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Elasticity
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refers to "responsiveness" or "sensitivity"--the sensitivity of one variable to a change in a second variable
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Price Elasticity of Demand
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a measure of the sensitivity of quantity demanded to a change in the product's price, all else unchanged
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Ed, coefficient of Demand Elasticity
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Ed is a numerical measure of price elasticity of demand, defined as
[percentage change in Quantity. Demanded / percentage change in Price]
when all that changes is the product's price.
Although the figure comes out negative, the convention is to drop the negative sign and speak of Ed as if it varies between zero and infinity
[percentage change in Quantity. Demanded / percentage change in Price]
when all that changes is the product's price.
Although the figure comes out negative, the convention is to drop the negative sign and speak of Ed as if it varies between zero and infinity
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Ed, calculating formula
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To calculate Ed, use the "midpoints" formula:
(Q2 - Q1)/(Q1+Q2)/2 _________________
(P2 - P1)/(P1 + P2)/2.
The formula is easier to read in chapter 5 of the textbook.
[Q1 is the initial quantity demanded Q2 the second quantity demanded P1 is the initial price; P2 the second price]
(Q2 - Q1)/(Q1+Q2)/2 _________________
(P2 - P1)/(P1 + P2)/2.
The formula is easier to read in chapter 5 of the textbook.
[Q1 is the initial quantity demanded Q2 the second quantity demanded P1 is the initial price; P2 the second price]
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Inelastic Demand
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when Ed is less than one
This means that the percentage change in quantity demanded was LESS than the percentage change in price
The demand curve is negatively sloped and relatively steep in this case
Meaning: this product's customers, in this price range, are NOT very sensitive to price changes
This means that the percentage change in quantity demanded was LESS than the percentage change in price
The demand curve is negatively sloped and relatively steep in this case
Meaning: this product's customers, in this price range, are NOT very sensitive to price changes
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Elastic Demand
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when Ed is greater than one
This means that the percentage change in quantity demanded was greater than the percentage change in price
The demand curve is negatively sloped but relatively flat in this case
Meaning: this product's customers, in this price range, are SENSITIVE to changes in price; they're comparison shoppers
This means that the percentage change in quantity demanded was greater than the percentage change in price
The demand curve is negatively sloped but relatively flat in this case
Meaning: this product's customers, in this price range, are SENSITIVE to changes in price; they're comparison shoppers
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Unit Elasticity
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when Ed is approximately equal to one
This means that in percentage terms quantity demanded changed just about as much as price changed, so Ed comes out equal to 1
This means that in percentage terms quantity demanded changed just about as much as price changed, so Ed comes out equal to 1
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Perfectly Elastic Demand
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when a small increase in price makes quantity demanded go to zero; Ed= infinity. Demand curve is perfectly flat
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Perfectly Inelastic Demand
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when a change in price leads to no change at all in quantity demanded. Ed = 0. Demand curve is straight up and down [vertical] in shape
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Total Revenue
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the total revenue a one-product firm brings in during a time period [all the money coming in] is equal to PxQ, or Price times Quantity. If you sell 5 units at $10 each, total revenue = $50.
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Change in total revenue if demand is elastic (Ed greater than 1) and price changes
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For ELASTIC demand:
If Price rises, total revenue [PxQ] decreases
If Price falls, total revenue [PxQ] increases
That's because price sensitive customers stop buying when price rises; they come to buy in large numbers when price falls
If Price rises, total revenue [PxQ] decreases
If Price falls, total revenue [PxQ] increases
That's because price sensitive customers stop buying when price rises; they come to buy in large numbers when price falls
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Changes in total revenue if demand is INelastic (Ed less than 1) and price changes
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If Demand is INELASTIC:
If P rises, total revenue [PxQ] increases
If P falls, total revenue ([PxQ] decreases
This is a huge point: If demand is inelastic, firms will tend to raise the price, since their total revenue goes up when price goes up, as they don't lose many customers, relatively speaking
If P rises, total revenue [PxQ] increases
If P falls, total revenue ([PxQ] decreases
This is a huge point: If demand is inelastic, firms will tend to raise the price, since their total revenue goes up when price goes up, as they don't lose many customers, relatively speaking
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Change in total revenue if demand is unitary elastic
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If Demand is unit elastic, total revenue DOES NOT CHANGE when price falls or price rises, as any price change is offset by an equal-sized change in quantity demanded, in percentage terms, so PxQ does not change
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Product Characteristics that tend to make demand elastic (price sensitive)
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Demand tends to be ELASTIC if
the product has many good substitutes;
the product is expensive, relative to the consumer's budget;
the product is more like a "luxury" than a "necessity;"
the consumer has a LONG time period to adjust to a price change, rather than a SHORT time period.
