Elasticity

Percent Change Formula

Elasticity measures the responsiveness of one variable to changes in another. The percent change formula is used to calculate elasticity:

• Percent Change Formula:

• This formula is foundational for calculating various types of elasticity in economics.

Demand Elasticity

Demand elasticity quantifies how much the quantity demanded of a good responds to changes in its price.

• Price Elasticity of Demand (PED):

• If PED > 1, demand is elastic; if PED < 1, demand is inelastic.

• Example: If the price of coffee rises by 10% and quantity demanded falls by 20%, PED = 2 (elastic demand).

Determinants of Elasticity

Several factors influence the elasticity of demand and supply:

• Availability of Substitutes: More substitutes make demand more elastic.

• Necessity vs. Luxury: Necessities tend to have inelastic demand; luxuries are more elastic.

• Time Horizon: Demand is more elastic over the long run.

• Proportion of Income: Goods that take up a larger share of income have more elastic demand.

Point Elasticity: Why Use?

Point elasticity measures elasticity at a specific point on the demand curve, rather than over a range.

• Formula:

• Useful for analyzing small changes and for continuous demand functions.

Revenue and Demand Elasticity

Understanding elasticity helps firms predict how changes in price affect total revenue.

• If demand is elastic: Lowering price increases total revenue.

• If demand is inelastic: Raising price increases total revenue.

• Example: A movie theater may lower ticket prices to increase attendance and revenue if demand is elastic.

Supply Elasticity

Supply elasticity measures how much quantity supplied responds to changes in price.

• Price Elasticity of Supply (PES):

• Determinants include production flexibility, time period, and availability of inputs.

Income Elasticity

Income elasticity of demand measures how quantity demanded changes as consumer income changes.

• Formula:

• Normal goods: Positive income elasticity.

• Inferior goods: Negative income elasticity.

Cross Price Elasticity

Cross price elasticity measures how the quantity demanded of one good responds to changes in the price of another good.

• Formula:

• Substitutes: Positive cross price elasticity.

• Complements: Negative cross price elasticity.

Utility and Consumer Choice

Total Utility (TU) and Marginal Utility (MU): Definitions and Relationship

Utility is the satisfaction a consumer derives from consuming goods and services.

• Total Utility (TU): The total satisfaction received from consuming a certain quantity of a good.

• Marginal Utility (MU): The additional satisfaction from consuming one more unit of a good.

• Relationship:

• As more units are consumed, TU increases but MU typically decreases.

Diminishing Marginal Utility: Intuition

The law of diminishing marginal utility states that as a person consumes more of a good, the additional satisfaction from each extra unit decreases.

• Example: The first slice of pizza gives more satisfaction than the fourth or fifth.

Optimal Consumption

Consumers maximize utility by allocating their budget so that the marginal utility per dollar spent is equal across all goods.

• Utility Maximization Rule:

• Where and are marginal utilities of goods A and B, and , are their prices.

Behavioral Economics

Expected Value and Mistakes in Probability and Value

Expected value is the weighted average of all possible outcomes, based on their probabilities.

• Formula:

• People often misjudge probabilities, leading to errors in decision-making.

• Example: Overestimating the chance of winning a lottery.

Sunk Cost Fallacy and Other Fallacies

The sunk cost fallacy occurs when individuals consider costs that cannot be recovered in their decision-making.

• Sunk Cost: A cost that has already been incurred and cannot be recovered.

• Fallacy: Continuing a project because of past investments, even if future costs outweigh benefits.

• Other fallacies include loss aversion and framing effects.

Other Topics in Behavioral Economics

Behavioral economics studies how psychological factors affect economic decision-making.

• Loss Aversion: People prefer avoiding losses to acquiring equivalent gains.

• Anchoring: Relying too heavily on initial information.

• Framing: Decisions are influenced by how choices are presented.

Costs and Profits

Explicit Costs

Explicit costs are direct, out-of-pocket payments for inputs to production.

• Examples: Wages, rent, materials.

Implicit Costs of the Firm

Implicit costs represent the opportunity costs of using resources owned by the firm.

• Example: Foregone salary by the owner working in their own business.

