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ECONOMICS & DECISION MAKING

Dr. R. JAYARAJ, M.A., Ph.D.,


COMES, UPES

What Is Economics?
Economics is the study of how people choose to use resources.
Resources include the time and talent people have available,
the land, buildings, equipment, and other tools on hand, and
the knowledge of how to combine them to create useful
products and services.
Important choices involve how much time to devote to work, to
school, and to leisure, how many dollars to spend and how
many to save, how to combine resources to produce goods and
services, and how to vote and shape the level of taxes and the
role of government.
Often, people appear to use their resources to improve their
well-being. Well-being includes the satisfaction people gain
from the products and services they choose to consume, from
their time spent in leisure and with family and community as
well as in jobs, and the security and services provided by
effective governments. Sometimes, however, people appear to
use their resources in ways that don't improve their well-being.

Definitions of Economics
In short, economics includes the study of labor, land, and
investments, of money, income, and production, and of taxes
and government expenditures. Economists seek to measure
well-being, to learn how well-being may increase overtime, and
to evaluate the well-being of the rich and the poor.
The most famous book in economics is the Inquiry into the
Nature and Causes of The Wealth of Nations written by Adam
Smith, and published in 1776 in Scotland.
The term wealth has a special meaning in Economics. In the
ordinary language, by wealth, we mean money, but in
economics, wealth refers to those goods which satisfy
human wants. But we should remember all goods which satisfy
human wants are not wealth. For example, air and sunlight are
essential for us. We cannot live without them. But they are not
regarded as wealth because they are available in abundance
and unlimited in supply. We consider only those goods which are
relatively scarce and have money value as wealth.

"Economics is the study of people in the ordinary business


of life.-- Alfred Marshall, Principles of economics; an
introductory volume (London: Macmillan, 1890)

"Economics is the science which studies human behaviour


as a relationship between given ends and scarce means
which have alternative uses.-- Lionel Robbins, An Essay on
the Nature and Significance of Economic Science (London:
MacMillan, 1932)

Economics is the "study of how societies use scarce


resources to produce valuable commodities and distribute
them among different people.-- Paul A. Samuelson,
Economics (New York: McGraw-Hill, 1948)

What do my students have to say


about Economics?

Economics is studying how people choose to spend their


limited incomes on unlimited wants.
Economics is about the world around us, how people spend
their money to benefit themselves. However, its complicated
and makes life very difficult for us.
Economics is about the economy and how it works. It seems
to be purely about efficiency.
Economics is about the relationship between producers &
consumers and the way in which the forces of supply &
demand affect prices & products in the economy.
Economics is the study of how a country runs globally and
within itself. How we use our limited resources ( in our country &
globally ) to satisfy the infinite wants of people living within the
country.
Economics is the rotation, management and analysis of

Economics does require a brain! Dont be fooled.


Economics is an interesting social science that is relevant to
our everyday lives. As you start learning more about it, you will
realise how it does apply to our lives.
Economics is awesome because of the deeper understanding
it helps us to reach the way we function in our daily lives.
Economics is about discovering new things, understanding
them and challenging those we believe in as a global
economy.
Economics is everywhere.
Economics is a way of looking at how societies organise
And finally, If your demand for the best quality education is
inelastic, UPES has the supply. Make the right decision.

Difference between Micro and


Macroeconomics

Macro and microeconomics are the two vantage points from which
the economy is observed.
Macroeconomics looks at the total output of a nation and the
way the nation allocates its limited resources of land, labor and
capital in an attempt to maximize production levels and
promote trade and growth for future generations. After
observing the society as a whole, Adam Smith noted that there
was an "invisible hand" turning the wheels of the economy: a
market force that keeps the economy functioning.
Microeconomics looks into similar issues, but on the level of the
individual people and firms within the economy. It tends to
be more scientific in its approach, and studies the parts that
make up the whole economy. Analyzing certain aspects of
human behaviour, microeconomics shows us how individuals
and firms respond to changes in price and why they
demand what they do at particular price levels.

Managerial Economics vs. Microeconomics:


Common and Different
Computer Manufacturer (e.g.: IBM)
Similar concepts
Microeconomics

In which way were the prices set?

Managerial Economics

How should the prices be set?

