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31. From Wikipedia, the free encyclopedia
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In economics, the marginal rate of substitution (MRS) is the least-favorable rate at which an agent is
willing to exchange units of one good or service for units of another. The MRS measures the value that
the consumer places on one extra unit of a good or service, where the opportunity cost is quantified by
amount of another sacrificed.
Textbook Definition: The rate at which a customer is ready to give up a product A in exchange for
product B , total satisfaction remaining the same is termed marginal rate of substitution of B for A
Marginal rate of substitution as the slope of indifference
curve
Under the standard assumption of neoclassical economics that goods and services are continuously
divisible, the marginal rates of substitution will be the same regardless of the direction of exchange, and
will correspond to the slope of an indifference curve (more precisely, to the slope multiplied by -1)
passing through the endowment in question, at that endowment. Further on this assumption, or otherwise
on the assumption that utility is quantified, the marginal rate of substitution of good or service X for good
or service Y (MRSxy) is also equivalent to the marginal utility of X over the marginal utility of Y.
Formally,
For example, if the MRSxy=2, the consumer will give up 2 units of Y to obtain 1 additional unit of X.
As one moves down a (standardly convex) indifference curve, the marginal rate of substitution decreases
(as measured by the absolute value of the slope of the indifference curve, which decreases). This is
known as the law of diminishing marginal rate of substitution.
Since the indifference curve is convex with respect to the origin and we have defined the MRS as the
negative slope of the indifference curve,
Normal good
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In economics, normal goods are any goods for which demand increases when income increases, i.e. with
a positive income elasticity of demand. The term does not refer to the quality of the good.
Depending on the indifference curves, the amount of a good bought can either increase, decrease, or stay
the same when income increases. In the diagram below, good Y is a normal good since the amount
purchased increases from Y1 to Y2 as the budget constraint shifts from BC1 to the higher income BC2.
Good X is an inferior good since the amount bought decreases from X1 to X2 as income increases.
Inferior good
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In consumer theory, an inferior good is a good that decreases in demand when the consumer's income
rises, unlike normal goods, for which the opposite is observed. Inferiority, in this sense, is an observable
fact rather than a statement about the quality of the good. As a rule, surfeit is easily achieved with such
goods, and as more costly substitutes that offer more pleasure or at least variety become available, the use
of the inferior goods diminishes.
Inter-city bus service is an example of an inferior good. This form of transportation is cheaper than air or
rail travel, but is more time-consuming. When money is constricted, traveling by bus becomes more
palatable, but when money is more abundant than time, more rapid transport is preferred.
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Luxury good
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A luxury sedan is an example of a luxury good.
In economics, a luxury good is a good for which demand increases more than proportionally as income
rises, contrast with inferior good and normal good. Luxury goods are said to have high income elasticity
of demand: as people become more wealthy, they will buy more and more of the luxury good. This also
means, however, that should there be a decline in income its demand will drop. It must be noted, though,
that income elasticity of demand is not constant with respect to income, and may change sign at different
levels of income. That is to say, a luxury good may become a normal good or even an inferior good at
different income levels, e.g. a wealthy person stops buying increasing numbers of luxury cars for his
automobile collection to start collecting airplanes (at such an income level, the luxury car would become
an inferior good).
Giffen good
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A Giffen good is an inferior good for which a rise in its price makes people buy even more of the product
as a consequence of the income effect. Evidence for the existence of Giffen goods is limited, but there is
an economic model that explains how such a thing could exist. Giffen goods are named after Sir Robert
Giffen, who was attributed as the author of this idea by Alfred Marshall in his book Principles of
Economics.
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For most products, price elasticity of demand is negative. In other words, price and demand pull in
opposite directions; if price goes up, then quantity demanded goes down, or vice versa. Giffen goods are
an exception to this. Their price elasticity of demand is positive. When price goes up, the quantity
demanded also goes up, and vice versa. In order to be a true Giffen good, price must be the only thing
that changes to get a change in quantity demand, and conspicuous consumption does not enter the picture
(such a situation would indicate a Veblen good).
The classic example given by Marshall is of inferior quality staple foods, whose demand is driven by
poverty that makes their purchasers unable to afford superior foodstuffs. As the price of the cheap staple
rises, they can no longer afford to supplement their diet with better foods, and must consume more of the
staple food.
Marshall wrote in the 1895 edition of Principles of Economics:
As Mr. Giffen has pointed out, a rise in the price of bread makes so large a
drain on the resources of the poorer labouring families and raises so much the
marginal utility of money to them, that they are forced to curtail their
consumption of meat and the more expensive farinaceous foods: and, bread
being still the cheapest food which they can get and will take, they consume
more, and not less of it.
Giffen goods are also related to experience goods and credence goods in that the two often exhibit
increases in demand with price, yet different in that close substitutes are available for the latter types.
