Economics Principles

Lecture 1

Why economic ?

• We study fields such as finance, innovation, management,

marketing and supply chain in business schools.

• These topics relate to the operation of firms and corporations, not the
economic system.

• Yet, the grand picture is more fundamental.

Global

Econom

Fir

The Grand Picture

 • Firms operate in markets, markets operate in the broader economic
environment and economies operate within the global economy.

• An understanding of how economies operate and interact with each

other is essential for making optimal decisions at the firm level.

• Think of corporate investment decisions.

What is Economics?

 Defined by its subject matter, Economics is the study of the ways in which society
decides what, how and for whom to produce:
 Economics is the science which studies human behaviour as a relationship between ends
and scarce means that have alternative uses (L. Robbins 1932)
 Economics is a study of mankind in the ordinary business of life; it examines that part of
individual and social action which is most closely connected with the attainment and with
the use of the material requisites of well-being (A. Marshall 1920)

Scarcity

 All economic questions arise because we want more than we can get.
 Scarcity – society has limited resources and therefore cannot produce all the goods and
services people wish to have.
 Our inability to satisfy all our wants is called scarcity.
 Because we face scarcity, we must make choices.

Scarcity & Choices

• If we save more, we can buy more capital and increase our

production.

• If we take less leisure time, we can educate and train ourselves to become
more productive.

• If businesses save less and devote more resources to research and

developing new technologies, they can produce more in the future.

• The choices we make in the face of these trade-offs determine the pace at
which our economic condition improves.

Choices & Trade-offs

  Every choice involves a trade-off  an exchange  giving up one thing to get something

else.

 The classic trade-off is “guns versus butter”.

 “Guns” and “butter” stand for any two objects of value e.g. defense goods and food.

Opportunity Cost

• Thinking about a choice as a trade-off emphasizes cost as an opportunity

forgone – opportunity cost.

• Opportunity Cost: the highest-valued alternative that we give up to get

something is the opportunity cost of the activity chosen.

• What is the opportunity cost of coming to

university?

• It is much higher than the cost of tuition

fees and books;
• It includes the amount of money you would have earned had
you decided to work rather than go to school.

• There’s no such thing as a free lunch!

The Economic Way of Thinking

• The choices we make depend on the incentives we face and our

preferences and tastes.

• An incentive is a reward – benefit – that

encourages an action or a penalty – cost – that discourages an action.

• People make decisions by comparing the costs and benefits of each

choice.

• Behaviour may change as costs and benefits change.

• How would a £10000 increase in tuition affect your decision to

come to university?
 • Economic rationality: people make the best decisions at the margin
(a more precise definition later)!

• A marginal change is a small incremental adjustment to a plan of

action.

The Economic Way of Thinking: Marginal Analysis

• Choosing at the Margin

 Rational individuals make choices at the margin, which means

that they evaluate the consequences of making incremental
changes in the use of their resources.

 The benefit from pursuing an incremental increase in an

activity is its marginal benefit.
  The opportunity cost of pursuing an incremental increase in an
activity is its marginal cost.

Economic Rationality

• Example: The marginal benefits and marginal cost of studying for one more
year (taking an MSc) or of studying one more hour of microeconomics.

• Key economic rationality principle: you continue studying

microeconomics until the marginal benefit of an extra hour of studying it
equals its marginal cost (a more precise definition later).

• The economic way of thinking places scarcity and its implication,

choice, at center stage, and assumes people solve choice problems by
considering the costs and benefits of each option.

What is Economics?
 However we define it, modern Economics emphasises:

• Scarcity – Cost-benefit Analysis

• Rationality – utility or long run profit maximisation

• Equilibrium theorising – interaction between supply and

demand forces

• Mathematical modelling – precisely state underlying

assumptions

• Statistical (econometric) modelling – The Rise of Big Data

Positive & Normative Statements

• Economists distinguish between two types of statements:

• Positive statements are descriptive and assert things about the world

• They are mostly testable

• e.g.: “If the price of rice rises the demand for rice falls”

• Normative statements are prescriptive and assert how things ought

to be

• They are not testable

• e.g.: “The government should lower the price of food to help
the poor”

• Positive economics versus Normative economics

Economics: A (descriptive) Social Science

• The task of economics as a descriptive science is to discover positive

statements that are consistent with what we observe in the world and that
enable us to understand how the economic world works.
 • This task is large and breaks into four steps:

 Theory Construction
 Observation and measurement
 Empirical Model building
 Testing models

