BUS 525: Managerial Economics

Basic Primer

Dr. Sakib Bin Amin

1 Associate Professor (Economics)
Director, Accreditation Project team (APT)
North South University
7/5/2020
 What Economics Is About?

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3 What is Economics?
 Economics is the social science that studies the
choice that individuals, businesses, governments
and the entire societies make as they cope with
scarcity.
Or
 Economics is the study of how societies use scarce
resources to produce valuable commodities and
distribute them among different people.

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4 Scarcity
 Economics deal with a central problem faced by all
individuals and all societies: The problem of
scarcity
Fundamental Reason:
 Our wants far exceed our resources. So, scarcity of
resources is the key problem.
 The excess of human needs over what can actually
be produced.
 Our inability to satisfy all our wants is called
scarcity.

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5 Scarcity (Cont’d)
 The problem of scarcity means that every time we
take an economic decision (for example, how much
to consume or for a firm how much to produce of a
given good) we face some constraints that affect our
decision.
 Scarcity arises because some resources that are used
to produce goods are limited by physical space.
 For example, to produce goods and services we need
to use productive resources like Labour, Land and
Raw Materials, Capital (machines, factories,
equipment, etc.

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6 Scarcity (Cont’d)
 The amount of labour is limited both in number and
in skills.
 The world’s land area is limited and so are raw
materials (think at petrol).
 The stock of capital is limited since we have a
limited amount of factories, machines,
transportation and other equipment.
 Labour, raw Materials, land and capital are what we
call factors of production (or productive Inputs).

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7 Scarcity (Cont’d)
 Furthermore, scarcity arises from other “resources”,
like time or income (normally we cannot consume
more than what we earn, a firm may not be able to
start a new factory if it not able to get a bank loan,
etc. etc.).
 Given the limited amount of resources we con only
produce and consume a limited amount of goods
and services.

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8 Why is scarcity a problem?
 If we know that we have limited resources we
could just behave accordingly. The problem arises
because in general human wants and needs are
virtually unlimited. We all would like to have more
money to be able to consume more goods and
services. Thus, scarcity becomes a problem
because it implies that the means of fulfilling
human needs are limited.
 Therefore economists tend to define scarcity in the
following way:
“the excess of human needs over what can
actually be produced.”
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9 Scarcity (Cont’d)
 Scarcity implies that we cannot choose whatever
we want when we decide about what and how
much to consume (I cannot buy today a BMW
that costs £50000 if my total income today is
£10000, etc. etc.) or when we decide about what
and how much to produce (I cannot produce a
good that requires 1000 workers if only 100 are
available, etc. etc.).

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10 Economic Categories

Four common Economic Categories are:

1. Microeconomics
2. Macroeconomics
3. Positive Economics
4. Normative Economics

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11 Microeconomics
 Adam Smith is usually considered the founder of
the field of Microeconomics. This is the branch of
Economics, which is concerned with the behaviour
of individual entities such as markets, firms and
households.
 In The Wealth of Nations, Smith considered how
individual prices are set, studied the determination
of prices of Land, Labour and Capital, and
inquired into the strengths and weaknesses of the
market mechanism.

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12 Microeconomics (Cont’d)
 Microeconomics studies the behaviour of
individual decision-making units, the
individual, the household ,the firm, the
industry and how these agents interact in
markets.
Or
 Microeconomics is the study of the economic
behaviour of single units (a consumer, a
household, a firm, a particular industries, etc.)
and of the interrelationship between those
units.

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13 Microeconomics (Cont’d)
 A micro economist might be interested in
answering such questions as:
 How does a market work?
 What level of output does a firm produce?
 What price does a firm charge for the good it
produces?
 How does a consumer determine how much of a
good he/she will buy?
 Can government policy affect business and
consumer behaviour?