The
Thenature
natureof
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managerialeconomic
economicdecision
decisionmaking
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The
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roleof
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economicsin
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Economic
Economicconcepts
concepts
Theory
Theoryof
ofconsumer
consumer
behaviour
behaviour
Theory
Theoryof
offirm
firm
Theory
of
market
structures
Theory of market structures
and
andpricing
pricing

Managerial Economics
Is a Tool for Improving
Management Decision
Making

Managerial
Managerialdecision
decision
problems
problems
Product
Productprice
priceand
andoutput
output
Make
or
buy
Make or buy
Production
Productiontechnique
technique
Internet
strategy
Internet strategy
Advertising
Advertisingmedia
mediaand
and
intensity
intensity
Investment
Investmentand
andfinancing
financing

Managerial
ManagerialEconomics
Economics
Use
of
economics
Use of economicsconcepts
concepts
and
decision
making
and decision makingtools
toolsto
to
solve
managerial
decision
solve managerial decision
problems
problems
Optimal
Optimalsolutions
solutions

Decision
Decisionmaking
makingtools
tools
Numerical
Numericalanalysis
analysis
Statistical
analysis
Statistical analysis
Forecasting
Forecasting
Game
Gametheory
theory
Optimisation
Optimisation

Categories of Basic
Principles of Economics
How do people make decisions?
How do people interact?
How does the economy work overall?

Principles of Economics
How Do People Make
Decisions?
Principle #1 - People face tradeoffs

Time allocation an example of


tradeoffs

Efficiency versus equity

Production Possibilities Frontier

Principle #2 - The cost of something is


what you have to give up to get it

Opportunity costs come from Von


Weiser, a German economist late
1800s

Opportunity costs are independent of


monetary units

The real costs of going to college

Principle #3 - Rational people think at


the margin

Rational or irrational decision-making

Marginal benefits and costs versus


total benefits and costs

Weighing marginal costs and benefits


leads to maximizing net benefits (total
welfare)

Principle #4 People respond to


incentives

Reactions to changes in marginal


benefits and costs

Increases (decreases) in marginal


benefits mean more (less) of an
activity

Increases (decreases) in marginal


costs mean less (more) of an activity

How Do People Interact?


Principle #5 - Trade can make
everybody better off

Adam Smith author of the An Inquiry


into the Causes and Consequences of
the Wealth of Nations 1776

Gains from the division of labor and


specialization

Mercantilists perspectives

Markets

Principles 1-5 combine with markets to


turn the pursuit of self-interest into
promoting the interests of society

Adam Smith and the invisible hand

creativity and productivity are


stimulated by the pursuit of selfinterest into improving resource
allocations

in some cases markets fail to allocate


resources effectively

Principle #6 - Markets are usually a good


way of organizing economic activity

Feudal (military security) times where


feudal states were self-supporting, also
haciendas (domestic factory) in the new
world

the benefits of trade are so powerful that


people began to trade

markets for economists are more


abstract than the notion of a middle
eastern bazaar or a flea market and
simply determine the prices and
quantities traded of different goods
and services

Principle #7 Governments can


sometimes improve interaction that
occurs in markets

there are circumstances when market


signals fail to allocate resources
efficiently or equitably

Public Goods, Externalities and Income


Distribution

Some goods or services that people


desire will not be produced by markets
(e.g. light houses).

Some goods or services will either be


under produced (vaccines) or
overproduced (pollution) because
markets fails to register certain benefits
or costs.

How Does the Economy


Work as a Whole?
Principle # 8 A countrys standard of
living depends upon its ability to
produce goods and services

Adam Smiths An Inquiry into the


Nature and the Consequences of the
Wealth of Nations

wealth: a necessary or sufficient


condition for happiness (are rich
people happier, children with lots of
toys)

productivity

Principle #9 The general level of


prices rises when the government
prints and distributes too much
money

money, the concept of inflation, and


economic language

inflation is an increase in the general


or average level of prices in an
economy

the establish of the Federal Reserve


and the introduction of sustained
inflation in the US

Principle #10 Society faces a shortrun tradeoff between inflation and


unemployment

Short-run and the long-run

demand and supply shocks

short-run increases (decreases) in


output above (below) long-run
potential output lead to adjustments

countercyclical stabilization versus


pro-cyclical destabilization

Markets
In economics, a market is not a place but
rather a group of buyers and sellers with
the potential to trade with each other

Market is defined not by its location


but by its participants

First step in an economic analysis is to


define and characterize the market or
collection of markets to analyze

Economists think of the economy as a


collection of individual markets

How Broadly Should We


Define The Market
Defining the market often requires
economists to group things together

