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Chapter 5

ELASTICITY

 ELASTICITY: response, or D, one variable as a result from the D another variable

 Most common measure of elasticity Ä

 PRICE ELASTICITY OF DEMAND
        how much will Qd D, when there is a D Price ??????

 a measure of the % D Qd
   divided by the % D P

              % DQd       DQd
Ed =                   =       Qd
                                   DP
               % DP            P
* Use the same formula for price elasticity of supply (es)

TERMS:

ELASTIC: Ed > 1 industry tends to be competitive and/or the product has many substitutes

INELASTIC: Ed < 1 industry lacks competition and/or there aren’t many substitutes for the product

UNIT ELASTIC: Ed = 1 proportional change
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PROBLEMS CALCULATING ELASTICITY

The conventional method is to use the initial number as a reference, but an argument could be made for either number.

Ä

ARC ELASTICITY: Divide both the change in quantity & price by the sum their respective endpoints, divided by two.

(also called the midpoint formula)
 
 

D Qd

Q1 + Q2
       2
_______     = Arc ed = Elasticity of a midpoint over a range
D P

P1 + P2                  * starting point is the average of the endpoints
    2
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CALCULATING ELASTICITY AT A POINT

Given point A, pick two quantity endpoints with point A as a midpoint. Use the prices associated with those quantities to calculate Arc ed formula. PERFECTLY ELASTIC & PERFECTLY INELASTIC

(true love vs. Jerry Seinfeld’s approach)
 

ELASTICITY ALONG LINEAR DEMAND & SUPPLY CURVES


Geometric tricks for estimating ed & es
 

ELASTICITY & SLOPE (slope does not D along a linear curve, but elasticity does)
 
 

Ed = DQ/Q / DP/P

     = DQ/Q x DP/P

     = DQ/DP x P/Q

     =1 / DP/DQ x P/Q

     = 1 / slope x P/Q

therefore, if we know the slope , P & Q we can determine Ed
 

Determinants of Price Elasticity: the influence of substitution

                         DEMANDÄ

1. In the long run the demand curve is more elastic e.g. ed for gas during the 70s

2. The less of a necessity, the more elastic is the demand curve, e.g., insulin vs. cheesecake

3. The more narrow a good is defined, the more elastic is the demand curve, e.g., cigarettes vs. Marlboro
 

                         SUPPLYÄ

1. Instantaneous, or momentary, supplyè ed <1

2. Short run supply more substitution possibleè more elastic
3. Long run supply curve is very elastic
 

ELASTICITY & TOTAL REVENUE

    TR = P x Q ( A = l x w ) 

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OTHER ELASTICITY CONCEPTS
 

CROSS ELASTICITY OF DEMAND

%DQdx             =>     positive sign: substitute
%DPy                         negative sign: complement

% D in Qd of good X divided by the % D in the P of good Y

Cross es
Jointly produced goodsÄ beef & leather
 
 

Cross es = % D Qsleather
                % D Pbeef                     positive sign/complements

  Cross es = % D Qscorn
                % D Pwheat                   negative sign/substitute
 

INCOME ELASTICITY OF DEMAND

Ey = % DQd                               => negative sign: inferior good
        % DY                                       positive sign: normal good

                                                        Ey>1: luxury good
                                                        Ey<1: necessity
 

<>Calculating Income & Cross-Price Elasticity

  <>Some examples of elasticity’s affect on P & Q

 

WHO BEARS THE BURDEN OF AN EXCISE TAX????

1. Inelastic demand & supply curve shifts in

2. Elastic demand & supply curve shifts in

3. Inelastic supply

4. Elastic supply & supply curve shifts up

*inelastic pays at the extremes
 

General Case: $10,000 tax

graph a => tax supplier

<>graph b => tax buyer

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FIRMS TRY TO SEPARATE CONSUMERS WHO HAVE DIFFERENT ELASTICITIES OF DEMAND

1. AIRLINES, business vs. tourist (movies)

2. CAR DEALERS, listed price vs. people who haggle

3. SALE ITEMS, wash machines every other week on sale

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ELASTICITY & MARKET FORECASTS
 

CASE ONE making adjustments to inventory

                 given: Ed = -2 & your price is going up by 10%

setup equation
 

                    %^Qd / 10% = -2
 
 

multiply through by 10 to isolate %^Qd
 
 

                     %^Qd = -20%
 

CASE TWO making adjustments to price to get rid of inventory

                     given: Ed = -4 & you want to increase sales by 20%
 
 

setup the equation

                        20% / %^P = -4
 

exchange -4 with %^P
 

                        %^P = -5%
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Chapters 7 & 8

COSTS OF PRODUCTION

We are concerned with the short-run supply of produced goods. Chapter 10 will cover the long run.