Micro & Macro

• Microeconomics analyses individual entities, such as markets,

firms and consumers

• Macroeconomics analyses broad aggregates at the level of the entire

economy, such as total output in the economy, the exchange rate and the
balance of payments

Microeconomics: Big Picture

1. Markets
• The demand and supply framework

2. The theory of the consumer

3. The theory of the firm

4. Market Structures (Industrial Organization)

• Perfect competition
• Monopoly
• Monopolistic competition
• Game theory
• Oligopoly
 5. Welfare Economics
• The Pareto criterion and the efficiency of markets
• Market failure and the role of government

Macroeconomics

Macroeconomics: Big Picture

 Key macroeconomic variables & their measurements (e.g., GDP)

 Macroeconomic data – patterns and trends
 Short run fluctuations
 The classical model – An open economy model
 The monetary system
 The IS-LM model

John Maynard Keynes

The Theory of Economics does not furnish a body of settled conclusions immediately applicable
to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking
which helps its possessor to draw correct conclusions

But big data and empirical economics changing this view

The Demand & Supply Framework

Lecture 2
What are Markets?

Because resources are scarce and our wants are unlimited (perhaps...), society needs some sort of
allocation mechanism

 Tradition and Culture, social norms, customs and past history

 Voting and Political Procedures, communication through the

development of a consensus/majority rule

 Markets, a set of arrangements by which buyers and sellers are in contact to exchange
goods or services, prices indicate availability and desire for resources

Markets (and Prices) Are Everywhere

❖Product Markets ❖Factor Markets

❖Housing Markets ❖Foreign Exchange Markets

❖Credit Markets ❖Stock Markets ❖Insurance Markets

The Theory of Markets

We shall abstract from many interesting features of markets in order to focus on three key
concepts:

• Demand, the quantity of a good or service that buyers (consumers) are willing to buy at a given
price (in a given time period)

• Supply, the quantity of a good or service that sellers (firms) are willing to sell at a given price
(in a given time period)

• Equilibrium Price, the price at which quantity demanded equals quantity supplied

Demand

 Demand refers to the quantity of a good or service that buyers are willing to buy during a
particular period at a given price.
 The Law of Demand states that there is an inverse relationship between the price of a
good and the quantity demanded of that good (but there are exceptions to this ‘Law’)

The Law of Demand

• The law of demand results from: ➢ Substitution effect

➢ Income effect

• Substitution effect

❖When the relative price (opportunity cost) of a good or service rises, people seek substitutes
for it, so the quantity demanded of the good or service decreases.

• Income effect

❖When the price of a good or service rises relative to income, people cannot afford all the
things they previously bought, so the quantity demanded of the good or services decreases.

The Determinants of the Demand

 D
• In addition to its own price (P), the quantity demanded (Q ) of a good depends on:

➢ Prices of other goods and services, notably • Substitute goods (PS)

• Complementary goods (PC)

➢ Incomes (Y)
➢ Expected future prices
➢ Expected future income
➢ Population
➢ Buyers’ tastes and preferences

Prices of Related Goods

Substitutes Complements

 A substitute is a good that can be used in place of another good.

 A complement is a good that is used in conjunction with another

good.

 When the price of a substitute for a drink rises or when the price of a complement of a
drink falls, the demand for drinks increases.

Demand

• Expected Future Prices

➢If the price of a good is expected to rise in the future, current demand fore the good increases
and the demand curve shifts rightward.

• Income

➢When income increases, consumers buy more of most goods and the demand curve shifts
rightward. A normal good is one for which demand increases as income increases.

➢An inferior good is a good for which demand decreases as income increases.

Expected Future Income

➢When income is expected to increase in the future, the demand

might increase now.

Population
➢The larger the population, the greater is the demand for all

goods.

Preferences
➢People with the same income have different demands if they

have different preferences.

The Demand Function

• ADemandFunctionrepresentstherelationshipbetween the quantity demanded of a good and the

factors that determine demand:

D
Q = D(P, P , P , Y)
S C

The Demand Curve

 The Demand Curve shows the relation between quantity demanded of a good and its
own price, other things remaining constant

Price of Good X

•Note - we will generally drop the ‘of Good X’ part of the axis labels when we draw these
diagrams, but remember which price and quantity we are referring to!

Quantity Demanded of Good X

Changes in Demand

• A change in own-price causes a movement along the Demand Curve

• Price falls from P to P leads to rise in quantity demanded from Q to Q

1 2 1 2

• Movement is along the curve

• A change in tastes, incomes, or the price of substitutes or complements, causes a movement of

the Demand Curve

A rise in the price of a substitute good causes the demand curve to shift outwards, from D to
• 1
D . Quantity demanded rises from Q to Q
2 1 2

Supply

• Supply refers to the quantity of a good or service that sellers are willing to sell at a given price
• It is usually assumed that there is a positive relationship between the price of a good and
quantity supplied of that good

The Law of Supply

• The law of supply states:

❖Other things remaining the same, the higher the price of a good, the greater is the quantity
supplied; and the lower the price of a good, the smaller is the quantity supplied.

