Econ 120 – Principles of Micro-Economics

ECON *120: Principles of Microeconomics Spring 2010 I. FOUNDATIONS OF ECONOMICS A. Scarcity, Production Possibilities, Efficiency and Exchange Section I. A Learning Objectives: †¢ Define or explain a number of basic economic terms and concepts. †¢ Explain, illustrate, and apply marginal analysis. †¢ Explain, illustrate, and apply the production possibilities model. †¢ Explain, illustrate, and apply the law of comparative advantage. 1. â€Å"Life is Economics† Q: Is this statement true or false? Why? 2. Economic Goals and Priorities of Society, or, â€Å"What does society want out of its economy? †¢ †¢ †¢ †¢ †¢ Economic growth/rising living standards Low unemployment/high employment Low inflation/stable prices Economic equity Economic efficiency Remark: On the individual decision-making level, the incentives that motivate economic activity and choices are utility maximization for consumers, profit maximization for producers/firms, a nd social welfare maximization for government units. 3. Economics Defined a) Economic Scarcity DEF: Economic scarcity exists when human needs and wants exceed an economy's ability to satisfy them given available resources and current technology.DEF: The four basic economic resources are labor, capital (a capital good is a produced good that is used as an input in the production of other goods and is not available for current consumption), land (energy, natural resources, raw materials and other â€Å"gifts of nature†) and entrepreneurial ability (the ability to recognize and exploit economic opportunities, develop and produce new goods/services and organize economic resources). Technology refers to the ability (based upon a body of knowledge or set of skills) to transform resources into goods and services. 1DEF: An economic good (bad) is something that increases (decreases) an individual’s â€Å"utility†, the economic term for well-being, happiness, satisfaction or welfare. Examples: Economic goods: kringle, DVDs and shoes. Economic bads: garbage and pollution. CLAIM: Economics is based on two axioms (self-evident truths): (i) society's material wants and needs are unlimited or insatiable; (ii) economic resources and current technology are limited. Remark: Physical scarcity alone does not cause economic scarcity. Economic goods are both physically and economically scarce.Economic bads, such as pollution, toxic wastes and garbage, are physically scarce but they are not economically scarce. CLAIM: Economic scarcity implies that (i) people must compete for scarce goods and resources, (ii) goods and resources must be rationed by some rationing device or mechanism, (iii) choices must be made and when choices are made, other opportunities and alternatives must be sacrificed. 2 Remark: Economic scarcity is most easily seen when a person has to give up or sacrifice something (in the form of money or time) in order to obtain more of something else. Price is a clear indicator or signal of economic scarcity. Remark: People and society in general are confronted with the following problem: The Economizing Problem: Attain the greatest or maximum fulfillment of a person's or society's unlimited wants (the goal of production) given limited resources and technology (the means of production). Question: How does one make the â€Å"best† or â€Å"optimal† choice? DEF: Economics is the study of economic scarcity and how individuals and society allocate their limited resources and technology to try to satisfy their unlimited needs, wants and desires; i. . , economics is the study of how best to solve the Economizing Problem. b) Opportunity Cost Claim: To solve the â€Å"Economizing Problem,† the decision-maker must make choices or decisions and so must know the value or cost of alternatives. DEF: The opportunity cost of a choice or decision is the value of the next best alternative that is forgone or sacrificed when th e choice or decision is made. What is the opportunity cost of (or sacrifices required by) the following? taking Econ *120 or working an additional 10 hrs/week †¢ buying 100 shares of Microsoft stock or conducting wars in Iraq and Afghanistan †¢ developing the oil fields in Alaska’s ANWR or operating a coal fired power plants Remarks: (i) Opportunity cost focuses on tradeoffs and so opportunity cost is measured in terms of sacrificed alternatives and not necessarily in terms of money. (ii) Opportunity cost is subjective and typically varies from person to person. (iii) The opportunity cost of an activity usually increases as more of the activity is pursued.Example: Suppose your employer wants to increase your work hours in increments of 2-hour blocks of time. What is the opportunity cost of each additional block of time and how does the opportunity cost of each additional block of time change? List alternatives. 1st 2-hr block of work, give up _____? 2nd 2-hr block o f work, give up _____? 3rd 2-hr block of work, give up _____? 4th 2-hr block of work, give up _____? 5th 2-hr block of work, give up _____? or, 1st hour of studying: give up _____? or, 2nd hour of studying: give up _____? r, 3rd hour of studying: give up _____? or, 4th hour of studying: give up _____? or, 5th hour of studying: give up _____? 3 (iv) Differences in opportunity cost provide the basis for mutually beneficial exchange. Example: Suppose that Max, a plumber, and Wanda, an electrician, each had 5 days of vacation time and each wanted to add a bedroom and bathroom onto their houses. Max can plumb a bathroom in 1 day and wire a bedroom in 4 days; Wanda can wire a bedroom in 1 day and plumb a bathroom in 4 days.In terms of opportunity cost: OCM1 wired bedroom = 4 plumbed bathrooms; OCM1 plumbed bathroom = 1/4 wired bedroom. OCW1 wired bedroom = 1/4 plumbed bathroom; OCW1 plumbed bathroom = 4 wired bedrooms. In five days, both Max and Wanda each could complete their house addit ions. How should they spend their time? Can Max and Wanda benefit from an exchange of some sort? Because of the differences in opportunity costs, Max should plumb both additions and Wanda should wire both additions and then each would have the desired additions to their houses plus three â€Å"extra† days. Trading† or exchanging 1 plumbed bathroom (one unit or day of plumbing) for in return for 1 wired bedroom (one unit or day of wiring) would be mutually beneficial. Example: Suppose Wilma has 20 cookies and 5 apples and Fred has 25 cookies and 10 apples. Wilma prefers apples over cookies and Fred prefers cookies over apples. Will Wilma and Fred eat the cookies and apples that they initially possess or will they exchange/trade? Explain. 