Products with the opposite characteristics [e.g., no good substitutes, low price, etc.,{salt is a good example} tend of course to have INELASTIC -- price insensitive -- demand]
the product has many good substitutes;
the product is expensive, relative to the consumer's budget;
the product is more like a "luxury" than a "necessity;"
the consumer has a LONG time period to adjust to a price change, rather than a SHORT time period.
Products with the opposite characteristics [e.g., no good substitutes, low price, etc.,{salt is a good example} tend of course to have INELASTIC -- price insensitive -- demand]
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Elasticity of Demand as you Move Along a straight-line demand curve
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Ed changes from point to point as you move along a straight-line demand curve. That is because it is measured in percentage terms, and percentage changes in price, for example, vary depending on how high a price you start from
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Elasticity of Supply
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Elasticity of Supply measures the responsiveness to price changes of the quantity supplied in a market.
It is measurable numerically by calculating the coefficient of supply elasticity, Es.
Es =
percentage change quantity supplied/ percentage change in price
when all that varies is the product price.
Es is a positive number.
If it is high (above 1 in value), quantity supplied increases a lot when price increases (and the supply curve would be relatively flat). Supply is price Elastic.
If Es is low (below 1 in value), quantity supplied does not increase much when price increases (and the supply curve would be relatively vertical). Supply is price Inelastic
It is measurable numerically by calculating the coefficient of supply elasticity, Es.
Es =
percentage change quantity supplied/ percentage change in price
when all that varies is the product price.
Es is a positive number.
If it is high (above 1 in value), quantity supplied increases a lot when price increases (and the supply curve would be relatively flat). Supply is price Elastic.
If Es is low (below 1 in value), quantity supplied does not increase much when price increases (and the supply curve would be relatively vertical). Supply is price Inelastic
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Elasticity of Supply and the time period considered
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Elasticity of Supply tends to be higher (and Es greater), the longer the time period considered. If price increases, firms can raise output more in the long run (since they have more time to get supplies, etc.) than they can in the short run
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utility
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the satisfaction, or want-satisfying power, a consumer expects to get from consuming a product
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marginal utility
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the added satisfaction a consumer gets from consuming ONE added unit of a product, like one slice of pizza
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util
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the [hypothetical] units in which utility is measured; a unit of satisfaction
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total utility
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the total satisfaction a consumer gets from ALL the units of a certain product consumed within a certain time period
sum of the marginal utilities of all the units consumed
sum of the marginal utilities of all the units consumed
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the law of diminishing marginal utility
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the principle that the marginal utility of a product decreases as more and more units of the product are consumed in a given time period; the 4th pizza slice doesn't please you as much as the 1st
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marginal utility per dollar (MU/P)
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how much satisfaction PER DOLLAR a product offers a consumer; sort of a "bang per buck" measure, obtainable by dividing the Marginal Utility of the last unit of the item consumed by its Price
If the marginal utility of the last unit of X bought is 8 utils, for example, and the price is $2, the marginal utility per dollar is 8utils/$2 = 4 utils per dollar.
If the marginal utility of the last unit of X bought is 8 utils, for example, and the price is $2, the marginal utility per dollar is 8utils/$2 = 4 utils per dollar.
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consumer equilibrium
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when the consumer has spent her/his money just so as to maximize the utility they can get from their budget; to reach this state the rule is that the marginal utility per dollar of the last dollar spent on each good must be the same: for goods X, Y, and so on,
MUx/Px = MUy/Py = ...MUz/Pz...
MUx/Px = MUy/Py = ...MUz/Pz...