Aggregation is the combining of a


group of distinct things into a single
whole

Markets can be defined broadly or


narrowly, depending on our purpose

How broadly or narrowly markets are


defined is one of the most important
differences between Macroeconomics
and Microeconomics

Defining Macroeconomic
Markets
Goods and services are aggregated to
the highest levels

Macro models lump all consumer


goods into the single category
consumption goods

Macro models will also analyze all


capital goods as one market

Macroeconomists take an overall view


of the economy without getting
bogged down in details

Defining Microeconomic
Markets
Markets are defined narrowly

Focus on models that define much


more specific commodities

Always involves some aggregation

But stops it reaches the highest level


of generality that macroeconomics
investigates

Buyers and Sellers


Buyers and sellers in a market can be

Households

Business firms

Government agencies
All three can be both buyers and
sellers in the same market, but are
not always

For purposes of simplification this text will


usually follow these guidelines

In markets for consumer goods, well


view business firms as the only sellers,
and households as only buyers

In most of our discussions, well be


leaving out the middleman

Demand
Demand is: the willingness and ability of
buyers to purchase different quantities of
a good at different prices during a
specific period of time.

The Law of Demand: as the price of a


good rises, quantity demanded of that
good falls; as the price of a good falls,
quantity demanded of that good rises.

Demand
A households quantity demanded of a good

Specific amount household would choose to buy


over some time period, given
A particular price that must be paid for the
good
All other constraints on the household

Market quantity demanded (or quantity


demanded) is the specific amount of a good that all
buyers in the market would choose to buy over
some time period, given

A particular price they must pay for the good

All other constraints on households

The Law of Demand


The price of a good rises and everything
else remains the same, the quantity of
the good demanded will fall

The words, everything else remains


the same are important
In the real world many variables
change simultaneously
However, in order to understand
the economy we must first
understand each variable
separately
Thus we assume that, everything
else remains the same, in order to
understand how demand reacts to
price

The Demand Schedule


Demand schedule

A list showing the quantity of a good


that consumers would choose to
purchase at different prices, with all
other variables held constant

Demand V.S. Quantities demanded


- demand is the entire relationship
between price and quantity
- quantities demanded are specific
amount of goods buyers want to buy

The Demand Curve


The market demand curve (or just
demand curve) shows the relationship
between the price of a good and the
quantity demanded , holding constant all
other variables that influence demand

Each point on the curve shows the


total buyers would choose to buy at a
specific price

Law of demand tells us that demand


curves virtually always slope downward

Figure 1: The Demand Curve


Price per
Bottle
When the price is $4.00
per bottle, 40,000 bottles
are demanded (point A).
$4.00

2.00

At $2.00 per bottle,


60,000 bottles are
demanded (point B).

D
40,000

60,000

Number of Bottles
per Month

Shifts vs. Movements


Along The Demand Curve
Move along the demand curve

From a change in the price of the


good we analyze

In maple syrup example, Figure 1

A fall in price would cause a


movement to the right along the
demand curve (point A to B)

Figure 3(a): Movements Along and


Shifts of The Demand Curve
Price
Price increase moves us
leftward along demand
curve
P2
Price increase moves us
rightward along demand
curve
P1
P3

Q2

Q1

Q3

Quantity

Shifts vs. Movements


Along The Demand Curve
Shift of demand curve

a change in other things than price of the good


causes a shift in the demand curve itself, for
example, income

In Figure 2

Demand curve has shifted to the right of the old


curve (from Figure 1) as income has risen

A change in any variable that affects demand


except for the goods pricecauses the demand
curve to shift

Figure 2: A Shift of The Demand


Curve
Price per
Bottle

An increase in income
shifts the demand curve for
maple syrup from D1 to D2.
At each price, more bottles
are demanded after the
shift

$2.00

60,000

C
D1

D2

80,000

Number of Bottles
per Month

Income: Factors That Shift


The Demand Curve
An increase in income has effect of
shifting demand for normal goods to the
right

However, a rise in income shifts


demand for inferior goods to the left

A rise in income will increase the demand


for a normal good, and decrease the
demand for an inferior good
Normal good and inferior good are
defined by the relation between demand
and income

Wealth: Factors That Shift


The Demand Curve
Your wealthat any point in timeis the
total value of everything you own minus
the total dollar amount you owe
- Example
An increase in wealth will

Increase demand (shift the curve


rightward) for a normal good

Decrease demand (shift the curve


leftward) for an inferior good

Prices of Related Goods:


Factors that Shift the
Demand Curve
Substitutegood that can be used in place of some
other good and that fulfills more or less the same
purpose

