Economics Terms Chapters 6 and 19-22

exam prep

price elasticity of demand (Eₚ)

the responsiveness of quantity demanded of commodity to changes in its price —> or the percentage change in quantity demanded divided by the percentage change in price

price elasticity of demand (Eₚ) formula

- percentage change in quantity demanded

Eₚ = ————————————————————

- percentage change in price

price of elasticity example

price of petroleum increases 10 percent, quantity demanded decreases 2 percent

price elasticity: relative quantities ONLY and always NEGATIVE

1. elasticity measuring the change in quantity relative to the change in price (measurement units don’t matter)

2. law of demand states an increase in price decreases the quantity demanded (but, by convention, the minus sign is ignored

formulas to calculate elasticity

(see image)

elasticity calculations example

price elasticity of 0.53 = each 1 percent decrease in price generated a 0.53 percent increase in the quantity of Tesla vehicles purchased

price elasticity ranges….

1. elastic demand

2. unit elasticity of demand

3. inelastic demand

elastic demand

a given percentage change in price will result in a larger percentage change in quantity demanded —> Eₚ > 1 or % change in Q > % change in P →inverse relationship between changes in prices and total revenue

unit elasticity of demand

the quantity demanded changes exactly in proportion (equal) to the change in price —> Eₚ = 1 or % change in Q = % change in P →changes in price do not change total revenue

inelastic demand

a given percentage change in price will result in a less-than-proportionate (smaller) percentage change in quantity demanded —> Eₚ < 1 or % change in Q < % change in P → positive relationship between change in prices and total revenue

perfectly inelastic demand (extreme elasticities)

demand that exhibits zero responsiveness to price changes (no matter what price is, quantity demanded remains the same) = zero elasticity, demand curve is a vertical line

perfectly elastic demand (extreme elasticity)

the slightest increase in price leads to zero quantity demanded = infinite elasticity, the demand curve is a horizontal line

total revenue formula

product of price per unit x number of units purchased

price elasticity of demand and total revenue relationship

(see image)

determinants of the price elasticity of demand

1. the existence/number of substitutes

2. the share of a consumer’s total budget devoted to purchases of that commodity

3. the length of time allowed for adjustment to changes in the price of that commodity

the existence of substitutes (determinant of Eₚ)

the closer the substitutes and the more substitutes there are, the more elastic the demand

share of budget (determinant of Eₚ)

the greater the share of the consumer’s total budget spent on a good, the greater the price elasticity

time for adjustment (determinant of Eₚ)

the longer any price change persists, the greater the elasticity of demand (other things held constant), —> elasticity of demand is greater in the long run than in the short run

short run vs. long run (time for adjustment - dofEₚ)

short run: a period too short for consumers to fully adjust to a price change

long run: a period long enough for consumers to fully adjust to a change in price, other things being constant

cross price elasticity of demand (Eₓᵧ)

the percentage change in the amount of an item demanded (holding its price constant) divided by the percentage change in the price of a related good

cross price elasticity of demand (Eₓᵧ) formula

- % change in amount of good X demanded

Eₓᵧ = ————————————————————

- % change in price of good

cross prices and substitutes

Eₓᵧ > 0 —> an increase in the price of X would increase the quantity of Y demanded at each price

cross prices and substitutes

Eₓᵧ < 0 —> an increase in the price of X would decrease the quantity of Y demanded at each price

income elasticity of demand (Eᵢ)

the percentage change in the amount of a good demanded (holding price constant) divided by the percentage change in income or the responsiveness of demand to changes in income (holding the good’s relative price constant)

income elasticity of demand (Eᵢ) formula

- % change in amount of good demanded

Eₓᵧ = ————————————————————

- % change in income

price elasticity of demand displayed on a curve

refers to a movement along the curve in response to price changes

income elasticity of demand displayed on a curve

refers to a horizontal shift in the demand curve in response to changes in income

price elasticity of supply (Eₛ)

the responsiveness of the quantity supplied of a commodity to a change in its price or the percentage change in quantity supplied divided by the percentage change in price

price elasticity of supply (Eₛ) formula

- percentage change in quantity supplied

E = ————————————————————

- percentage change in price

perfectly elastic supply

the quantity supplied falls to zero when there is the slightest decrease in price (the supply curve is horizontal at a given supply)

perfectly inelastic supply

the quantity supplied is constant, no matter what happens to the price (the supply curve is vertical at a given price)

price elasticity of supply and time adjustment

1. the longer the time allowed for adjustment, the more resource can flow into (out of) and industry through expansion (contraction) of existing firms

