Micro economics unit 2

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Micro Economics Unit-2 : Application of Supply & Demand, Demand and Consumer Behavior.

Transcript of Micro economics unit 2

  1. 1. Unit-2 : Application of Supply & Demand, Demand and Consumer Behavior.
  2. 2. Meaning of Elasticity The term elasticity was developed by Alfred Marshall, and is used to measure the relationship between price and quantity demanded. Elasticity means responsiveness.
  3. 3. Elasticity A measure of a variable's sensitivity to a change in another variable. In economics, elasticity refers the degree to which individuals (consumers/producers) change their demand/amount supplied in response to price or income changes.
  4. 4. Elasticity In economics, elasticity is the measurement of how responsive an economic variable is to a change in another. For example: "If I lower the price of my product, how much more will I sell?" "If I raise the price of one good, how will that affect sales of this other good?" "If we learn that a resource is becoming scarce, will people scramble to acquire it?"
  5. 5. An elastic variable (or elasticity value greater than 1) is one which responds more than proportionally to changes in other variables. In contrast, an inelastic variable (or elasticity value less than 1) is one which changes less than proportionally in response to changes in other variables. Elasticity can be quantified as the ratio of the percentage change in one variable to the percentage change in another variable, when the latter variable has a causal influence on the former.
  6. 6. Elasticity of supply Elasticity of supply refers to the degree of response of the supply of a commodity to the change in price Responsiveness of producers to changes in the price of their goods or services Elasticity of supply is measured as the ratio of proportionate change in the quantity supplied to the proportionate change in price. Supply elasticity is defined as the percentage change in quantity supplied divided by the percentage change in price
  7. 7. Price elasticity of supply The price elasticity of supply measures how the amount of a good that a supplier wishes to supply changes in response to a change in price. Elasticity of supply measures the responsiveness of supply to a change in price. THE RATIO BETWEEN % CHANGE IN QUANTITY SUPPLIED TO THE % CHANGE IN PRICE.
  8. 8. Price Elasticity of Supply Percentage Change in Quantity Supplied Percentage Change in Price PES = Remember: Es = coefficient of price elasticity QS = Quantity Supplied P = Price PES = % QS % P
  9. 9. PEs > 1 supply is elastic PEs < 1 supply is inelastic PEs = 1 Unitary Elastic PEs= Perfectly Elastic PEs= 0 perfectly In-Elastic Types of price elasticity of supply
  10. 10. Figure 1. Elastic Supply Curve PRICE P1 P2 0 Q1 Q2 S QUANTITY When the proportionate change in supply is more than the proportionate changes in price, it is known as elastic supply or relatively elastic supply.
  11. 11. Figure 2. Inelastic Supply Curve PRICE P1 P2 0 Q1 Q2 S QUANTITY When the proportionate change in supply is less than the proportionate changes in price, it is known as inelastic supply or relatively inelastic supply
  12. 12. Figure 3. Unitary Supply Curve PRICE P1 P2 0 Q1 Q2 S QUANTITY When the proportionate change in supply is equal to proportionate changes in price, it is known as unitary elastic supply
  13. 13. Figure 4. Perfectly Elastic Supply Curve PRICE P1 0 S QUANTITY We say that supply is perfectly elastic when a 1% change in the price would result in an infinite change in quantity supplied.
  14. 14. Figure 5. Perfectly Inelastic Supply Curve PRICE P1 P2 0 S QUANTITY We say that supply is perfectly inelastic when a 1% change in the price would result in no change in quantity supplied.
  15. 15. Problem #1 An individual used to raise 10 bags which sell on the market at a minimum of $8 each. For some reasons, the market price per bag reached $10. He decided to raise 20. Let us find out how elastic or responsive the production was to price.
  16. 16. Given variables? Qs1 = 10 P1 = $8 each Qs2 = 20 P2 = $10 Qs = ? ; P = ? PES = ?
