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Lecture 2
Elasticity
Costs
Perfect Competition
Elasticity
• Elasticity is a measure of how responsive
the quantity demanded is to changes in
environmental variables that determine
demand.
• To make the measure units free, elasticity
is calculated as the % change in quantity
demanded per % change in a variable.
Own Price Elasticity
• For own price elasticity, the variable is product
price.
• Own price elasticity is: % change in quantity
demanded of X / % change in price of X.
• Own price elasticity is negative; demand is
referred to as elastic if elasticity is greater than 1
(in absolute value), inelastic if it is less than 1 (in
absolute value) and unitary elastic if elasticity
equals -1.
Sales Revenue and Elasticity
• Why care about own price elasticity?
• If demand is elastic, then a price reduction
increases sales revenue; if demand is
inelastic, then a price rise leads to an
increase in sales revenue.
Cross Price Elasticity
• Cross price elasticity measures how
responsive quantity demanded is to
changes in price of other goods.
• Cross price elasticity is: % change in
quantity demanded of X / % change in
price of Y.
• Often used to measure whether or not two
goods are in same market
Income Elasticity
• Income elasticity measures how
responsive quantity demanded is to
changes in income.
• Income elasticity is: % change in quantity
demanded of X / % change in income.
• If positive—normal good
• If negative—inferior good
Elasticity of Supply
• Elasticity of supply measures how
responsive quantity supplied is to changes
in its price.
• Elasticity of supply is: % change in
quantity supplied of X / % change in price
of X.
The Cost Function
• As the demand function summarizes the
customer/sales side of the market, the
cost function summarizes the production
side of the market.
• What should costs depend on?
– input prices (including price of raising capital)
– quantity produced
– Technology
Cost Function Cont’d
• Cost function properties:
– Cost increasing in quantity produced
– Cost increasing in input prices
– Cost decreasing for technology
improvements.
• Cost can be divided into two components:
a fixed cost component (F) and a variable
cost component (c(x)).
Marginal and Average Cost
• Average cost gives cost per unit: C / x
• Since price gives revenue per unit, price
relative to average cost determines if
profits positive or negative
• Marginal cost gives the increase in costs
due to an increase in quantity produced.
Formally, marginal cost is the slope of the
variable cost function.
The Marginal Cost Function
• The amount by which costs increase as
quantity produced increases (i.e., marginal
cost) may or may not vary with output
• We consider two cases:
– constant marginal cost: c(x) = cx
– increasing marginal cost
• The latter is typically viewed as the result
of some input being in fixed supply
The Average Cost Function
• Average cost also varies with quantity
produced: AC = C / x
• The way that average cost varies with x is
determined by the way that marginal cost
varies:
– if c(x) = cx, then AC = F / x + c and so AC
declining with x if F > 0 and constant if F = 0
– If c(x) increasing, then AC = F / x + c(x) / x.
AC is U – shaped if F > 0, increasing if F = 0
Market Structures
Perfect Competition
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Large numbers of “small” producers
Identical product
All firms are “price takers”
Free entry into and exit from market
Perfect information
Perfect Competition Cont’d
• Choose output such that PX = MC(x)
• Firm supply curve is that part of MC curve
above AC. Market supply curve is sum of
firm supply curves
• Entry/exit occurs until profits 0: PX = minX
AC(x)