I.    The Elasticity of Demand

A.   Definition of elasticity:

B.   The Price Elasticity of Demand and Its Determinants

1.   Definition of price elasticity of demand:

2.   Determinants of the Price Elasticity of Demand

a.   Availability of Close Substitutes: the more substitutes a good has, the more elastic its demand.

b.   Necessities versus Luxuries: necessities are more price inelastic.

c.    Definition of the market: narrowly defined markets (ice cream) have more elastic demand than broadly defined markets (food).

d.   Time Horizon: goods tend to have more elastic demand over longer time horizons.

C.   Computing the Price Elasticity of Demand

1.   Formula

2.   Example: the price of ice cream rises by 10% and quantity demanded falls by 20%.

Price elasticity of demand = (20%)/(10%) = 2

3.   Because there is an inverse relationship between price and quantity demanded (the price of ice cream rose by 10% and the quantity demanded fell by 20%), the price elasticity of demand is sometimes reported as a negative number. We will ignore the minus sign and concentrate on the absolute value of the elasticity.

D.   The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

1.   Because we use percentage changes in calculating the price elasticity of demand, the elasticity calculated by going from one point to another on a demand curve will be different from an elasticity calculated by going from the second point to the first. This difference arises because the percentage changes are calculated using a different base.

a.   A way around this problem is to use the midpoint method.

b.   Using the midpoint method involves calculating the percentage change in either price or quantity demanded by dividing the change in the variable by the midpoint between the initial and final levels rather than by the initial level itself.

c.    Example: the price rises from $4 to $6 and quantity demanded falls from 120 to 80.

% change in price = (6 - 4)/5 × 100% = 40%

% change in quantity demanded = (120-80)/100 = 40%

price elasticity of demand = 40/40 = 1

E.   The Variety of Demand Curves

1.   Classification of Elasticity

a.   When the price elasticity of demand is greater than one, demand is defined to be elastic.

b.   When the price elasticity of demand is less than one, the demand is defined to be inelastic.

c.    When the price elasticity of demand is equal to one, the demand is said to have unit elasticity.

2.   In general, the flatter the demand curve that passes through a given point, the more elastic the demand.

3.   Extreme Cases

a.   When the price elasticity of demand is equal to zero, the demand is perfectly inelastic and is a vertical line.

b.   When the price elasticity of demand is infinite, the demand is perfectly elastic and is a horizontal line.

F.   Total Revenue and the Price Elasticity of Demand

1.   Definition of total revenue: the amount paid by buyers and received by sellers of a good, computed as the price of the good times the quantity sold.

2.   If demand is inelastic, the percentage change in price will be greater than the percentage change in quantity demanded.

a.   If price rises, quantity demanded falls, and total revenue will rise (because the increase in price will be larger than the decrease in quantity demanded).

b.   If price falls, quantity demanded rises, and total revenue will fall (because the fall in price will be larger than the increase in quantity demanded).

3.   If demand is elastic, the percentage change in quantity demanded will be greater than the percentage change in price.

a.   If price rises, quantity demanded falls, and total revenue will fall (because the increase in price will be smaller than the decrease in quantity demanded).

b.   If price falls, quantity demanded rises, and total revenue will rise (because the fall in price will be smaller than the increase in quantity demanded).

G.   Elasticity and Total Revenue along a Linear Demand Curve

We did not do this in class, but it is here and in the book! 

1.   The slope of a linear demand curve is constant, but the elasticity is not.

a.   At points with a low price and a high quantity demanded, demand is inelastic.

b.   At points with a high price and a low quantity demanded, demand is elastic.

2.   Total revenue also varies at each point along the demand curve.

I.    Other Demand Elasticities--These are in the text, but are not on the test.  The focus is on Price Elasticity of Demand

II.   The Elasticity of Supply--Again in the book, but not on the test.  Focus on the HW problems.

III. Three Applications of Supply, Demand, and Elasticity

A.   Can Good News for Farming Be Bad News for Farmers?

1.   A new hybrid of wheat is developed that is more productive than those used in the past. What happens?

2.   Supply increases, price falls, and quantity demanded rises.

3.   If demand is inelastic, the fall in price is greater than the increase in quantity demanded and total revenue falls.

4.   If demand is elastic, the fall in price is smaller than the rise in quantity demanded and total revenue rises.

5.   In practice, the demand for basic foodstuffs (like wheat) is usually inelastic.

a.   This means less revenue for farmers.

b.   Because farmers are price takers, they still have the incentive to adopt the new hybrid so that they can produce and sell more wheat.

c.    This may help explain why the number of farms has declined so dramatically over the past two centuries.

d.   This may also explain why some government policies encourage farmers to decrease the amount of crops planted.

B.   Why Did OPEC Fail to Keep the Price of Oil High?

1.   In the 1970s and 1980s, OPEC reduced the amount of oil it was willing to supply to world markets. The decrease in supply led to an increase in the price of oil and a decrease in quantity demanded. The increase in price was much larger in the short run than the long run. Why?

2.   The demand and supply of oil are much more inelastic in the short run than the long run. The demand is more elastic in the long run because consumers can adjust to the higher price of oil by carpooling or buying a vehicle that gets better mileage. The supply is more elastic in the long run because non-OPEC producers will respond to the higher price of oil by producing more.