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profit
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total revenue - total cost in a time period
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total economic costs of production
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economic costs of production include both explicit costs and implicit costs
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explicit costs (or accounting costs)
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actual payments a firm must make in order to hire the inputs it needs to carry out its production in a period
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implicit costs
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opportunity costs the owner(s) of a firm incur by investing their own resources -- labor, savings, buildings, etc. -- in the firm
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the short run
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a time period short enough that at least one input into the firm's production [generally the building, or 'plant'] is fixed; it cannot be increased as output increases
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the long run
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a time period long enough that all inputs are variable -- firms have enough time to build larger factories, new factories, and whatever else they need to increase production
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variable inputs
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inputs which a firm can vary even in the short run if it wishes to increase output . Generally thought of as labor and materials inputs
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fixed inputs
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inputs which firms are unable to vary in the short run. Fixed inputs do not vary as output levels vary. Example: the "plant" or building the firm operates in, or the interest payments the firm owes on a loan
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(Total) Fixed Costs (FC)
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total costs of fixed inputs during a time period
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(Total) Variable Costs (VC)
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total costs of variable inputs during a time period
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Total Costs (TC)
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(total costs = fixed costs + variable costs). Remember also that all economic costs -- explicit and implicit -- are included in these variables.
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economic profit
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total revenue - total economic costs
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zero economic profit
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means the firm has made a NORMAL rate of return on its owners' invested resources -- enough to pay the owners for their opportunity costs--but no more than that.
Zero economic profit means in effect that the firm DID OK
Zero economic profit means in effect that the firm DID OK
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accounting profit
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total revenue - accounting costs) Accounting profit is larger than economic profit, since implicit costs are not subtracted from accounting profit
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marginal product of labor
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the added output produced when one more unit of labor is added to a firm, all else constant
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production function
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a function or listing showing how output levels [Q] vary as variable inputs vary, all else constant
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law of diminishing marginal returns
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the principle that as a firm adds more and more of a variable input [like labor] to a fixed input [like the plant, or building], after a certain point it gets less and less ADDED output from each added unit of variable input;
OR: ... after a certain point the marginal product of labor decreases
OR: ... after a certain point the marginal product of labor decreases
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marginal cost
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the ADDED total cost a firm has to pay when it increases its output (Q) by ONE UNIT;
If for example Total Costs change from $2,000 to $2010 when output (Q) rises from 100 to 101, the marginal cost of the 101st unit is $10
If for example Total Costs change from $2,000 to $2010 when output (Q) rises from 100 to 101, the marginal cost of the 101st unit is $10
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Average Fixed Cost (AFC)
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Fixed costs per unit at a certain output level.
AFC = FC/Q.
If for example FC in a time period are $800 and Q = 100, AFC = $8
AFC = FC/Q.
If for example FC in a time period are $800 and Q = 100, AFC = $8
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Average Variable Cost (AVC)
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Variable Costs per unit at a certain output level.
AVC = VC/Q.
If for example VC in a time period are $1200 and Q = 100, AVC = $12
AVC = VC/Q.
If for example VC in a time period are $1200 and Q = 100, AVC = $12
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Average Total Cost (ATC)
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Total Costs per unit at a certain output level.
ATC = TC/Q.
If for example TC in a time period are $2,000 and Q = 100, ATC = $20
ATC = TC/Q.
If for example TC in a time period are $2,000 and Q = 100, ATC = $20
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short-run cost curves for an average firm
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know how generic or average short-run cost curves work:
AVC fall then rise as Q increases (as you move to the right on the graph)
ATC lies above AVC, since it also includes AFC (ATC=AVC+ AFC). Like AVC, ATC falls for a period then rises as Q increases.
The Marginal Cost [MC] curve starts below the average cost curves and eventually rises to cut both AVC and ATC at each one's minimum point and thereafter lie above the AVC and ATC curves
If you are confused, see Exhibit 4 on page 153 in the book, or lecture 9 in the course WebCT lectures
AVC fall then rise as Q increases (as you move to the right on the graph)
ATC lies above AVC, since it also includes AFC (ATC=AVC+ AFC). Like AVC, ATC falls for a period then rises as Q increases.
