Microeconomics

Lesson 2

Topics

1. Homework

2. Review Supply and Demand

3. Floors and Ceilings

4. Elasticity

5. Consumer Choice

Another S & D example

Price Q d Price Q s

60 0 60 500

50 100 50 400

40 200 40 300

30 300 30 200

20 400 20 100

10 500 10 0

Answer:

Price = $ Quantity =

What happens to price and quantity if the price of a substitute good increases?

What happens to price and quantity if the cost of production decreases?

Floors and Ceilings

See the examples on the board.

Price Elasticity of Demand

Measures the sensitivity or (responsiveness) of quantity consumers demand to changes in the price of a product

Equation for Coefficient of Elasticity of Demand

% change in quantity ÷ % change in price

The equation for determining the coefficient elasticity of demand is:

[(Q1-Q2)÷(Q1+Q2)]÷[(P1-P2)÷(P1+P2)]

Examples

1. Q1 = 250 Q2 = 300 P1=50 P2=40

Answer = ___ ( <1, inelastic)

2. Q1 = 250 Q2 = 500 P1 = $6 P2=$5

Answer = ___ (>1, elastic)

3. Q1 = 250 Q2 = 300 P1 = $6 P2=$5

Answer = __ (unit elastic)

More examples

4. Q1 = 500 Q2 = 500 P1 = $6 P2=$5

Answer = __ (perfectly inelastic)

5. Q1 = 500 Q2 = 600 P1 = $5 P2=$5

Answer = undefined (perfectly elastic)

Sesame Street School of Ed

A key to identifying elastic or inelastic demand is the shape of the Demand Curve:

The more the curve looks like a capital I, the more inelastic the demand, and the fewer the substitutes

The more the curve looks like a capital E, the more elastic the demand, and there must be many substitutes

Uses of Elasticity of Demand

We can use Elasticity of Demand to determine the price where we Maximize Total Revenue

Remember the equation for Total Revenue TR = Price x Quantity

Elasticity, Price, Total Revenue

If Ed > 1 then: an increase in price will cause TR to drop A decrease in price will cause TR to go up

If Ed < 1 then: An increase in price will cause TR to go up A decrease in price will cause TR to drop

If Ed = 1 then: TR is maximized!

Bill and his priceBill Gates called and he wants to know if he should raise the price of his Office software package.Currently, the package is $400 and they sell 10,000/day. Bill’s research shows that if they raise the price to $440 sales will drop to 8,000/day. What is the Ed of the Office software?Should Bill raise the price if he wants to maximize Total Revenue?

Bill’s Answer

Since Ed was ___ (greater than 1) then Bill should lower his price not raise if he wants to maximize revenue

Other uses for Ed

Tax incidence

Predict the change in quantity from a change in price

Evaluate the effectiveness of social policies

Circular Flow

Consumer Behavior

Utility Theory

Indifference Curves (the abbreviated version)

Satisfaction

What if there were some way to measure the satisfaction a person derived from consuming a certain quantity of a good?

sound

Utility Theory

The nearest we can come in Economics to measuring satisfaction is the UTIL.

The UTIL

Is an imaginary measure of satisfaction

Total utility measures the total UTILS of satisfaction the consumer enjoys

Marginal utility is the change in total utility from one additional unit of the good

UTILS and Mounds Bars

Mounds Bars

Total Utility

Marginal Utility

0 0

1 15 15.0 TU2-TU1/Q2-Q1

2 20 5.0 TU3-TU2/Q3-Q2

3 2 -18.0 TU4-TU3/Q4-Q3

Utility and Consumer Behavior

Choosing a diaper

Q Choice MU Price MU/P

49 Cloth 5 $2.00 2.5

49 Service 30 $6.25 4.8

49 Disposable 60 $8.25 7.5

Utility again

Choosing a windshield wiper

Choice MU Price MU/P

Good 8 $4.00 2.0

Better 24 $6.00 4.0

Best 30 $10.00 3.0

Maximizing Utility

Pick the affordable combination of consumer goods that makes the marginal utility per dollar of one good equal to the marginal utility per dollar spent on a second good.

Choosing a combination of two goods to maximize utility

See the example on the board

Indifference Curves

Indifference curves are like a topographic map of the “Hill of Happiness”

You want to consume that combination that gets you highest on the hill of happiness given your budget constraint.

Indifference Curves

The word to remember if this ever comes up again is TANGENT

The key is to choose that point on the budget constraint that is TANGENT to the highest indifference curve.