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14 Macroeconomics
 Macroeconomics is the study of the entire economy
in terms of the total amount of goods and services
produced, total income earned, the level of
employment of productive resources, and the general
behavior of prices.
 Macroeconomics can be used to analyse how best to
influence policy goals such as economic growth,
price stability, full employment and the attainment of
a sustainable balance of payments.
 Rather than worrying about why the price of
gasoline has risen or fallen over the last several days
macroeconomics is concerned with the inflation rate,
a measure of how the average price of all goods and
services has changed.
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15 Macroeconomics (Cont’d)
A Macroeconomist might be interested in answering
such questions as:
 How does the economy work?
 Why is the unemployment rate sometimes high and
sometimes low?
 What causes inflation?
 Why do some national economies grow faster than
other national economies?
 What might cause interest rates to be low one year
and high the next?
 How do the changes in the money supply affect the
economy?

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16 Micro vs. Macro
 Macroeconomics and Microeconomics are
obviously related and the distinction between them
is not as sharp as it looks at first sight.

 In ECO 101 we will deal with microeconomic

problems whereas in ECO 104 will study
macroeconomic problems.

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17 Positive Economics
 Positive economics involves ‘if-then’ statements: e.g.
“a tax on cigarettes will cause the price to rise and the
quantity consumed to fall”.
 Positive economics attempts to determine What is. It
also attempts to describe how the economy functions.
Generally, it relies on testable hypotheses.
 Essentially positive economics deal with cause-effect
relationships that can be tested.

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18 Normative Economics
 Normative economics makes recommendations
about what should be based on value judgments:
e.g. “the government should put more tax on
cigarettes to cut smoking”.
 Normative economics deals with value judgments
and opinions that can not be tested.

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19 Positive and Normative Economics
 Many topics in Economics can be discussed within
both a positive framework and a normative
framework.
 Let us consider a propose cut in Income Taxes.
 An economist practicing positive economics would
want to know the effect of a cut in income taxes,
whether it affect the unemployment rate, economic
growth, inflation and so on.
 An economist practicing normative economics
would address issues that directly or indirectly relate
to whether income tax should be cut.
 He may mention that income tax should be cut
because the burden is currently very high.
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20 Rationality
 Each individuals select the choices that make them
happiest, given the information available at the time
of a decision.
 Every economic decisions have been made by
rationality.
 We assume that people act in their own rational self
interest. People make the choices they believe leave
them best off.

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21 Three Basic Questions of Economics
All Economic systems must have some way of
answering 3 basic questions:
1. What goods and services are produced and in
what quantities?
2. How are the goods and services produced and
who produces them?
3. Who gets the goods and services that are
produced?

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22 Three Basic Questions of Economics
What goods and services are produced and in
what quantities?
 A society must determine how much of each of
the many possible goods and services it will
make, and when they will be produced? Will we
produce pizzas and or shirts today?
 A few high quality shirts or many cheap shirts?
 Will we use scarce resources to produce many
consumption goods( like pizzas)?

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23 Three Basic Questions of Economics
How are the goods and services produced
and who produces them?
 A society must determine who will do the
production, with what resources, and what
production techniques they will use.
 Whether we will apply the labour intensive
technology or capital intensive technology?

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24 Three Basic Questions of Economics

Who gets the goods and services that are

produced?
 Who gets to eat the fruit of economic activity?
 How is the national product divided among
different households?

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25 Three Basic Questions of Economics

There are two extreme systems for answering

these questions. In a command economy, the
Government decides all the answers. In a market
economy, the questions get answered through the
interaction of buyers and sellers in the market

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26 Market Economy
 A market economy is one in which individuals and
private firms make the major decisions about
production and consumption.
 Firms produce the commodities that yield the highest
profits ( the what) by the techniques of production
that are least costly(the how).
 Consumption is determined by individuals’ decisions
about how to spend the wages and property incomes
generated by their labour and property ownership( the
for whom)

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27 Market Economy (Cont’d)
 A free-market economy is an economy where agents
decide for themselves which product to produce or
to buy. Another way to say the same thing: a free-
market economy is an economy where property
rights are voluntarily exchanged at a price arranged
completely by the mutual consent of sellers a
buyers.
 The extreme case of a market economy, in which
the government keeps it hands off economic
decisions is called a laissez-faire economy.

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28 Command Economy
 By contrast, a command economy is one in which
the government makes all important decisions
about production and distribution through its
ownership of resources and its power to enforce
decisions.
 A typical example of such an economy was the
Soviet Union before the 1989, or nowadays, Cuba
and North Korea.