OPPORTUNITY COST REVISITED

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                 how much labor would you supply to the market?

it depends on your opportunity cost => how much you value your leisure time?
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supply depends on the opportunity cost of the supplier

    as the P of the factor increases the Qs of that factor expands

**This is the basis for the law of supply: When price increases the quantity    supplied increases, ceteris paribus
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TERMS:

 FIRM: an economic institution that transforms factors of production into consumer goods

 SHORT RUN: Firm is constrained in its production decisions - some inputs are fixed

 LONG RUN: The time necessary to change all factors of production - all inputs are variable>

 PRODUCTION TABLE: A table that shows the output produced f/ various combinations of inputs
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EXAMPLE

*in our example we assume inputs are fixed, except for one, labor

we will add the variable input to the fixed inputs & see what happens
 

PRODUCTION FUNCTION: Is a graph of the production table information
 

MARGINAL PRODUCT: The additional output produced by an additional input, ceteris paribus
 

AVERAGE PRODUCT: Total product divided by the variable input

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THE LAW OF DIMINISHING MARGINAL PRODUCTIVITY

As more of a variable input is added to fixed inputs, the additional output one gets from the additional input will fall

 
 


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TERMS:

FIXED COSTS (FC): Costs that can not be changed in the time under consideration

VARIABLE COSTS (VC): Costs of the variable inputs; they change as output changes

TOTAL COST (TC): Sum of FC + VC

TC = FC + VC

 *to find the average divide by Q (output)
 
 

TC = FC + VC = ATC = AFC + AVC
Q       Q       Q

ATC = TC/Q

AFC = FC/Q

AVC = VC/Q

Marginal Costs: cost of increasing output by one unit (MC)

 

     u-shaped MC curve; AVC curve & ATC curve

Initially marginal product increases & costs fall (MC, AVC & ATC). Then "The Law of Diminishing Marginal Productivity" sets in & MP falls forcing costs up (first MC, then AVC and finally ATC).

 

MC < AVC, then AVC is falling
MC = AVC, then AVC is @ a minimum
MC > AVC, then AVC is rising

MC < ATC, then ATC is falling
MC = ATC, then ATC is @ a minimum
MC > ATC, then ATC is rising


Chapter 9

Supply decisions in the long run => all inputs are variable
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 Production decisions are based on

                             Available Technology & Cost
 

Technical Efficiency: using the least amount of inputs in the

                                        production of a given output
 

Economic Efficiency: the lowest cost method of production for a given level
                                        of output

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production of identical products in different countries depends
                                                on the price of   inputs

U.S. vs. Mexico => clothes

U.S. vs. China => roads

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Technical Efficiency is not always Economic Efficiency

this depends on the level of output
 
 

Indivisible set-up costs: an investment in technology that would only payoff after a MINIMUM EFFICIENT LEVEL OF PRODUCTION
=============================================
E.G., Pontiac Fiero (200,000) vs. Mazda Miata (30,000)

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WHAT SHAPES THE LR COST CURVE?

Short-run cost curve is u-shaped because of the law of diminishing marginal productivity

*but in the long run all inputs are variable

 Long-run cost curve is u-shaped because of :

 1. Economies of scale: cost per unit fall as output rises, e.g., Henry Ford

 2. Diseconomies of scale: an increase in per unit cost as output rises,
                                            e.g., firm too big

                        a. Monitoring Cost

                        b. Team Spirit


 

Importance of Economies & Diseconomies of Scale

                 Economies of scale promotes expansion/mergers

                 Diseconomies promote contraction/takeover defense
                                        Raiders

Real-World Issues:

 1. Economies of scope: costs of production are interdependent - costs savings for one product because of producing another. E.G., Purina/Jack-in-the-Box, Pepsico

2. Learn by Doing: firms become more efficient over time w/out any changes in inputs

3. Technological change shifts the cost curve down

4. Unmeasured costs/ accounting vs. economics

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