Download Chapter 5: Consumer Choice

Elasticity:
A.
Elasticity of demand measures how much the quantity demanded changes with a
given change in price of the item, change in consumers’ income, or change in price of
related product.
B.
Price elasticity is a concept that also relates to supply.
C.
The chapter explores both elasticity of supply and demand and applications of the
concept.
Price Elasticity of Demand
A.
Law of demand tells us that consumers will respond to a price decrease by buying
more of a product (other things remaining constant), but it does not tell us how much
more.
B.
The degree of responsiveness or sensitivity of consumers to a change in price is
measured by the concept of price elasticity of demand.
1.
If consumers are relatively responsive to price changes, demand is said to be
elastic.
2.
If consumers are relatively unresponsive to price changes, demand is said to be
inelastic.
3.
Note that with both elastic and inelastic demand, consumers behave according to
the law of demand; that is, they are responsive to price changes. The terms elastic or
inelastic describe the degree of responsiveness. A precise definition of what we mean by
“responsive” or “unresponsive” follows.
C.
Price elasticity formula:
Quantitative measure of elasticity, Ed = percentage change in quantity/ percentage
change in price.
1.
Using two price-quantity combinations of a demand schedule, calculate the
percentage change in quantity by dividing the absolute change in quantity by one of the
two original quantities. Then calculate the percentage change in price by dividing the
absolute change in price by one of the two original prices.
2.
Estimate the elasticity of this region of the demand schedule by comparing the
percentage change in quantity and the percentage change in price. Do not use the ratio
formula at this time. Emphasize that it is the two percentage changes that are being
compared when determining elasticity.
4.
Show that if the other original quantity and price were used as the denominator
that the percentage changes would be different. Explain that a way to deal with this
problem is to use the average of the two quantities and the average of the two prices.
5.
Emphasis: What is being compared are the percentages changes, not the absolute
changes.
a.
Absolute changes depend on choice of units. For example, a change in the price
of a $10,000 car by $1 and is very different than a change in the price a of $1 can of beer
by $1. The auto’s price is rising by a fraction of a percent while the beer rice is rising
100 percent.
b.
Percentages also make it possible to compare elasticities of demand for different
products.
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6.
Because of the inverse relationship between price and quantity demanded, the
actual elasticity of demand will be a negative number. However, we ignore the minus
sign and use absolute value of both percentage changes.
7.
If the coefficient of elasticity of demand is a number greater than one, we say
demand is elastic; if the coefficient is less than one, we say demand is inelastic. In other
words, the quantity demanded is “relatively responsive” when Ed is greater than 1 and
“relatively unresponsive” when Ed is less than 1. A special case is if the coefficient
equals one; this is called unit elasticity.
8.
Note: Inelastic demand does not mean that consumers are completely
unresponsive. This extreme situation called perfectly inelastic demand would be very
rare, and the demand curve would be vertical.
9.
Likewise, elastic demand does not mean consumers are completely responsive to
a price change. This extreme situation, in which a small price reduction would cause
buyers to increase their purchases from zero to all that it is possible to obtain, is perfectly
elastic demand, and the demand curve would be horizontal.
D.
The best formula for elasticity is:
Ed = [(change in Q)/(sum of Q’s/2)] divided by [(change in P)/(sum of P’s/2)]
1.
Have the students calculate each of the percentage changes separately
using to determine whether the demand is elastic or inelastic. After the students have
determined the type of elasticity, then have them insert the percentage changes into the
formula.
E.
Graphical analysis:
a.
Demand is more elastic in upper left portion of curve (because price is higher,
quantity smaller).
b.
Demand is more inelastic in lower right portion of curve (because price is lower,
quantity larger).
3.
It is impossible to judge elasticity of a single demand curve by its flatness or
steepness, since demand elasticity can measure both elastic and inelastic at different
points on the same demand curve.
F.
Total-revenue test is the easiest way to judge whether demand is elastic or
inelastic. This test can be used in place of elasticity formula, unless there is a need to
determine the elasticity coefficient.
1.
Elastic demand and the total-revenue test: Demand is elastic if a decrease in price
results in a rise in total revenue, or if an increase in price results in a decline in total
revenue. (Price and revenue move in opposite directions).
2.
Inelastic demand and total revenue test: Demand is inelastic if a decrease in price
results in a fall in total revenue, or an increase in price results in a rise in total revenue.
(Price and revenue move in same direction).
3.
Unit elasticity and the total revenue test: Demand has unit elasticity if total
revenue does not change when the price changes.
G.
There are several determinants of the price elasticity of demand.
1.
Substitutes for the product: Generally, the more substitutes, the more elastic the
demand.
2.
The proportion of price relative to income: Generally, the larger the expenditure
relative to one’s budget, the more elastic the demand, because buyers notice the change in
price more.
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3.
Whether the product is a luxury or a necessity: Generally, the less necessary the
item, the more elastic the demand.
4.
The amount of time involved: Generally, the longer the time period involved, the
more elastic the demand becomes.
I.
There are many practical applications of elasticity.
1.
Inelastic demand for agricultural products helps to explain why bumper crops
depress the prices and total revenues for farmers.
2.
Governments look at elasticity of demand when levying excise taxes. Excise
taxes on products with inelastic demand will raise the most revenue and have the least
impact on quantity demanded for those products.
3.
Demand for cocaine is highly inelastic and presents problems for law
enforcement. Stricter enforcement reduces supply, raises prices and revenues for sellers,
and provides more incentives for sellers to remain in business. Crime may also increase
as buyers have to find more money to buy their drugs.
a.
Opponents of legalization think that occasional users or “dabblers” have a more
elastic demand and would increase their use at lower, legal prices.
b.
Removal of the legal prohibitions might make drug use more socially acceptable
and shift demand to the right.
Price Elasticity of Supply
A.
The concept of price elasticity also applies to supply. The elasticity formula is the
same as that for demand, but we must substitute the word “supplied” for the word
“demanded” everywhere in the formula.
Es = percentage change in quantity supplied / percentage change in price
1.
The market period is so short that elasticity of supply is inelastic; it could be
almost perfectly inelastic or vertical. In this situation, it is virtually impossible for
producers to adjust their resources and change the quantity supplied. (Think of
adjustments on a farm once the crop has been planted.)
2.
The short-run supply elasticity is more elastic than the market period and will
depend on the ability of producers to respond to price change. Industrial producers are
able to make some output changes by having workers work overtime or by bringing on an
extra shift.
3.
The long-run supply elasticity is the most elastic, because more adjustments can
be made over time and quantity can be changed more relative to a small change in price.
The producer has time to build a new plant.
Cross and income elasticity of demand:
A.
Cross elasticity of demand refers to the effect of a change in a product’s price on
the quantity demanded for another product. Numerically, the formula is shown for
products X and Y.
Exy = (percentage change in quantity of X) / (percentage change in price of Y)
1.
If cross elasticity is positive, then X and Y are substitutes.
2.
If cross elasticity is negative, then X and Y are complements.
3.
Note: if cross elasticity is zero, then X and Y are unrelated, independent
products.
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B.
Income elasticity of demand refers to the percentage change in quantity demanded
that results from some percentage change in consumer incomes.
Ei = (percentage change in quantity demanded) / (percentage change in income)
1.
A positive income elasticity indicates a normal or superior good.
2.
A negative income elasticity indicates an inferior good.
Consumer Choice
Every consumer must face two facts of economic life:
1. They have to pay prices for the goods and services they buy.
2. They have limited funds to spend.

