APPLIED ECO REVIEWER 3.
2 Law of Diminishing Marginal Utility
LAW OF DEMAND
Demand
 Relationship between quantity and price.
 Different quantities of a resource, good or
service that consumers are willing and able to
buy at any given time at various possible prices.
Law of Demand
 Quantity of good demanded per period relates
inversely to its price, ceteris paribus, or other
things constant.
 The lower the price, the greater the quantity
demanded and vice versa.
Demand Schedule
 Reflects the quantities of goods and services
demanded by a consumer or an aggregate of
consumers at any given price.
Demand Curve
 Derived from a demand for a commodity since
it only reflects the relationship between
quantity demand and the price of the
commodity.
 Schedule of willingness and capacity of a
consumer to buy a commodity at alternative
prices at a given point in time, ceteris paribus.
 It is important to consider not only the
willingness to buy a good but not all is able to
buy because some do not have the capacity to
buy.
Substitution Effect
 Consumers are more willing if its relative price
falls.
 Change in the relative price – the price of one
good relative to the prices of other goods.
 If all prices changed by the same percent, there
will be no change in relative prices and no
substitution effect.
Income Effect
 Income effect of a lower price increases your
real income and thereby increases your ability
to purchase, making you better off.
 Consumers typically increases your quantity
demanded after a price decrease. An increase in
the price of goods, ceteris paribus, reduces your
real income, thereby reducing your ability to
buy the goods.
 Marginal Utility is the satisfaction derived from
an additional unit of a product.
 The marginal utility you derive from each
additional product declines as your
consumption increases.
 It states that the more of a good an individual
consumes per period, other things constant, the
smaller the marginal utility of each additional
unit consumed.
 Consumers buy things to increase satisfaction
or utility.
 Helps explain why people buy more when the
price increases.
 In deciding what to buy people make rough
estimates about the marginal utility or benefit,
they expect from the good or bad service.
 Based on this expected marginal benefit, people
then decide how much they are willing and able
to pay.
Individual Demand vs Market Demand
 Individual Demand – demand of an individual
consumer.
 Market Demand – sums of the individual
demands of all consumers in the market; total
quantities demanded by period by all
consumers at various prices.
Factors that Affect the Shift in the Demand Curve
1. Consumer Income (Normal vs Inferior Goods)
2. Price of Related Goods (Substitute and Complement)
3. Size or Composition of the Population
4. Consumer Expectations
5. Consumer Taste / Preference
Movement in Demand Curve
 Refers to the change in quantity demand
resulting from the change in the price of
commodity.
 As the price of the commodity decreases, the
movement along the curve will lead to an
increase in the quantity demand of the
commodity, vice versa.
Shifts in Demand Curve
 Changes in demand curve caused by any of the
other factors beside the price commodity.
  Positive Effect – to the right; Negative Effect –
to the left, implying a decrease in the demand
for the commodity in each point.
LAW OF SUPPLY
 With demand, consumers try to maximize the
utility, the incentives that motivates their
behavior.
 With supply, producers try to maximize the
profit.
Profit
 Incentives that motivates the behavior of
suppliers; equals to total revenue minus total
cost.
Total Cost
 Includes the cost of all the resources used by a
firm in producing goods and services, including
the entrepreneur’s opportunity cost.
Supply
 Relation showing the quantities of good
producers are willing and able to sell at various
prices during a given period, ceteris paribus.
Law of Supply
 Quantity of a good supplied during a given time
period is usually directed related to its price,
other things constant.
Supply Curve
 Curve or line showing the quantities of a
particular good supplied at various prices during