Durable good
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A car (Toyota Corolla S) is a durable good in economics.
In economics, a durable good or a hard good is a good which does not quickly wear out, or more
specifically, it yields services or utility over time rather than being completely used up when used once.
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Most goods are therefore durable goods to a certain degree. Perfectly durable goods never wear out. As
an example, a rubber band is not very durable.
Examples of durable goods include cars, appliances, business equipment, electronic equipment, home
furnishings and fixtures, houseware and accessories, photographic equipment, recreational goods,
sporting goods, toys and games.
Durable goods are typically characterized by long interpurchase times (Next product to buy models).
Nondurable goods or soft goods are the opposite of durable goods. They may be defined either as goods
that are used up when used once, or that have a lifespan of less than 3 years.
Examples of nondurable goods include cosmetics, food, cleaning products, office supplies, packaging and
containers, paper and paper products, personal products, rubber, plastics, textiles, clothing, footwear and
most services.
Durable goods, nondurable goods and services together constitute the consumption of an economy.
Price elasticity of demand
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In economics and business studies, the price elasticity of demand (PED) is an elasticity that measures the
nature and degree of the relationship between changes in quantity demanded of a good and changes in its
price.
Introduction
When the price of a good falls, the quantity consumers demand of the good typically rises--if it costs less,
consumers buy more. Price elasticity of demand measures the responsiveness of a change in quantity
demanded for a good or service to a change in price.
Mathematically, the PED is the ratio of the relative (or percent) change in quantity demanded to the
relative change in price. For most goods this ratio is negative, but in practice the elasticity is represented
as a positive number and the minus sign is understood. For example, if for some good when the price
decreases by 10%, the quantity demanded increases by 20%, the PED for that good will be 2.
When the PED of a good is greater than one in absolute value, the demand is said to be elastic; it is
highly responsive to changes in price. Demands with an elasticity less than one in absolute value are
inelastic; the demand is weakly responsive to price changes.
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[edit] Interpretation of Elasticity
Value
n=0
Meaning
Perfectly inelastic.
0 < n < 1 Relatively inelastic.
n=1
Unit elastic.
1 < n < ∞ Relatively elastic.
n=∞
Perfectly elastic.
For all normal goods and most inferior goods, a price drop results in an increase in the quantity demanded
by consumers. The demand for a good is relatively inelastic when the quantity demanded does not change
much with the price change. Goods and services for which no substitutes exist are generally inelastic.
Demand for an antibiotic, for example, becomes highly inelastic when it alone can kill an infection
resistant to all other antibiotics. Rather than die of an infection, patients will generally be willing to pay
whatever is necessary to acquire enough of the antibiotic to kill the infection.
Price elasticity of demand is rarely constant throughout the ranges of quantity demanded and price. A
good or service can have relatively inelastic demand up to a certain price, above which demand becomes
elastic. Even if automobiles, for example, were extremely inexpensive, parking or other related ownership
issues would presumably keep most people from owning more than some "maximum" number of
automobiles. For these and other reasons, elasticity of demand remains valid only over a specific (and
small) range of price. Demand for cars (as well as other goods and services) is not elastic or inelastic for
all prices. Elasticity of demand can change dramatically across a range of prices.
Inelastic demand is commonly associated with "necessities," although there are many more reasons a
good or service may have inelastic demand other than the fact that consumers may "need" it. Demand for
salt, for instance, at its modern levels of supply is highly inelastic not because it is a necessity but because
it is such a small part of the household budget. (Technology has increased the supply of salt modernly
and reduced its historically high price.) Demand for water, another necessity, is highly inelastic for
similar supply side reasons. Demand for other goods, like chocolate, which is not a necessity, can be
highly elastic.
Substitution serves as a much more reliable predictor of elasticity of demand than "necessity." For
example, few substitutes for oil and gasoline exist, and as such, demand for these goods is relatively
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inelastic. However, products with a high elasticity usually have many substitutes. For example, potato
chips are only one type of snack food out of many others, such as corn chips or crackers, and predictably,
consumers have more room to turn to those substitutes if potato chips were to become more expensive.
It may be possible that quantity demanded for a good rises as its price rises, even under conventional
economic assumptions of consumer rationality. Two such classes of goods are known as Giffen goods or
Veblen goods. Another case is the price inflation during an economic bubble. Consumer perception plays
an important role in explaining the demand for products in these categories. A starving musician who
offers lessons at a bargain basement rate of $5.00 per hour will continue to starve, but if the musician
were to raise the price to $35.00 per hour, consumers may perceive the musician's lessons ability to
charge higher prices as an indication of higher quality, thus increasing the quantity of lessons demanded.