These two facts are summarized by the consumer’s budget constraint.
Definition: A consumer’s budget constraint identifies which combinations of goods and
services the consumer can afford with a limited budget, at given prices.
Definition: Budget Line: The graphical representation of a budget constraint.
It is very important to see the relationship between the prices of two goods and the
opportunity cost of having more of one or the other. The prices Max faces tell us how
many dollars he must give up to get another unit of each good. If, however, we divide
one money price by another money price, we get what is called a relative price—the price
of one good relative to the other.
Definition: Relative Price: The price of one good relative to the price of another.
 The slope of the budget line indicates the spending trade-off between one
good and another—the amount of one good that must be sacrificed in
order to buy more of another good. If Py is the price of the good on the
vertical axis and Px is the price of a good on the horizontal axis, then the
 Px
slope of the budget line is:
.
Py
 An increase in income will shift the budget line upward and (rightward).
 A decrease in income will shift the budget line downward (and leftward).
 These shifts are parallel - changes in income do not affect the budget line’s slope.
Changes in Price:
 What happens to the budget line when a price changes?
•
When the price of a movie falls, the budget line rotates outward—the vertical
intercept moves higher.
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Keep in mind:
 When the price of a good changes, the budget line rotates: Both its slope
and one of its intercepts will change.
Question: What would be the effect of a lower price of “Product x” {in this example
“Px”}?
 Due to the lower price, the graph will “rotate” only on the side of the
graph corresponding to where the price lowered; we know that the lower
price will allow the consumer to purchase more of a product, thus we
can extend the “budget constraint line” on the x axis to represent an
increase in the “ability” to be able to buy more total units of “x.”