a given time period, ceteris paribus.
 Producers are more willing to supply as the
price increases, ceteris paribus. It creates a
profit incentive to shift some resources out of
producing other goods.
 Higher prices increase the producer’s ability to
supply the good. The marginal cost of
production increases as output increases.
 Higher price makes the producers willing and
more able to increase quantity supplied.
Price per Pizza Quantity Supplied
150 28
120 24
90 20
60 16
30 12
Market Supply Curve
 Shows the total quantities supplied by all
producers at various prices.
Factors Affecting Shift of Supply Curve
1. Cost of Resources Used to Make the Good
 An increase in supply – a rightward shift of the
supply curve – means that producers are willing
and able to supply more goods at each price.
2. The Price of Other Goods These Resources Could
Make the Good
 A change in the price of another good these
resources could make affects the opportunity
cost of making the good.
3. The Technology Used to Make the Good
 If better technology is discovered, the cost of
production fails, making this market more
profitable.
4. Producer Expectations
 Expecting higher prices in the future might
prompt some producers to reduce their current
supply while awaiting the higher price.
5. The Number of Sellers in the Market
 Any change in the environment also affect the
number of suppliers in that market
(government actions).
ELASTICITY OF DEMAND
Demand Function
 Mathematical expression that shows the
dependent relationship of quantity demanded
to price.
 Qd=a−bP
where Qd = quantity demand
a = maximum quantity that a consumer
is willing to get if the good were free (or
if the price is zero)
b = slope of the demand equation
(quantity demand per unit change in
price)
P = price of a good
 A change in quantity demanded result in a
change in price, holding the nonprice
determinants as constant.
Example: Qd=100−2 P
Qd=100−2 ( 25 )
Qd=100−50
Qd=50
 Price of Rice per Kilo (in Quantity Demanded of Relationship of
Responsivenes
Pesos) Rice (in kilos) εP % ∆ QD to Demand
s of QD to P
20 60 %∆P
25 50 Very
30 40
ε P >1 % ∆ QD> % ∆ P Elastic
Responsive
35 30 % ∆ QD> % ∆ P Extremely Perfectly
40 20 ε P=∞
but % ∆ P=0 Responsive Elastic
Same
Elasticity of Demand ε P=1 % ∆ QD=% ∆ P Unitary
Responsiveness
 Measures of the extent of responsiveness in Weakly
ε P <1 % ∆ QD< % ∆ P Inelastic
quantity demanded to changes in price of Responsive
goods. % ∆ QD< % ∆ P Perfectly
ε P=0 Not Responsive
 Percent change in quantity demanded divided but % ∆ QD=0 Inelastic
by the percent change in price.
% ∆QD Effect of Price Elasticity of Demand on Total Revenue
 PED=¿ ∨¿ or
%∆P Relationship of Effect on
Action of
Demand % ∆ QD to Total
Q D2−D1 Price
%∆P Revenue
D1 Decrease Increase
PED= Elastic % ∆ QD> % ∆ P
P2−P1 Increase Decrease
P1 Increase Constant
Unitary % ∆ QD=% ∆ P
QD 2−QD1 Decrease (no effect)
(QD 1+ QD2 ) Increase Increase
Inelastic % ∆ QD< % ∆ P
2 Decrease Decrease
 Midpoint Formula: PED=
P 2−P1
The Demand Curve and the Price Elasticity
(P1+ P 2)
2
 Unit Elastic – if equal to 1.0
o Reducing the price causes quantity demand
to increase and the total revenue remain
unchanged.
 Elastic – if greater than 1.0
o Reducing the price will cause quantity
demand to increase and the total revenue
will increase.
 Inelastic – if less than 1.0
o Reducing the price will cause quantity
Example:
demand to increase but the total revenue
Month Price QD ∆P ∆ QD PED
will fall.
Jan 15 600
 Perfectly Inelastic – if equal to 0 Feb 16 570 0.07 -0.05 -0.71
o Increasing the price makes the quantity March 17 540 0.06 -0.05 -0.83
demand to remain the same. April 18 520 0.06 -0.04 -0.67
 Perfectly Elastic – if equal to ∞ May 19 510 0.06 -0.02 -0.33
o Where a very small change in price causes
the quantity demand to become 0.
Summary of Price Elasticity of Demand
Interpretation: The good / product is inelastic, Interpretation: Since the IED is negative and less than 0,
therefore an increase in price will decrease the quantity we could say that the good / product is an inferior good
demanded and the firm will profit a little (breakeven). to the people.