4. EconomicMethodology a) Model/Theory Building The process: (i) Observe economic phenomena; (ii) Identify important variables; (iii) State assumptions that clarify, simplify and focus the relevant economic issues and questions being inv estigated; (iv) State the hypothesis or propositions; (v) Evaluate the validity of the propositions by proving the proposition logically and by testing the propositions against â€Å"reality† or â€Å"real-world† evidence; and, (vi) Accept the theory/model or reject it and reformulate the theory/model or construct a new theory/model. ) Marginal Analysis and Efficiency â€Å"DEF†: Marginal means incremental or additional and refers to a small change in an economic variable resulting from a unit change in some other economic variable; e. g. the marginal utility of a good X, the marginal cost of a good Y, the marginal product of labor. Remark: Marginal analysis evaluates and compares the marginal benefit and the marginal cost of a decision or choice and provides the solution to the â€Å"Economizing Problem. † 4 DEF: The marginal benefit, MB, of an economic variable Q is the change in the total benefit, ?TB, resulting from a unit change in Q); the marginal c ost, MC, of an economic variable Q is the change the change in the total cost, ? TC, resulting from a unit change in Q); that is, MB = ? TB/? Q, and, MC = ? TC/? Q. CLAIM: A rational economic decision-maker will increase a economic variable Q as long as the marginal benefit of that change in Q exceeds the marginal cost of that change; that is, if MB > (( MC at the quantity Q1 (or, MB < MC at the quantity Q2), then the quantity Q1 (Q2) is inefficient.Example: Suppose that you buy a used car for $500 but after you gain possession of the car you discover that repairs are needed to make it go and stop. The MB from driving the car is $1,000, MB = $1,000; the MC of fixing it up is $700, MC = $700. Do you spend an additional $700 to fix up and keep the car? Yes! Because, the MB of having and driving the car = $1,000 > $700 = the MC of having and driving the car, repair the car. The net benefit of repairing the car is $300 > 0. The $500 spent to buy the car is a sunk cost, a cost that has b een incurred in the past and cannot be changed and or ecovered. Thus, a sunk cost does not enter into the decision/choice to repair the car. Example: A pizza place next to a residence hall on a university campus operates from 11 am to 9 pm and sells 400 pizzas for $10 each during its business hours. After observing a large number of students carrying-in pizza boxes during the later part of the evening, a part-time pizza worker and economics student has suggested that the firm stay open later into the night. The student estimated the total benefits and total costs for different closing times (hours of operation) and created the table below.Should the pizza place stay open later? If so, how late? What should be its closing time? That is, what is the efficient or optimal closing time? 5 Closing Time 9 pm 10 pm 11 pm 12 am 1 am 2 am Total Benefit, TB $4,000 $4,500 $4,900 $5,200 $5,400 $5,500 Marginal Benefit, MB – Total Cost, TC $1,000 $1,100 $1,250 $1,500 $1,900 $2,500 Marginal Cost, MC – Answer: For the hour ending at 12 am, MB = $300 > $250 = MC and so the pizza place should still be open at 12 am. For the hour ending at 1 am, MB = $200 < $400 = MC and so it doesn’t â€Å"pay† to be open until 1am.Thus, the firm should close somewhere between 12 am and 1 am. Formally, the efficient o r optimal closing time is somewhere between 12 am (midnight) and 1 am, at which point MB = MC. Graphically: c) Microeconomics vs. Macroeconomics DEF: Microeconomics is the study of (i) economic decision-making by the individual consumer, firm or governmental unit, (ii) the allocation of resources and the determination of prices and output in specific markets and industries, (iii) the distribution of income in society, and, (iv) market structures. DEF: Macroeconomics is the study of conomic â€Å"aggregates† or â€Å"totals† such as Gross Domestic Product (GDP), national income, national employment/unemployment, economic growth, the price le vel/inflation, interest rates, the money supply, total consumption, total investment, govt. spending, total spending, industrial capacity, and trade/budget deficits. Remark: Microeconomics focuses on the decision-making of the individual economic agent (a person, firm, or governmental unit) and the â€Å"small† individual parts of the economy. Macroeconomics focuses on the whole economy and the sum of its individual parts. 6 d) Positive vs.Normative Economics Positive economics is descriptive and predictive and investigates â€Å"what was, what is and what will be† and is value free (does not depend on one's value system or religious beliefs). Normative economics is prescriptive and investigates â€Å"what should be†; it evaluates the desirability of economic decisions and policies using value judgements and depends upon one’s moral code or religious beliefs. e) Fallacy of Composition Claim: What is true for a single economic agent (individual consumer or producer) is NOT necessarily true for the economy as a whole.Examples: the balanced budget amendment; 15% wage increase for one person vs. everyone. f) Assumptions in Economics Remark: Assumptions simplify and distill the real world into its basic component parts in order to obtain a better understanding of the basic structure of an economy and its parts and the fundamental relationships; â€Å"separates the wheat from the chaff. † Assumption: ceteris paribus or â€Å"all other things held constant† or â€Å"nothing else changes. † g) Causation vs.Correlation â€Å"DEF†: Correlation (or association) occurs when two variables are related in some systematical and dependable way; the variables change together but a change in one variable does NOT necessarily cause a change in the other. Causation occurs when a change in one variable causes a change in the other. Remark: Economic analysis focuses on causation, not correlation. The ceteris paribus assumption simplifies the analysis and enables one to determine and understand the causal relationships between variables Remark: Unintended effects generally complicate economic analysis.For example, installing and using seatbelts and airbags are intended to reduce traffic deaths and injuries. But, despite the presence of these safety devices, the number of traffic accidents and deaths and the severity of traffic accident injuries initially increased instead. Why? The greater protection offered by these devises in auto crashes actually encouraged greater highway speeds and reckless and risky driving, all of which tend to increase the number of accidents and traffic deaths and injuries.Seatbelts and airbags do not cause more traffic deaths and injuries, but these variables are correlated or related in a systematic way. h) Teakettle and Table Problem 7 5. The Production Possibilities Frontier (Curve) Model a) Definitions and Properties of the PPF Model DEF: The Production Possibilities Frontier , PPF (or Curve, PPC) shows the different combinations of goods and services that an economy can produce given the efficient use of available fixed resources and current technology. Example: Consider the Guns – Butter PPF below.If the economy is operating at point C and producing 370 units of guns, then the maximum quantity of butter that the economy can produce using its technology and available resources efficiently and fully is 200 units. Alternatively, if the economy is producing 400 units of butter, the maximum quantity of guns it can produce is 200 units. Remark: Construct your own PPF; can you work 20 hours per week and achieve a 3. 67 (A–) gpa? Alternatively, construct the PPF for the U. S. for health care and cell phones or for food and energy (should we grow corn and sugar to eat or to make biofuels? . Remark: The PPF model can be used to illustrate three basic concepts: (i) the opportunity cost of a good; (ii) the law of increasing opportunity cost in the ca se of a concave outward PPF; and (iii) economic efficiency (productive efficiency, full employment and allocative efficiency). DEF: Productive (technical) efficiency is achieved when given quantities of goods are produced in the least costly way, or equivalently, when employed resources produce the maximum possible output of goods and services. Full employment is achieved when all available resources are employed. Remark.Productive efficiency and full employment are achieved at output combinations that lie on the PPF. Inefficiency occurs at output combinations that lie inside the PPF (resources or technology are either not being fully or efficiently used). Unattainable output combinations lie outside the PPF. 8 DEF: Allocative efficiency is achieved when the economy is producing the combination of goods most desired by society. Remark: Which point on the PPF that is â€Å"best† depends upon society’s