2. the longer the time allowed for adjustment, the entry (or exit) of firms increases (or decreases) production in an industry

elasticity of demand measures…

how sensitive the quantity demanded of a good/service is to a change in price

• the responsiveness of consumers to changes in prices in the market

utility

the want-satisfying power of a good or service (the ability of a good or service to satisfy a want)

utility analysis

the analysis of a consumer decision-making based on utility maximization

util

a representative unit by which utility is measured

marginal utility

the change in total utility due to a one-unit change in the quantity of a good or service consumed

• the extra satisfaction a person gets from consuming one additional unit of a good or service

change in total utility

————————————————— = marginal utility

change in number of units consumed

utility theory (marginal section)

• marginal utility falls as more is consumed

• marginal utility equals zero when total utility is at its maximum

• when marginal utility becomes negative, goods in effect become “bads” →a rational consumer will stop consuming the good even when it’s available at a price of 0

types of marginal utility

positive: each extra item adds to overall satisfaction

zero: an extra item adds no satisfaction

negative: an extra item causes discomfort or lowers total satisfaction

diminishing marginal utility

the principle that as more of any good or service is consumed, its extra benefit declines

• increases in total utility from consumption of a good or service become smaller and smaller as more is consumed during a given time period

the law of diminishing marginal utility

extra satisfaction shrinks as consumption increases.

• first unit: provides high satisfaction and value.

• later units: provide smaller additions to total happiness.

  • as an individual consumes more of a commodity, the total level of utility (satisfaction) derived from that consumption increased →eventually, the rate at which it increases diminishes as more is consumed

consumer optimum

a choice of a set of goods or services that maximizes the level of satisfaction for each consumer, subject to limited income

substitution effect

the tendency of people to purchase cheaper commodities when expensive commodities of the same type are priced higher

principle of substitution

the principle that consumers shift away from goods and services that become priced relatively higher in favor of goods and services that are now priced relatively lower

• (consumers shift to goods that are priced lower when prices of original goods rise)

purchasing power

the value of money for buying goods and services

• if your income stays the same while the price of one good that you’re buying rises, your effective purchasing power falls (VV)

real-income effect

the change in people’s purchasing power that occurs when (other things constant) the price of one good that they can’t purchase changes

• when that price rises, real income/purchasing power falls, and when that price decreases, real income increases

indifference curve

a curve composed of a set of consumption alternatives, each of which yields the same total amount of satisfaction

• downward slope, not a straight line, convex

indifference map

• a set of indifference curves

• a higher indifference curve = possibility of higher rates of consumption of both goods (more preferred than a lower one, more is better than less)

budget constraint

all the possible combinations of goods that can be purchased (at fixed prices) with a specific budget

deriving the demand curve

when the price of one good changes, (holding both the price of another good and income constant) the budget line rotates, resulting in a new optimum point

• demand curve slopes downward

economic rent

a payment for the use of any resource over and above its opportunity cost

• ex. house rent: payment for use of land

economic rent for labor

entertainment figures would undoubtedly work for less than they earn, much of their rent occurs because specific resources cannot be replicated exactly (no one can duplicate todays most paid entertainment figures)

examples of economic rent for labor

paychecks delivered to: professional sports superstars, r&b entertainers, movie stars, world-class models, successful inventors and innovators, world-famous opera performers

economic rent and resource allocation

economic rent allocates resources to their highest-valued use

firms

• an organization that brings together factors of production: labor, land physical capital, human capital, and entrepreneurial skill, to produce a product or service that is hoped to sell at a profit

• seek to earn the highest possible returns

• normally owns and operates one “plant” or facility in order to produce

the 3 legal organizations of firms

1. proprietorship

2. partnership

3. corporation

proprietorship (legal organization of firms)

a business owned by one individual who:

• makes the business decisions

• receives all the profits

• is legally responsible for all the debts of the firm

advantages of proprietorships

• is easy to form and end

• all decision-making power is given to the sole proprietor

• profit is only taxed once

disadvantages for proprietorships

• is subject to unlimited liability:

  • a legal concept whereby the personal assets of the owner of a firm can be taken to pay off the firm’s debts

• limited ability to raise funds

• ends with the death of the proprietor

partnership (legal organization of firms)

a business owned/managed by two or more co-owners, or partners, who:

• share the responsibilities and profits of the firm

• are individually liable for all of the debts of the partnership

advantages of partnerships

• easy to form and end

• limits the costs of monitoring job performance

• permits more effective specialization

• subject only to personal taxation

disadvantages of partnerships

• partners each have unlimited liability

• decision-making is generally more costly than a proprietorship

• dissolution occurs when a partner dies or leaves the firm

corporation (legal organization of firms)

• a legal entity that may conduct business in its own name, just as an individual does

• the owners of a corporation are shareholders who:

  • own shares of the firms profits

  • are protected by limited liability

    • the responsibility, or liability, of the owners of a corporation is limited to the value of the shares in the firm that they own

advantages of corporations

• limited liability

• continues to exist when owners leave

• positioned to raise large sums of financial capital

disadvantages of corporations

• double taxation (profits of firm and dividends)

  • portion of a corporation’s profits paid to it’s owners (shareholders)

• separation of ownership and control

limited liability company (LLC)

a hybrid form of business enterprise that offers the limited liability of a corporation and the tax advantages of a partnership

accounting profit

total revenue - explicit costs

explicit costs

costs that business managers must take account of because they must be paid off

• ex. wages, taxes, and rent

implicit costs

expenses that managers do not have to pay out of pocket and hence do not normally explicitly calculate

• ex. opportunity cost of factors that are production-owned, owner provided capital, owner provided labor

normal rate of return (or opportunity cost of capital)

the amount that must be paid to an investor to induce investment in a business

• the available return on the next-best alternative investment

economic profit

total revenue - total opportunity costs of all inputs used

• total revenue - (implicit + explicit costs)

the goal of firms

profit maximization and utility (or satisfaction) maximization

• pm: firms that can provide relatively higher risk-corrected returns will have an advantage in obtaining financing needed to continue or expand production

financial capital

funds used to purchase physical capital goods, such as buildings and equipment, and patents and trademarks

interest

• price paid by debtors to creditors for the use of loanable funds

• the payment for current rather than future command over resources

• the cost of obtaining credit

determinants of the interest rate

length of loan, risk, handling charges

nominal rate of interest

the market rate of interest expressed in today’s dollars

real rate of interest

nominal rate of interest - anticipated rate of inflation

• iₙ = iᵣ + anticipated rate of inflation

the allocative role interest

interest is a price that allocates loanable funds (credit) to consumers and businesses

• allocates financial capital, thus ultimately allocating physical capital

present value (PV)

• the value of a future amount expressed in today’s dollars

• the most that someone would pay today to receive a certain sum at some point in the future

examples of present value

$105 to be received one year from now with an interest rate of 5%

• PV₁ = $105/(1.05) = $100

for distant periods: $105 to be received two years from now with an interest rate of 5% per year, compounded annually

• PV₁ = $105/(1.05)² = $95.24

discounting

the method by which the present value of a future sum or a future stream of sums is obtained

rate of discount

the rate of interest used to discount future sums back to present value

share of stock

• a legal claim to a share of a corporation’s future profits (common stock)

  • common stock: incorporates certain voting rights regarding major policy decisions of the corporation

  • preferred stock: accords owners preferential treatment in the payment of dividends but does not include voting rights

bond

a legal claim against a firm

• usually entitles its owner to receive a fixed annual coupon payment, plus a lump-sum payment at the bond’s maturity date

• issued in return for funds lent to the firm

reinvestment

profits (or depreciation reserves) used to purchase new capital equipment

• sales of stock are an important source of financing for new firms

• reinvestment and borrowing are the primary means of financing for existing firms

inside information

information that is not available to the general public about what is happening in a corporation

• one way to “beat the market,” although it is illegal and is punishable by substantial fines and imprisonment