Example

A rise in the price of a substitute increases the


demand for a good, shifting the demand curve
to the right

Complementused together with the good we are


interested in

Example

A rise in the price of a complement decreases


the demand for a good, shifting the demand
curve to the left

Other Factors That Shift the


Demand Curve
Population

As the population increases in an area


Number of buyers will ordinarily increase
Demand for a good will increase

Expected Price

An expectation that price will rise (fall) in the future


shifts the current demand curve rightward (leftward)

Tastes

Combination of all the personal factors that go into


determining how a buyer feels about a good

When tastes change toward a good, demand


increases, and the demand curve shifts to the right

When tastes change away from a good, demand


decreases, and the demand curve shifts to the left

Small Summary
-- Factors Affecting Demand
Income (depends on goods nature:
normal or inferior)
Wealth (depends on goods nature)
Prices of substitutes (positively related)
Prices of complements (negatively
related)
Population (positively related)
Expected price (positively related)
Tastes (positively related)

Figure 3(b): Movements Along


and Shifts of The Demand Curve
Price

Entire demand curve shifts


rightward when:
income or wealth
price of substitute
price of complement
population
expected price
tastes shift toward good

D2
D1
Quantity

Figure 3(c): Movements Along


and Shifts of The Demand Curve
Price

Entire demand curve shifts


leftward when:
income or wealth
price of substitute
price of complement
population
expected price
tastes shift toward good

D1
D2
Quantity

Supply
Supply is the willingness and

ability of sellers to produce and


offer to sell different quantities of a
good at different prices during a
specific period of time
Law of Supply: As the price of a
good rises, the quantity supplied of
the good rises; and as the price of
a good falls, the quantity supplied
of the good falls.

Supply
A firms quantity supplied of a good is the
specific amount its managers would choose to
sell over some time period, given

A particular price for the good

All other constraints on the firm

Market quantity supplied (or quantity supplied)


is the specific amount of a good that all sellers
in the market would choose to sell over some
time period, given

A particular price for the good

All other constraints on firms

The Law of Supply


States that when the price of a good rises
and everything else remains the same,
the quantity of the good supplied will rise

The words, everything else remains the same


are important
In the real world many variables change
simultaneously
However, in order to understand the
economy we must first understand each
variable separately
We assume everything else remains the
same in order to understand how supply
reacts to price

The Supply Schedule and The


Supply Curve
Supply scheduleshows quantities of a
good or service firms would choose to
produce and sell at different prices, with
all other variables held constant
Supply curvegraphical depiction of a
supply schedule

Shows quantity of a good or service supplied at


various prices, with all other variables held
constant

Figure 4: The Supply Curve


Price per
Bottle

When the price is $2.00


per bottle, 40,000 bottles
are supplied (point F).

$4.00

2.00

G
At $4.00 per bottle,
quantity supplied is
60,000 bottles (point G).

40,000

60,000

Number of Bottles
per Month

Shifts vs. Movements Along the


Supply Curve
A change in the price of a good causes a movement
along the supply curve

In Figure 4
A rise (fall) in price would cause a rightward
(leftward) movement along the supply curve

A drop in transportation costs will cause a shift in the


supply curve itself

In Figure 5
Supply curve has shifted to the right of the old
curve (from Figure 4) as transportation costs
have dropped
A change in any variable that affects supply
except for the goods pricecauses the supply
curve to shift

Figure 5: A Shift of The Supply Curve

Price per
Bottle

A decrease in transportation
costs shifts the supply curve for
syrup from S1 to S2.

S1

S2

At each price, more bottles


are supplied after the shift
$4.00

60,000

80,000

Number of Bottles
per Month

Factors That Shift the Supply


Curve
Input prices

A fall (rise) in the price of an input causes an


increase (decrease) in supply, shifting the supply
curve to the right (left)

Price of Related Goods

When the price of an alternate good rises (falls),


the supply curve for the good in question shifts
leftward (rightward)

If a producer sees more profit in another good, and


if the producer is easily able to switch, it will start
making the other good, thereby reducing the
supply for the good in question.
Eg: If a farmer is currently growing wheat and he
calculates more profit in growing barley, next year
he will plant barley, thereby reducing supply of
wheat.

For purposes of supply analysis related goods refer to


goods from which inputs are derived to be used in the
production of the primary good.