preferences and thereby becomes a normative issue. In the PPF below, is point C â€Å"better† than point D or is D â€Å"better† than C?Democrats and Republicans have different perspectives on which combination of butter and guns is â€Å"best. † Claim. Moving from one efficient output allocation (point on the PPF) to another requires a transfer of resources from the production of one good to another. Consequently, when more guns are produced, less of butter can be produced; the opportunity cost of an increase in the production of guns is the resulting decrease in the production of butter. Furthermore, the |slope| of the PPF at a point shows the opportunity cost of one additional unit of good X as measured in terms of the other good Y.That is, the |slope| indicates how much of good Y must be sacrificed in order to obtain one additional unit of good X. Graphically: (see above graph) Points A, B, C, D, E and F represent three different combinations of guns and butter that the economy can produce when using all of its resources in a technologically efficient manner. When all resources and technology are used to produce butter, 500 units of butter can be produced but zero units of guns can be produced (pt. F). At any point on the PPF, the economy must sacrifice some guns to obtain more butter.Point G is inefficient because more of either or both goods can be produced; in this case, the opportunity cost of either good is zero. b) Constant Opportunity Costs and the Linear PPF Model DEF: A resource is specialized if it is not completely adaptable to alternative uses or cannot easily be substituted for another resource in the production of some good. Claim: If resources used in the production of goods X and Y are non-specialized or perfectly substitutable, then the opportunity costs are constant and the PPF is linear.That is, if the opportunity cost of a good X (as measured in terms of another good Y) is constant, then the same quantity of Y must be sacrificed for each additional unit of X, regardless of the quanti ty of X produced, and so the PPF is linear (a downward sloping straight line). Example: Assume that a farmer has 80 acres of land (of uniform fertility) and given quantities of other economic resources (labor, capital and entrepreneurial ability) with which to produce either corn or soybeans. On each acre of land, the farmer can produce either 100 bu. f corn or 50 bu. of soybeans. The opportunity cost of one bu. of soybeans is 2 bu. of corn and the opportunity cost of one bu. of corn is 1/2 bu. of soybeans. The farmer changes the combination of corn and soybeans produced by changing the number of acres planted in corn or soybeans. Non-specialized Resources – Linear PPF Production Possibility Schedule Possible Output Combinations A B C D E 0 2000 4000 6000 8000 4000 3000 2000 1000 0 Corn: Soybeans: 9 Note: At pt. A, all acres are in soybeans. At pt. B, 20 acres are in corn and 60 acres are in soybeans.At pt. C, 40 acres are in corn and 40 acres are in soybeans. At pt. D, 60 ac res are in corn and 20 acres are in soybeans. At by E, all acres are in corn. Remark: The opportunity cost of 4000 bu. of soybeans is 8000 bu. of corn; the opportunity cost of 8000 bu. of corn is 4000 bu. of soybeans. The opportunity cost of 2000 of corn is 1000 bu. of soybeans whereas the opportunity cost of 3000 bu. of soybeans is 6000 bu. of corn. Remark: At any point on the PPF, the opportunity cost of one additional bu of corn is 1/2 bu. of soybeans = |slope| of the PPF; i. . , OCcorn = ? bu. of soybeans per bu. of corn. Likewise, the opportunity cost of one additional bu of soybeans is 2 bu of corn = 1/|slope| of the PPF; i. e. , OCsoybeans = 2 bu. of corn per bu of soybeans = 1/(1/2) bu of corm per bu. of soybeans. Note that ? soybeans/? corn = |slope| of PPF can be written as (i) ? soybeans = |slope| ? ?corn, or, (ii) ? corn = ? soybeans/|slope|. Thus, if ? corn = 1, then ? soybeans = |slope| of PPF ? ?corn = ? ? 1 bu = ? bu, or, OCcorn = ? bu of soybeans. Likewise, if ? soy beans = 1 bu. , then ? corn = ? oybeans/|slope| = 1 bu. /(? ) = 2 bu. , or , OCsoybeans = 2 bu of corn. b) Increasing Opportunity Costs and the Concave-outward PPF Model The Law of Increasing Opportunity Cost: When resources are specialized, increased production of a good X comes at increased opportunity cost. That is, as the production of a good X increases, the quantity of a good Y that must be sacrificed for each additional unit of good X increases. Claim: The Law of Increasing Opportunity Costs and specialized resources are represented by a concave outward PPF.A movement down along a concave outward PPF implies that the opportunity cost of X is increasing. Remark: Most economic resources are specialized in the production of some good and so PPFs are most often drawn bowed outward. 10 Specialized Resources – Concave Outward PPF Production Possibility Schedule Possible Output Combinations A B C D E Good X (butter) 0 100 200 300 400 Good Y (guns)400 400 395 370 315 200 F 500 0 Examples: Given pt. B, the opportunity cost of 100 additional units of good X (butter) is 25 units of good Y (guns). At pt. C = (200X,370Y), suppose the |slope| of the PPF at C is OCX = ? 0. 5, then the opportunity cost of one additional unit of X (butter) is 0. 5 units of good Y(guns); alternatively, the opportunity cost of one additional Y is 2X. I. e. , at pt C, OCX = ? Y and OCY = 2X. At pt. D = (300X,315Y), suppose the |slope| of the PPF at D is 0. 8. The opportunity cost of one additional unit of X is 0. 8 units of good Y and the OC of one additional Y is 1/0. 8 = 1. 25 units of X. Formally, recall that ? Y/? X = |slope| of PPF. So, at pt D, |slope| = ? Y/? X = 0. 8, which can be rewritten as either (i) ? Y = 0. 8 ? ?X, or, (ii) ? X = ? Y/0. 8. So, at pt. D, if ?X = 1 (good X increases by 1 unit from 300 to 301 units of X), then good Y must be decreased by approximately 0. 8 units. That is, given ? X = 1 unit, it follows that ? Y = |slope| ? ?X = 0. 8 ? ?X = 0. 8 ? 1 unit, or OCX = 0. 8 units of Y. Likewise, at pt. D, if ? Y = 1 (good Y increases by 1 unit from 315 to 316 units of Y), then good X must be decreased by approximately ? X = 1/(0. 8) = 5/4 units. That is, given ? Y = 1 unit, it follows that ? X =? Y/0. 8 = 1 unit/0. 8 = 1 unit/(4/5) = 5/4 units = 1. 25 units, or OCy = 1. 25 units of X. Similarly, if at pt. E the |slope| = 1. , then OCX = 1. 5 Y = 3/2 Y and OCY = 2/3 X = 0. 67 X. 11 d) Shifts of the PPF Claim: Shifts of the PPF are caused by †¢ changes in the quantities available resources: L^ or K^ ? PPF shifts from PPF1 to PPF2. †¢ changes in technology: TechX^ ? PPF shifts from PPF2 to PPF3. †¢ changes in capital good vs. current consumption good choices Examples: Remark: An economic recession, a decrease in national real output for six or more months, is represented by a movement to a point inside the PPF and not an inward shift of the PPF, because in a recession not all resources (e. g. labor and capital) are fully or ef ficiently employed. 6. Choices and the PPF a) Choices Claim: Any society must decide: (i) What, how much and when to produce. (ii) How to produce (production technology) and distribute goods (allocation mechanism). (iii) For whom to produce, how to divide the economic pie. b) An Illustration: Present Choices, Future Possibilities and the PPF Model Claim: A choice of fewer capital goods and more current consumption goods implies smaller future increases (outward shifts) of the PPF, less capital accumulation, slower economic growth and smaller increases in living standards.In other words: â€Å"Party now, pay later. Pay now, party much more later. † 12 Graphically: Choose wisely! 