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 Command Economy (Cont’d)
29

 In a planned economy all the relevant economic

decisions are made centrally, by an individual or a
small number of individuals on behalf of a larger
group of people. In general a central planner or
government would establish the production target for
the country’s factories, would develop master plan for
how to achieve those targets and would set up
guidelines for the distribution and use of the goods
and services produced (in the ancient Soviet Union
those targets were set up on a 5 year base.
 All the productive sectors are nationalised (under the
direct control of the government) and so individuals
are not free to start their own businesses as they do in
free-market economy. 7/5/2020
30 Mixed Economies
 The free market and the planned economies
represent two extremes of how to organize economic
activity in a given economy. In reality, most of the
economies we see can be called mixed economies.
 A mixed economy is an economy where not all the
economic decisions are left to the private individuals
but governments intervene as well.
 There has never been a 100 percent market economy
( although nineteenth-century England came close).

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31 Economic Resources
Economists divide resources into four broad
categories:
1. Land
2. Labour
3. Capital and
4. Entrepreneurship
Sometimes resources are referred to as inputs or
factors of production

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 Economic Resources
32
 Land Includes natural resources, such as minerals, forests,
water, and unimproved land. For example, oil, wood and
animals fall into this category.
 Labour consists of the physical and mental talents people
contribute to the production process. For example, a person
building a house is using his or her own labour.
 Capital consists of produced goods that can be used as
inputs for further production. Factories, machinery, tools,
computers and buildings are examples of capital.
 Entrepreneurship refers to the particular talent that some
people have for organizing the resources of land, labour, and
capital to produce goods, seek new business opportunities,
and develop new ways of doing things.
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33 Economic Resources (Cont’d)

Economic Resource Resource payment

land rent
labor wages
capital interest
entrepreneurial ability profit

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34 Logical Fallacies
The following are some of the common fallacies
encountered in Economics reasoning:
1. The post hoc fallacy
2. Failure to hold other things constant
3. The fallacy of composition

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 Logical Fallacies
35

 The post hoc fallacy occurs when we assume that,

because one event occurred before another event, the
first event caused the second event.
A Post Hoc is a fallacy with the following form:
1. A occurs before B
2. Therefore A is the cause of B
 Remember to hold other things constant when you are
analyzing the impact of a variable on the economic
system.
 When you assume that what is true for the part is also
true for the whole, you are committing the fallacy of
composition. 7/5/2020
36 Opportunity Cost
 Opportunity cost of any action: is the best or next
highest ranked alternative foregone because of
choosing the given action.
 Another way to say the same thing: an opportunity
cost is the cost of any activity measured in terms
of the best alternative foregone.
 Opportunity costs arise because time and
resources are scarce. Nearly all decisions involve
Trade-offs.

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37 Opportunity Cost
 For example, the opportunity cost for a student that
buys the textbook for Eco 101 may be a new pair of
jeans that he could have bought instead. Obviously
we should consider only the best alternative in
evaluating the opportunity cost.
 For example, if the best alternative was to go to a
restaurant and buy a dinner with the money spent for
the book, then the opportunity cost I represented by
the dinner and NOT by the pair of jeans.

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38 Marginalism
 In weighing the costs and benefits of a decision,
it is important to weigh only the costs and
benefits that arise from the decision.
 For example, when deciding whether to produce
additional output, a firm considers only the
additional cost (or marginal cost) with the
additional benefit.

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39 Marginalism
 Marginal benefit = additional benefit resulting
from a one-unit increase in the level of an activity
 Marginal cost = additional cost associated with
one-unit increase in the level of an activity
 According to economists, when individual make
decisions by comparing marginal benefits to
marginal costs, they are making decisions at the
margin.
 MB > MC  expand the activity
 MB < MC  contract the activity

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40 Efficiency
 Optimal level of activity: MB = MC (Net benefit
is maximized at this point). This is the efficient
amount of output.
 Suppose we are studying for an economist test:
 If MB Studying first hour> MC studying first hour;
keep studying.
 If MB Studying second hour> MC studying second
hour; keep studying.
 You should stop reading when MB=MC. This is
where efficiency is achieved.