  17. 17. Q2-Q1 20-10 10 Qs = = = = 1 Q1 10 10 P2-P1 10-8 2 P = = = = 0.25 P1 8 8
  18. 18. Qs 1 PES = = = 4 P 0.25 We conclude that the PEOS is 4 . So PEOS is used to see how responsive or sensitive is supply of a good to change in price.
  19. 19. What factors affect the elasticity of supply Spare production capacity: If there is plenty of spare capacity then a business can increase output without a rise in costs and supply will be elastic in response to a change in demand. Stocks of finished products and components: If stocks of raw materials and finished products are at a high level then a firm is able to respond to a change in demand - supply will be elastic. The ease and cost of factor substitution: If both capital and labour are occupationally mobile then the elasticity of supply for a product is higher than if capital and labour cannot easily be switched. Time period and production speed: Supply is more price elastic the longer the time period that a firm is allowed to adjust its production levels. In some agricultural markets the momentary supply is fixed and is determined mainly by planting decisions made months before, and also climatic conditions, which affect the production yield.
  20. 20. Elasticity of demand refers to the responsiveness of quantity demanded of a commodity to change in its determinant Elasticity of Demand The degree to which demand for a good or service varies with its price. Normally, sales increase with drop in prices and decrease with rise in prices The demand elasticity refers to how sensitive the demand for a good is to changes in other economic variables.
  21. 21. Price elasticity of demand Price elasticity of demand is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price (ceteris paribus, i.e. holding constant all the other determinants of demand, such as income).
  22. 22. The Price Elasticity of Demand Price elasticity of demand: The percentage change in quantity demanded caused by a 1 percent change in price. Price elasticity of demand: how sensitive is the quantity demanded to a change in the price of the good. This is a measure of the responsiveness of quantity demanded relative to a given price change. % Quantity Ep % Price D = D
  23. 23. PED > 1 Demand is elastic PED < 1 Demand is inelastic PED = 1 Unitary Elastic PED= Perfectly Elastic PED= 0 perfectly In-Elastic The Price Elasticity of Demand
  24. 24. Degrees Of Price Elasticity Of Demand 1) Perfectly elastic demand 2) Relatively elastic demand 3) Elasticity of demand equal to unity 4) Relatively inelastic demand 5) Perfectly inelastic demand
  25. 25. Perfectly elastic demand P R I C E y 0 x Perfectly elastic demand curve D D When the demand for a product changes increases or decreases even when there is no change in price, it is known as perfectly elastic demand.
  26. 26. Relatively elastic demand Relatively elastic demand curve P R I C E demand0 x y D D When the proportionate change in demand is more than the proportionate changes in price, it is known as relatively elastic demand.
  27. 27. Elasticity of demand equal to unity Elasticity of demand equal to unity curve y x0 demand P R I C E D D When the proportionate change in demand is equal to proportionate changes in price, it is known as unitary elastic demand
  28. 28. Relatively inelastic demand Relatively inelastic demand curve XO Y demand D D P R I C E When the proportionate change in demand is less than the proportionate changes in price, it is known as relatively inelastic demand
  29. 29. Perfectly inelastic demand demand D D Perfectly inelastic demand curve 0 Y X P R I C E When a change in price, however large, change no changes in quality demand, it is known as perfectly inelastic demand
  30. 30. Choice and utility theory Utility : An economic term referring to the total satisfaction received from consuming a good or service. Total utility: Total utility is the total satisfaction obtain by a consumer by consuming all units of commodity. Marginal utility is the additional satisfaction you get for every additional unit Marginal utility : Marginal utility is a term used in the field of economics. This term describes the utility of a product or item. In other terms, it is the marginal use, or the amount of use, of a good or service.
  31. 31. Difference: The difference between total utility and marginal utility refers to the fact that a marginal utility is in addition to the total utility. When a consumer increases the total utility of a good consumed, the additional increase is then referred to as a marginal utility.
  32. 32. Definition of Law of Diminishing Marginal Utility The law of diminishing marginal utility states that as consumer consumes more and more units of a specific commodity, utility from the successive units goes on diminishing.