7. Opportunity Cost, Comparative Advantage and Exchange (See Arnold, pp. 457-62). DEF: A(n) nation, firm or individual has a comparative advantage (CA) in the production of a good X if it can produce good X at a lower opportunity cost than can any other nation, firm or individual. A(n) nation, firm or individual has an absolute advantage in the production of a good X if it can produce more of good X with a given amount of resources than can any other nation, firm or individual.CLAIM: Every country has a CA is the production of at least one good. CLAIM: If nations, firms or individuals specialize in the production of the good in which they have a comparative advantage and engage in free, unrestricted trade (exchange), then total production will increase and exchange/trade can result in mutual gain for every nation, firm or individual. Remark: Specialization based on comparative advantage and free trade implies that a nation can consume outside its economy's PPF and that â€Å"self-sufficiency breeds inefficiency. An Example of Comparative Advantage and Mutual Gain Given: Wilma and Fred, computers and pizza, 100 units of labor, and linear PPFs. †¢ Wilma can produce either 50 comps or 1000 pizzas ? 1 comp â€Å"? â€Å" 20 pizzas ? OCWcomp = 20 pizzas and OCWpizza = 1/20 com p †¢ Fred can produce either 20 computers or 900 pizzas ? 1 comp â€Å"? â€Å" 45 pizzas ? OCFcomp = 45 pizzas and OCFpizza = 1/45 comp 13 Hence, Wilma has a CA in computers because OCWcomp = 20 pizzas < 45 pizzas = OCFcomp, and, Fred has a CA in pizza because OCFpizza = 1/45 comp < 1/20 comp = OCWpizza. Remark.Even though Wilma has an absolute advantage in the production of both pizza and computers, Fred still has a comparative advantage in the production of one of the goods. (i) â€Å"Autarky†: Initial no trade production and consumption: Labor Allocation Wilma 50% on comps 50% on pizza Fred: 50% on comps 50% on pizza Totals Production 25 comps 500 pizzas 10 comps 450 pizzas 35 comps 950 pizza Consumption 25 comps 500 pizzas 10 comps 450 pizzas 35 comps 950 pizza (ii) Mutual Gain from specialization and free trade. Fred and Wilma each specialization in the production of the good in which they hold a comparative advantage.Labor Allocation Wilma 80% on comps 20% on pi zza Fred: 0% on comps 100% on pizza Totals Production 40 comps 200 pizzas 0 comps 900 pizzas 40 comps 1100 pizza #1 Trade –15 comps +425 pizzas +15 comps –425 pizzas #1 Cons Allocation 25 comps 625 pizzas 15 comps 475 pizzas #2 Trade –12 comps +360 pizzas +12 comps –360 pizzas #2 Cons. Allocation 28 comps 560 pizzas 12 comps 540 pizzas Remark. Note that â€Å"all-or-nothing† specialization for both Wilma and Fred is not required to establish the result. This is true in general as well.Remark: The mutually agreeable terms of trade, or mutually beneficial price, for one good X as measured in terms of the other good Y is established between the opportunity costs of good X of each individual/country. That is, OCWcpu = 20 pizzas < terms of trade (tot) < 45 pizzas = OCFcpu, or, OCWpizza = 1/20 computer > 1/(tot) > 1/45 computers = OCFpizza. 14 In the above example, Wilma trades away 12 computers in exchange/return for 360 pizzas and so the terms of trade , tot, are 1 computer for 30 pizzas; i. e. , the tot or â€Å"price† of 1 computer = 30 pizzas.Hence, total (world) production and consumption are both greater under specialization and free trade than under autarky. Mutual gain results because Fred and Wilma each consume more of both goods. That is, specialization and free trade leads to an allocation that is Pareto superior to autarky. DEF: An allocation A is Pareto superior to an allocation B if no person is worse off at allocation A than at allocation B and at least one person is better off at allocation A than at allocation B. An allocation C is Pareto efficient (Pareto optimal) there does not exist an allocation D that is Pareto superior to allocation C.That is, allocation C is Pareto optimal if it is impossible to find another allocation D that makes one person better off without making someone else worse off. [The concept of Pareto efficiency is attributed to Vilfredo Pareto, a late 19th – early 20th century Ita lian economist. ] Graphically: The â€Å"specialization and free trade† consumption bundle (EW, EF) = ((560 pizza, 28 comps), (540 pizza, 12 comps)) is Pareto superior to the â€Å"autarky† consumption bundle ((500 pizza, 50 comps), (450 pizza, 10 comps)) because, compared to autarky, at least one person is better off and no one is worse off (in this case, both Fred and Wilma are better off). 5 ECON *120: Principles of Microeconomics I. FOUNDATIONS OF ECONOMICS B. Demand Section I. B Learning Objectives: †¢ Explain and differentiate the quantity demanded of a good and the demand for a good †¢ Explain, illustrate, and apply the law of demand and the demand curve †¢ Explain and illustrate the effects of changes in the determinants of demand (a. k. a. , non-own price factors or demand â€Å"shifters†) †¢ Explain and illustrate the effects of taxes and subsidies on demand 1. Definitions â€Å"DEF†: Demand represents the behavior f the cons umer and the relationships between the quantities of a good an individual consumes and other factors such as the good's price, the consumer's income, the consumer's tastes and preferences, the prices of goods related in consumption (substitutes and complements), expectations, government policies (taxes and subsidies), and the number of consumers. DEF: The quantity demanded of a good X, QXd, is the specific quantity of good X that a consumer is willing and able to purchase at a particular price.DEF: The demand curve, DX, shows the maximum quantity demanded of good X, QXd, by a consumer at each possible price in a series of prices for good X, ceteris paribus; alternatively, it shows the maximum price that a consumer is willing and able to pay for each possible quantity demanded of good X, QXd, in a series of quantities for good X, ceteris paribus. Remark: Demand is represented by the entire demand curve. The quantity demanded is represented by a single point on the demand curve a particular price and quantity pair. 2.The Law of Demand The Law of Demand: the quantity demanded of a good X, QXd, varies inversely with the price of good X, PX, ceteris paribus; i. e. , PX^(v) ? QXdv(^) and so the demand curve is downward sloping. 16 A brief explanation of the notation: The expression â€Å"PX^(v) ? QXdv(^)† is a form of symbolic shorthand, which will appear frequently in the lecture notes. The items outside the parentheses are associated with each other and the items within parentheses are associated with each other. Thus, the above expression can be separated and re-written as two separate expressions: â€Å"PX^ ?QXdv†, and, â€Å"PXv ? QXd^†. The expression â€Å"PX^ ? QXdv† reads: â€Å"an increase in the price of good X, PX, causes a decrease in the quantity demanded of good X, QXd. † Similarly, the expression â€Å"PXv? QXd^† reads: â€Å"a decrease in the price of good X, PX, causes an increase in the quantity de manded of good X, QXd†. Thus, the initial expression â€Å"PX^(v) ? QXdv(^)† states that an increase in the price of good X, PX, implies or causes a decrease in the quantity demanded of good X, QXd, and a decrease in the price of good X, PX, implies or causes an increase in the quantity demanded of good X, QXd.CLAIM: The Law of Demand is based on (i) substitution and income effects and (ii) the Law of Diminishing Marginal Utility. Intuitively: The income effect is the change in the quantity demanded of a good X, QXd, caused by a change in the purchasing power of a consumer's income, a. k. a. real income, which results when the price of good X, PX, changes, i. e. , PX^(v) ? purchasing power v (^) ? QXdv(^) The substitution effect, SE, is the change in the quantity demanded of a good X, QXd, caused by a change in the relative price of