❖The law of supply results from the general tendency for the marginal cost of producing a good
or service to increase as the quantity produced increases (Chapter 2, page 39, but we will explain
this later).

❖Producers are willing to supply a good only if they can at least cover their marginal cost of
production.

The Supply Curve

⚫ The Supply Curve shows the relation between quantity supplied of a good and its own price,
other things remaining constant

Theupply

Minimum Supply Price

•A supply curve is also a minimum-supply-price curve.

•As the quantity produced increases, marginal cost increases.

•The lowest price at which someone is willing to sell an additional unit rises.
•This lowest price is marginal cost.

The Determinants of Supply

S
• In addition to its own price (P), the quantity supplied (Q ) of a good depends on:

➢Technology (T)
F
➢The costs (P ) of factors of production (labour costs, capital

costs, raw material prices etc.)

➢Government regulations (G) (e.g. safety regulations, emissions standards)

➢Expected future prices ➢The number of suppliers

Prices of Productive Resources

➢If the price of resources used to produce a good rises, the minimum price that a supplier is
willing to accept for producing each quantity of that good rises.
➢A rise in the price of productive resources decreases supply and shifts the supply curve

leftward. Demand & Supply Framewor

Prices of Related Goods Produced

 A substitute in production for a good is another good that can be produced using the
same resources.
 The supply of a good increases if the price of a substitute in production falls.
 Goods are complements in production if they must be produced together.
 The supply of a good increases if the price of a complement in production rises.

Substitute in Production

When the price of oat rises, more lands are allocated to the production of oat, the supply of rice
goes down, and its supply curve shifts leftwards. As the price of oat falls, more lands are
reallocated to the production of rice, the supply of rice increases and its supply curve shift
rightwards.

Complements in Production

Meat and leather are complement in production; they are produced together. As the price of meet
rises, the production of leather increases, and its supply curve shift to the right. And, as the price
of meat falls, the production of leather falls and its supply curve shift to the left.

Expected Future Princes and Number of Suppliers • Expected Future Prices

• If the price of a good is expected to rise in the future, supply of the good today decreases and
the supply curve shifts leftward.

• The Number of Suppliers

• The larger the number of suppliers of a good, the greater is the supply of the good. An increase
in the number of suppliers shifts the supply curve rightward. d & Supply Framework

Technology

 Advances in technology create new products and lower the cost of producing existing
products, so advances in technology increase supply and shift the supply curve rightward.
 A natural disaster is a negative technology change, which decreases supply and shifts the
supply curve leftward.

The Supply Function

• A Supply Function represents the relationship between quantity supplied of a good and the
factors that determine supply:

Q = S(P, T, P , G)

Changes in Supply

• A change in own- price causes a movement along the Supply Curve

Price fall from P to P leads to fall in quantity supplied from Q to Q

• 1 2 1 2
Movement is along the curvehe Demand & Supply Framework

Changes in Supply

• A change in factors such as technology or the price of inputs, causes a movement of the Supply
Curve

A rise in raw material prices causes the supply curve

•
to shift inwards, from S to S . Quantity supplied falls from Q to Q
1 2 1 2

Market Equilibrium
 *
• The equilibrium price, P , is the price at which quantity demanded equals quantity supplied

Markets: The Key Idea

• Having simplified markets down to three components – Demand, Supply and the Equilibrium
Price – the crux of our theory of markets is the idea that prices adjust so as to bring demand and
supply into equilibrium

• This seems an intuitively plausible theory of how prices are determined, since if prices are ‘too’
low (Demand exceeds Supply) we would expect prices to be bid upwards and if prices are ‘too’
high (Supply exceeds Demand) we would expect prices to bid downwards

The Method of Comparative Statics

• Analysis concentrates on how the equilibrium price changes in response to some change in the
economic environment: this is the method of Comparative Statics

• The importance of ‘Ceteris Paribus’ – the assumption that everything else remains equal.

• The theory says little about how prices adjust to the equilibrium, implicitly assuming simply
that they do
Illustration 1:
A Fall in Raw Material Prices

• Consider the market for personal computers Price

• Suppose that the price of memory chips falls. What impact would we expect this to have on the
price of PCs?