C.   Does Drug Interdiction Increase or Decrease Drug-Related Crime?

1.   The federal government increases the number of federal agents devoted to the war on drugs. What happens?

a.   The supply of drugs decreases, which raises the price and leads to a reduction in quantity demanded. If demand is inelastic, total expenditure on drugs (equal to total revenue) will increase. If demand is elastic, total expenditure will fall.

b.   Thus, because the demand for drugs is likely to be inelastic, drug-related crime may rise.

2.   What happens if the government instead pursued a policy of drug education?

a.   The demand for drugs decreases, which lowers price and quantity supplied. Total expenditure must fall (because both price and quantity fall).

b.   Thus, drug education should not increase drug-related crime.

I.    What Are Costs?

A.   Total Revenue, Total Cost, and Profit

1.   The goal of a firm is to maximize profit.

2.   Definition of total revenue:

3.   Definition of total cost:

4.   Definition of profit:

B.   Costs as Opportunity Costs

1.   The cost of something is what you give up to get it.

2.   The costs of producing an item must include all of the opportunity costs of inputs used in production.

3.   Total opportunity costs include both implicit and explicit costs.

a.   Definition of explicit costs:

b.   Definition of implicit costs:

c.    The total cost of a business is the sum of explicit costs and implicit costs.

d.   This is the major way in which accountants and economists differ in analyzing the performance of a business.

e.   Accountants focus on explicit costs, while economists examine both explicit and implicit costs.

D.   Economic Profit versus Accounting Profit

   Definition of economic profit:

a.   Economic profit is what motivates firms to supply goods and services.

b.   To understand how industries evolve, we need to examine economic profit.

3.   Definition of accounting profit:

4.   If implicit costs are greater than zero, accounting profit will always exceed economic profit.

II.   Production and Costs

A.   The Production Function

1.   Definition of production function:

2.   Example: Caroline's cookie factory. The size of the factory is assumed to be fixed; Caroline can vary her output (cookies) only by varying the labor used.

3.   Definition of marginal product:

a.   As the amount of labor used increases, the marginal product of labor falls.

b.   Definition of diminishing marginal product:
 

4.   We can draw a graph of the firm's production function by plotting the level of labor (x-axis) against the level of output (y-axis). 

a.   The slope of the production function measures marginal product.

b.   Diminishing marginal product can be seen from the fact that the slope falls as the amount of labor used increases.

B.   From the Production Function to the Total-Cost Curve

1.   We can draw a graph of the firm's total cost curve by plotting the level of output (x-axis) against the total cost of producing that output (y-axis).

a.   The total cost curve gets steeper and steeper as output rises.

b.   This increase in the slope of the total cost curve is also due to diminishing marginal product: As Helen increases the production of cookies, her kitchen becomes overcrowded, and she needs a lot more labor.

III. The Various Measures of Cost

  Fixed and Variable Costs

1.   Definition of fixed costs:

2.   Definition of variable costs:

C.   Average and Marginal Cost

1.   Definition of average total cost:

2.   Definition of average fixed cost:

3.   Definition of average variable cost: 

4.   Definition of marginal cost:

5.   Average total cost tells us the cost of a typical unit of output and marginal cost tells us the cost of an additional unit of output.

D.   Cost Curves and Their Shapes

1.   Rising Marginal Cost

a.   This occurs because of diminishing marginal product.

b.   At a low level of output, there are few workers and a lot of idle equipment. But as output increases, the coffee shop gets crowded and the cost of producing another unit of output becomes high.

2.   U-Shaped Average Total Cost

a.   Average total cost is the sum of average fixed cost and average variable cost.                                         

b.   AFC declines as output expands and AVC typically increases as output expands. AFC is high when output levels are low. As output expands, AFC declines pulling ATC down. As fixed costs get spread over a large number of units, the effect of AFC on ATC falls and ATC begins to rise because of diminishing marginal product.

c.    Definition of efficient scale: the quantity of output that minimizes average total cost.

3.   The Relationship between Marginal Cost and Average Total Cost

a.   Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising.

b.   The marginal-cost curve crosses the average-total-cost curve at minimum average total cost (the efficient scale).

4.   Typical Cost Curves

a.   Marginal cost eventually rises with output.

b.   The average-total-cost curve is U-shaped.

c.    Marginal cost crosses average total cost at the minimum of average total cost.

IV.  Costs in the Short Run and in the Long Run

A.   The division of total costs into fixed and variable costs will vary from firm to firm.

B.   Some costs are fixed in the short run, but all are variable in the long run.

1.   For example, in the long run a firm could choose the size of its factory.

2.   Once a factory is chosen, the firm must deal with the short-run costs associated with that plant size.

C.   The long-run average-total-cost curve lies along the lowest points of the short-run average-total-cost curves because the firm has more flexibility in the long run to deal with changes in production.

D.   The long-run average-total-cost curve is typically U-shaped, but is much flatter than a typical short-run average-total-cost curve.

E.   The length of time for a firm to get to the long run will depend on the firm involved.

F.   Economies and Diseconomies of Scale

1.   Definition of economies of scale:

2.   Definition of diseconomies of scale: