Micro Economics

[MNG 609]
Trupti Mishra
Shailesh J Mehta School Of
Management
IIT Bombay

Session Outline

Elasticity of Demand
Price ceiling and Price Floor
Utility Analysis
Price, Income and Substitution Effect
Consumer Surplus

Elasticity of Demand
Price Elasticity of Demand
Income Elasticity of Demand
Cross Elasticity of demand

Elasticity of Demand

Elasticity of Demand measures the degree

of responsiveness of the quantity demanded
of a commodity to a given change in any of
the determinants of demand.

Price elasticity of demand is a measure of

how much the quantity demanded of a good
responds to a change in the price of that good.

Percentage change in quantity demanded

given a percent change in the price.

Price elasticity of demand

P & Q are inversely related by the law of demand so E is always negative.

The larger the absolute value of E, the more sensitive buyers are to a change in price

%Q
E
%P

Degree of Price Elasticity of Demand

Inelastic Demand
Quantity demanded
Elastic Demand
Quantity demanded
Perfectly Inelastic
Quantity demanded
Perfectly Elastic
Quantity demanded
Unit Elastic
Quantity demanded

does not respond strongly to price changes.

responds strongly to changes in price.
does not respond to price changes.
changes infinitely with any change in price.
changes by the same percentage as the price.

Perfectly Elastic & Inelastic Demand

Price

Price
D
D

Quantity

Perfectly Elastic

Quantity

Perfectly Inelastic

Inelastic Demand
Price

Demand

E<1

5.00

4.00
1. A 25%
increase in
price

90

100

Quantity

2. Leads to a 10% decrease in quantity demanded.

Unit Elastic Demand

E=1

Price

Demand

5.00

4.00
1. A 25%
increase in
price

75

100

Quantity

2. Leads to a 25% decrease in quantity demanded.

Elastic Demand
E>1

Price

Demand

5.00

4.00
1. A 25%
increase in
price

50

100

Quantity

2. Leads to a 50% decrease in quantity demanded.

10

Measurement
Demand

of Price Elasticity of

Point Elasticity of
Demand

Q
100
Q
P
%Q
Q

E
P
P
Q
%P
100
P

ARC Elasticity of Demand

Q Average P
E

P Average Q

Determinants of Price Elasticity of

Demand

Nature of Commodity
Availability and proximity of Substitutes
Proportion of Income Spent on the Commodity
Time
Durability of the Commodity
Items of addiction

Total Revenue
Price

4.00

P x Q = 400
(revenue)

Demand

100

Quantity

13

How Total Revenue Changes When Prices

Changes: Inelastic Demand
Price

3.00

P x Q = 240
(revenue)
1.00

P x Q = 100
(revenue)
0

Demand
80

100

Quantity

14

How Total Revenue Changes When Prices

Changes: Elastic Demand
Price

Change in Total Revenue when Price Changes

5.00

4.00

Demand

Revenue = 200
Revenue = 100

20

50

Quantity

15

Price Elasticity & Total Revenue

Elastic

Unitary elastic

Inelastic

%
Q % P

%
Q % P

%
Q % P

No dominant effect

P-effect dominates

Price
rises

TR falls

No change in TR

TR rises

Price
falls

TR rises

No change in TR

TR falls

Q-effect dominates

16

Demand & Marginal Revenue

When inverse demand is linear,

P = A + BQ

Marginal revenue is also linear, intersects the

vertical (price) axis at the same point as
demand, & is twice as steep as demand
MR = A + 2BQ

17

Linear Demand, MR, & Elasticity

18

MR, TR, & Price Elasticity

Marginal
revenue

Total revenue

Price elasticity of
demand

MR > 0

TR increases as Q
increases

Elastic ( E >
Elastic
( E > 1)
1)

MR = 0

TR is maximized

MR < 0

TR decreases as Q
increases

Unit
elastic
Unit
elastic
E = 1)
( E =( 1)
Inelastic
Inelastic
( E <
( E < 1)
1)

19

Income Elasticity of
Demand
Income elasticity (EM) measures the responsiveness
of quantity demanded to changes in income,
holding the price of the good & all other demand
determinants constant.
EM

