Chapter 3 demand and elasticity

law of demand

people do less of what they wan to do as the cost of doing rises. It implies that a “run” i the sum of all sacrifices monetary and non-monetary.

applying this shows how income and substitution are important in explaining differences in consumption patterns.  

real price

the dollar price of a good relative to tge average dollar price of all goods

nominal price

the absolute price of a good in dollar terms

horizontal addition 

when adding individual demand curves to get the market demand curve. Emphasizes that they are adding quantities that are measured on the horizontal axes of individual demand curves.  

price elasticity of demand

the percentage change in the quantity demanded of a good or service that results from a 1 percent change in its price

measures the responsiveness of quantity demanded to changes in price

the price elacticity of demand equation

price change in quantity demanded/percentage change in price

its usually negative, but for the sake of the justification, the absolute value is taken

elastic 

the demand for a good is elastic with respect to price if its price elasticity of demand is greater 1 

inelastic

the demand for a good is this with respect to price if the price elasticity of demand is less than 1

unit elastic

the demand for a good is this with respect to price if its price elasticity of demand equals 1

factors that influence price elasticity 

it tends to be larger when substitutions for the good are more readily available, when the goods share in the consumers budget is larger, and when consumers have more time to adjust to a chance in price  

price elasticity

p=current price of good. change in price=small change in the current price

Q=the quantity demanded at that price. change in quantity=resulting change in quantity demanded

E=(change in quantity/quantity)/(change in price/price)

price elasticity at a point

E_A = P/Q (ratio at point A) x 1/slope

intersection of price elasticity 

if two demand curves have a part in common, the steeper curve must be less price-elastic of the two with respect to price at that point 

perfectly elastic demand

demand is perfectly elastic with respect to price if price elasticity demanded is infinite

perfectly inelastic demand 

demand is perfectly inelastic with respect to price if price elasticity of demand is zero

total expenditure (total revenue)

the dollar amount that consumers spend on a product (PxQ) is equal to the dollar amount that sellers receive

rules of elasticity 

rule 1: when price elasticity of demand is greater than one, changes in price and changes in total expenditures more in opposite directions 

rule 2: when price elasticity of demand is less than 1, changes in price and changes in total expenditures always move in the same direction 

cross-price elasticity of demand

the percentage by which the quantity demanded of the first good changes in response to a 1 precent change in the price of the second

income elasticity of demand

the percentage by which a goods quantity demanded changes in response to a one percent change in income 

substitutes and elasticity

when the cross-price elasticity of demand for one good with respect to the price of aother good is positive then the goods are this

complements and elasticity

when the cross price elasticity of demand is negative, the two goods are this

normal goods and elasticity 

has a positive income elasticity of demand

inferior goods and elasticity

has a negative income elasticity of demand

determinants of price elasticity of demand

1) luxuries vs. necessities

2) substitutes (availability of substitution)

3) relative price of the good to income

4) time: immediate period, short-run, long run

coefficient of price elasticity of demand

Ed= % change in Qd/ % change in P

Ed>1 

Qd>p 

elastic 

Ed<1

p>Qd

inelastic

Ed=1

Qd=P 

unit elastic 

Ed=0

perfectly inelastic

Ed=infinity

perfectly elastic

Point Method

percent change in variable =

X1-X2/X1 ×100

Mid point Method

percent change in variable= X1-X2/(1/2(P1+P2)

upward sloping supply curve

this reflects the fact that costs tend to rise at the margin when producers expand production, partially because even individual exploits the most attractive opportunities first, but also because different potnetial sellers face different opportunity costs

profit

the total revenue a firm receives from the sale of its product minus all costs-explicit and implicit- incurred in producing it

profit-maximizing firm

a firm whose primary goal is to maximize the difference between its total revenues and costs 

perfectly competitive markets

a market which no individual supplier has significant influence on the market price of the product

price taker

a firm that has no influence over the price at which it sells its product

conditions of a perfectly competitive market 

1) all firms sell the same standardized product→ usually in reality this is roughly approximated. 