The Marginal Cost [MC] curve starts below the average cost curves and eventually rises to cut both AVC and ATC at each one's minimum point and thereafter lie above the AVC and ATC curves
If you are confused, see Exhibit 4 on page 153 in the book, or lecture 9 in the course WebCT lectures
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the marginal-average rule
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If at a certain level of output
MC is above ATC, then average total costs are rising as Q increases [the ATC curve slopes up]
MC is below ATC,. then average total costs are falling as Q increases [the ATC curve slopes down]
MC equals ATC, then average total costs are constant [the ATC curve is flat]
MC is above ATC, then average total costs are rising as Q increases [the ATC curve slopes up]
MC is below ATC,. then average total costs are falling as Q increases [the ATC curve slopes down]
MC equals ATC, then average total costs are constant [the ATC curve is flat]
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Long Run Average Cost (LRAC) Curves
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Long Run Average Cost curves show how a firm's Average Total Costs would vary as the firm got larger and larger (so that on the graph you moved further and further to the right on the graph
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Where does the LRAC curve come from?
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Long run average cost [LRAC] curves show all the lowest possible cost points from various short-run ATC curves as the firm gets larger and larger
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Shape of Long Run Average Cost Curves
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LRAC curves are ordinarily thought to be U-shaped -- long run average costs fall as output increases, then stay constant, then begin to rise
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Economies of Scale (region of the LRAC curve)
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The left-most portion of the LRAC curve, where average costs of product fall as output increases [the LRAC curve is negatively sloped]; in this range of output, costs fall as the firm gets larger.
Possible reasons: firms can use more efficient [larger] machines as firm size grows, as well as division of labor, and mass production-style production processes
Possible reasons: firms can use more efficient [larger] machines as firm size grows, as well as division of labor, and mass production-style production processes
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Constant Returns to Scale (region of the LRAC curve)
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the middle region of the LRAC curve, where costs stay the same as output levels [and firm size] increase
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Diseconomies of Scale (region of the LRAC curve)
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the right-most region of an LRAC curve, where as output levels [and firm size] increase, average costs start to rise.
LRAC curve slopes up.
Possible reasons: too many layers of management make production less efficient as the firm gets too large
LRAC curve slopes up.
Possible reasons: too many layers of management make production less efficient as the firm gets too large
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perfectly competitive markets
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markets in which
many small firms produce the product
the product is homogeneous
entry into and exit from the industry are easy [no big barriers], and
information [about the product, etc.] is readily available to both buyers and sellers
many small firms produce the product
the product is homogeneous
entry into and exit from the industry are easy [no big barriers], and
information [about the product, etc.] is readily available to both buyers and sellers
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homogeneous output
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output which is identical in the eyes of buyers regardless of which firm makes it -- like grade A wheat
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the price charged by perfectly competitive firms
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firms in perfectly competitive industries are price takers -- they cannot control the price they charge; they can only sell their product at the market price existing at the moment
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perfectly competitive firm's firm demand curve
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perfect competitors face a perfectly elastic [totally flat] firm demand curve -- that is, they can only charge one price -- the market price for their product
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market demand curve for perfectly competitive markets
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the market demand curve in perfectly competitive markets, like other markets, slopes down
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marginal revenue
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the added revenue a firm gets from selling one more unit of its product
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marginal revenue for a perfectly competitive firm
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for perfectly competitive firms, marginal revenue = price
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profit-maximizing output level for a perfectly competitive firm
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increase output until
price = marginal cost;
or, more accurately, until marginal cost is driven up just equal to the market price level--that's the profit-maximizing output level.
price = marginal cost;
or, more accurately, until marginal cost is driven up just equal to the market price level--that's the profit-maximizing output level.
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profit-maximizing output level for any firm
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increase output until marginal revenue = marginal cost
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Analyzing profit per unit and total profit for a competitive firm
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profit per unit is the difference between Price and Average Total Cost at the profit-maximizing output level;
if Price is $10 and average total costs are $8, for example, profit per unit is $2.
total profit is profit per unit times the profit-maximizing output level [or quantity produced]
If profit per unit is $2 and quantity produced is 200, total profit is $400.
if Price is $10 and average total costs are $8, for example, profit per unit is $2.
total profit is profit per unit times the profit-maximizing output level [or quantity produced]
If profit per unit is $2 and quantity produced is 200, total profit is $400.