For example, Spam (tinned meat) is made from pork


shoulders and ham. Both are derived from Pigs.
Therefore pigs would be considered a related good to
Spam. In this case the relationship would be negative or
inverse. If the price of pigs goes up the supply of
Spam would decrease (supply curve shifts left)
because the cost of production would have
increased.

A related good may also be a good that can be


produced with the firm's existing factors of production.

For example, a firm produces leather belts. The firm's


managers learn that leather pouches for smart phones
are more profitable than belts. The firm might reduce
its production of belts and begin production of cell phone
pouches based on this information. Finally, a change in
the price of a joint product will affect supply.

For example mutton and leather are joint products

Factors That Shift the Supply


Curve
Number of Firms

An increase (decrease) in the number of


sellerswith no other changesshifts the
supply curve to the right (left)

Technology
Cost-saving technological advances
increase the supply of a good, shifting the
supply curve to the right
Expected Price

An expectation of a future price increase


(decrease) shifts the current supply curve
to the left (right)

Factors That Shift the Supply Curve


Changes in weather

Favorable weather
Increases crop yields
Causes a rightward shift of the supply curve for
that crop

Unfavorable weather
Destroys crops
Shrinks yields
Shifts the supply curve leftward

Other unfavorable natural events may effect all firms in


an area

Causing a leftward shift in the supply curve

Figure 6(a): Changes in Supply and in


Quantity Supplied
Price

Price increase moves


us rightward along
supply curve

P2

P1

Price increase moves


us leftward along
supply curve

P3

Q3

Q1

Q2

Quantity

Figure 6(b): Changes in Supply and


in Quantity Supplied
Price

Entire supply curve shifts


rightward when:
price of input
price of alternate good
number of firms
expected price
technological advance
favorable weather

S1
S2

Quantity

Figure 6(c): Changes in Supply and in


Quantity Supplied
Price

Entire supply curve shifts


rightward when:
price of input
price of alternate good
number of firms
expected price
unfavorable weather

S2
S1

Quantity

Summary: Factors That Shift


The Supply Curve
The short list of shift-variables for supply
that we have discussed is far from
exhaustive
In some cases, even the threat of such
events can cause serious effects on
production
Basic principle is always the same

Anything that makes sellers want to


sell more or less of a good at any
given price will shift supply curve

Equilibrium: Putting Supply


and Demand Together
When a market is in equilibrium

Both price of good and quantity


bought and sold have settled into a
state of rest

The equilibrium price and equilibrium


quantity are values for price and
quantity in the market but, once
achieved, will remain constant
Unless and until supply curve or
demand curve shifts

The equilibrium price and equilibrium


quantity can be found on the vertical and
horizontal axes, respectively

At point where supply and demand


curves cross

Figure 7: Market Equilibrium


Price per
Bottle

2. causes the price


to rise . . .

3. shrinking the
excess demand . . .
S

E
$3.00

1.00

1. At a price of $1.00 per


bottle an excess demand
of 50,000 bottles . . .

H
Excess Demand

4. until price reaches its


equilibrium value of $3.00
.
J

25,000 50,000 75,000

D
Number of Bottles
per Month

Excess Demand
Excess demand

At a given price, the excess of quantity


demanded over quantity supplied

Price of the good will rise as buyers


compete with each other to get more of
the good than is available

Figure 8: Excess Supply and Price


Adjustment
Price per
Bottle

1. At a price of $5.00 per


bottle an excess supply
of 30,000 bottles . . .
Excess Supply at $5.00 S

$5.00
2. causes the
price to drop,
3.00

K
E

3. shrinking the
excess supply . . .

4. until price reaches its


equilibrium value of
$3.00.
D

35,000 50,000 65,000

Number of Bottles
per Month

Excess Supply
Excess Supply

At a given price, the excess of quantity supplied


over quantity demanded

Price of the good will fall as sellers


compete with each other to sell more of
the good than buyers want

Income Rises: What Happens


When Things Change
Income rises, causing an increase in
demand

Rightward shift in the demand curve


causes rightward movement along the
supply curve

Equilibrium price and equilibrium


quantity both rise

Shift of one curve causes a movement


along the other curve to new equilibrium
point

Figure 9
Price per
Bottle

4. Equilibrium
price
increases

3. to a new
equilibrium.
S
F'

$4.00
3.00

2. moves us along
the supply
curve . . .

1. An increase in
demand . . .
D2
D1

5. and equilibrium quantity


increases too.

