Elasticities and Consumer Choice-Mod 2

Elasticity

Elasticity measures responsiveness: how much one economic variable changes in percentage terms when another variable changes.

Price elasticity of demand (PED)

PED = % change in quantity demanded / % change in price. PED is negative because price and quantity demanded move in opposite directions, so classification uses its absolute value.

Midpoint method

% change = change / average of the starting and ending values × 100. Use the midpoint method for both quantity and price before calculating elasticity.

PED classifications

|PED| > 1 is elastic; |PED| < 1 is inelastic; |PED| = 1 is unit elastic; |PED| = 0 is perfectly inelastic; |PED| = infinity is perfectly elastic.

What makes demand more or less elastic

Demand is generally more elastic when more substitutes are available, the good is less necessary, the cost is large relative to income, the good is less addictive or habit forming, and consumers have more time to adjust.

Elasticity along a linear demand curve

PED is not constant along a linear demand curve. Demand is more elastic at high prices and low quantities and more inelastic at low prices and high quantities.

PED and total revenue

With elastic demand, price and total revenue move in opposite directions. With inelastic demand, price and total revenue move in the same direction. With unit elastic demand, total revenue does not change.

Income elasticity of demand

Income elasticity = % change in quantity demanded / % change in income. A positive value identifies a normal good; a negative value identifies an inferior good.

Cross-price elasticity of demand

Cross-price elasticity = % change in quantity demanded of one good / % change in the price of another good. A positive value means substitutes; a negative value means complements.

Price elasticity of supply (PES)

PES = % change in quantity supplied / % change in price. Supply becomes more elastic when firms have greater production flexibility, goods are easier to store, and more time is available to adjust production.

Utility and diminishing marginal utility

Utility is satisfaction from consumption. Marginal utility is the additional utility from one more unit: MU = change in total utility. Diminishing marginal utility means MU eventually falls as consumption increases.

The consumer optimization problem

Choose the affordable consumption bundle that maximizes utility subject to the budget constraint.

Budget constraint and opportunity cost

For two goods, P₁Q₁ + P₂Q₂ = M. A bundle is affordable if its total cost does not exceed income. The price ratio shows the opportunity cost of one good in terms of the other.

How income and price change the budget line

Higher income shifts the entire budget line outward and lower income shifts it inward. A change in one good's price rotates the budget line by changing that good's intercept and the price ratio.

Unlimited-budget consumer rule

Consume a good until P = MU. If MU > P, consume more; if MU < P, consume less.

Limited-budget utility-maximizing rule

Two conditions are required: spend the entire budget and equalize marginal utility per dollar across goods, so MU₁/P₁ = MU₂/P₂ = … = MUₙ/Pₙ.

How to fix unequal marginal utility per dollar

If MU₁/P₁ > MU₂/P₂, consume more of good 1 and less of good 2 until the marginal utility per dollar is equal.

Consumer surplus

Consumer surplus is the difference between what a consumer is willing to pay and what the consumer actually pays.