lecture 4

• Rational agents will select the choice which presents the highest benefits
• Producers act rationally by

  Selling goods/services in a way that maximises their profits
• Rationality in classical economic theory is a flawed assumption as people usually don't act rationally
• If a firm increases advertising then their demand curve shifts right. This increases the equilibrium price and quantity
• If you add up marginal utility for each unit you get total utility
• Elasticity


  A measure of the "responsiveness" or "sensitivity" of one variable to changes in another variable
• Elasticities are measured in percentage changes (and not in terms of absolute changes)
• Elasticities are independent of the units in which variables are measured and can therefore easily be compared across different variables
• Main application of elasticities: How responsive are demand and supply to changes in the factors influencing them?
• Two main methods of calculation: "Point" elasticity and "Arc" elasticity
• The price elasticity of demand (ped) measures the responsiveness of quantity demanded (Qd) to changes in price (P)
• ped represents the percentage change in Qd that arises due to a one-percent change in P
• If the law of demand holds, ped is negative
• If the demand function Qd = f(P) is known, ped can be determined using calculus: ped = dQd/dP * P/Qd
• The sign of ped is negative if the law of demand holds
• Unit-elastic demand

  ped = 1, quantity demanded reacts proportionately to a change in price
• The value of ped depends on the current price, because ped varies along a linear demand curve
• At high prices, demand is elastic. At low prices, demand is inelastic. There is exactly one price at which demand is unit-elastic
• A firm's total revenue (TR) equals total expenditure by its customers: TR = P*Q
• When a firm increases (decreases) the price, two countervailing effects occur: a price effect and a quantity effect
• With elastic demand, the quantity effect is stronger than the price effect, so TR and P change in opposite directions
• With inelastic demand, the price effect is stronger than the quantity effect, so TR and P change in the same direction
• Price elasticity of demand (ped)

  It affects total revenue
• Relationship between ped and TR

  • Elastic demand (ped > 1): Quantity effect stronger than price effect. P and TR change in opposite directions
  • Inelastic demand (ped < 1): Price effect stronger than quantity effect. P and TR change in the same direction
  • Unit-elastic demand (ped = 1): Price effect and quantity effect offset each other. If P changes, TR remains constant
• Total revenue is maximized at the price where demand is unit-elastic
• The flatter the demand curve, the higher is ped ("relatively more elastic" demand). The steeper the demand curve, the lower is ped ("relatively more inelastic" demand)
• Extreme cases of the price elasticity of demand


  • "Perfectly elastic" demand (ped = -∞)
  • "Perfectly inelastic" demand (ped = 0)
• Five important determinants of the ped

  • Availability of substitutes
  • Necessities vs. luxuries
  • Definition of the market
  • Proportion of income devoted to the product
  • Time horizon
• Income elasticity of demand (ied)

  Measures the responsiveness of quantity demanded (Qd) to changes in consumer income (M)
• Characterizing the income elasticity of demand

  • ied > 0: The good is a normal good
  • ied < 0: The good is an inferior good
  • ied > 1: Demand is income elastic
  • ied < 1: Demand is income inelastic
  • ied = 1: Demand is income unit-elastic
• Cross-price elasticity of demand (xed)

  Measures the responsiveness of quantity demanded of one good (Qx

  1. to changes in the price of a related good (Py)
• Characterizing the cross-price elasticity of demand

  • xed > 0: Goods X and Y are substitutes
  • xed < 0: Goods X and Y are complements
  • xed > 1: Demand is cross-price elastic
  • xed < 1: Demand is cross-price inelastic
  • xed = 1: Demand is cross-price unit-elastic
• Price elasticity of supply (pes)


  Measures the responsiveness of quantity supplied (Qs) to changes in price (P)
• Characterizing the price elasticity of supply


  • pes > 0 if the law of supply holds
  • pes > 1: Supply is elastic
  • pes < 1: Supply is inelastic
  • pes = 1: Supply is unit-elastic
• Price elasticity of supply (pes)


  Responsiveness of quantity supplied (Qs) to changes in price (P)
• pes


  Represents the percentage change in Qs that arises due to a one-percent change in P
• If P increases by 12 percent and Qs increases by 12 percent, (point) pes is 1
• Characterizing the price elasticity of supply

  • Sign: pes > 0 if the law of supply holds
  • Absolute value: pes > 1 (elastic supply), pes < 1 (inelastic supply), pes = 1 (unit-elastic supply)
• Extreme cases of the price elasticity of supply

  • Perfectly elastic supply (pes = ∞)
  • Perfectly inelastic supply (pes = 0)
• Estimated price elasticities of supply

  • Retail store space (3.2, elastic)
  • Housing (long run, San Francisco) (2.4, elastic)
  • Uranium (2.3 to 3.3, elastic)
  • Oysters (1.6 to 2.0, elastic)
  • Labor in South Africa (0.4 to 1.8, inelastic to elastic)
  • Housing (long run, New Orleans) (0.9, inelastic)
  • Corn (short run) (0.9, inelastic)
  • Recycled aluminium (0.5, inelastic)
  • Natural gas (short run) (0.5, inelastic)