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Perfect competitors' short-run profit levels
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In the short run in perfectly competitive markets, a firm may make negative, zero, or positive economic profits.
Market prices get pushed up or down by changing market conditions in the short run.
If market price falls below the firm's minimum Average Total Cost, the firm runs a loss.
If market price rises above the firm's Average Total Cost at the profit-maximizing output level, the firm runs a profit,
If market price equals Average Total Cost at the firm's profit-maximizing output level, the firm earns zero profit.
Market prices get pushed up or down by changing market conditions in the short run.
If market price falls below the firm's minimum Average Total Cost, the firm runs a loss.
If market price rises above the firm's Average Total Cost at the profit-maximizing output level, the firm runs a profit,
If market price equals Average Total Cost at the firm's profit-maximizing output level, the firm earns zero profit.
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Competitive firms' shut-down point in the short run
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shut down only if price falls below the minimum point on the average VARIABLE cost curve;
if market price stays above that point, even if it is below the firm's average TOTAL costs, the firm is better off staying in business. It will run a loss, but it will be a smaller loss than it would suffer if it shut down altogether
if market price stays above that point, even if it is below the firm's average TOTAL costs, the firm is better off staying in business. It will run a loss, but it will be a smaller loss than it would suffer if it shut down altogether
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Perfect competitors' long-run profit levels
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in the long run, perfectly competitive firms earn zero economic profit
that is because if in an initial situation there IS positive profit, new firms will enter the industry [since entry is by definition easy in these industries, and new firms are always attracted by positive profit--and in the long run there's enough time to enter]. When they enter, they increase market supply and that pushes the market price down. Firms will keep entering until market price is pushed all the way down to the point that it just equals Average Total Cost at the firm's profit-maximizing output level: that means zero economic profit
that is because if in an initial situation there IS positive profit, new firms will enter the industry [since entry is by definition easy in these industries, and new firms are always attracted by positive profit--and in the long run there's enough time to enter]. When they enter, they increase market supply and that pushes the market price down. Firms will keep entering until market price is pushed all the way down to the point that it just equals Average Total Cost at the firm's profit-maximizing output level: that means zero economic profit
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Firm's short-run supply curve
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the firm's short-run supply curve is
its marginal cost curve, or at least the portion of the marginal cost curve above the minimum average variable cost
a firm's short-run supply curve shows -- as you may remember--the quantities it would like to produce and sell at each possible price, all else constant.
Given a certain price, firms wish to raise output right to the point that the price line crosses the marginal cost line; that makes the marginal cost curve (above a certain point) the same as the firm's supply curve.
The portion of the MC line below minimum average variable cost does not count, because the minimum average variable cost point is the firm's shut-down point--the firm would not produce if the price falls below that point.
its marginal cost curve, or at least the portion of the marginal cost curve above the minimum average variable cost
a firm's short-run supply curve shows -- as you may remember--the quantities it would like to produce and sell at each possible price, all else constant.
Given a certain price, firms wish to raise output right to the point that the price line crosses the marginal cost line; that makes the marginal cost curve (above a certain point) the same as the firm's supply curve.
The portion of the MC line below minimum average variable cost does not count, because the minimum average variable cost point is the firm's shut-down point--the firm would not produce if the price falls below that point.
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Short Answer Questions
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1. A. Explain how consumers are thought to choose the utility-maximizing combination of goods in Chapter 6. What (two things) do they take into account in deciding which goods are most desirable to purchase with their budget?
1, B. What is the law of diminishing marginal utility?
2. A. Explain what a firm's "production function" is. What does it show?
2 B. In production theory, what is the law of diminishing marginal returns? (And is it a short-run or long-run idea?)
1, B. What is the law of diminishing marginal utility?
2. A. Explain what a firm's "production function" is. What does it show?
2 B. In production theory, what is the law of diminishing marginal returns? (And is it a short-run or long-run idea?)
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