how much money they make at each price amount. At $10, they make $30,000 ($10 x 3,000). When the price is reduced to $8, they make $40,000 ($8 x 5,000). Obviously, total revenue has increased.