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41 Efficiency

MB, MC of Studying
MC

MB=MC

MB>MC MC>MB

MB of Studying

Time Spent
3 Hrs Studying (Hrs)
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42
Working with Diagrams and Slope:
Positive and Negative Relationships

An upward-sloping
line describes a
positive relationship
between X and Y

A downward sloping
line describes a
negative relationship
between X and Y

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43 Working with Diagrams and Slope:
The Component of a Line
• The algebraic expression of this line is as
follows:
Y = a + bX
where:
Y = dependent variable
X = independent variable
a = Y-intercept, or value of
Y when X = 0.
+ = positive relationship
between X and Y
Y Y1  Y0
b=  b = slope of the line, or the
 X X1  X 0 rate of change in Y
given a change in X.
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44 Working with Diagrams and Slope:
Strength of the Relationship Between X and Y
• This line is relatively flat. Changes
in the value of X have only a small
influence on the value of Y.

• This line is relatively steep.

Changes in the value of X have a
greater influence on the value of
Y.

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45
Working with Diagrams and Slope:
Different Slope Values
5 7
b  0.5 b    0.7
10 10

0
b 0 b
10

10 0

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Demand Supply & Equilibrium Analysis

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 Demand
47

 A relationship between price and quantity

demanded in a given time period, ceteris
paribus.

 Ceteris paribus is a Latin phrase that means all

variables other than the ones being studied are
assumed to be constant. Literally, ceteris
paribus means “other things being equal.”

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48 Demand Schedule

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49 Demand Curve

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50 Market Demand
 Market demand refers to the sum of all individual
demands for a particular good or service.

 Graphically, individual demand curves are summed

horizontally to obtain the market demand curve.

 Market demand is the horizontal summation of

individual consumer demand curves

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51 Market Demand Curve

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52 Two Simple Rules for Movements vs. Shifts

 Rule One
When an independent variable changes and
that variable does not appear on the graph, the
curve on the graph will shift.
 Rule Two
When an independent variable does appear on
the graph, the curve on the graph will not shift,
instead a movement along the existing curve
will occur.

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 Change in Quantity Demanded versus Change
53
in Demand

Change in Quantity Demanded

Movement along the demand curve.
Caused by a change in the price of the product.

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 Changes in Quantity Demanded
54

Price of
Cigarettes A tax that raises the price
per Pack
of cigarettes results in a
C movement along the
$4.00
demand curve.

2.00 A

D1

0 12 20 7/5/2020
Number of Cigarettes
Smoked per Day
55 Change in Quantity Demanded versus Change
in Demand

Change in Demand
 A shift in the demand curve, either to the left or right.
 Caused by a change in a determinant other than the
price.

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56 Shift in Demand Curve

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57 Determinants of Demand

 Market price
 Consumer income
 Prices of related goods
 Tastes
 Expectations of Future Price and
Income

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 Consumer Income (Normal Good)
58
Price of
Ice-Cream
Cone
$3.00 An increase
2.50 in income...
Increase
2.00 in demand

1.50

1.00

0.50 D2
D1
Quantity of
0 1 2 3 4 5 6 7 8 9 10 11 12 7/5/2020
Ice-Cream
Cones
 Consumer Income (Inferior Good)
59
Price of
Ice-Cream
Cone
$3.00

2.50 An increase
2.00
in income...
Decrease
1.50 in demand
1.00

0.50
D2 D1
Quantity of
0 1 2 3 4 5 6 7 8 9 10 11 12 7/5/2020
Ice-Cream
Cones
60
Prices of Related Goods
Substitutes & Complements

 When a fall in the price of one good reduces the

demand for another good, the two goods are
called substitutes. On the other hands an increase
in the price of one results in an increase in the
demand for the other.
 When a fall in the price of one good increases the
demand for another good, the two goods are
called complements. an increase in the price of
one results in a decrease in the demand for the
other. 7/5/2020
 Change in the Price of a Substitute Good
61

 Price of coffee rises:

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62 Change in the Price of a Complementary
Good
 Price of DVDs rises:

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 Demand and the Number of Buyers
63

An increase in the number of buyers results in

an increase in demand.