If, suppose, the price of product “x” decreases. We would “rotate” only
the x intercept (the x intercept is the point on the graph where the graph
touches the x axis).
Income /Price of Good = Quantity the consumer can purchase
The Consumer’s Goal
What is Utility?
 Definition: Pleasure or satisfaction obtained from consuming goods and
services.

Pleasure or satisfaction obtained from consuming and services.

The satisfaction that a consumer gets from consuming goods or
services.
What is Marginal Utility?

Marginal utility is the increment change in utility (pleasure) an
individual “gets” from an additional unit of a good. The marginal
utility of a thing to anyone diminishes with every increase in the
amount of it he already has.
How to calculate Marginal Utility?
MU = (Change) in Total Utility /  (Change) in Consumption

Note: “Utility” is a subjective (or normative) notion in economics.
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Total and Marginal Utility
Lisa’s Total and Marginal Utility from Consuming Ice Cream Cones
Number of Cones
Total Utility
Marginal Utility
0
0 Utils
1
30 Utils
30 Utils
2
50 Utils
20 Utils
3
60 Utils
10 Utils
4
65 Utils
5 Utils
5
68 Utils
3 Utils
6
68 Utils
0 Utils
 Panel (a) shows Lisa’s total utility from her consumption of ice cream cones. As her
consumption of ice cream rises, so does her total utility. Panel (b) shows the
corresponding marginal utility. MU falls as ice cream consumption rises, indicating
that each additional ice cream cone per week provides less additional utility than the
previous one did.
# of plates of pasta Total utility Marginal utility
0
0
-
1
15
15
2
17
2
3
18
1
4
18
0
5
17
-1
6
14
-3
 Total utility increases as each additional plate of pasta is consumed,
but TU (total utility) rises at a diminishing rate, since each plate adds
less and less to the consumer’s satisfaction.
 At some point, MU (marginal utility) becomes zero, and then negative,
which means that after that point, TU (total utility) begins to fall. This
is called the law of diminishing returns.
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 The economic theory of choice is based on the concept of utility. Utility is
defined as the level of happiness or satisfaction associated with alternative
choices. Economists assume that when individuals are faced with a choice
of feasible alternatives, they will always select the alternative that
provides the highest level of utility.
Total and marginal utility
 The total utility associated with a good is the level of happiness derived
from consuming the good. Marginal utility is a measure of the additional
utility that is received when an additional unit of the good is consumed.
 The Utility Maximum Rule: a consumer will maximize utility by
choosing a point on the budget line where MU per dollar is the same
for both goods.
 In algebraic form, this may be expressed as:
 As long as one good provides more utility per dollar than another, the consumer will
buy more of that good. As more of that product is consumed, its MU diminishes until
the amount of utility per dollar equals (MU/p) that of the other product.
Consumer Decision Making:
1. Rationality: if product “a” is preferred to product “b,” and “b” is preferred to “c,”
then (product) “a” should be preferred to (product) “c.”
 When a consumer makes comparisons, s/he tries to maximize his/her
utility. In other words, the consumer’s preferences are said to be
rational.
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2. MU (marginal utility) is positive.
3. MU (marginal utility) diminishes as more of a good is consumed (The law of
diminishing marginal utility).
 The consumer will always choose a point on the budget line, rather than a
point below it.
Concerts at $30 each
Movies at $10 each
(1) Point on
(2) Number
(3)
(4)
(5) Number
(6)
(7)
the Budget
of Concerts
Marginal
Marginal
of Movies
Marginal
Marginal
line
per Month
Utility from
Utility per
per Month
Utility from
Utility per
last concert
Dollar
Last Movie
Dollar
spent on
Spent on
Last
Last Movie
Concert
A
0
-
-
15
50
5
B
1
1,500
50
12
100
10
C
2
1,200
40
9
150
15
D
3
600
20
6
200
20
E
4
390
13
3
350
35
F
5
300
10
0
-
-
The budget line shows the maximum number of movies Max could attend for each number
of concerts he attends. He would never choose an interior point like G because there are
more affordable points—on the line—that make him better off. Max will choose a point
on the budget line. More specifically, he will choose the point at which the marginal
utilities per dollar spent on movies and concerts are equal. This occurs at point D.
Marginal decision making: the process of making decisions based on their incremental
or marginal effects.
 To understand and predict the behavior of individual decision
makers, we focus on the incremental or marginal effects of their
actions.
 A utility maximizing consumer will choose the point on
the budget line where marginal utility per dollar is the
same for both goods (
MU x MU y