Various research methods are used to calculate price elasticity:



Test markets
Analysis of historical sales data
Conjoint analysis
[edit] Mathematical definition
The formula used to calculate the coefficient of price elasticity of demand is
Or, using the differential calculus:
or alternatively:
where:
P = price
Q = quantity
Qd = original quantity
Pd = original price
ΔQd = Qdnew - Qdold
ΔPd = Pdnew - Pdold
One caveat in using this (valid) formula: Will you use the original or the new quantity demanded in the
denominator? Will you use the original or new price in the denominator? Be consistent at least and use
one set or the other. A more elegant and reliable calculation uses a midpoint analysis--instead of the
original or the new, try using the point half way between the two for your calculations.
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Interestingly, repeated use of the chain rule reveals that:
From the following process:
Note:
Further Note:
Implying:
Substitution reveals:
http://www.tutor2u.net/economics/content/topics/elasticity/income_elasticity.htm
Marginal revenue
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In microeconomics, Marginal Revenue (MR) is the extra revenue that an additional unit of product will
bring a firm. It can also be described as the change in total revenue/change in number of units sold.
More formally, marginal revenue is equal to the change in total revenue over the change in quantity when
the change in quantity is equal to one unit (or the change in output in the bracket where the change in
revenue has occurred)
This can also be represented as a derivative. (Total revenue) = (Price) times (Quantity) or
. Thus, by the product rule:
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.
For a firm facing perfectly competitive markets, price does not change with quantity sold (
), so
marginal revenue is equal to price. For a monopoly, the price received will decline with quantity sold
(
), so marginal revenue is less than price. This means that the profit-maximizing quantity, for
which marginal revenue is equal to marginal cost will be lower for a monopoly than for a competitive
firm, while the profit-maximizing price will be higher. When marginal revenue is positive, price elasticity
of demand [PED] is elastic, and when it is negative, PED is inelastic. When marginal revenue is equal to
zero, price elasticity of demand is equal to 1.
Marginal cost
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In economics and finance, marginal cost is the change in total cost that arises when the quantity produced
changes by one unit. Mathematically, the marginal cost (MC) function is expressed as the derivative of
the total cost (TC) function with respect to quantity (Q). Note that the marginal cost may change with
volume, and so at each level of production, the marginal cost is the cost of the next unit produced.
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A typical Marginal Cost Curve
In general terms, marginal cost at each level of production includes any additional costs required to
produce the next unit. If producing additional vehicles requires, for example, building a new factory, the
marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is
segregated into short and long-run cases, and over the longest run, all costs are marginal. At each level of
production and time period being considered, marginal costs include all costs which vary with the level of
production, and other costs are considered fixed costs.
It is a general principle of economics that a (rational) producer should always produce (and sell) the last
unit if the marginal cost is less than the market price. As the market price will be dictated by supply and
demand, it leads to the conclusion that marginal cost equals marginal revenue. These general principles
are subject to a number of other factors and exceptions, but marginal cost and marginal cost pricing play
a central role in economic definitions of efficiency.
Marginal cost pricing is the principle that the market will, over time, cause goods to be sold at their
marginal cost of production. Whether goods are in fact sold at their marginal cost will depend on
competition and other factors, as well as the time frame considered. In the most general criticism of the
theory of marginal cost pricing, economists note that monopoly power may allow a producer to maintain
prices above the marginal cost; more specifically, if a good has low elasticity of demand (consumers are
insensitive to changes in price) and supply of the product is limited (or can be limited), prices may be
considerably higher than marginal cost. Since this description applies to most products with established
brands, marginal pricing may be relatively rare; an example would be in markets for commodities.
A number of other factors can affect marginal cost and its applicability to real world problems. Some of
these may be considered market failures. These may include information asymmetries, the presence of
negative or positive externalities, transaction costs, price discrimination and others.
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Short-run
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In economics, the concept of the short-run refers to the decision-making time frame of a firm in which at
least one factor of production is fixed. Costs which are fixed in the short-run have no impact on a firms
decisions. For example a firm can raise output by increasing the amount of labour through overtime.
A generic firm can make three changes in the short-run:



Increase production
Decrease production
Shut down
In the short-run, a profit maximizing firm will:




Increase production if marginal cost is less than price;
Decrease production if marginal cost is greater than price;
Continue producing if average variable cost is less than price, even if average
total cost is greater than price;
Shut down if average variable cost is greater than price. Thus, the average
variable cost is the largest loss a firm can incur in the short-run.
Long run
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It has been suggested that this article or section be merged with Long-run. (Discuss)
For other uses of the term, see The Long Run
In economic models, the long run time frame assumes no fixed factors of production. Firms can enter or
leave the marketplace, and the cost (and availability) of land, labor, raw materials, and capital goods can
be assumed to vary. In contrast, in the short-run time frame, certain factors are assumed to be fixed,
because there is not sufficient time for them to change. This is related to the long run average cost (LRAC)
curve, an important factor in microeconomic models.