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 Expectations
64

 A higher expected future price will increase

current demand.
 A lower expected future price will decrease
current demand.
 A higher expected future income will
increase the demand for all normal goods.
 A lower expected future income will reduce
the demand for all normal goods.

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 Change in Quantity Demanded versus
65 Change in Demand

Variables that A Change in

Affect Quantity
Demanded This Variable . . .
Price Represents a movement
along the demand curve
Income Shifts the demand curve
Prices of related Shifts the demand curve
goods
Tastes Shifts the demand curve
Expectations Shifts the demand curve
Number of Shifts the demand curve
buyers
 Supply
66

The relationship that exists between the price

of a good and the quantity supplied in a given
time period, ceteris paribus.

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67 Supply

Quantity supplied is the amount of a good that

sellers are willing and able to sell.

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68 Supply Schedule

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69 Law of Supply

The law of supply states that there is a direct

(positive) relationship between price and
quantity supplied.

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 Change in Quantity Supplied
70
Price of
Ice-Cream S
Cone

C
$3.00 A rise in the
price of ice
cream cones
results in a
movement along
A the supply
1.00
curve.

Quantity of
0 1 5 7/5/2020
Ice-Cream
Cones
 Change in Supply
71
S3
Price of
Ice-Cream S1
S2
Cone

Decrease in
Supply

Increase in
Supply

Quantity of
0 7/5/2020
Ice-Cream
Cones
72 Market Supply

Market supply refers to the sum of all

individual supplies for all sellers of a particular
good or service.
Graphically, individual supply curves are
summed horizontally to obtain the market
supply curve.

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73 Determinants of Supply

 Market price
 Input prices
 Technology
 Expectations
 Number of producers

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74
Change in Quantity Supplied versus Change in
Supply

Variables that
Affect Quantity A Change in This Variable . . .
Supplied
Price Represents a movement
along the supply curve
Input prices Shifts the supply curve
Technology Shifts the supply curve
Expectations Shifts the supply curve
Number of sellers Shifts the supply curve
 Price of Inputs
75

 As the price of a inputs rises, profitability

declines, leading to a reduction in the quantity
supplied at any price.

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76 Technological Improvements
 Technological improvements (and any changes
that raise the productivity of labor) lower
production costs and increase profitability.

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77 Expectations and Supply

 An increase in the expected future price of

a good or service results in a reduction in
current supply.

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 Increase in the Number of Sellers
78

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 79
Equilibrium of
Price of
Supply and Demand
Ice-Cream
Cone
Supply
$3.00

2.50 Equilibrium

2.00

1.50

1.00

0.50 Demand
Quantity of
0 1 2 3 4 5 6 7 8 9 10 11 12 7/5/2020
Ice-Cream
Cones
 80 Excess Supply
Price of
Ice-Cream
Cone
Supply
$3.00 Surplus

2.50

2.00 If the price exceeds the

equilibrium price, a surplus
occurs:
1.50

1.00

0.50 Demand
Quantity of
0 1 2 3 4 5 6 7 8 9 10 11 12 7/5/2020
Ice-Cream
Cones
 81 Excess Demand

Price of If the price is below the

Ice-Cream equilibrium a shortage
Cone
occurs:
Supply

$2.00

$1.50

Shortage Demand

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity7/5/2020
of
Ice-Cream Cones
82 Three Steps To Analyzing
Changes in Equilibrium

 Decide whether the event shifts the supply or demand

curve (or both).
 Decide whether the curve(s) shift(s) to the left or to the
right.
 Examine how the shift affects equilibrium price and
quantity.