%Qd
Qd
M

%M
M
Qd

Positive for a normal good

Negative for an inferior good
Zero for a neutral goods

Income Elasticity of
Demand
If Em > 1, Luxury good
If Em < 1, Necessity Goods
If Em = 1, Semi Luxury goods

Cross-Price Elasticity of demand

Cross-price elasticity of demand (EXY) measures
the responsiveness of quantity demanded of good
X to changes in the price of related good Y,
holding the price of good X & all other demand
determinants for good X constant
Positive when the two goods are substitutes
Negative when the two goods are complements

E XY

%Q X
Q X
PY

%PY
PY
QX

22

Using Elasticities in Managerial

Decision Making
Demand for coffee X as follows:
QX= 1.5 3.0PX+ 0.8I+ 2.0PY0.6PS+ 1.2A
where:
QX = sales of coffee X, in millions of pounds per year.
PX = price of coffee X, in dollars per pounds.
I= personel disposable income, in trillions of dollars per
year.
PY = price of competitive brand of coffee, in dollars per
pounds.
PS = price of sugar, in dollars per pounds.
A = advertising expenditures for coffee X, in hundreds of
thousands of dollars per year..
23

Using Elasticities in Managerial

Decision Making
Supposed that, PX= $2, I= $2.5, PY= $1.80, PS=
$0.50
and A = $1
We get
QX= 1.5 3.0(2) + 0.8(2.5) + 2.0(1.8) 0.6(0.50)+
1.2(1) = 2
Thus, the firm would sell 2 million pounds of
coffee X

24

Using Elasticities in Managerial

Decision Making

From this info, the firm can find elasticity of

demand for coffee X with respect to its price,
income, price of competitive coffee Y, price of
sugar and advertising
EP= -3(2/2)) = -3
EI= 0.8(2.5/2) = 1
EXY= 2(1.8/2) = 1.8
EXS= -0.6(0.50/2) = -0.15
EA= 1.2(1/2) = 0.6

25

Using Elasticities in Managerial

Decision Making
To estimate/forecast demand for next year.
Suppose the firm:
increase price by 5%.
increase advertisement by 12%.
expect personal disposable income rise by 4%
PY to rise by 7%.
PS to fall by 8%

26

Using Elasticities in Managerial

Decision Making

Using level of sales (QX) for this year of 2 million

pounds, the firm can determine its sales for next
year:
QX= QX+ QX(PX/PX)EP+ QX(I/I)EI+
QX(PY/PY)EXY+ QX(PS/PS)EXS+ QX(A/A)EA
= 2 + 2(5%)(-3) + 2(4%)(1) + 2(7%)(1.8) + 2(8%)(-0.15) + 2(12%)(0.6)= 2.2 million pounds.

27

Government Policies That Alter the Private

Market Outcome

Price controls
Price ceiling: a legal maximum on the price
of a good or service. Example: rent control.
Price floor: a legal minimum on the price of
a good or service. Example: minimum wage.

Taxes
The govt can make buyers or sellers pay a
specific amount on each unit bought/sold.

The Market for Apartments

P

Rental
price of
apts

$800

Eqm
Eqm w/o
w/o
price
price
controls
controls
D
300

Quantity of
apartments

How Price Ceilings Affect Market Outcomes

A price ceiling
above the
eqm price is
not binding

it has no
effect on the
market
outcome.

Price
ceiling

$1000
$800

D
300

How Price Ceilings Affect Market Outcomes

The eqm price
($800) is above
the ceiling and
therefore
illegal.
The ceiling
is a binding
constraint
on the price,
and causes
a shortage.

$800
Price
ceiling

$500
shortage
250

400

How Price Ceilings Affect Market Outcomes

In the long
run, supply
and demand
are more
price-elastic.
So, the
shortage
is larger.

$800
Price
ceiling

$500
shortage
150

450

D
Q

Shortages and Rationing

With a shortage, sellers must ration the goods

among buyers.

Some rationing mechanisms: (1) long lines

(2) discrimination according to sellers biases

These mechanisms are often unfair, and inefficient:

the goods dont necessarily go to the buyers who
value them most highly.