50,000 60,000

Number of Bottles of
Maple Syrup per Period

An Ice Storm Hits: What


Happens When Things
Change
An ice storm causes a decrease in supply

Weather is a shift variable for supply


curve
Any change that shifts the supply
curve leftward in a market will
increase the equilibrium price
And

decrease the equilibrium


quantity in that market

Figure 10: A Shift of Supply and A


New Equilibrium
Price per
Bottle
$5.00

3.00

S2

S1

E'

D
35,000 50,000

Number of Bottles

Using Supply and Demand:


The Invasion of Kuwait
Why did Iraqs invasion of Kuwait cause
the price of oil to rise?

Immediately after the invasion, United States


led a worldwide embargo on oil from both Iraq
and Kuwait

A significant decrease in the oil industrys


productive capacity caused a shift in the supply
curve to the left
Price of oil increased

Figure 12: The Market For Oil


Price per
Barrel of Oil

S2
S1
E'

P2
E

P1

D
Q2

Q1

Barrels of Oil

Using Supply and Demand:


The Invasion of Kuwait
Why did the price of natural gas rise as
well?

Oil is a substitute for natural gas

Rise in the price of a substitute


increases demand for a good

Rise in price of oil caused demand


curve for natural gas to shift to the
right
Thus, the price of natural gas rose

Figure 13: The Market For Natural


Gas
Price per Cubic
Foot of Natural
Gas

F'
P4
P3

D2
D1

Q3

Q4

Cubic Feet of
Natural Gas

Figure 11: Changes in the Market for


Handheld PCs
Price per
Handheld
PC

3. moved the market to


a new equilibrium.
2. and a decrease
in demand . . .

4. Price
decreased . . .

$500
B

$400

S2002
S2003
1. An increase in
supply . . .

D2002

5. and quantity
decreased as well.

D2003
2.45 3.33

Millions of Handheld PCs


per Quarter

Both Curves Shift


When just one curve shifts (and we know
the direction of the shift) we can
determine the direction that both
equilibrium price and quantity will move
When both curves shift (and we know the
direction of the shifts) we can determine
the direction for either price or quantity
but not both

Direction of the other will depend on


which curve shifts by more

The Three Step Process


Key Step 1Characterize the Market

Decide which market or markets best suit problem


being analyzed and identify decision makers
(buyers and sellers) who interact there

Key Step 2Find the Equilibrium

Describe conditions necessary for equilibrium in the


market, and a method for determining that
equilibrium

Key Step 3What Happens When Things Change

Explore how events or government polices change


market equilibrium

Example: rental apartment


Demand & Supply
Diagram
Equilibrium P & Q
Why $1000 can not
be equilibrium?
Effects from a
tornado destroying
some apartments.

rent($)

quantity
demanded

quantity
supplied

800

30

10

1000

25

14

1200

22

17

1400

19

19

1600

17

21

1800

15

22

Demand for two bedroom


rental apartment

Summaries
Through the study of the chapter, you will be able to
Characterize a market.
Use a demand schedule and a demand curve to demonstrate the law of
demand.
Explain the difference between a change in demand (shift of the curve)
and a change in quantity demanded (movement along the curve).
List the factors that will lead to a change in demand, and give
examples of each.
Similar analysis for supply side.
Explain how equilibrium price and quantity are determined in a
competitive market.
Explain what will happen in a competitive market after a shift in the
supply curve, the demand curve, or both.
Describe the three steps economists take to answer almost any
question about the economy.

Demand
and Supply
Elasticities

78

THE ELASTICITY OF
DEMAND
The price elasticity of demand is a
measure of how much the quantity
demanded of a good responds to a change
in the price of that good.
When we talk about elasticity, that
responsiveness is always measured in
percentage terms.
Specifically, the price elasticity of demand
is the percentage change in quantity
demanded due to a percentage change in
the price.

Price Elasticity of Demand


Price elasticity of demand: the percentage change in the

quantity demanded that results from a 1 percent change in


the price

The midpoint method:

Q2 Q1
ep
Q2 Q1

P2 P1
P2 P1

Special Cases of Demand


Elasticities
1. Perfectly inelastic demand: ep = 0
2. Inelastic demand: ep < 1
3. Unit elastic demand: ep = 1
4. Elastic demand: ep > 1
5. Perfectly elastic demand: ep = infinity

Determinants of Price Elasticity of


Demand
Substitutability
More substitutable more elastic
Less substitutable less elastic
Proportion of Income
Greater proportion of income more elastic
Lesser proportion of income less elastic
Examples: Autos vs. Salt
Luxuriousness
More luxurious more elastic
Less luxurious less elastic
Examples: Cruise vs. Surgery
Time (More time greater elasticity, vice versa.)
Size of Market

Total Revenue and


Demand Elasticity
Total revenue: TR = P x Q

If ep < 1, then an increase (decrease) in P


will increase (decrease) TR

If ep = 1, then a change in P will not


change TR

If ep > 1, then an increase (decrease) in P


will decrease (increase) TR

The Price Elasticity of


Demand and Its
Determinants
Demand tends to be more elastic:

the larger the number of close substitutes.

if the good is a luxury.

the more narrowly defined the market.

the longer the time period.