  33. 33. Explanation and Example of Law of Diminishing Marginal Utility: Suppose, a man is very thirsty. He goes to the market and buys one glass of sweet water. The glass of water gives him immense pleasure or we say the first glass of water has great utility for him. If he takes second glass of water after that, the utility will be less than that of the first one If he drinks 3rd glass of water the utility declines again and so on.
  34. 34. Units Total Utility Marginal Utility 1st glass 20 20 2nd glass 32 12 3rd glass 40 8 4th glass 42 2 5th glass 42 0 6th glass 39 -3 Schedule of Law of Diminishing Marginal Utility From the above table, it is clear that in a given span of time, the first glass of water to a thirsty man gives 20 units of utility. When he takes second glass of water, the marginal utility goes on down to 12 units; When he consumes fifth glass of water, the marginal utility drops down to zero and if the consumption of water is forced further from this point, the utility changes into disutility (- 3).
  35. 35. Curve/Diagram of Law of Diminishing Marginal Utility: In the figure (2.2), along OX we measure units of a commodity consumed and along OY is shown the marginal utility derived from them. The marginal utility of the first glass of water is called initial utility. It is equal to 20 units. The MU of the 5th glass of water is zero. It is called satiety point. The MU of the 6th glass of water is negative (-3). The MU curve here lies below the OX axis. The utility curve MM/ falls left from left down to the right showing that the marginal utility of the success units of glasses of water is falling.
  36. 36. Assumptions of Law of Diminishing Marginal Utility The law is true under certain assumptions as follows: (i) Rationality: The consumer aims at maximization of utility subject to availability of his income. (ii) Constant marginal utility of money: The marginal utility of money for purchasing goods remains constant. (iii) Diminishing marginal utility: The utility gained from the successive units of a commodity diminishes in a given time period. (iv)Utility is additive: The utilities of different commodities are independent.
  37. 37. (v) Consumption to be continuous (vi) Suitable Reasonable quantity: If the units are too small, then the marginal utility instead of falling may increase up to a few units. (vii) Character of the consumer does not change. (viii) No change to fashion, Customs and Tastes. (ix) No change in the price of the commodity.
  38. 38. Limitations/Exceptions of Law of Diminishing Marginal Utility (i) Case of intoxicants: The more a person drinks liquor (alcohol), the more s/he likes it. (ii) Rare collection: If there are only two diamonds in the world, the possession of 2nd diamond will push up the marginal utility. (iii) Application to money: It is true that more money the man has, the greedier he is to get additional units of it.
  39. 39. Law of diminishing return A concept in economics that if one factor of production (number of workers, for example) is increased while other factors (machines and workspace, for example) are held constant, the output per unit of the variable factor will eventually diminish. The law of diminishing returns is a classic economic concept that states that as more investment in an area is made, overall return on that investment increases at a declining rate, assuming that all variables remain fixed.
  40. 40. Law of diminishing return
  41. 41. Total, average and marginal product Total product: This is the quantity of output produced by a given number of workers over a given period of time. Remember the amount of capital (or machines) is fixed. Average product: This is the quantity of output per unit of input. In this model, the input is labour. In other words, we are dealing with the output per worker, on average. Marginal product:The addition to total output produced by one extra unit of input (again, labour). It is the extra output produced at the margin (i.e. by adding a marginal unit of labour).
  42. 42. Example Look at the table below. Let us assume that the firm in question is making computer laser printers and they have four machines in the factory (capital = 4). Capital Labour (L) Marginal product (MP) Total product (TP) Average product (AP) 4 0 - 0 - 4 1 5 5 5.0 4 2 8 13 6.5 4 3 10 23 7.7 4 4 11 34 8.5 4 5 10 44 8.8 4 6 7 51 8.5 4 7 4 55 7.9 4 8 1 56 7.0 4 9 -2 54 6.0
  43. 43. Remember that capital is fixed in the short run. I have assumed that capital is fixed at 4 units (or machines, in this case). The second column shows the progressive addition of units of labour. The third column shows marginal product (MP). Each figure represents the output produced as a result of adding an extra worker.