). At that point,
Px
Py
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there is no further gain from reallocating expenditures
in either direction.
Changes in Income, Price, and Demand
In a market economy things change. How can changes in income, price, or demand
affect the budget line?
 Recall: Normal vs. Inferior Goods: Has nothing to do with quality, but
with choices based on income.
 Normal goods: goods that people demand as their income rises; chosen
when the marginal utilities per dollar are equal after an increase in income.
 Inferior goods: goods that people demand less of as their income rises.
 Recall: The Law of Demand: A rise in the price of a good reduces the
quantity demanded, and a fall in price increases quantity demanded.
Definition: The individual demand curve: A curve showing the quantity of a good
or service demanded by a particular individual at each different price.
 Combining Substitutions and Income Effects:
1. The Substitution Effect:
 The substitution effect of a price change arises from a change in the relative
price of a good, and it always moves quantity demanded in the opposite
direction to the price change. When price decreases, the substitution effect
works to increase quantity demanded; when price increases, the substitution
effect works to decrease quantity demanded.
2. The Income Effect:
 The income effect of a price change is the impact on quantity demanded
that arises from a change in purchasing power over both goods. A drop in
price increases purchasing power, while a rise in price decreases
purchasing power.
3. Combining Substitution and Income Effects:
 For normal goods, the substitution and income effects work together,
causing quantity demanded to move in the opposite direction of the price.
Normal goods, therefore, must always obey the law of demand.