Computing the Price


Elasticity of Demand
The price elasticity of demand is
computed as the percentage change in
the quantity demanded divided by the
percentage change in price.

P ric e e la s tic ity o f d e m a n d =

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P e rc e n ta g e c h a n g e in p ric e

Computing the Price


Elasticity of Demand
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:
P ric e e la s tic ity o f d e m a n d =

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P e rc e n ta g e c h a n g e in p ric e

(1 0 8 )
100
20%
10

2
( 2 .2 0 2 .0 0 )
100 10%
2 .0 0

The Midpoint Method: A Better


Way to Calculate Percentage
Changes and Elasticities
The midpoint formula is preferable when
calculating the price elasticity of demand
because it gives the same answer
regardless of the direction of the price
change.

Price elasticity of demand =

(Q2 Q1 ) /[(Q2 Q1 ) / 2]
( P2 P1 ) /[( P2 P1 ) / 2]

The Midpoint Method: A Better


Way to Calculate Percentage
Changes and Elasticities
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,
using the midpoint formula, would be
calculated as:

(10 8)
22%
(10 8) / 2

2.32
(2.20 2.00)
9.5%
(2.00 2.20) / 2

The Variety of Demand


Curves
Inelastic Demand

Quantity demanded does not respond strongly


to price changes.

Price elasticity of demand is less than one.

Elastic Demand

Quantity demanded responds strongly to


changes in price.

Price elasticity of demand is greater than one.

Computing the Price


Elasticity of Demand
(100 50)

ED
Price
$5
4

Demand

50

(4.00 5.00)

(100 50)/2
(4.00 5.00)/2

67 percent

3
22 percent

100 Quantity

Demand is price elastic.

The Variety of Demand


Curves
Perfectly Inelastic

Quantity demanded does not respond to price


changes.

Perfectly Elastic

Quantity demanded changes infinitely with any


change in price.

Unit Elastic

Quantity demanded changes by the same


percentage as the price.

The Variety of Demand


Curves
Because the price elasticity of demand
measures how much quantity demanded
responds to the price, it is closely related
to the slope of the demand curve.
But it is not the same thing as the slope!

Figure 1 The Price


Elasticity of Demand
(a) Perfectly Inelastic Demand: Elasticity Equals 0
Price
Demand
$5
4
1. An
increase
in price . . .

100

Quantity

2. . . . leaves the quantity demanded unchanged.

Figure 1 The Price


Elasticity of Demand
(b) Inelastic Demand: Elasticity Is Less Than 1
Price

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

Demand

90

100

2. . . . leads to an 10% decrease in quantity


demanded.

Quantity

Figure 1 The Price


Elasticity of Demand
(c) Unit Elastic Demand: Elasticity Equals 1
Price

$5
4
Demand

1. A 25%
increase
in price . . .

80

100

Quantity

2. . . . leads to a 25% decrease in quantity demanded.

Figure 1 The Price


Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Price

$5
4

Demand

1. A 25%
increase
in price . . .

50

100

Quantity

2. . . . leads to a 50% decrease in quantity demanded.

Figure 1 The Price


Elasticity of Demand
(e) 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.

0
3. At a price below $4,
quantity demanded is infinite.

Quantity

Total Revenue and the Price


Elasticity of Demand
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 Q

Price

Figure 2 Total Revenue


When the price is $4,
consumers will demand 100
units, and spend $400 on
this good.

$4

P Q = $400
(revenue)

Demand

100
Q

Quantity

Elasticity and Total Revenue


along a Linear Demand Curve
With an inelastic demand curve, an
increase in price leads to a decrease in
quantity that is proportionately smaller.
Thus, total revenue increases.