X (and while holding real income constant).PX^(v) ? the consumer substitutes the relatively cheaper good Y (X) in ? QXdv(^) place of the re latively more expensive good X (Y) Assumption: A consumer's total utility or happiness can be measured in terms of â€Å"utils. † DEF: The marginal utility of a good X, MUX, is the increase in total utility, TU, (satisfaction, happiness) that a consumer derives from the consumption of an additional unit of good X, ceteris paribus: MUX = ? Total Utility/? QX = ? TUX/? QX.The Law of Diminishing Marginal Utility (LDMU) states that the marginal utility derived from the consumption of a good X decreases (increases) as the quantity of good X consumed increases (decreases), ceteris paribus, i. e. , MUXv(^) as QX^(v) Remark: The LDMU implies that as the quantity consumed of a good increases, the price a consumer is willing to pay for those additional quantities decreases: QX^(v) ? MUXv(^) ? the price the consumer is willing to pay v(^).In the D2L â€Å"Interactive Graphs† section, click on the link â€Å"Demand Schedule & Curve† to see the interactive graph â€Å"An Ex ample of a Demand Schedule and Demand Curve. † 17 3. Determinants of Demand (Non-own Price Factors or â€Å"Demand Shifters†) Remark: An increase in demand means that at any given price, consumers are willing and able to buy a larger quantity of the good, or, alternatively, that at any given quantity, consumers are willing and able to pay a higher price per unit.A decrease in demand means that at any given price, consumers are willing and able to buy a smaller quantity of the good, or, alternatively, that at any given quantity, consumers are willing and able to pay a lower price per unit. Claim: Movements vs. Shifts. Changes in a good's â€Å"own† price, PX, cause changes in the quantity demanded of X, QXd, and movements along the good X demand curve, DX. Changes in the determinants of demand (a. k. a. the non-own price factors or â€Å"shifters† of demand) cause changes the demand for good X, DX, and shifts of the entire demand curve, DX.Example: A decrea se in the price of gas, Pgas causes an increase in the quantity demanded of gas, Qgasd, and a downward movement along the demand curve for gas because Pgas is the â€Å"own† price of gas. In contrast, the same change in Pgas causes an increase in the demand for SUVs and an outward or upward shift of the SUV demand curve because Pgas is a â€Å"non-own price† factor with respect to SUV demand. In the D2L â€Å"Interactive Graphs† section, click on the link â€Å"An Increase/Shift in Demand† to see the interactive graph â€Å"An Explanation of an Increase in Demand and a Shift of the Demand Curve. a) Tastes and preferences Tastes and preferences for good X ^(v) ? DX^(v), the demand curve shifts up/right (down/left). An â€Å"increase† in preferences implies that at any given price, say P1, the consumer is willing and able to buy a greater quantity, Q2d instead of Q1d. Or equivalently, at any given quantity, Q1d, the consumer is willing and able to p ay a higher price, P2 instead of P1. 18 Examples: †¢ summer vacation travel ? the demand for gasoline increases, DX shifts up/right †¢ tornado destruction in the Midwest ? he demand for lumber increases, DX shifts up/right †¢ mad cow disease ? demand for McDonald’s hamburgers decreases (DX shifts down/left) and demand for chicken sandwiches (good Y) increases (DY shifts up/right) †¢ medical studies change the demand for various goods (cigarettes, bran, mercury, etc. ) b) Consumer income: normal and inferior goods DEF: A good X is a(n) normal (inferior) good if an increase in the consumer's income I increases (decrease) the demand for good X, ceteris paribus; i. e. , Normal good: I ^(v) ? DX^(v) Inferior good: I ^(v) ?DXv(^) 19 Remark: Whether a good is normal or inferior depends upon an individual's preferences and tastes. Goods such as computers, new cars, eating out and jewelry are typically considered normal goods whereas goods such as pasta, potatoes, hotdogs, beer and the Bible. c) Prices of goods related in consumption: substitutes and complements DEF: Two goods, X and Y, are substitutes (complements) in consumption if an increase in the price of good Y, PY, increases (decreases) the demand for good X, DX, ceteris paribus; i. . , X and Y are substitutes: PY^(v) ? DX^(v). X and Y are complements: PY^(v) ? DXv(^). Examples: †¢ †¢ Complement goods: beer and pizza, gasoline and cars, staples and staplers, and computers and software, printers and printer cartridges, shoes and socks. Substitute goods: Pepsi and Coke, sub sandwiches and hamburgers, tea and coffee, ice cream and frozen yogurt, and staples and paperclips. Example: If jelly and peanut butter are complements in consumption, then Pjelly^(v) ? Qdjellyv(^) ? Dpeanut butterv(^).In this example, an increase in the price of jelly, Pjelly^, decreases the quantity demanded of jelly, Qdjellyv, which then (because consumers are buying less jelly) decreases the demand for peanut butter, Dpeanut butterv and shifts the demand curve for peanut butter down and to the left: when the intermediate step is removePjelly^ ? Dpbv . 20 Example: If coffee and tea are substitutes in consumption. Then Pcoffee^(v) ? Qdcoffeev(^) ? Dtea^(v). d) Expectations about future income, prices, and availability of goods. e) Government policies (taxes and subsidies).Remark: An excise tax (subsidy) on the consumption of a good shifts the â€Å"effective† demand curve vertically down (up) by the amount of the tax (subsidy). Graphically: An excise tax on consumption and the effective (after tax) demand curve. 21 Example: A $0. 50 excise tax shifts the â€Å"effective† demand curve down vertically by $0. 50 from the perspective of the producer because of the tax, the maximum price consumers are willing and able to pay producers (again, from the producers perspective) for Q0 = 100 units falls from $2. 25 to $1. 75. Consumers still pay the original $2. 25 but after the tax is imposed, producers receive $1. 5 and the rest goes to the government. Graphically: An excise subsidy on consumption and the effective (after subsidy) demand curve. Example: From the perspective of producers, an excise subsidy increases the maximum price consumers are willing and able to pay and so shifts the demand curve up vertically by $1. f) Number of consumers ^(v) ? DX^(v) Remark: Follows directly from the derivation of the market demand curve (next page). In the D2L â€Å"Interactive Graphs† section, click on the link â€Å"Examples of Changes in Demand† to see the interactive graph â€Å"Determinants of Demand and Shifting the Demand Curve. Please note the remark about the incorrect scripting of one of the cases of a demand change. 22 4. The Market Demand Curve Claim: The market demand curve is the horizontal summation of the individual demand curves of all consumers. Graphically: 23 ECON *120: Principles of Microeconomics I. FOUNDATIONS OF ECONOMICS C. Supply Section I. C Learning Objectives: †¢ Explain and differentiate the quantity supplied of a good and the supply for a good †¢ Explain, illustrate, and apply the law of supply and the supply curve †¢ Explain and illustrate the effects of changes in the determinants of supply (a. k. a. nonown price factors or supply â€Å"shifters†) †¢ Explain and illustrate the effects of taxes and subsidies on supply 1. Definitions â€Å"DEF†: Supply represents the behavior of the producer and the relationships between the quantities of a good a firm produces and other factors such as the good's price, technology, prices of inputs, prices of goods related in production, expectations, government policies (taxes and subsidies), the number of producers. DEF: The quantity supplied of a good X, Qs, is the specific quantity of good X that a producer is willing and able to produce and make available for sale at a specific price.DEF: The supply curve for a good X, SX, shows the maximum quantity supplied of good X by a producer at each possible price in a series of prices, ceteris paribus; alternatively, it shows the minimum price per unit that a producer must receive (or is willing to accept) for each possible quantity of a good X in a series of quantities, ceteris paribus. Remark: Supply is represented by the entire supply curve; the quantity supplied at a specific price is represented by a single point on the supply curve—a particular price and quantity pair. 2.The Law of Supply The Law of Supply: the quantity supplied of a good, Qs, varies positively with the good's price P, ceteris paribus; i. e. , P^(v) ? Qs^(v) and so the supply curve is upward sloping. 