Illustration 1

 Memory chips are one of the components used in the production of PCs
 The Supply Curve (S) for PCs will therefore shift to the right (S’)

The Equilibrium Price of PCs falls from P* **

to P

Illustration 2:
An Increase in the Price of a Substitute Good

 Now consider the market for tea

  Suppose that the price of coffee rises. Coffee is a substitute for tea, meaning that the
Demand curve for tea will shift to the right, from D to D’

The Equilibrium Price of tea rises

Illustration 3: Price Controls

• The Demand and Supply framework allows us to analyse the effects of Price Controls on a
market

➢Price Ceilings
• Amaximumlegalpricethatsellerscancharge • Imposed to the benefit of buyers
• e.g. rent controls

➢Price Floors
• A minimum legal price that sellers can charge
• Imposed to the benefit of sellers
• e.g.minimumwages,CommonAgriculturalPolicy

Price Ceilings

C *
• To be effective, a price ceiling (P ) must lie below the original equilibrium price (P )

 Initially, Q* units sold at price P*

  With price ceiling, QC sold at price PC
 The result is a shortage of (QD – QC) units, requiring some form of rationing
 In effect, the demand curve is now the line PCXD

Price Floors

F *
To be effective, a price floor (P ) must lie above the original equilibrium price (P )

 Initially, Q* units sold at price P*

 With price floor, QF sold at price PF

 The result is a surplus of (QS – QF)

units, (possibly) requiring the government to purchase the excess

 In effect, the supply curve is now PFXS

Key Mechanisms Driving Oil Prices

• The excess demand and excess supply forces

continuously adjust petroleum prices

• The role of expectations about future demand and supply • The sensitivity of expectations to
political events;

• High sensitivity to expectations gives rise to high price volatility!

Lecture 3
Elasticities & Corporate Decisions

Price Elasticity of Demand Market I

•Consider this figure: an increase in supply brings

 A large fall in price

 A small increase in the quantity demanded

Price Elasticity of Demand Market II

• Now consider this figure: an increase in supply brings

• A small fall in price

• A large increase in the quantity demanded

Price Elasticity of Demand

• The contrast between the two markets highlights the need for:

A measure of the responsiveness of the quantity demanded to a price change.

• The price elasticity of demand is a units-free measure of the responsiveness of the quantity
demanded of a good to a change in its price when all other factors affecting demand remain the
same.
Calculating Elasticity of Demand

The price elasticity of demand is calculated by using the formula:

 We express the change in price as a percentage of the average price—the average of the
initial and new price,
 We express the change in the quantity demanded as a percentage of the average quantity
demanded - the average of the initial and new quantity.

Price Elasticity of Demand

Example:

Calculating Percentage Changes

Standard method
of computing the percentage (%) change:

Problem:

The standard method gives different answers depending on where you start.

From B to A, the % change in P equals

(200 -250) / 250 = -20% The % change in Q (12-8)/8 = 50% and elasticity = 50/20 = 2.50

Calculating Percentage Changes

Demand for your websites

8 12

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Calculating Percentage Changes

• So, we instead use the midpoint method:

end value – start value

x 100%

midpoint

 The midpoint is the number halfway between the start & end values, the average of those
values.
 It doesn’t matter which value you use as the “start” and which as the “end” – you
get the same answer either way!
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Calculating Percentage Change

• Suppose the current price is £3.10, and then drops to £2.90

• The change in price - £.20

• The average price is £3
• The change in price as a percentage of the average price is

2.90  3.10 0.20 2 0

100 100 0.67
3 3 3

6.

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Calculating the Price Elasticity of Demand for Smoothies

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Calculating the Price Elasticity of Demand for Smoothies

• The percentage change in quantity demanded, %ΔQ, is calculated as

t t1
QQ 119 2
%Q 100 100 10020%

Q 10 10
Ave
• The percentage change in price, % Δ P, is calculated as
t t1
PP £2.90£3.10 £20
%P 100 100 6.67

P £3.00 £3.00 Ave

The price elasticity of demand is

%Q 20
PED  3 %P 6.67
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The Properties of the Elasticity Measure

 By using the average price and average quantity, we get the same elasticity value
regardless of whether the price rises or falls.
 The formula yields a negative value, because price and quantity move in opposite
directions.
 But it is the magnitude, or absolute value, of the measure that reveals how responsive the
quantity change has been to a price change.
 Demand can be inelastic, unit elastic, or elastic, and can range from zero to infinity.

