Elasticity, Costs, and Market Structures in Economics

Posted on Oct 24, 2024 in Economy

Elasticity

Elasticity measures how much the quantity demanded or supplied of a good changes in response to a change in price or other factors.

Price Elasticity of Demand

Price elasticity of demand measures how responsive quantity demanded is to a change in price. It is defined as:

Ed = (% change in quantity) / (% change in price) (Absolute value)

  • Inelastic: Ed < 1 (Not responsive to price changes)
  • Elastic: Ed > 1 (Responsive to price changes)
  • Unit Elastic: Ed = 1 (Percentage change in quantity demanded equals the percentage change in price)

Factors affecting elasticity:

  • Percentage of income spent on the good
  • Necessity vs. Luxury
  • Time period

Total Revenue: Units sold (Q) x Price (P)

Cross Elasticity of Demand

Cross elasticity of demand measures how responsive the quantity demanded of one good (product A) is to changes in the price of another (product B).

EAB = (% change in quantity demanded of product A) / (% change in price of product B)

  • Substitutes: EAB > 0
  • Complements: EAB < 0
  • Not Related: EAB = 0

Income Elasticity of Demand

Income elasticity of demand (EY) measures how responsive the demand for a good is to changes in consumer income.

EY = (% change in quantity) / (% change in income)

  • Normal Good: 0 < EY < 1
  • Luxury Good: EY > 1
  • Inferior Good: EY < 0

Price Elasticity of Supply

Price elasticity of supply measures the responsiveness of quantity supplied to changes in price. The sign is always positive due to the law of supply.

ES = (% change in quantity supplied) / (% change in price)

  • Inelastic: ES < 1
  • Elastic: ES > 1
  • Unit Elastic: ES = 1

Market Periods

Market Period: Very short period where output and number of firms are fixed.

Short Run: Period where plant capacity and the number of firms cannot change.

Long Run: Period long enough for firms to vary all factors and enter or leave industries.

Taxes

  • Progressive Taxes: Percentage increases as income increases.
  • Flat Taxes: Constant percentage of income.
  • Regressive Taxes: Percentage decreases as income increases. Example: Lump-sum tax.
  • Excise Taxes: Taxes on specific goods (e.g., gasoline, alcohol).

Incidence of Taxation: Who bears the economic burden of a tax.

  • Elastic Demand/Supply: Less burden
  • Inelastic Demand/Supply: More burden

Elasticity and Total Revenue

  • Inelastic Demand: Price increase causes a net revenue increase.
  • Elastic Demand: Price increase causes a net revenue decrease.
  • Unit Elastic Demand: Price change equals quantity change.

Consumer Behavior

Budget Line

Similar to the production possibilities frontier (PPF), the budget line constrains consumption based on income.

Utility

Total Utility: Total satisfaction from consuming a specific quantity.

Marginal Utility: Additional satisfaction from consuming one more unit.

Utility Maximization

Utility Maximizing Rule: Maximize total utility where marginal utility per dollar is equal for all goods and services (Marginal Utility / Price).

Law of Diminishing Marginal Utility

As consumption increases, the additional satisfaction from each unit declines.

Behavioral Economics

  • Sunk Cost Fallacy: Considering sunk costs in current decisions.
  • Framing Bias: Being influenced by how choices are presented.
  • Overconfidence: Irrational decisions due to inflated self-belief.
  • Overvaluing the Present: Neglecting future consequences.
  • Altruism: Making decisions that benefit others at personal expense.

Firm Behavior

Types of Firms

  • Sole Proprietorship: One owner, unlimited liability.
  • Partnership: Multiple owners, unlimited liability.
  • Corporation: Separate legal entity, limited liability.

Costs and Profit

Profit: Total Revenue – Total Cost

Economic Costs: Explicit Costs + Implicit Costs

Explicit Costs: Direct expenses (e.g., wages, rent).

Implicit Costs: Opportunity costs of resources.

Accounting Profit: Revenue – Explicit Costs

Economic Profit: Revenue – (Explicit Costs + Implicit Costs)

Normal Profit: Zero economic profit.

Production and Costs

Short Run: At least one factor of production is fixed.

Long Run: All factors are variable.

Marginal Product: Change in output from a change in labor (ΔQ / ΔL).

Average Product: Output per worker (Q / L).

Increasing Marginal Returns: Each additional worker increases output more than the last.

Diminishing Marginal Returns: Each additional worker adds to output, but at a decreasing rate.

Fixed Costs (FC): Costs that don’t change with output.

Variable Costs (VC): Costs that change with output.

Total Costs (TC): FC + VC

Marginal Cost (MC): Change in total cost from producing one more unit.

Average Fixed Cost (AFC): FC / Q

Average Variable Cost (AVC): VC / Q

Average Total Cost (ATC): TC / Q

Long-Run Costs

Long-Run Average Total Cost (LRATC): Lowest unit cost for any output level in the long run.

Economies of Scale: Average cost falls as firm size increases.

Diseconomies of Scale: Average cost rises as firm size increases.

Economies of Scope: Cost savings from producing interdependent products.