(12) Topics in Demand and Supply Analysis Flashcards
LOS 14.a: Calculate and interpret, income, and cross price elasticities of demand and describe factors that affect each measure. Describe own-price elasticity.
Own-price elasticity is a measure of the responsiveness of the quantity demanded to a change in price. It is calculated as the ratio of the percentage change in quantity demanded to a percentage change in price.
LOS 14.a: Calculate and interpret, income, and cross price elasticities of demand and describe factors that affect each measure. Describe when demand is elastic and inelastic.
When quantity demanded is very responsive to a change in price, we say demand is elastic; when quantity demanded is not very responsive to a change in price, we say that demand is inelastic.
LOS 14.a: Calculate and interpret, income, and cross price elasticities of demand and describe factors that affect each measure. What are other factors that affect demand elasticity in addition to the quality and availability of substitutes?
- Portion of income spent on a good:* The larger proportion of income spent on a good, the more elastic an individual’s demand for that good.
- Time:* Elasticity of demand tends to be greater the longer the time period since the price change. For example, when energy prices initially rise, some adjustments to consumption are likely made quickly (lowering thermostat). Over time, adjustments such as smaller living quarters, better insulation, more efficient windows, and installation of alternative heat sources are more easily made, and the effect of price change on consumption of energy is greater.
LOS 14.a: Calculate and interpret, income, and cross price elasticities of demand and describe factors that affect each measure. Describe the price elasticity along a linear demand curve.
At point (a), in a higher price range, the price elasticity of demand is greater than at point (c) in a lower price range.
The elasticity at point (b) is -1.0; a 1% increase in price leasds to a 1% decrease in quantity demanded. This is the point of greatest total revenue (P x Q), which is 4.5 x 45 = $202.50
At prices less than $4.50 (inelastic range), total revenue will increase when price increases. The percentage decrease in quantity demanded will be less than the percentage increase in price. (% dec. Q < % inc. P)
At prices above $4.50 (elastic range), a price increase will decrease total revenue since the percentage decrease in quantity demanded will be greater than the percentage increase in price. (% dec. Q > % inc. P)
LOS 14.a: Calculate and interpret, income, and cross price elasticities of demand and describe factors that affect each measure. Define income elasticity of demand as well as how it relates to normal and inferior goods.
The sensitivity of quantity demanded to a change in income is termed income elasticity. Holding other independent variables constant, we can measure income elasticity as the ratio of the percentage change in quantity demanded to the percentage change in income.
For most goods, the sign of income elasticity is positive-an increase in income leads to an increase in quantity demanded. Goods for which this is the case are termed normal goods. For other goods, it may be the cast that an increase in income leads to a decrease in quantity demanded. Goods for which this is true are termed inferior goods.
LOS 14.a: Calculate and interpret, income, and cross price elasticities of demand and describe factors that affect each measure. Define cross price elasticity of demand.
Recall that some of the independent variables in a demand function are the prices of related goods (related in the sense that their prices affect the demand for the good in question). The ratio of th percentage change in the quantity demanded of a good to the percentage change in the price of a related good is termed the cross price elasticity of demand.
LOS 14.a: Calculate and interpret, income, and cross price elasticities of demand and describe factors that affect each measure. In cross price elasticity of demand, when are goods considered substitutes?
When an increase in the price of a related good increases demand for a good, the two goods are substitutes. If Bread A and Bread B are two brands of bread, considered good substitutes by many consumers, an increase in the price of one will lead consumers to purchase more of the other (substitute the other). When the cross price elasticity of demand is positive (price of one is up and quantity demanded for the other is up), we say those goods are substitutes.
LOS 14.a: Calculate and interpret, income, and cross price elasticities of demand and describe factors that affect each measure. In cross price elasticity of demand, when are goods considered complements?
When an increase in the price of a related good decreases demand for a good, the two goods are complements. If an increase in the price of automobiles (less automobiles purchased) leads to a decrease in the demand for gasoline, they are complements.
LOS 14.a: Calculate and interpret, income, and cross price elasticities of demand and describe factors that affect each measure. In cross price elasticity of demand, main difference between complement and substitute goods?
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Overall, the cross price elasticity of demand is more positive the better substitutes two goods are and more negative the better complements the two goods are.
LOS 14.a: Calculate and interpret, income, and cross price elasticities of demand and describe factors that affect each measure. What is the equation for price elasticity of demand.
LOS 14.a: Calculate and interpret, income, and cross price elasticities of demand and describe factors that affect each measure. In your own words.
