Elasticity; Consumer Surplus; Consumer Behavior; Utility
Elasticity
 Definition of Ed
 Elasticity gives us a more quantitative measurement. It measures responsiveness of buyers and sellers to price changes. Ed is the Elasticity of Demand. It is the responsiveness of buyers to price change.
 Ed is negative because the line is downsloping – rise in price drops Qd. Eliminate this using the absolute value.
 Recognize elastic, inelastic, unit elastic
 Perfectly elastic: Ed=8(infinity) Small change in price causes consumers to buy all that they possibly want/can
 Curve is a flat line going straight across)
 Relatively elastic: Ed>1 (occurs when %?QD > %?P)
 Unit elastic: Ed=1 (occurs when %?QD = %?P)
(Note: The curve graph also represents unit elastic, because the changes in p and q offset straight through)
 Perfectly inelastic: Ed=0 Change in price has no affect on Qd
 (Curve is a straight line going up and down)
 Relatively inelastic: Ed<1 (occurs when %?QD < %?P)
 If 2 lines are on the same graph, and intersect, you know for certain which is more elastic. In this graph, D2 is more elastic than D1
 How to compute Ed using
 Ed=% ?Qd/% ?P
 From demand curve ((Q2Q1)/(Q2+Q1))/((P2P1)/(P2+P1))
 Compute % ?Qd ((Q2Q1)/((Q2+Q1)/2))
 Compute % ?P ((P2P1)/((P2+P1)/2))
 Relationship between Ed & TR
 If demand is elastic and price goes down, TR goes up (inverse relationship)
 If demand is inelastic and price goes down, TR goes down (direct relationship)
 If demand is unit elastic, there is no affect on TR by a change in price.
 Be able to compute TR TR=P*Q
 Recognize TR from a graph – In the graph below, P is $4, and at that price, the merchant can sell 2 units. Therefore, TR is $4*2 = $8, and is represented by the shaded area of the graph.
 Know the difference between Ed and slope
 Elasticity is not slope. On a straight line, slope (y/x) is the same, it is a measure of the change from one point to the next. Elasticity is a measure of the percent change from one point to the next. Because of this, you get numbers over 1 at the top, and numbers under 1 at the bottom, of the demand curve. This means it’s more elastic at the top than at the bottom.
 Know the determinants of Elasticity (3 identified)
 Necessities are typically in elastic; luxury goods are typically very elastic.
 1. The number and closeness of available substitutes.
 The more substitute goods that are available for a product, the greater the price elasticity of demand for the product.
 2. Time – elasticity increases over time.
 3. % of total budget.
 The smaller the good is as a % of your total budget, the more inelastic it will be.
 Budget of $1000. Rent goes up $30, milk goes up $0.20. The larger chunk will be felt in the budget, where as the smaller chunk is hardly noticeable in the overall budget.
 Elasticity of supply
 Elasticity of supply is the responsiveness of sellers to price changes.
 Over time, supply becomes more elastic.
 %?Qs/%?P
 There is no total revenue test for Es, as they move in the same direction regardless of the elasticity of supply.
 Perfectly elastic: Es=8(infinity) Small change in price causes as much as possible to be supplied.
 Graph is a straight line across.
 Relatively elastic: Es>1 Small change in price causes a lot more to be supplied.
 Represents the long run. Producers can make adjustments to all inputs to vary production.
 Perfectly inelastic: Es=0 Change in price has no effect on the amount supplied.
 Graph is a straight line up and down.
 Represents the market period. There is too little time for producers to change output.
 Relatively inelastic: Es<1 It takes a larger change in price to have a smaller amount more supplied.
 Represents the short run. Producers have less flexibility due to fixed costs to produce more (limited control over the range in which they can vary their output).
Utility
 Law of Diminishing marginal utility
 Utility is the power of a good to satisfy a want as evidenced by the satisfaction you receive from consuming it.
 The more you have of a good, the less you’re willing to pay for another unit of it, because the amount of utility you get from the next unit is less than from the previous (enjoy the second burger less than the first, the third less than the second). Therefore, customers won’t pay the same amount for the additional units, and that explains the downward sloping demand curve.
 At some point, start feeling dissatisfaction (negative untility).
 Consumer equilibrium
 A consumer is at equilibrium (can’t increase utils) when he allocates his expenditures such that the marginal utility per $ spent on any 2 goods is equal.
 Formula is (MUa/Pa)=(MUb/Pb)
 Example MUa=20, MUb=10, Pa and Pb both are $10
 (20/$10)=(10/$10) – consumer is not at equilibrium. Stop buying as much of good A and buy more of good B. This will cause the MU of B to increase and the MU of A to decrease to an equilibrium
 (15/$10)=(15/$10) – consumer is at equilibrium
 Can be used for more than two goods: (MUa/Pa)=(MUb/Pb)=(MUc/Pc)
 Know MUm (Money)
 Money can be a good as having money can give you satisfaction
 Feeling of security, or insecurity if you have too much of it, same as satisfaction/dissatisfaction
 Money can be used to purchase other goods.
 Formula is Mum/$1 = The marginal utility per dollar.
 MUm can be used to find price and marginal utility of a good. Price is a function of money, and the MUm that a person has affects the MU of the product
 MUm=(MUa/Pa)
 MUa=MUm*Pa
 Pa=MUa/MUm
 Explains how the demand curve is created (following uses Pa formula above) Knowing the MUa and MUm allows us to identify the price based off of quantity.
 Know the relationship between TU and MU
 MU=Marginal Utility= The change in total utility resulting from a unit change in the quantity of the product consumed. Negative number shows dissatisfaction.
 Formula = ?TU/?Q
 TU is the total measure of utility (satisfaction) that the consumer receives. It is the sum of the MU for the product.
 In the graph below, MU falls between the TU numbers (that’s why the .5s are listed).
 Section I
 TU is increasing at an increasing rate
 MU is increasing per unit of the product consumed
 Section II
 TU is increasing, but at a decreasing rate
 MU is diminishing per unit of the product consumed (you like the 5th, but not as much as the 4th)
 Section III (dissatisfaction)
 TU declines
 MU is negative per unit of the product consumed.
 At the two point As:
 TU point A – TU is at a maximum
 MU point A – MU is zero
 TotalMarginal relationship is represented by points A
 When MU=0, TU is at a maximum
 When MU is greater than 0 and Q increases, TU increases
 When MU is less than 0 and Q increases, TU decreases
 Criticisms of utility
 Difficult to measure
 We generally measure utils in ordinal measurements (I like this more than I like that). To properly measure, we need cardinal measurements (I like this more than I like that by a measure of 3)
 Indivisibility of products
 Know what consumer and producer surplus are
 APE /// triangle is Consumer surplus (the area where consumers are willing to pay more for the product, but it doesn’t cost as much as they’re willing to pay).
 Formula is ½(Base*Height) = ½(2.5 (A to E) * 2.5 (A to P)) = 3.125
 Has an inverse relationship to the equilibrium price. Higher the price, the smaller the triangle, the smaller the surplus.
 Measure of the additional satisfaction (utility) consumers get when they do not have to pay the price they were willing to pay.
 ABE \\\ triangle is Producer surplus (the area where producers are willing to sell the product for less, but are able to get more).
 Formula is ½(Base*Height) = ½(2.5 (A to E) * 2.5 (B to A)) = 3.125
 Has a direct relationship to the equilibrium price. Higher the price, the bigger the triangle, the larger the surplus.
 In this example, both are the same, but won’t always be the case depending on slopes of the demand and supply curves.
Other terms and items
 Consumption takes time, and time is a scarce resource. This can be included in the marginal utility theory. The full price of any consumer good or service is equal to the market price, plus the value of time taken to consume it.
 Total revenue minus total costs is what leads to profits.