Normal Goods: Substitution and income effects work together
 demand moves in the opposite direction of the price
 normal goods must always obey the law of demand
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
Inferior Goods: Substitution and income effects work against each other.
 substitution effect moves quantity demanded in the opposite direction of
the price
 income effect moves quantity demanded in the same direction as the price
 Substitution effect almost always dominates, so consumption of inferior
good and normal goods will almost always obey the law of demand.
 For inferior goods, the substitution and income effects of a price change
work against each other. The substitution effect moves quantity demanded
in the opposite direction of the price, while the income effect moves it in
the same direction as the price. But since the substitution effect virtually
always dominates, consumption of inferior goods—like normal goods—
will virtually always obey the law of demand.
From Individual to Market Demand:
Definition: The market demand curve is the horizontal summation of the
individual demand curves of every consumer in the market.
Production and Cost:
The Short Run and the Long Run:
Definition: Long run: A time horizon long enough for a firm to vary all of its inputs.
Definition: Short run: A time horizon during which at least one of the firm’s inputs
cannot be varied.
Production in the Short Run:
Definition: Fixed inputs: Fixed inputs are those whose quantity must remain constant,
regardless of how much output is produced.
Definition: Variable inputs: Variable inputs are those whose quantity can change as the
level of output changes
Definition: Total product: is the maximum quantity of output that can be produced
from a given combination of inputs.
Marginal Returns to Labor:
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1. Increasing marginal returns to labor: The marginal product of labor increases as
more labor is hired.
2. Diminishing marginal returns to labor: The marginal product of labor decreases
as more labor is hired.
 Definition: The Law of diminishing marginal returns: The law of
diminishing (marginal returns) states that as we continue to add more of
any one input (holding the other inputs constant), its marginal product
will eventually decline.
Thinking About Costs:
 A firm’s total cost of production is the opportunity cost of the owners—
everything they must give up in order to produce output.
The Irrelevance of Sunk Costs:
 A sunk cost is a cost that was paid in the past and will not change
regardless of your present decision. Sunk costs should be ignored when
making current decisions.
Explicit versus Implicit Costs:
Definition: Explicit costs: Money actually paid out for the use of inputs.
Definition: Implicit costs: The cost of inputs for which there is no direct money
payment.
Explicit Costs
1.
2.
3.
4.
5.
Rent paid out
Interest on loans
Managers’ salaries
Hourly workers’ wages
Cost of raw materials
Implicit Costs
Opportunity cost of:
1. Owner’s land (rent forgone)
2. Owner’s money (investment income forgone)
3. Owner’s time (labor income forgone)
Costs in the Short Run:
Definition: Fixed costs: costs of fixed inputs
Definition: Variable costs: costs of variable inputs
Total Costs:
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Definition: Total fixed cost: The cost of all inputs that are fixed in the short run
Definition: Total variable costs: The cost of all variable inputs used in producing a
particular level of output
Definition: Total costs: The costs of all inputs—fixed and variable
 Total cost = Total fixed costs + total variable costs
 TC = TFC + TVC
Average Costs:
1. Average fixed cost (AFC): The total fixed cost divided by the quantity of output
produced.
AFC 
TFC
Q
2. Average variable cost (AVC): The total variable cost divided by the quantity of
output produced.
AVC 
TVC
Q
3. Average total cost (ATC): The total cost divided by the quantity of output
produced.
TC
ATC 
Q
 When the marginal product of labor (MPL) rises, marginal cost (MC)
falls. When MPL falls, MC rises. Since MPL ordinarily rises and then
falls, MC will do the opposite—it will fall and then rise. Thus, the MC
curve is U shaped.
 The relationship between average and marginal costs: MC, AVC, and
ATC—first fall and then rise, but not all at the same time. The MC curve
bottoms out before either the AVC or ATC curve. Further, the MC curve
intersects each of the average curves at their lowest point.
Production and Cost in the Long Run:
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 In the long run, there are no fixed inputs or fixed costs; all inputs and all costs
are variable. The firm must decide what combination of inputs to use in
producing any level of output.
 To produce any given level of output, the firm will choose the input mix with the
lowest cost.
Definition: Long Run Total Cost: The cost of producing each quantity of output
when the least cost input mix is chosen in the long run.
Definition: Long Run Average Total cost: The cost per unit of output in the long
run, when all inputs are variable.
LRATC 
LRTC
Q
 Long-average total cost is similar to average total cost—there is one
important difference, however: To calculate ATC, we used total cost (TC),
which pertains to the short run, in the numerator. In calculating LRATC,
we use long run total cost (LRTC) in the numerator. Thus, LRATC tells
us the cost per unit when the firm can vary all of its inputs and always
chooses the cheapest input mix possible. ATC, however, tells us the cost
per unit when the firm is stuck with some collection of fixed inputs.
The Relationship between Long-Run and Short Run Costs:
 Long-run total cost of producing a given level of output can be less than
or equal to, but never greater than, short-run total cost ( LRATC  TC ).
 Long-run average total cost of producing a given level of output can be
less than or equal to, but never greater than, short-run average total cost
( LRATC  ATC ).
 Average-total cost curves ATC0, ATC1, ATC2, and ATC3 show average
costs when the firm has zero, one, two, and three production lines,
respectively. The LRATC curve combines portions of all the firm’s ATC
curves. The firm will choose the lowest cost ATC curve for each level of
output. In the short run, a firm can only move along its current ATC
curve. In the long run, however, it can move from one ATC to another by
varying the size of its plant. As it does so, it will also be moving along its
LRATC curve.
Explaining the Shape of the LRATC Curve:
1. Economies of scale: Definition: Long-run average total cost decreases as output
increases.
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
LRATC decreases as output increases

Gains from specialization

More efficient use of “lumpy” inputs
2. Diseconomies of scale: Definition: Long-run average total cost increases as
output increases. When long-run total cost rises more than in proportion to
output, there are diseconomies of scale, and the LRATC curve slopes upward.

LRATC increases as output increases
3. Constant returns to scale: Definition: Long-run average total cost is unchanged
as output increases. When both output and long-run total cost rise by the same
proportion, production is characterized by constant returns to scale, and the
LRATC curve is flat.

LRATC is unchanged as output increases
 While long-run total cost rises proportionately less than output, production
is characterized by economies of scale, and the LRATC curve slopes
downward.
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