2) the market has many buyers and sellers, each of which buys or sells only a small fraction of the total quantity exchanged  

3) productive resources are mobile

imperfectly competitive firm (or price setter) 

a firm that has at least some control over the market price of its product 

factors of production

input used in the production of a good or service

short run

a period of time sufficiently short that at least some of the firms factors of production are fixed 

long run

a period of time of sufficient length that all the firms factors of production are variable.

the law of diminishing returns 

a property of the relationship between the amount of a good or service produced and the amount of a variable factor required to produce it; says that when some factors of production are fixed, increased production of the good eventually required ever-larger increases in the variable factor

fixed factor of production

an input whose quality cannot be altered in the short run

variable factor of production

an input whose quantity can be altered in the short run

fixed cost 

the sum of all payments made to the firms fixed factor of production 

total cost

the sum of all payments made to the firms fixed and variable factors of production

marginal cost

the increase in total cost that results from carrying out one additional unit of activity

variable cost 

the sum of all payments made to the firms variable factors of production

supply curve and marginal cost

supply curves and marginal costs should be equal in a perfectly competitive firm

price elasticity of supply

the percent change in the quantity supplied that occurs in response to a 1 percent change in the price of a good or service

(P/Q)* (1/slope0

perfectly inelastic supply

supply is this with respect to price if elasticity is zero

perfectly elastic supply

supply is this with respect to price if elasticity of supply is infinate

inelasticty and total revenue

price and total revenue move in the same direction

elasticity and total revenue

price and total revenue move in opposite directions

price change, total revenue, and elasticity

the effect of price change on total revenue completely depends on elasticity. When it is unit elastic, there is no effect on total revenue. Elasticity and in elasticity are opposites when it comes to total revenue.

total revenue

p * q

income elasticity of demand

Ei the responsiveness of quantity demanded to a change in income

equation for income elasticity of demand

Ei= % change in Q / % change in I

where I is income

point method for income elasticity

(change in Q/change in I) * (I/Q)

Normal good

Ei>0

necessity good

0<Ei<1

luxury goods

Ei>1

inferior good

Ei<0

cross price elasticity of demand 

enables us to determine the relationship between say, 2 goods, A and B. More specifically, the impact of a price change of good A on the quantity demanded of good B. 

cross price elasticity equation

midpoint: % change in Qb/ % change in Pa

point method: (% change in Qb/% change in Pa)* (Pa/Qb)

determinates of price elasticity of supply 

flexibility of producers: manufactured goods have more elasticity because they can simply run their factories for longer when prices go up 

time and adjustment process: over short periods, firms are not very responsive to change in price because they can’t easily expand their factories. 

mutuals and elasticity

when E= 0, then there is no relationship between the goods

supply point formula

Es= 1/B * P/Q

supply and elasticity

When Es is > 1 then it is elastic

supply and inelasticity

When Es is < 1 then it is inelastic

supply and unit elasticity

when Es=1 then it is unit elastic

explicit costs

the actual payment a firms makes to its factors of production and other supplies

accounting profits

the difference between a firm’s total revenue and its explicit costs

implicit profit (or excess profit) 

the difference between the firms total revenue and the sum of its explicit and implicit costs 

normal profit

the opportunity cost of the resources supplied by the firms owners , equal to the accounting profit-economic profit.

economic loss

an economic profit that is less than zero 

rationing function of price

changes in prices distribute scare goods to those consumers who value them the most highly (like an auction)

Allocative function of price

changes in prices direct resources away from overcrowded markets and toward markets that are underserved

invisible hand theory 

a theory that says that the actions of independent self-interested buyers and sellers will often result in the most efficient allocation of resources. 

barriers to entry

any force that prevents firms from entering a new market→ if this is the case, invisible hand does not hold.

economic rent

the part of the payment for a factor of production that exceeds the owners reservation, the price below which the owner would not supply the factor

efficient (or Pareto efficiency) 

a situation is this if no change is possible that will help some people without harming others. 

utility

we can define this as the satisfaction demanded from the consumption of a good or service

total utility

is the total satisfaction serviced from consuming a good or service

marginal utility

is the incremental utility derived from the consumption of an additional unit of a good

guiding principals for utilities

preferences

constraints

choice

marginal utility equation

change in TU/ change in quantity

when MU=0 TU is at its max

law of diminishing marginal utility of diminishing returns

as you consume increments of a good, beyond a certain point, the marginal utility derived from each additional unit of the good consumed decreased ceteris paribus

rational choice and marginal utility

we examine how consumers chose goods within their budget in order to maximize total utility. to maximize total utility we understand marginal utility. to understand this we assume consumers are rational. i. simple terms, they prefer more than less.

Px X + Py Y <_ I