In contrast, when prices are not controlled,

the rationing mechanism is efficient (the goods
go to the buyers that value them most highly)
and impersonal (and thus fair?).

The Market for Unskilled Labor

Wage
paid to
unskilled
workers

$4

Eqm
Eqm w/o
w/o
price
price
controls
controls

D
500

Quantity of
unskilled workers

How Price Floors Affect Market Outcomes

A price floor
below the
eqm price is
not binding

it has no
effect on the
market
outcome.

$4
Price
floor

$3
D
500

How Price Floors Affect Market Outcomes

The eqm wage
($4) is below the
floor and
therefore
illegal.
The floor
is a binding
constraint
on the wage,
and causes
a surplus
(i.e.,
unemployment).

labor
surplus S

Price
floor

$5
$4

D
400

550

The Minimum Wage

W

unemployment
S

Min.
wage

$5

Min wage laws

do not affect
highly skilled
workers.
They do affect
teen workers.

$4

D
400

550

Taxes

The govt levies taxes on many goods &

services to raise revenue to pay for
national defense, public schools, etc.

The govt can make buyers or sellers pay

the tax.

The tax can be a percentage of the goods

price, or a specific amount for each unit
sold.
For simplicity, we analyze per-unit taxes only.

Equilibrium without Tax

P
S1
$10.00

D1
500

A Tax on Buyers
A
A tax
tax on
on
buyers
buyers
shifts
shifts the
the D
D
curve
curve down
down
by
by the
the
amount
amount of
of
the
the tax.
tax.

The
The price
price
buyers
buyers pay
pay
rises,
rises, the
the
price
price sellers
sellers
receive
receive falls,
falls,
eqm
eqm Q
Q falls.
falls.

Effects of a $1.50 per unit tax

on buyers
P
PB = $11.00

Tax

S1

$10.00
PS = $9.50
D1
D2
430 500

The Incidence of a Tax

How the burden of a tax is shared among
market participants
P
Because
Because
of
of the
the tax,
tax,
buyers
buyers pay
pay
$1.00
$1.00 more,
more,
sellers
sellers get
get
$0.50
$0.50 less.
less.

PB = $11.00

Tax

S1

$10.00
PS = $9.50
D1
D2
430 500

A Tax on Sellers
A
A tax
tax on
on
sellers
sellers
shifts
shifts the
the S
S
curve
curve up
up by
by
the
the amount
amount
of
of the
the tax.
tax.

The
The price
price
buyers
buyers pay
pay
rises,
rises, the
the
price
price sellers
sellers
receive
receive falls,
falls,
eqm
eqm Q
Q falls.
falls.

Effects of a $1.50 per unit tax on

sellers
P
S2

PB = $11.00

Tax

S1

$10.00
PS = $9.50
D1
430 500

The Outcome Is the Same in Both Cases!

The effects on P and Q, and the tax incidence are the
same whether the tax is imposed on buyers or sellers!
P
What
matters is
PB = $11.00
this:
$10.00
A tax drives
a wedge
PS = $9.50
between the
price buyers
pay and the
price sellers
receive.

Tax

S1

D1
430 500

Elasticity and Tax Incidence

CASE 1: Supply is more elastic than demand

In
In this
this case,
case,
buyers
buyers bear
bear
most
most of
of the
the
burden
burden of
of
the
the tax.
tax.

Buyers share
of tax burden

PB
Tax

Price if no tax
Sellers share
of tax burden

PS
D
Q

Elasticity and Tax Incidence

CASE 2: Demand is more elastic than supply

Buyers share
of tax burden

PB

Price if no tax
Sellers share
of tax burden

In
In this
this case,
case,
sellers
sellers bear
bear
most
most of
of the
the
burden
burden of
of
the
the tax.
tax.

Tax
PS

D
Q

Elasticity and Tax Incidence

If buyers price elasticity > sellers price
elasticity, buyers can more easily leave the
market when the tax is imposed, so buyers
will bear a smaller share of the burden of
the tax than sellers.
If sellers price elasticity > buyers price
elasticity, the reverse is true.