Accounting Profits vs. Economic Profits

Accounting profit is total revenue minus explicit costs, while economic profit subtracts both explicit and implicit costs.

• Accounting Profit:

• Economic Profit:

Normal Rate of Return

The normal rate of return is the minimum profit necessary to keep a firm in business, covering both explicit and implicit costs.

• It represents zero economic profit.

Meaning of Economic Profits

Economic profit indicates whether a firm is earning more than its opportunity costs.

• Positive economic profit attracts new firms; negative economic profit leads to exit.

Theory of the Firm

The theory of the firm explains how businesses make decisions about production and costs to maximize profits.

• Firms choose input combinations and output levels to achieve objectives.

Production and Costs

Production Function, Inputs, Outputs

The production function shows the relationship between inputs (labor, capital) and outputs (goods/services).

• General Form: , where is output, is labor, is capital.

Short Run

In the short run, at least one input is fixed.

• Firms can only adjust variable inputs (e.g., labor).

Marginal Product of Labor (MPL), Diminishing MPL

MPL is the additional output from hiring one more unit of labor.

• Formula:

• Diminishing MPL: As more labor is added, MPL eventually decreases.

Relationship Between Product and Costs

As productivity increases, costs per unit decrease; as productivity falls, costs rise.

• Inverse relationship between marginal product and marginal cost.

Shape of Product and Cost Curves in Short Run

Product curves (TP, MP, AP) and cost curves (MC, ATC, AVC) have characteristic shapes due to diminishing returns.

• Marginal cost curve is U-shaped.

• Average total cost curve is also U-shaped.

Average and Margin

Average measures (e.g., average cost) are calculated per unit, while marginal measures reflect changes from one additional unit.

• Average Cost:

• Marginal Cost:

Cost Equations

Key cost equations used in microeconomics:

• Total Cost (TC):

• Average Total Cost (ATC):

• Marginal Cost (MC):

Small Table: Cost Calculations

Tables are often used to calculate cost measures for different output levels.

Additional info: Table entries are illustrative; actual values depend on the firm's cost structure.

Long Run

In the long run, all inputs are variable, allowing firms to adjust scale.

• Firms can enter or exit the market.

Economies of Scale

Economies of scale occur when increasing production lowers average cost.

• Due to factors like specialization and bulk purchasing.

Diseconomies of Scale

Diseconomies of scale arise when increasing production raises average cost.

• Often due to management inefficiencies or communication problems.

Minimum Efficient Scale (MES)

MES is the lowest level of output at which long-run average cost is minimized.

• Firms operating at MES are most efficient.

Health Economics and Market Issues

Supply, Demand, and Health Care Costs

Health care markets are influenced by supply and demand, but unique factors affect costs.

• Inelastic demand and government intervention often lead to higher costs.

Intermediaries in Health Care

Intermediaries such as insurance companies and government agencies play a major role in health care markets.

• They affect pricing, access, and quality of care.

Principal-Agent Problem

This problem arises when one party (the agent) makes decisions on behalf of another (the principal), but their interests may not align.

• Example: Doctors (agents) may order more tests than necessary for patients (principals).

Adverse Selection

Adverse selection occurs when one party has more information than another, leading to market inefficiency.

• Example: Sick individuals are more likely to buy health insurance, raising costs for insurers.

Moral Hazard

Moral hazard refers to changes in behavior when individuals are insulated from risk.

• Example: People with insurance may take greater health risks.

U.S. vs Canada

Comparing health care systems in the U.S. and Canada highlights differences in cost, access, and outcomes.

• Canada has a single-payer system; the U.S. relies on private and public insurers.

• Costs are generally lower in Canada, with universal coverage.

Articles, Applications, and Videos

Economist Goes to a Bar

Real-world applications of economic principles in everyday settings.

• Analyzing choices, incentives, and market behavior in informal environments.

AI Replacing Your Job

Technological change affects labor markets and the future of work.

• Automation can increase productivity but may displace certain jobs.

Elderly People and Health Care

Aging populations increase demand for health care and challenge existing systems.

• Policy responses include long-term care insurance and reforms to Medicare/Medicaid.