  44. 44. The fourth column gives total product (TP). This is calculated quite easily by adding, cumulatively, the marginal products. The first worker makes 5 units, so the total is 5. The second worker adds a further 8 units, so the total is now 13 (5 + 8), and so on. In fact, you can work out the marginals from the totals. Take the sixth worker, for example. His marginal product is 7. This can be calculated by taking the TP from six workers and subtracting the TP from five workers (51 - 44). Algebraically: MP6 = TP6 TP5. (i.e. 7 = 51 44).
  45. 45. The fifth column gives average product (AP). The figures in this column represent output (or product) per worker. The average product once the eighth worker has been added is 7. This was calculated by taking the TP with eight workers and dividing by the number of workers (also eight). Algebraically:
  46. 46. Notice that the point at which diminishing marginal returns sets in is to the left of the point where diminishing average returns begins. Also, the total product keeps rising even though the marginal, and the average, product is falling. This is not hard to understand. Just because the marginal product is falling, it is still positive. Hence, these extra workers may well be adding less than previous workers, but they are still contributing to the grand total. Total product keeps rising, albeit at a diminishing rate. It is only when the marginal product is negative, with the addition of the ninth worker that total product starts to fall. Finally, notice that the marginal product curve cuts the average product curve at its highest point, where it is momentarily flat. It is important that you understand why this happens because this concept is applied to the cost and revenue curves.
  47. 47. Definition: Consumer surplus is defined as the difference between the consumers' willingness to pay for a commodity and the actual price paid by them, or the equilibrium price. An economic measure of consumer satisfaction, which is calculated by analyzing the difference between what consumers are willing to pay for a good or service relative to its market price. A consumer surplus occurs when the consumer is willing to pay more for a given product than the current market price. Consumer Surplus
  48. 48. Consumer surplus is the difference between what consumers are willing to pay for a good or service (indicated by the position of the demand curve) and what they actually pay (the market price). The level of consumer surplus is shown by the area under the demand curve and above the ruling market price
  49. 49. Consider the demand for public transport shown in the diagram. The initial fare is price P for all passengers and at this price, Q1 journeys are demanded by local users. At price P the level of consumer surplus is shown by the area APB. If the bus company cuts price to P1 the demand for bus journeys expands and the new level of consumer surplus rises to AP1C. This means that the level of consumer welfare has increased by the area PP1CB.
  50. 50. Indifference curve A diagram depicting equal levels of utility (satisfaction) for a consumer faced with various combinations of goods. Definition: An indifference curve is a graph showing combination of two goods that give the consumer equal satisfaction and utility. Each point on an indifference curve indicates that a consumer is indifferent between the two and all points give him the same utility. Indifference curve, in economics, graph showing various combinations of two things (usually consumer goods) that yield equal satisfaction or utility to an individual.
  51. 51. As an example, consider the diagram above. This consumer would be most satisfied with any combination of products along curve U3. This consumer would be indifferent between combination Q1a, Q1b, and Q2a, Q2b
  52. 52. The above diagram shows the U indifference curve showing bundles of goods A and B. To the consumer, bundle A and B are the same as both of them give him the equal satisfaction. In other words, point A gives as much utility as point B to the individual. The consumer will be satisfied at any point along the curve assuming that other things are constant
  53. 53. Characteristics of indifference curve 1) An indifference curve is always negatively sloping downward from left to right.
  54. 54. 2) An indifference curve is always convex to the origin.
  55. 55. 3) Indifference curve to the right represent higher level of satisfaction
  56. 56. 4) Two or more than two indifference curve never intersect/cross each other.
  57. 57. 5) Another additional property of an indifference curve is that an indifference curve never touches "X" axis or "Y" axis.