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 Demand Rises
83

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 Demand falls
84

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85 Supply rises

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86 Supply Falls

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 How an Increase in Demand Affects the
87 Equilibrium
Price of 1. Hot weather increases
Ice-Cream the demand for ice cream...
Cone

Supply

$2.50 New equilibrium

2.00
2. ...resulting Initial
in a higher equilibrium
price...
D2

D1
0 7 10 Quantity
7/5/2020of
3. ...and a higher Ice-Cream Cones
quantity sold.
 How a Decrease in Supply Affects the
88 Equilibrium
Price of
Ice-Cream 1. An earthquake reduces
Cone the supply of ice cream...
S2
S1

New
$2.50 equilibrium

2.00 Initial equilibrium

2. ...resulting
in a higher
price...
Demand

0 1 2 3 4 7 8 9 10 11 12 13 Quantity of
7/5/2020
3. ...and a lower Ice-Cream Cones
quantity sold.
89 Price Ceiling
 Price ceiling - legally mandated
maximum price
 Purpose: keep price below the market
equilibrium price
 Examples:
• rent controls
• price controls during wartime
• gas price rationing in 1970s

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 Price Ceiling (continued)
90

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 Price Floor
91

price floor - legally mandated minimum

price
designed to maintain a price above the
equilibrium level
examples:
• agricultural price supports
• minimum wage laws

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92 Price Floor (continued)

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Elasticity and Its Application
 What is an Elasticity?
 Measurement of the percentage change in one variable
that results from a 1% change in another variable.

 When the price rises by 1%, quantity demanded might

fall by 5%.

 The price elasticity of demand is -5 in this example.

 Types of Elasticity

1.Elasticity of Demand
i) Price Elasticity of Demand
ii) Income Elasticity of Demand
iii) Cross Price Elasticity of Demand

2.Elasticity of Supply
 Price Elasticity of Demand
 Price elasticity of demand is the percentage change in
quantity demanded given a percent change in the price.

 It is a measure of how much the quantity demanded of

a good responds to a change in the price of that good.
 Price Elasticity of Demand

Q / Q Q P
 
P / P P Q

•The price elasticity of demand is always negative.

•Economists usually refer to the price elasticity of demand by its

absolute value (ignore the negative sign).
 Computing the Price Elasticity of Demand

Percentage change in quatity demanded

Price elasticity of demand 
Percentage change in price

Example: If the price of an ice cream cone increases

from $2.00 to $2.20 and the amount you buy falls from 10
to 8 cones then your elasticity of demand would be
calculated as:

(8  10)
100
10 20 percent
 2
(2.20  2.00)
100 10 percent
2.00
 Price elasticity of demand

Unit elastic

Inelastic Elastic
0 1 2 3 4 5 6

Demand is said to be:

elastic when Ed > 1,
unit elastic when Ed = 1, and
inelastic when Ed < 1.
 Inelastic Demand
 Inelastic demand
 The percentage change in quantity is less than the
percentage change in price.
 Price elasticity of demand < 1
 Inelastic Demand
- Elasticity is less than 1
Price

1. A 25% $5
increase
in price... 4

Demand

90 100 Quantity
2. ...leads to a 10% decrease in quantity.
 Elastic Demand
 Elastic demand
 The percentage change in quantity is greater than
the percentage change in price.
 Price elasticity of demand > 1
 Elastic Demand
- Elasticity is greater than 1
Price

1. A 25% $5
increase
in price... 4

Demand

50 100 Quantity
2. ...leads to a 50% decrease in quantity.
 Unit Elastic Demand

 Unit elasticity
 The percentage change in quantity equals the percentage
change in price.
 Price elasticity of demand = 1
 Unit Elastic Demand
- Elasticity equals 1
Price

1. A 25% $5
increase
in price... 4

Demand

75 100 Quantity
2. ...leads to a 25% decrease in quantity.
The flatter the demand curve, the more price elastic is the
demand.

P P

flatter steeper

Qd Qd

The flatter the demand Hence, the flatter the

curve, the more room demand curve, the more
there is for the quantity responsive is the quantity
to adjustment. to a price change.
 Perfectly Elastic Demand
- Elasticity equals infinity
Price
1. At any price
above $4, quantity
demanded is zero.

