Reading 12: Topics in Demands and Supply Analysis

Elasticity

For normal goods, Price going up means Demand going down

Own Price Elasticity

PED > |1|: Demand is elastic

PED < |1|: Demand is inelastic

Cross Price Elasticity

Formula: $E_{CrossPrice}=\frac{\%\Delta Q_{demanded}}{\%\Delta P_{RelatedGood}}$

Cross Price Elasticity > 0: Related goods is a substitute

Cross Price Elasticity < 0: Related goods is a complement

Income Elasticity

Formula: $E_{Income}=\frac{\%\Delta Q_{demanded}}{\%\Delta Income}$

Income Elasticity > 0: Normal goods (Income Increases, Demand Increases)

Income Elasticity < 0: Inferior goods (Income Increases, Demand Decreases)

Substitution and Income Effect when price decreases

Substitution effect: always increase consumption of the good for which the price has fallen

Income effect: is positive for normal good, and negative for inferior good

Normal vs. Inferior Goods

Normal Goods: as price decreases, quantity purchased increases (due to both substitution and income effects)

Inferior Goods: as price decreases, quantity purchased increases ( Positive Substitution Effect > Negative Income Effect)

Giffen Goods: as price decreases, quantity purchased decreases ( Positive Substitution Effect < Negative Income Effect) IS AN INFERIOR GOOD

Veblen Goods: is a status-symbol good. Increasing Price causes higher demand.
NOT AN INFERIOR GOOD

Diminishing Marginal Return

Increasing one factor of production input while holding others constant will increase the marginal return. However, marginal return will gradually decrease, eventually become negative

Breakeven & Shutdown

Under perfect competition

Breakeven quantity of production: is quantity for which:
Price (P) = Marginal Cost (MC) = Average Total Cost (ATC), and
Total revenue (TR) = Total Cost (TC)

Long-run shutdown quantity when P < ATC and thus TR < TC

Short-run shutdown quantity when
P < Average Variable Cost (AVC), and thus
TR < Total Variable Cost (TVC)

Under imperfect competition
Firms face downward-sloping demand

Breakeven quantity: quantity for which TR=TC

Long-run shutdown if TR < TC

Short-run shutdown if TR < TVC

Economies of Scale

Diseconomies of Scales:

Long-run average total cost (LRATC) curve shows the minimum average total cost fo each level of output.

% increase in price leads to a larger % decrease in demand

% increase in price leads to a smaller % decrease in demand

Price Elasticity of Demand $ (PED)=\frac{\%\Delta Q}{\%\Delta P}=\frac{P_{0}}{Q_{0}}\times \frac{\Delta Q}{\Delta P}$

Extremity

Perfectly Inelastic (Vertical Demand)

Only in extremity (Perfectly Elastic or Inelastic), PED is constant

Perfectly Elastic (Horizontal Demand)

Factor influencing Elasticity

Availability of Substitutes

Proportion on income spent on the item

Time elapsed since previous price change

More substitutes, more elastic

More money spent on the good, more elastic

Longer the time since price changes, more elastic

Elasticity is NOT CONSTANT on a straight-line demand curve

Slope of demand curve $\neq$ price elasticity

Slope depends on units price and quantity are measured in

Elastiticity is based on % change

There is a point on the demand curve that is UNITARY ELASTICITY (PED = -1)

For Firms in High Elasticity Zone: Drop price a little bit, pick up huge increase in sale

For Firms in Low Elasticity Zone: Raise price a little bit, only a little drop in sale

Both are movement toward Unitary Elasticity Point

Price Elasticity & Total Revenue

Greatest Revenue (PxQ) at the UNITARY ELASTICITY POINT (PED =1)
(Different from maximizing PROFIT)

Inelastic Range

%Demand decreased < %Price increased

Price increase will raise total revenue

Elastic Range

%Demand decreased > %Price increased

Price increase will lower total revenue

$\frac{\Delta Q}{\Delta P}$ : the Slope Coefficient (b)
from Demand Function (Quantity= a + b $\times$ Price )

When price is lower, effectively have more purchasing power

When price is lower, buy more

indicated by the downward-sloping segment of LRATC, where increasing production reduce average total cost.

indicated by the upward-sloping segment of LRATC, where increasing production quantity will increase average total cost.

Profit Maximization

Under perfect competition, in the long run market price is the price where all firms move to minimum efficient scale (lowest point of LRATC)