Principles of Microeconomics

Principles of Microeconomics

Principles of Microeconomics

1. Supply and Demand

Everyone knows the unpleasant feeling that results from the price of something you've been longing to buy increasing – or the excitement of seeing your favorite snack go on sale! When the price of a good changes, consumers' demand for that good changes. We can understand these changes by graphing supply and demand curves and analyzing their properties.

What is Elasticity

Elasticity measure the relationship between a good and its price based on consumer demand, consumer income, and its availability. It refers to the degree to which individuals (consumers/producers) change their demand/amount supplied in response to price or income changes.

 

To calculate this change, we can use the following formula:

Elasticity = % Change in Quantity / % Change in Price

In economics, the elastic product means that any change in price can result in changes in supply or demand. The inelastic product means that changes in price do not affect to a noticeable degree the supply or demand.

Now, let's examine the theory of elasticity with the aid of the diagram and real-life example below.

Elasticity

The diagram above shows the changes in price (p) of Sandra Cookies, and the corresponding change in the quantity demanded (q). The red slanting line is called the demand curve. At a price of $1.50, the quantity demanded is three units. When the price is lowered to $0.50, the quantity in demand increased to five units. Ms. Sandra can then make the assumption that every increase in price will result in fewer purchases of her cookies.

Income Elasticity of Demand

Income elasticity of demand is a measure of the responsiveness of the demand for a particular good or service, as a result of a change in income of the target market all things being equal.

To calculate this change, we use a different formula:

Income Elasticity of Demand = % change in quantity demanded / % change in income

Cross and Advertising Elasticity of Demand

As with income elasticity of demand, cross and advertising elasticity of demand measure the responsiveness of the quantity demanded of a product or service to changes in price of another product or service and changes in advertising spending respectively. Their formulas are as follows:

Cross elasticity of demand = % change in quantity demanded of product A / % Change in price of product B

Advertising elasticity of demand = % change in quantity demanded / % change in advertising spending

Elasticity of Demand

When we calculate the elasticity of demand, we are measuring the relative change in the total amount of goods or services that are demanded by the market or by an individual. The quantity demanded depends on several factors. Some of the more important factors are the price of the good or service, the price of other goods and services, the income of the population or person and the preferences of the consumers.

movement along the demand curve

Movement along the demand: when the price increases, the quantity demanded decreases

 

Elasticity of Supply

When we calculate the elasticity of supply, we are measuring the relative change in the the total amount of goods or services that one or several firms supply. The quantity supplied depends on several factors. Some of the more important factors are the price of the good or service, the cost of the input and the technology of production.

movement along the demand curve

Movement along the supply: when the price increases, the quantity supplied increases

As we have mentioned, the demand depends on several factors. We can calculate the elasticity of demand according to each one of these inputs.

If we calculate the elasticity of demand according to the price of the good, we are calculating the price elasticity of demand.

If we calculate the elasticity according to the price of other goods, we are calculating the cross elasticity of demand.

If we calculate the elasticity of the demand according to the income, we are calculating the income elasticity of demand.

 

Price Elasticity of Demand

The price elasticity of demand is the proportional change in the quantity demanded, relative to the proportional change in the price of the good.

Price elasticity of demand = Percentage change in quantity demanded / percentage change in price = ΔQ/Q / ΔP/P

price elasticity of demand

 

Cross Elasticity of Demand

The cross elasticity of demand is the proportional change in the quantity demanded, relative to the proportional change in the price of another good.

Price elasticity of demand = Percentage change in quantity demanded / percentage change in price of another good = ΔQ1/Q1 / ΔP2/P2

Looking at the chart, the change in the price of another good shifts the demand curve to the left or to the right.

shift in the demand

If the two goods are substitutes, the cross elasticity of demand is positive.

If the two goods are complements, the cross elasticity of demand is negative.

Income Elasticity of Demand

The income elasticity of demand is the proportional change in the quantity demanded, relative to the proportional change in the income.

Income elasticity of demand = Percentage change in quantity demanded / percentage change in the income = ΔQ/Q / ΔI/I

shift in the demand

Price Elasticity of Supply

The price elasticity of supply is the proportional change in the quantity supplied, relative to the proportional change in the price of the good.

Price elasticity of supply = Percentage change in quantity supplied / percentage change in price = ΔQs/Qs / ΔP/P

elasticity supply

 

Cross Elasticity of Supply

The cross elasticity of supply is the proportional change in the quantity supplied, relative to the proportional change in the price of another good.

Cross elasticity of supply = Percentage change in quantity supplied / percentage change in the price of another good = ΔQs1/Qs1 / ΔP2/P2

elasticity supply shift

Complements in production goods are goods that must be produced together. If the price of a complement in production good increases (let’s call it “good B”), then the quantity produced of B usually increases. As a result, the supply curve of the good we are analyzing (let’s call it “good A”), shift to the right. Thus, the cross elasticity of complements in production goods is positive.

complements in production

Substitutes in production : goods that use the same resources for production. Producing more of one good, requires producing less of the other good. If the good B is a substitute in production of A, and the price of B increases, then the supply of the good A shifts to the left. Thus, the cross elasticity of substitutes in production goods is negative.

substitutes in production

 

Up to here, we have pointed out different types of elasticity according to the function we are analyzing, and according to the inputs we are considering. Now we will see how the supply and the demand can be classified according to the value of the elasticity.

Elasticity of Demand

Perfect Elastic Demand

perfect elastic demand

Perfect Elastic Demand: The elasticity tends towards -∞.

 

Relatively elastic demand, unitary elasticity demand and relatively inelastic demand

several values of elasticity

Relatively elastic demand: The elasticity is between -1 and -∞

Unitary elasticity demand: The elasticity is -1

Relatively inelastic demand: The elasticity is between 0 and -1.
 

Perfect Inelastic Demand

perfect inelastic demand

A perfect inelastic demand has an elasticity of 0.

 

Elasticity of Supply

Perfect Elastic Supply

several values of elasticity

An horizontal supply is a perfect elastic supply and has an elasticity that tends towards ∞

Relatively Elastic Supply

relatively elastic supply

A relatively elastic supply has an elasticity bigger than 1

Supply with Unitary Elasticity

unitary elasticity supply

An unitary elasticity supply has an elasticity of 1

 

Relatively Inelastic Supply

 

relatively inelastic supply

A relatively inelastic supply has an elasticity of less than 1

 

Perfectly Inelastic Supply

perfect inelastic supply

A perfect inelastic supply has an elasticity of 0

 

REFERENCES

 

http://ocw.mit.edu/courses/economics/14-01sc-principles-of-microeconomics-fall-2011/index.htm

http://www.investopedia.com/terms/m/microeconomics.asp

https://www.economics.utoronto.ca/jfloyd/modules/appn.html

https://www.boundless.com/business/textbooks/boundless-business-textbook/product-and-pricing-strategies-15/pricing-products-96/impacts-of-supply-and-demand-on-pricing-449-1939/

http://www.econlib.org/library/Enc/Supply.html

http://www.netmba.com/images/econ/micro/demand/curve/demandcurve.gif

http://www.investopedia.com/video/play/elasticity/#ixzz416iw3igK

http://study.com/academy/lesson/what-is-elasticity-in-economics-definition-theory-formula.html

http://economicpoint.com/types-of-elasticity

https://www.youtube.com/watch?v=Vss3nofHpZI

https://www.youtube.com/watch?v=zFIB8-30YhA

https://www.youtube.com/watch?v=HHcblIxiAAk





 

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