$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

3. At a price below $4, Quantity

quantity demanded is infinite.
 Perfectly Inelastic Demand
- Elasticity equals 0
Price Demand

1. An $5
increase
in price... 4

100 Quantity
2. ...leaves the quantity demanded unchanged.
 Examples of Demand Elasticity

 When the price of gasoline rises by 1% the

quantity demanded falls by 0.2%, so gasoline
demand is not very price sensitive.
Price elasticity of demand is -0.2 .
 When the price of gold jewelry rises by 1% the
quantity demanded falls by 2.6%, so jewelry
demand is very price sensitive.
Price elasticity of demand is -2.6 .
 Determinants of
Price Elasticity of Demand

 Necessities versus Luxuries

 Availability of Close Substitutes
 Time Horizon
 Determinants of
Price Elasticity of Demand
Demand tends to be more elastic :

 if the good is a luxury.

 the longer the time period.
 the larger the number of close substitutes.
 Determinants of Price Elasticity of
Demand
 Demand tends to be more inelastic

 If the good is a necessity.

 If the time period is shorter.
 The smaller the number of close substitutes.
 Computing the Price Elasticity of
Demand Using the Midpoint Formula
The midpoint formula is preferable when calculating the
price elasticity of demand because it gives the same answer
regardless of the direction of the change.

(Q 2  Q 1 )/[(Q 2  Q 1 )/2]
P rice Elasticity of Demand =
(P2  P1 )/[(P 2  P1 )/2]
 Computing the Price Elasticity of
Demand
(Q 2  Q 1 )/[(Q 2  Q 1 )/2]
P rice Elasticity of Demand =
(P2  P1 )/[(P 2  P1 )/2]
Example: If the price of an ice cream cone increases
from $2.00 to $2.20 and the amount you buy falls from 10
to 8 cones the your elasticity of demand, using the
midpoint formula, would be calculated as:

(10  8)
(10  8) / 2 22 percent
  2.32
(2.20  2.00) 9.5 percent
(2.00  2.20) / 2
 Elasticity and Total Revenue

 Total revenue is the amount paid by buyers and

received by sellers of a good.
 Computed as the price of the good times the
quantity sold.

TR = P x Q
 Elasticity and Total Revenue
Price

$4

P x Q = $400
P (total revenue)
Demand

0 100 Quantity
Q
 Elasticity and Total Revenue
 If demand is elastic in the relevant range of prices, price and
total revenue vary inversely.

 That is, a price increase will decrease total revenue.

 An elastic demand means that the percentage change in

quantity demanded is greater than the percentage change in
price.

 Hence, an increase in price will result in a more than

offsetting percentage decrease in quantity taken.

Elastic:
p q TR
 Elasticity and Total Revenue
 If demand is inelastic in the relevant range of prices,
price and total revenue vary directly.

 That is, a price increase will increase total revenue.

 An inelastic demand means that the percentage change in

quantity demanded is less than the percentage change in price.

 Hence, an increase in price will result in a less than offsetting

percentage decrease in quantity taken.

Inelastic:
p q TR
 Elasticity and Total Revenue
 If demand is unitary in the relevant range of prices, total
revenue does not change in response to price changes.

 A unitary own-price elasticity of demand means that

the percentage change in quantity demanded is equal
to the percentage change in price.

 Hence, an increase in price will result in an offsetting

percentage decrease in quantity taken.

Unitary: TR
p q
STAYS
The Total Revenue Test for Elasticity

Increase in Decrease in
Total Revenue Total Revenue

Increase in INELASTIC ELASTIC

Price DEMAND DEMAND

Decrease in ELASTIC INELASTIC

Price DEMAND DEMAND
 Income Elasticity of Demand

 Income elasticity of demand measures how

much the quantity demanded of a good
responds to a change in consumers’ income.
 It is computed as the percentage change in the
quantity demanded divided by the percentage
change in income.
 Computing Income Elasticity

Percentage Change
Income Elasticity in Quantity Demanded
of Demand =
Percentage Change
in Income
 Income Elasticity
- Types of Goods -
 Normal Goods
Income Elasticity is positive.
 Inferior Goods
Income Elasticity is negative.
 Higher income raises the quantity demanded for
normal goods but lowers the quantity demanded for
inferior goods.
 Cross Price Elasticity of Demand
 Elasticity measure that looks at the impact a change in
the price of one good has on the demand of another
good.
 % change in demand Q1/% change in price of Q2.
 Positive-Substitutes
 Negative-Complements.
 Cross-Price elasticity (cont.)

Cross-price elasticity is positive if and only if the

goods are substitutes
Cross-price elasticity is negative if and only if the
goods are complements.