INCOME ELASTICITY OF DEMAND ELASTICITY OF SUPPLY

Income Elasticity of Demand Elasticity of Supply
 Measures the responsiveness in quantity  Measures of the responsiveness of quantity
demanded of an item to changes in income. supplied to a price change; the percent change
% ∆ QD in quantity supplied divided by the percent
 IED=¿ ∨¿ or
%∆ Y change in price.
QS 2−QS 1
QD2−QD 1
% ∆ QS QS1
QD 1  PES=¿ ∨¿ or PES=
IED= %∆P P 2−P1
Y 2−Y 1
Y1 P1
 Normal and Superior Good – with IED>0;  Unit Elastic – if equal to 1.0
increases in demand/expenditure when there is o Increases in price will also be an equal
an increase in income; positive relationship. increase in quantity supplied.
 Necessity – with IED<1; income inelastic;  Elastic – if greater than 1.0
increases in income will increase the o An increase in price would lead to a higher
expenditure in a less proportionate level. increase in quantity supplied.
 Inferior - IED<0; decrease in demand when  Inelastic – if less than 1.0
there is an increase in income; negative o A large increase in price will cause quantity
relationship. supply to increase but very minimal.
 Luxury - IED>1; when the income increases  Perfectly Elastic – if equal to ∞
expenditures also increases. o Price remains the same but the quantity
Examples: supply is infinite.
Incom Quantity  Perfectly Inelastic – if less than 0
Month ∆ Y ∆ QD IED o A chance in price, quantity supply would
e Demanded
Jan 60,323 880 remain the same.
Feb 55,128 840 -0.09 -0.05 0.56 The Demand Curve and the Price Elasticity
March 42,077 800 -0.24 -0.05 0.21
April 33,011 770 -0.22 -0.04 0.18

Interpretation: Since the IED is positive and less than 1,

we could say that the good / product is
normal/necessary goods to the people.

Incom Quantity
Month ∆Y ∆ QD IED
e Demanded
Jan 60,323 880
Feb 55,128 900 -0.09 0.02 -0.22
March 42,077 990 -0.24 0.1 -0.42
April 33,011 1,000 -0.22 0.01 -0.05
Summary of Price Elasticity of Supply
May 22,300 1,200 -0.32 0.2 -0.63
Relationship of
Responsivenes
εS % ∆ QS to Demand
s of QS to P
%∆P
 Very them with higher prices; higher than the
ε S >1 % ∆ QS>% ∆ P Elastic
Responsive equilibrium price; lowest price set by the
% ∆ QS>% ∆ P Extremely Perfectly government at which buyers can buy the good.
ε S=∞
but % ∆ P=0 Responsive Elastic Example: Market Schedule of Pizza Per Week
Same Quantity
ε S=1 % ∆ QS=% ∆ P Unitary Price Quantity
Responsiveness Supplied Surplus or Effect
Weakly per Demanded
ε S <1 % ∆ QS<% ∆ P Inelastic Pizza (in million)
(in Shortage on Price
Responsive million)
% ∆ QS<% ∆ P Perfectly
ε S=0 Not Responsive P150 8 28
Surplus of
Falls
but % ∆ QS=0 Inelastic 20
Surplus of
Example: P120 14 24 Falls
10
Incom Quantity Remains
Month ∆Y ∆ QS IED Equilibriu
e Supplied P90 20 20 the
Jan 700 100 m
Same
Feb 600 80 -0.14 -0.2 1.43 Shortage
March 500 60 -0.17 -0.25 1.47 P60 26 16 Rises
of 10
April 400 40 -0.2 -0.33 1.65 Shortage
May 300 20 -0.25 -0.5 2 P30 32 12 Rises
of 20

Interpretation: Since the PES is positive and more than

1, it is elastic. We could say that increase in the goods’
price would yield to higher quantity supply.

Market Equilibrium
 Equilibrium Price – price at which the quantity
demanded equals quantity supply.
 Equilibrium Quantity – quantity bought and
sold at the equilibrium price. Interpretation: The equilibrium price is P90 and the
 In equilibrium, the independent plans of the equilibrium quantity is 20. The price above the
buyers and sellers exactly match, and this is no equilibrium price, the quantity supplied exceeds the
incentives for change. quantity demanded of 10 million and 20 million. At
 Market Equilibrium – situation when the these prices, there is a surplus, which puts the
quantity consumers are willing and able to buy downward pressure on the price. At prices below the
equals the quantity producers are willing and equilibrium, quantity demanded exceeds quantity
able to sell. supplied of 10 million and 20 million which resulted
 Surplus – at a given price, the amount by which upward pressure on the price. If the demand curve
quantity supplied exceeds quantity demanded; moved to the right, and the supply curve to the left,
a surplus usually forces the price down. then the equilibrium price increased. If the demand and
 Shortage – at a given price, the amount by supply curve with the same amount, then equilibrium
which quantity demanded exceeds quantity price will remain the same.
supplied; shortage usually forces the price up.
 Price Ceiling – price lower than the equilibrium
price; highest price at which the goods can be
sold.
 Price Floor – intended to protect sellers from
the failure of the market mechanism to provide