Managerial Economics

Kingshuk Sarkar
Relationship between price elasticity of demand and total revenue

• When the price rises, the quantity decreases. The original price and
quantity and the slope of the demand curve determine whether
overall revenue will increase or decrease.
• If the percentage increase in quantity is greater than the % decrease
in price, overall revenue will grow as a result of the increase in
quantity.
• A product's elastic or inelastic demand is determined by the
percentage change in price and quantity.
1. When demand is inelastic (price elasticity 1), price and total revenue
have a positive relationship, which means that as price rises, total
revenue rises as well.
2. When demand is elastic (price elasticity >1), price and total revenue
have a negative relationship, meaning that price rises lead to lower
total revenue.
3. When demand is unit elastic (price elasticity), price changes have no
effect on total revenue.
The first thing to note is that revenue is maximized at the point where
elasticity is unit elastic. Why? If you are the coffee shop owner, you will notice
that there are untapped opportunities when demand is elastic or inelastic.

If elastic: The quantity effect outweighs the price effect, meaning if we

decrease prices, the revenue gained from the more units sold will outweigh
the revenue lost from the decrease in price.

If inelastic: The price effect outweighs the quantity effect, meaning if we

increase prices, the revenue gained from the higher price will outweigh the
revenue lost from less units sold.
The Relationship between MR and E
There is a useful relationship between marginal revenue (MR) and the
price elasticity of demand (Ed). It is derived by taking the first derivative
of the total revenue (TR) function. The product rule from calculus is
used.
What Is Consumer Surplus?
• Consumer surplus is an economic measurement of consumer benefits
resulting from market competition. A consumer surplus happens
when the price that consumers pay for a product or service is less
than the price they're willing to pay. It's a measure of the additional
benefit that consumers receive because they're paying less for
something than what they were willing to pay.
What Is a Producer Surplus?
• Producer surplus is the difference between how much a person would
be willing to accept for a given quantity of a good versus how much
they can receive by selling the good at the market price. The
difference or surplus amount is the benefit the producer receives for
selling the good in the market.

• A producer surplus is generated by market prices in excess of the

lowest price producers would otherwise be willing to accept for their
goods.
Measuring Consumer Surplus
Consumer surplus is measured as the area below the downward-
sloping demand curve, or the amount a consumer is willing to spend for
given quantities of a good, and above the actual market price of the
good, depicted with a horizontal line drawn between the y-axis and
demand curve. Consumer surplus can be calculated on either an
individual or aggregate basis, depending on if the demand curve is
individual or aggregated
• Consumer surplus is the benefit or good feeling of getting a good deal. For example,
let's say that you bought an airline ticket for a flight to Disney World during school
vacation week for $100, but you were expecting and willing to pay $300 for one ticket.
The $200 represents your consumer surplus.

• However, businesses know how to turn consumer surplus into producer surplus or for
their gain. In our example, let's say the airline realizes your surplus and as the calendar
draws near to school vacation week raises its ticket prices to $300 each.

• The airline knows there will be a spike in demand for travel to Disney World during
school vacation week and that consumers will be willing to pay higher prices. So by
raising the ticket prices, the airlines are taking consumer surplus and turning it into
producer surplus or additional profits.
Price Control
• Price controls are government-mandated minimum or maximum
prices set for specific goods and services.
• Price controls are put in place to manage the affordability of goods
and services on the market.
• Minimums are called price floors while maximums are called price
ceilings.
• These controls are only effective on an extremely short-term basis.
• Over the long term, price controls can lead to problems such as
shortages, rationing, inferior product quality, and illegal markets.
Pros and Cons
Pros
• Protects consumers by eliminating price gouging

• Helps producers remain competitive and profitable

• Eliminates monopolies

Cons
• Can lead to shortages and illegal markets

• May create excess demand or excess supply

• Often result in losses for producers and a drop in quality of products and services
What Is the Law of Diminishing Marginal
Utility?
• The law of diminishing marginal utility states that all else equal, as
consumption increases, the marginal utility derived from each
additional unit declines. Marginal utility is the incremental increase in
utility that results from the consumption of one additional unit.
"Utility" is an economic term used to represent satisfaction or
happiness.

• In simple terms, the law of diminishing marginal utility means that the
more of an item that you use or consume, the less satisfaction you get
from each additional unit consumed or used.
Assumptions
• The goods being consumed are identical.
• The units are consumed quickly with few breaks in between.
• Units are not too big or too small.
• The consumer's taste is constant.
• There is no change in the price of the goods or of their substitutes.
• The unit can be measured.
• The consumer is making rational decisions about consumption.
Examples of the Law of Diminishing
Marginal Utility
• Imagine you can purchase a slice of pizza for $2. You're very hungry, so you decide to buy
five slices of pizza. When you eat the first slice of pizza, you gain a certain amount of
positive utility from eating. Because you were hungry and this is the first food you are
eating, the first slice of pizza has a high benefit.

• After you eat the second slice of pizza, your appetite is becoming satisfied. You're not as
hungry as before, so the second slice of pizza had a smaller benefit and enjoyment than
the first. The third slice holds even less utility since you're only a little hungry at this point.

• The fourth slice of pizza has experienced a diminished marginal utility as well. It might be
difficult to eat because you're already full from the first three slices. Finally, you can't even
eat the fifth slice of pizza. You're so full from the first four slices that consuming the last
slice of pizza results in negative utility.
Examples of the Law of Diminishing
Marginal Utility in Business
• The law of diminishing marginal utility can also affect what goods and
services businesses offer to customers, as it encourages a certain level
of diversification. In the above example with the pizza, if the
consumer knows they won't want the fourth or fifth slice of pizza,
they might not buy them in the first place. But they may see a high
level of utility in a different food, such as a salad. By diversifying its
menu, the shop selling pizza can avoid diminished marginal utility and
encourage consumers to purchase more.
How the Law Affects Pricing
• The law of diminishing marginal utility affects how businesses price their goods and
services. Because the first quantity of something has the most utility, consumers are
usually willing to pay more for it.

• For example, a store might have a deal on backpacks for sale: one backpack for $30, two
for $55, or three pairs for $75. A person buying backpacks can get the best cost per
backpack if they buy three.

• Not all buyers will want three backpacks, even though they are the best deal. However,
anyone who is shopping for backpacks needs at least one, so the first backpack has the
highest price. After that, because the marginal utility of each additional backpack
decreases, the business must decrease the cost per unit in order to entice shoppers to
purchase more units.