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Long run marginal cost (LRMC) refers to the cost of providing an additional unit of service or
commodity under assumption that this requires investment in capacity expansion. LRMC pricing is
appropriate for best resource allocation, but may lead to a mismatch between operating costs and
revenues.
In macroeconomic models, the long run assumes full factor mobility between economic sectors, and often
assumes full capital mobility between nations.
The concept of long run cost is used in cost-volume-profit analysis and product mix analysis.
A famous use of the phrase was by John Maynard Keynes, who said in dry humor, "In the long run, we
are all dead."
Derived demand
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Derived demand is a term in economics, where demand for one good or service occurs as a result of
demand for another. This may occur as the former is a part of production of the second. For example,
demand for coal leads to derived demand for mining, as coal must be mined for coal to be consumed.
Demand for transport is a good example of derived demand, as users of transport are very often
consuming the service not because they benefit from consumption directly (except in cases such as
pleasure cruises), but because they wish to partake in other consumption elsewhere.
Derived demand applies to both consumers and producers. Producers have a derived demand for
employees, the employees themselves are not demanded, rather the skills and productivity that they bring.
Tickets are a derived demand for entertainment. Entertainment is the demand being satisfied when a
ticket is bought, it is purely a means to an end. The ticket is not an end in itself. The ticket is merely a
licence to attend a specified event at a specified time and place. The ticket agency is merely that, an agent
of the principal (the event owner) authorised to make a transaction with a prospective attendee on the
behalf of the principal.
Balance of payments
The balance of payments, (or BOP) measures the payments that flow between any individual country and
all other countries. It is used to summarize all international economic transactions for that country during
a specific time period, usually a year. The BOP is determined by the country's exports and imports of
goods, services, and financial capital, as well as financial transfers. It reflects all payments and liabilities
to foreigners (debits) and all payments and obligations received from foreigners (credits).
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Components
Blue = countries in current account surplus; Red = countries in current account deficit,
2005
The Balance of Payments for a country is the sum of the current account, the financial account (formerly
capital account), and the change in official reserves.
[Note: The name of the "capital account" was changed in the US in 1999. It is now referred to as the
financial account. [1]]
[edit] Current account
The current account is the sum of net sales from trade in goods and services, net factor income (such as
interest payments from abroad), and net unilateral transfers from abroad. Positive net sales from abroad
corresponds to a current account surplus; negative net sales from abroad corresponds to a current account
deficit. Because exports generate positive net sales, and because the trade balance is typically the largest
component of the current account, a current account surplus is usually associated with positive net
exports.
The Income Account or Net Factor Income, a sub-account of the Current Account, is usually presented
under the headings "Income Payments", as outflows, and "Income Receipts", as inflows. If the Income
Account is negative, the country is paying more than it is taking in interest, dividends, etc. For example,
the United States' net income has been declining exponentially since it allowed the Dollar's price relative
to other currencies to be determined by the market to a point where income payments and receipts are
roughly equal. The difference between Canada's Income Payments and Receipts have been declining
exponentially as well since its' central bank in 1998 began its' strict policy not to intervene in the
Canadian Dollar's foreign exchange. The various subcategories in the Income Account are linked to
specific respective subcategories in the Financial account. From here, economists and central banks
determine implied rates of return on the different types of capital exchanged in the Financial Account.
The United States, for example, gleans a substantially larger rate of return from foreign capital than
foreigners from domestic capital.
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When analyzing the current account theoretically, it is often written as a function X of the real exchange
rate, p, domestic GDP, Y, and foreign GDP, Y*. Thus the current account can be written as X(p, Y, Y*).
According to theory, the current account X should increase if (1) the domestic currency depreciates (p
increases), (2) domestic GDP decreases, or (3) foreign GDP increases. A domestic currency depreciation
makes domestic goods relatively cheaper, boosting exports relative to imports. A decrease in domestic
GDP reduces domestic demand for foreign goods, lowering imports without affecting exports. An
increase in foreign GDP increases foreign demand for domestic goods, increasing exports without
affecting imports.
Current account =



Trade Balance
o Net Exports (Exports - Imports) of Merchandise (tangible goods)
o Net Exports (Exports - Imports) Services (such as legal and
consulting services)
+ Net Factor Income From Abroad (such as interest and dividends)
+ Net Unilateral Transfers From Abroad (such as foreign aid, grants,
gifts, etc.)
[edit] Capital account
The capital account used to entitle the section now familiarly known as the financial account. This section
usually includes special debt transactions between nations and migrants' goods as they cross a country's
borders.
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