24 CLAIM: The Law of Supply and the upward sloping short run (SR) supply curve are based on the Law of Increasing Opportunity Costs. As the quantity supplied/produced increases, more inputs or resources must be used. Because inputs experience increasing opportunity cost, the opportun ity costs of additional inputs increase thereby increasing the per unit cost of producing additional output.Producers must receive a higher price in order to cover the higher costs of production. 3. Determinants of Supply (Non-own price factors or supply â€Å"shifters†) Remark: An increase in supply means that at any given price, producers are willing and able to produce a larger quantity of the good, or, alternatively, that at any given quantity, producers are willing and able to accept a lower price per unit. A decrease in supply demand means that at any given price, producers are willing and able to producer a smaller quantity of the good, or, alternatively, that at any given quantity, producers must receive a higher price per unit.Remark: Movements vs. Shifts. Changes in the good's own price cause changes in the quantity supplied of good X, QXs, and movements along the supply curve. Changes in the determinants of supply (the non-own price factors) cause changes in supply of good X, SX, and shifts of the entire supply curve, SX. a) Production technology: Tech ^(v) ? S^(v) 25 b) Input prices/resource costs: Input prices ^(v) ? Sv(^) Graphically: c) Prices of goods related in production: substitutes and joint products DEF: Two goods/products, X and Y, are substitutes in production if PY^(v) ? SXv(^).Two goods/products, X and Y, are joint products if PY^(v) ? SX^(v) X and Y are substitutes in production: PY^(v) ? QsY^(v) ? SXv(^). X and Y are joint products: PY^(v) ? QsY^(v) ? SX^(v). Example of Joint Products: Beef and Leather (Other examples: Donuts and donut holes, electricity and wall board/gypsum). Example of Substitutes in Production: Kringle and donuts. (Other examples: Jockey sweatshirts and T-shirts, SUVs and pickups, corn and soybeans. ) 26 d) Expectations with respect to. Inventories, future prices (of both inputs and output) and resource availability ) Government policies (taxes, subsidies and regulations) Remark: An excise tax (subsidy) on production shifts the â€Å"effective† supply curve vertically up (down) by the amount of the tax (subsidy). Graphically: An excise tax on production and the effective (after tax) supply curve. Graphically: An excise subsidy on production and the effective (after tax) supply curve. 27 f) Number of producers 4. The Market Supply Curve Claim: The market supply curve is the horizontal summation of the individual supply curves of all producers/firms. Graphically: 28 ECON *120: Principles of Microeconomics I. FOUNDATIONS OF ECONOMICS D.Market Equilibrium Section I. D Learning Objectives: †¢ Explain and illustrate a market equilibrium quantity and price †¢ Explain and illustrate market disequilibrium (shortage or surplus) †¢ Explain and illustrate the functions of market prices †¢ Explain and illustrate the effects of changes in the determinants of demand and supply on the market equilibrium quantity and price 1. Definitions DEF: A market equilibrium is a price P* and a quantity Q* such that at P* the quantity demanded equals the quantity supplied, Qd = Q* = Qs. DEF: A surplus exits at a price P1 if Qd ; Qs at P1. A shortage exits at the price P2 if Qd ; Qs at P2.Remark: Intuitively, a market equilibrium exists when market forces (demand and supply) are balanced and there is nothing that causes a change in the market price or quantity of a good. Illustrations: a marble at the bottom of a bowl. Remark: At a market equilibrium quantity and price, Q* and P*, the quantity demanded, Qd, equals the quantity supplied, Qs, equals Q* (Qd = Q* = Qs) at P*. At a market equilibrium, demand DOES NOT EQUAL supply; i. e. , it is NOT the case that D = S. To state that D = S means that the demand curve is identical to the supply curve, which clearly is an incorrect statement! 9 2. The Functions of Prices Claim: Prices play a critical role in competitive markets: (i) Prices are flexible and adjust to â€Å"clear† the market; prices ensure internal c onsistency by coordinating the production and consumption plans made independently by producers and consumers. DEF: The price adjustment mechanism: at a price P0, Qd ;( Q0* = Qs at P0* ? P^(v) as consumers bid up (down) prices ? Qdv along D1 from Q1 and Qs^ along S0 from Q0* (Qd^ along D1 from Q1 and Qsv along S0 from Q0*) until Qd = Q1* = Qs at P1*. Graphically: Dv and S constant ? P*v and Q*v. 30Examples: Be able to work through changes in preferences, income for normal goods (e. g. , cell phones and computers) and inferior goods (e. g. , hotdogs and pasta); prices of substitutes (e. g. , tea and coffee, Coke and Pepsi, staples and paperclips), prices of complements (beer and brats, staples and staplers, computers and floppy disks), etc. For the case of an increase in demand, see with the interactive graph â€Å"Demand Increase & Market Clearing,† which is available on the D2L ECON 120 website. b) S^(v) and D constant ? P*v(^) and Q*^(v). Remark: S^(v) from S0 to S1 ? surpl us (shortage) is created at the initial equilibrium price P0*, i. e. , Qd = Q0* ; Q1 = Qs at P0* ? Pv(^) as consumer bid down (up) price ? Qd^ along D0 from Q0* and Qsv along S1 from Q1 (Qdv along D0 from Q0* and Qs^ along S1 from Q1) until Qd = Q1* = Qs at P1*. Graphically: Sv and D constant ? P*^ and Q*v. For the case of an increase in supply, see with the interactive graph â€Å"Supply Increase & Market Clearing,† which is available on the D2L ECON 120 website. Examples: Be able to work through changes in technology, input prices or resource costs (e. g. , wages, pizza toppings, energy), prices of substitutes in production (e. . , kringle and donuts, corn and soy beans), prices of joint products (donuts and donut holes, hamburger beef and leather, electricity and bricks). c) Simultaneous changes in D and S Claim: When demand and supply change simultaneously, then the change in the equilibrium price and quantity demand upon the magnitudes of the change in demand and supply. Four cases exist: 31 (i) (ii) (iii) (iv) D^ and S^ ? Q*^ and the change in P* is indeterminate D^ and Sv ? P*^ and the change in Q* is indeterminate Dv and Sv ? Q*v and the change in P* is indeterminate Dv and S^ ? P*v and the change in Q* is indeterminateGraphically: Case (i) D^ and S^ ? Q*^, P* may increase, remain constant, or decrease (? P* ). Or, equivalently: Work through the remaining cases on your own! 32 ECON *120: Principles of Microeconomics I. FOUNDATIONS OF ECONOMICS Section I. E Learning Objectives: †¢ Explain and illustrate consumer surplus and producer surplus †¢ Explain and illustrate total benefit and total cost †¢ Explain and illustrate the efficiency of a competitive market equilibrium for a pure private good †¢ Explain and illustrate the effects of price controls, taxes and