  58. 58. 6. Indifference curves are infinite: Sample pictures of indifference curves may show you one or two indifference curves. However, the fact is that you can draw an infinite number of indifference curves between two indifference curves.
  59. 59. 7. Indifference curves are not influenced by market or economic circumstances. An indifference curve is purely a subjective phenomenon and it has nothing to do with the external economic forces. Indifference Map : A set of indifference curves which shows different combinations is called an indifference map.
  60. 60. Marginal rate of substitution : In economics, the marginal rate of substitution is the rate at which a consumer is ready to give up one good in exchange for another good while maintaining the same level of utility.
  61. 61. The marginal rate of substitution (MRS) is calculated between two goods placed on an indifference curve, displaying a frontier of equal utility for each combination of "good A" and "good B". The marginal rate of substitution is always changing for a given point on the curve, and mathematically represents the slope of the curve at that point. MRS is calculated using the following formula: MRS= YX Good A Good B
  62. 62. Budget line A budget is defined as a financial plan. Its a good idea to have a plan, a budget for your home and your business. A budget is a financial plan , expressed numerically , prepared in a year prior to the execution year. A budget line is a line showing the alternative combinations of any two goods that a consumer can afford at given prices for the goods and a given level of income
  63. 63. Budget constraint Budget line :A graphical depiction of the various combinations of two selected products that a consumer can afford at specified prices for the products given their particular income level. When a typical business is analyzing a two product budget line, the amounts of the first product are plotted on the horizontal X axis and the amounts of the second product are plotted on the vertical Y axis
  64. 64. The budget line is the total amount of money a consumer is has to spend on 2 goods. The price of the goods and the income of the consumer are the constraints that limit the consumer from buying how much he really wants. He has to decide on the correct combination of the goods to buy and this would happen where the budget line is tangent to the indifference curve. Indifference curve showing budget line An individual should consume at (Qx, Qy).
  65. 65. Shift in budget line Budget line is drawn with the assumptions of constant income of consumer and constant prices of the commodities. A new budget line would have to be drawn if either (a) Income of the consumer changes, or (b) Price of the commodity changes.
  66. 66. 1. Effect of a Change in the Income of Consumer: If there is any change in the income, assuming no change in prices of apples and bananas, then the budget line will shift. When income increases, the consumer will be able to buy more bundles of goods, which were previously not possible. It will shift the budget line to the right from AB to A1B1, as seen in Fig. 2.9. The new budget line A1B1 will be parallel to the original budget line AB.
  67. 67. 2. Effect of change in the relative Prices (Apples and Bananas): If there is any change in prices of the two commodities, assuming no change in the money income of consumer, then budget line will change. It will change the slope of budget line, as price ratio will change, with change in prices.
  68. 68. (i) Change in the price of commodity on X-axis (Apples): When the price of apples falls, then new budget line is represented by a shift in budget line (see Fig. 2.10) to the right from AB to A1B. The new budget line meets the Y- axis at the same point B, because the price of bananas has not changed. But it will touch the X-axis to the right of A at point A1, because the consumer can now purchase more apples, with the same income level. Similarly, a rise in the price of apples will shift the budget line towards left from AB to A2B.
  69. 69. (ii) Change in the price of commodity on Y-axis (Bananas): With a fall in the price of bananas, the new budget line will shift to the right from AB to AB1 (see Fig. 2.11). The new budget line meets the X-axis at the same point A, due to no change in the price of apples. But it will touch the Y-axis to the right of B at point B1, because the consumer can now purchase more bananas, with the same income level. Similarly, a rise in the price of bananas will shift the budget line towards left from AB to AB2.
  70. 70. A2 A A1 BB1 B B2 A
  71. 71. Utility maximization The process or goal of obtaining the highest level of utility from the consumption of goods or services. The goal of maximizing utility is a key assumption underlying consumer behavior studied in consumer demand theory. Economics concept that, when making a purchase decision, a consumer attempts to get the greatest value possible from expenditure of least amount of money. His or her objective is to maximize the total value derived from the available money