Figure 3 How Total Revenue


Changes When Price Changes:
Inelastic Demand
Price

Price
An Increase in price
from $1
to $3

leads to an Increase
in total revenue from
$100 to $240

$3

Revenue = $240
$1

Demand

Revenue = $100
0

100

Quantity

Demand
0

80

Quantity

Elasticity and Total Revenue along a


Linear Demand Curve
With an elastic demand curve, an
increase in the price leads to a decrease
in quantity demanded that is
proportionately larger. Thus, total
revenue decreases.

Figure 3 How Total Revenue


Changes When Price Changes:
Elastic Demand
Price

Price
An Increase in price
from $4
to $5

leads to an decrease
in total revenue from
$200 to $100

$5
$4
Demand

Demand
Revenue = $200

50

Revenue = $100

Quantity

20

Quantity

Note that with each price increase, the Law of Demand still
holds an increase in price leads to a decrease in the quantity
demanded. It is the change in TR that varies!

Elasticity of a Linear
Demand Curve

Figure 4 Elasticity of a Linear Demand Curve


Demand is elastic;
demand is responsive
to changes in price.

Price
$
7
6

When price increases


from $4 to $5, TR
declines from $24 to
$20.

Elasticity is > 1 in this


range.
Elasticity is < 1 in this
range.
Demand is inelastic;

5
4
3
2
1

1
0

1
2

1
4

demand is not very


responsive to changes in
When price increases
price.
from $2 to $3, TR
increases from $20 to
$24.
Quantity

Other Demand Elasticities


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.

Other Demand
Elasticities
Computing Income Elasticity

P e rc e n ta g e c h a n g e
in q u a n tity d e m a n d e d
In c o m e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e
in in c o m e

Other Demand Elasticities


Income Elasticity

Types of Goods
Normal Goods
Inferior Goods

Higher income raises the quantity


demanded for normal goods but
lowers the quantity demanded for
inferior goods.

Other Demand Elasticities


Income Elasticity

Goods consumers regard as necessities


tend to be income inelastic
Examples include food, fuel, clothing,
utilities, and medical services.

Goods consumers regard as luxuries tend


to be income elastic.
Examples include sports cars, furs, and
expensive foods.

Other Demand Elasticities


Cross-price elasticity of demand
A

measure of how much the quantity demanded


of one good responds to a change in the price of
another good, computed as the percentage
change in quantity demanded of the first good
divided by the percentage change in the price of
the second good

Cross - price elasticity of demand

%change in quantity demanded of good 1


%change in price of good 2

THE ELASTICITY OF
SUPPLY
Price elasticity of supply is a measure
of how much the quantity supplied of a
good responds to a change in the price of
that good.
Price elasticity of supply is the
percentage change in quantity supplied
resulting from a percentage change in
price.

Figure 5 The Price Elasticity


of Supply

(a) Perfectly Inelastic Supply: Elasticity Equals 0


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

100

Quantity

2. . . . leaves the quantity supplied unchanged.

Figure 5 The Price Elasticity of Supply


(b) Inelastic Supply: Elasticity Is Less Than 1
Price
Supply
$5
4
1. A 25%
increase
in price . . .

100

110

Quantity

2. . . . leads to a 10% increase in quantity supplied.

Figure 5 The Price


Elasticity of Supply

(c) Unit Elastic Supply: Elasticity Equals 1


Price
Supply
$5

(If SUPPLY is unit


elastic and linear, it
will begin at the
origin.)

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

100

125

Quantity

2. . . . leads to a 25% increase in quantity supplied.

Figure 5 The Price


Elasticity of Supply
(d) Elastic Supply: Elasticity Is Greater Than 1
Price
Supply
$5
4
1. A 25%
increase
in price . . .

100

200

Quantity

2. . . . leads to a 100% increase in quantity supplied.

Figure 5 The Price


Elasticity of Supply
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Price
1. At any price
above $4, quantity
supplied is infinite.
$4

Supply
2. At exactly $4,
producers will
supply any quantity.

0
3. At a price below $4,
quantity supplied is zero.

Quantity

The Price Elasticity of Supply


and Its Determinants
Ability of sellers to change the
amount of the good they produce.

Beach-front land is inelastic.

Books, cars, or manufactured goods are


elastic.

Time period

Supply is more elastic in the long run.

Computing the Price


Elasticity of Supply
The price elasticity of supply is computed
as the percentage change in the quantity
supplied divided by the percentage
change in price.

P e rc e n ta g e c h a n g e
in q u a n tity s u p p lie d
P ric e e la s tic ity o f s u p p ly =
P e rc e n ta g e c h a n g e in p ric e