The demand and price of a good can either affect each other or not at all. In one extreme case, where the price affects the demand of the good highly, it is known to be elastic. In the other extreme case, when the price affects the demand of the good minutely, it is known to be inelastic. There are many factors that affect demand elasticity, they can be: quality, availability of substitutes, portion of income spent on a good and time. As a businessman, it is our goal to maximize revenues of the good being sold. Price elasticity plays into that goal by finding the sweet spot where the % change in price is equal to the percent change in demand, this is known as the unitary elasticity, where elasticity equals -1.0.
Income elasticity can be easily described as the greater portion a good is related to your income, the more or less of the good you will buy. A normal good will increase in demand as your income rises while an inferior good will decrease in demand as your income rises. An example of this is you’d probably eat more steak dinners (normal good) rather than dining at McDonalds (inferior good) as your income rises.
LOS 14.b: Compare substitution and income effects. How is the substitution effect and income effect related in respect to the change in price of good X? What is the key difference?
When the price of Good X decreases, there is a substitution effect that shifts consumption towards more of Good X. Because the total expenditure on the consumer’s original bundle of goods falls when the price of Good X falls, there is also an income effect. The income effect can be towards consumption of Good X. This is the key point here: the substitution effect always acts to increase the consumption of good that has fallen in price, while the income effect can either increase or decrease consumption of a good that has fallen in price.
LOS 14.b: Compare substitution and income effects. What is an indifference curve?
An indifference curve represents a series of combinations between two different economic goods, between which an individual would be theoretically indifferent regardless of which combination he received.
Indifference curves are heuristic devices used in contemporary microeconomics to demonstrate consumer preference and the limitations of a budget. Later economists adopted the principles of indifference curves in the study of welfare economics.
The substitution effect as no effect on the indifference curve while the income effect does.
LOS 14.b: Compare substitution and income effects. Based on the analysis of substitution effect and income effect, what are the three possible outcomes of a decrease in the price of Good X?
1) The substitution effect is positive, and the income effect is also positive – consumption of Good X will increase.
2) The substitution effect is positive, and the income effect is negative but smaller than the substation effect-consumption of Good X will increase.
3) The substitution effect is positive, and the income effect is negative and larger than the substitution effect-consumption of good X will decrease
LOS 14.b: Compare substitution and income effects. In your own words.
The substitution and income effects work in tandem to change the demand of Good X with it’s change in price. In most cases, if Good X is a normal good, the substitution effect and the income effect will work together to increase the quantity demanded of Good X. If an increase in income is great enough to make the income effect out weight the substitution effect, the quantity of Good X demanded will actually decrease.
To maximize satisfaction of a consumer, there will normally be a combination of budgeted demand for Good X and Good Y. This budget line lays tangent to the indifference curve, the curve which a combination of Good X and Y lay on to create equal satisfaction for a consumer. The substitution effect will not change the indifference curve, but the income effect will.
LOS 14.c: Distinguish between normal goods and inferior goods. What is a Giffen good?
A Giffen good is an inferior good for which the negative income effect outweighs the positive substitution effect when price falls, as in Panel (c) of Figure 3. A Giffen good is theoretical and would have an upward-sloping demand curve. At lower prices, a smaller quantity would be demanded as a result of the dominance of the income effect over the substitution effect. Note that the existence of a Giffen good is not rules out by the axioms of the theory of consume choice.
LOS 14.d: Describe the phenomenon of diminishing marginal returns.
Marginal returns refer to the additional output that can be produced by using one more unit of productive input while holding the quantities of another inputs constant. Marginal returns may increase as the first units of an input are added, but as input quantities increase, they reach a point at which marginal returns begin to decrease. Inputs beyond this quantity are said to produce diminishing marginal returns.
LOS 14. e: Determine and describe breakeven and shutdown points of production. What is the shutdown and breakeven under perfect competition?
In the case of a firm under perfect competition, price = marginal revenue = average revenue. For a feirm under perfect competition (a price taker), we can use a graph of cost functions to examine the profitability of the firm at different output prices.
To sum up, if average revenue is less than average variable costs in the short run, the firm should shut down. This is its short-run shutdown point. If average revenue is greater than average variable cost in the short run, the firm should continue to operate, even if it has losses. In the long run, the firm should shut down if average revenue is less than average total cost. This is the long-run shutdown point. If average revenue is just equal to average total cost, total revenue is just equal to total (economic) cost, and this is the firm’s breakeven point.