subsidies and the resulting deadweight losses E.Applications 1. Consumer and Producer Surplus Recall: The Marginal Benefit, MB (Marginal Cost, MC) of a good Q is the incr ease in total benefit, TB (cost, TC) resulting from a unit increase in Q; i. e. , MB = ? TB/? Q (MC = ? TC/? Q). Claim: Because the maximum price a consumer is willing and able to pay for an additional unit of a good is based upon the consumer’s MB from consuming that additional unit, the demand curve represents the marginal benefit derived from the consumption of the good.Likewise, because the minimum price a producer is willing and able to accept for an additional unit of a good is based upon the producer’s MC from producing that additional unit, the supply curve represents the marginal cost incurred from the production of the good. Thus, the demand (supply) curve can be used to measure a consumer's (producer’s) â€Å"economic welfare† at a given quantity. CS (PS) is used to measure the change in consumer (producer) welfare resulting from a change in the price and quantity and of a good consumed by consumers (produced by producers).DEF: Consumer Surplus , CS, is the difference between the price that a consumer is willing and able to pay and the price the consumer must actually pay in the market. 33 Remark: CS at a quantity Q1 is the difference between the total benefit of the consumer at Q1 (represented by the area under the demand curve between 0 and Q1 or the area of 0abQ1) and consumer total expenditures at Q1 (= P1? Q1 or the area of 0cbQ1). Thus, CS at Q1 represents the net benefits of consumers and is illustrated by the area between the demand curve and the market price line.DEF: Producer Surplus, PS, is the difference between the price that a producer is willing and able to accept and the price the producer actually receives for that good in the market. Remark: PS of a given quantity Q1 is the difference between the total revenue of the producer at Q1 ( = P1? Q1 or the area of 0cbQ1) and the total cost at Q1 (represented by the area under the supply curve between 0 and Q1 or the area of 0dbQ1). Thus, PS at Q1 represents the net benefits of producers at Q1 and is illustrated by the area between the supply curve and the market price line.Remark: For consumers, a price increase (decrease) lowers (raises) consumer surplus CS. The los (gain) of CS measures the decrease (increase) in consumer economic welfare. For prioducers, a price increase (decrease) raises (lowers) producers surplus PS. The gain (loss) of PS measures the increase decrease) in producer economic welfare. 34 Recall: The Total Benefit, TB (Total Cost, TC) at a given quantity Q1 is represented by the area under the MB (MC) curve between 0 and the quantity Q1. In the graph below, TB at Q1 = area abQ10 and TC at Q1 = area deQ10. Similarly, TB at Q2 = area acQ20 and TC at Q2 = area dfQ20.Remark: The change in TB caused by a change in Q is given by the area under the MB curve for that change in Q. For example, given an increase in Q from Q1 to Q2, the increase in TB = ? TB = area bcQ2Q1. Likewise, given an increase in Q from Q1 to Q2, the increas e in TC = ? TC = area efQ2Q1. Remark: At a given quantity, Q1, the economic gain to consumers and producers at the market equilibrium is represented by the Total Surplus or Net (Social) Benefit = net benefit of consumers + net benefit of producers = CS(Q1) + PS(Q1) = TB(Q1) – TC(Q1) = area abd in the graph below. 35 2.Market Equilibrium and Efficiency in the â€Å"Private Good† MB/MC Model DEF: A good is a pure private good if there are no external benefits or costs from the consumption or production of that good and so Dmkt = MB = ? iMBi and Smkt = MC = ? jMCj. DEF: In a market, the quantity Q* is efficient if the maximum price consumers are willing and able to pay per unit for Q*, which represents the marginal benefit to consumers or â€Å"consumers price† equals the minimum price producers are willing and able to accept per unit for Q*, which represents the marginal (opportunity) cost to producers or â€Å"producers price†.That is, the quantity Q* is ( socially or economically) efficient if MB = MC at Q*. Claim: (The First Fundamental Theorem of Welfare Economics) In a market for a pure private good, the market equilibrium quantity is efficient, provided that certain technical conditions are satisfied; i. e. , at the market equilibrium Q* and P*, P* = MB(Q*) = MC(Q*). Remark: In other words, net social benefit is maximized at Q*. In addition, if at a quantity Q0, MB ) MC, then Q0 is inefficient and a deadweight loss, DWL, (also know as a â€Å"welfare cost† or â€Å"loss in efficiency†) is imposed upon society.The DWL at Q1 (Q2) is represented below by the area bce (cgh). Remark: The quantity Q1 is inefficient because MB(Q1) > MC(Q1); similarly, the quantity Q2 is inefficient because MB(Q2) < MC(Q2). At Q1 (Q2), society can be made better off by producing one more (less) unit of Q. Increasing Q from Q1 to Q* increases social welfare by the amount DWL at Q1 = area bce = ? TB – ? TC = area beQ*Q1 – area e cQ*Q1. Alternatively, decreasing Q from Q2 to Q* increases welfare by DWL at Q2 = area cgh = ? TB – ? TC = area Q*chQ1 – area Q*cgQ1. 3.Price Controls DEF: A price ceiling is a maximum legal price that a producer/seller may charge for a good or service; a price ceiling, Pc, is effective only if it is below the market equilibrium price (Pc < P*mkt). A price floor is a minimum price, fixed and â€Å"supported† by the government, that a producer/seller can receive for a good or service; a price floor, Pf, is effective only if Pf > P*mkt. 36 Claim: At a price floor Pf, the quantity supplied in the market, Qsmkt, is inefficient and the good is â€Å"overproduced† (i. e. , Qsmkt > Q*mkt) because t Qsmkt, the maximum price consumers are willing and able to pay per unit for Qsmkt is less than the minimum price producers are willing and able to accept per unit for Qsmkt. That is, at Qsmkt, MB < MC and so Qsmkt is inefficient. Graphically: (iii) At a price ceiling, Pc, the quantity supplied in the market, Qsmkt, is inefficient and the good is â€Å"under-produced† (i. e. , Qsmkt < Q*mkt) because at Qsmkt, the maximum price consumers are willing and able to pay per unit for Qsmkt is greater than the minimum price producers are willing and able to accept per unit for Qsmkt.That is, MB > MC and so Qsmkt is inefficient. Graphically: 37 4. Taxes and Subsidies: Who Pays and Who Benefits? DEF: Consumers price vs. producers price. Claim: An excise tax (subsidy) drives a â€Å"wedge† between the consumers’ price and the producers’ price and imposes a deadweight loss (welfare cost or loss in efficiency) upon society because the losses in CS and PS exceed the tax revenues. Graphically: Excise tax on consumption. Remark: The after-tax equilibrium quantity, Qtax, is inefficient because MB > MC at Qtax, and so a deadweight loss is imposed upon society, represented by DWL(Qtax) = area abc.The tax revenue is not an economic loss f or society in general but does constitute a redistribution of economic welfare from consumers and producers of the good to society in general. The DWL is the difference between the sum of the loss in consumers surplus, area P*dab, and the loss of producers surplus, area eP*bc and the tax revenue generated by the excise tax, area edac, i. e. , DWL(Qtax) = ? CS + ? PS – Tax Revenue = area P*dab + area eP*bc – area edac = area abc Graphically: Excise tax on production. 38 ECON 120: Principles of Microeconomics Spring 2010 II. MICROECONOMIC MODELS AND DECISION-MAKING Section II. ALearning Objectives: †¢ Explain and calculate the price elasticity of demand †¢ Explain and illustrate elastic, inelastic, unit elastic, perfectly elastic, and perfectly inelastic demand and corresponding demand curves †¢ Explain the determinants of elasticity †¢ Explain and illustrate the effects on total revenue of producers or total expenditures of consumers of a change in p rice given elastic, unit elastic, and inelastic demand †¢ Explain and calculate other elasticities of demand (income and cross price elasticities) †¢ Explain and calculate the price elasticity of supply and its basic determinant †¢ Explain and illustrate how the elasticity of demand and supply affect consumers and producers prices given an excise tax on production A. Elasticity of Demand and Supply 1. Elasticity of Demand a) The Concept of Elasticity and Elastic/Inelastic Demand Curves DEF: The (own) price elasticity of demand, Ed, is a numerical measure of the sensitivity or responsiveness of the quantity demanded to changes in price, ceteris paribus, and is calculated as Ed = ? %? Qd/%? P?. Examples: Suppose that the quantity demanded of gas, Qgas, decreases by 10% when the price of gas, Pgas, increases by 20%. Then Ed = ? –10%/20%? = 0. 5.If the Qd of Mountain Dew decreases by 50% when the price of Mountain Dew increases by 20%, then Ed = ? –50%/20%? = 2. 5. Remark: %? Qd = – Ed? %? P. Example: If Ed = 2 and price increases by 8%, %? P = +8%, then %? Q = –2? (8%) = –16%. If Ed = 0. 4 and price decreases by 25%, %? P = –25%, then %? Q = –0. 4? (–25%) = +10%. Alternatively, if a firm wants to increase its sales by 30% and Ed = 1. 5, then it should decrease price by 20% because %? P = %? Q/ –Ed = 30%/ –1. 5 = –20%. DEF: Midpoint elasticity formula: Given two points on a demand curve, (Q1,P1) and (Q2,P2), the (own) price elasticity of demand at the midpoint between these two points is calculated by Ed = ? %? Qd/%? P? = ? (Q1 – Q2)/(Q1 + Q2)]/[(P1 – P2)/(P1 + P2)] ?. 39 Example: Let pt A = (Q1,P1) = (8,16); pt. B = (Q2,P2) = (12,14); pt. C = (Q3,P3) = (28,6); pt. D = (Q4,P4) = (32,4). The midpoint price elasticity of demand between pts A & B: Ed = ? [(8 – 12)/(8 + 12)]/[(16 – 14)/(16 + 14)]? = (4/20)/(2/30) = 3. pts B & C: Ed = ? [(12 – 28)/(12 + 28)]/[(14 – 6)/(14 + 6)]? = (16/40)/(8/20) = 1. pts C & D: Ed = ? [(28 – 32)/(28 + 32)]/[(6 – 4)/(6 + 4)]? = (4/60)/(2/10) = 1/3. Remark: A linear demand curve has a different elasticity coefficient, Ed, at each point on the demand curve, Ed ranges from Ed = 0 at the horizontal intercept to Ed = ? at the vertical intercept.DEF: Demand is said to be: elastic if Ed > 1 or ? %? Qd? > ? %? P? , unit elastic if Ed = 1 or ? %? Qd? = ? %? P? , inelastic if Ed < 1 or ? %? Qd? < ? %? P? , perfectly elastic if Ed = ? and perfectly inelastic if Ed = 0. Remarks: (i) Perfectly elastic demand is represented by a demand curve that is horizontal at the market price. A perfectly elastic demand curve implies that, at the market price, consumers will buy whatever quantity producers are willing and able to produce. (ii) Perfectly inelastic demand is represented by a demand curve that is vertical at the market quantity and implies that consumers will pay whatever price pro ducers want for the market quantity. iii) Elastic demand can be represented by a demand curve that is relatively flat, such as D3. The majority of the demand curve D3 that appears in the graph is the elastic portion of the demand curve because the midpoint of the demand curve, where Ed = 1, is near the â€Å"lower-end† of D3. 40 (iv) Likewise, inelastic demand can be represented by a demand curve that is relatively steep, such as D2. The majority of the demand curve D2 that appears is the inelastic portion of the demand curve because the midpoint of the demand curve, where Ed = 1, is near the â€Å"upper-end† of D2. b) Determinants of Elasticity Claim: The demand for good X is more elastic (inelastic) (i) the greater (fewer) the number of substitutes there are for good X.Remark: In general, Edcaterory < Edbrand. For example, because very few substitutes for gas exist but many substitutes for Mobil gas exist (such as BP, Citgo, Phillips, Shell, etc. ), Edgas < EdMobil g as. Likewise, Edsoda < EdMountain Dew. (ii) the more (less) an item absorbs as a share or portion of a consumer's budget, Example: Because student expenditures on tuition or rent as a percentage are much greater than their expenditures on toothpicks or salt as a percentage of their income, Edcollege ; Edsalt. (iii) the less of a necessity and the more of a luxury (the more of a necessity and the less of a luxury) good X is; for example, Edfood ; Eddiamond jewelry. iv) the longer (shorter) the time interval considered, which allows for changes in preferences or the emergence of more substitutes; i. e. Edshort run ; Edlong run. c) Elasticity and Total Expenditures (Total Revenue) Remarks: Total Revenue of producers = TR = P? Q = TE = Total Expenditures of consumers. Because TR = TE = P? Q, total revenue or total expenditures can be represented graphically by the area of a rectangle of width Q and height P. 41 Claim: Along the (i) elastic portion of the demand curve, Ed ; 1 or ? %? Qd? ; ? %? P? : Pv(^) ? TE^(v). (ii) unit elastic point of the demand curve, Ed = 1 or ? %? Qd? = ? %? P? : Pv(^) ? ?TE = 0. iii) inelastic portion of the demand curve, Ed ; 1 or ? %? Qd? ; ? %? P? : Pv(^) ? TEv(^). Remark: In the graphs below, consider a given change in price, ? P (= P1 – P2 = P3 – P4), and change in quantity demanded, ? Q (= Q1 – Q2 = Q3 – Q4). Along the elastic section of the demand curve (left graph), the decrease in price, ? P, from P1 to P2, and the increase in the quantity demanded, ? Q, from Q1 to Q2, increases total expenditures of consumers (or total revenue of producers); i. e. , TE1 = P1 ·Q1 ; P2 ·Q2 = TE2 because the increase in expenditures from a greater quantity is greater than the decrease in expenditures from a lower price.Alternatively, along the inelastic section of the demand curve (right graph), the same decrease in price, ? P (from P3 to P4), and increase in quantity demanded, ? Q (from Q3 to Q4), decreases total e xpenditures of consumers (or total revenue of producers); i. e. , TE3 = P3 ·Q3 ; P4 ·Q4 = TE4 because the increase in expenditures from a greater quantity is less than the decrease in expenditures from a lower price. 42 Claim: TR is at a maximum at the quantity at which Ed = 1. d) Other Elasticities of Demand (i) Income elasticity of demand, EI, is a numerical measure of the responsiveness or sensitivity of the quantity demanded to changes in income, ceteris paribus. If EI ;(( %? P), then supply is elastic, 1 ; Es ; ?. f production costs do NOT increases as output increases, then supply is perfectly elastic, Es = ?. †¢ 44 P perfectly inelastic : ES = 0 S1 S2 inelastic: 0 ; E S ; 1 S3 elastic: 1 ; E S ?P S4 perfectly elastic : E S = ? ?Q 2 ? Q 3 0 Q0 Q †¢ Given S2, a change in price of ? P yields a relatively small change in the quantity supplied (i. e. , %? P ; 0 ? %? Qs ; 0 but %? P ; %? Qs) and so 0 ; ES = %? Qs/%? P ; 1. For example, if supply is inelastic, then a 5 % increase in price results in a less than 5% (perhaps 3%) increase in Qs. Given S3, a change in price of ? P yields a relatively large change in the quantity supplied (i. e. , %? P ; 0 ? %? Qs ; 0 but %? P ; %? Qs) and so 1 ; ES = %? Qs/%? P.For example, if supply is elastic, then a 5% increase in price results in a more than 5% (perhaps 8%) increase in Qs. Given S4, a change in price of ? P yields an â€Å"infinite† response from producers. Producers are willing to produce and sell whatever quantity consumers are willing and able to buy at the market price (i. e. , %? P ; 0 ? %? Qs = ? and so ES = %? Qs/%? P = ? ). †¢ †¢ 3. Elasticity and Taxes Claim: Given an excise tax on either consumption or production, if the elasticity of demand is greater (less) than the elasticity of supply, then the portion of the tax paid by consumers is less (greater) than the portion of