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Elastic and Inelastic Demand

 If the percentage change in the quantity demanded is smaller than the percentage change
in price, the price elasticity of demand is less than 1 and the good has inelastic demand.
 If the percentage change in the quantity demanded is greater than the percentage change
in price, the price elasticity of demand is greater than 1 and the good has elastic demand.

∆Q% > ∆P%  Elastic  PED > 1 (absolute value) ∆Q% < ∆P% Inelastic PED < 1
∆Q% = ∆P% Unit elastic PED = 1

1. 2. 3.

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Elastic and Inelastic Demand

1. ∆Q% > ∆P%  Elastic  PED > 1 (absolute value) 10% > 5%

2. ∆Q% < ∆P% Inelastic PED < 1 5% < 10%

3. ∆Q% = ∆P% Unit elastic PED = 1 5% = 5%

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Perfectly Inelastic Demand

• If the quantity demanded doesn’t change when the price changes, the price elasticity of demand
is zero and the good has a perfectly inelastic demand.

• The demand curve is vertical. In other words, the quantity demanded is independent of price.

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Unit Elasticity

Unit Elasticity: If the percentage change in the quantity demanded equals the percentage change
in price, the price elasticity of demand equals 1 and the good has unit elastic demand.

% change in price = (6-12) / 9= - 67%

% change in quantity = (2-1) / 1.5 = 67% PED = 67% / 67% = 1

•
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Perfect Elasticity

• If the percentage change in the quantity demanded is infinitely large when the price barely
changes, the price elasticity of demand is infinite and the good has a perfectly elastic demand.

• Perfectly elastic demand gives rise to a horizontal demand curve.

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Class Question

 Would the shape of the demand line change over time as an industry become more and
more mature? Why?
 Could you imagine how a perfectly inelastic demand line become more and more elastic
over time? Explain?
 Could you think of situations where a perfectly elastic demand line become increasingly
inelastic?
 Any general lesson for corporate strategy?
 And how the price elasticity changes over time as the

product (e.g., TV) diffuses the market more and more?

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Elasticity Along a Linear Demand Curve

• For example, if the price falls from £5 to £3, the quantity demanded increases from 0 to 10
smoothies an hour.

• The average price is £4 and the average quantity is 5.

• The price elasticity of demand is (10/5)/(2/4), which equals 4.

The price elasticity of demand is (10/5)/(2/4), which equals 4.

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Elasticity along a Linear Demand Curve

 If the price falls from £2 to £0, the quantity demanded increases from 15 to 25 smoothies
an hour.
  The price elasticity of demand is (10/20)/(2/1), which equals 1/4.

 If the price falls from £3 to £2, the quantity demanded increases from 10 to 15 smoothies
an hour.
 The price elasticity of demand is (5/12.5)/(1/2.5), which equals 1.

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Class Question

• What types of data the firm can use to test whether the demand facing the firm is elastic?

• Could you think of a test for price elasticity of demand?

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Total Revenue and Elasticity

• The total revenue from the sale of a good or service equals the price of the good multiplied by
the quantity sold.

 When the price changes, total revenue also changes.

 But a rise in price doesn’t always increase total revenue.

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Total Revenue and Demand Elasticity

• The change in total revenue due to a change in price depends on the elasticity of demand:

 If demand is elastic, a 1 per cent price cut increases the quantity sold by more than 1 per
cent, and total revenue increases.
 If demand is inelastic, a 1 per cent price cut increases the quantity sold by less than 1 per
cent, and total revenues decreases.
 If demand is unitary elastic, a 1 per cent price cut increases the quantity sold by 1 per
cent, and total revenue remains unchanged.

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Total Revenue Test

• The total revenue test is a method of estimating the price elasticity of demand by observing the
change in total revenue that results from a price change (when all other influences on the
quantity sold remain the same).

 If a price cut increases total revenue, demand is elastic.

 If a price cut decreases total revenue, demand is inelastic.
 If a price cut leaves total revenue unchanged, demand is unit elastic.

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Total Revenue Test: Foundations

 Rule: Percentage change in A×B = % A + %B

 Application: % TR = % P×Q = % Q + % P
 If demand is elastic, a 5% cut in price could give rise to 10% increase in quantity
demanded. Total revenue goes up by 5%.

% TR = % 10 - % 5 = 5%

 If demand is inelastic, a 10% cut in price could give rise to 5%

increase in quantity demanded. Total revenue goes down by 5%.

% TR = % 5 - % 10 = -5%

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Total Revenue Test

1. Price
2. Price
3. Price or unit-elastic

Total Revenue Total Revenue

Total Revenue

Elastic Inelastic

No change

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Elasticity, Total Revenue and Linear Demand

Price change = 50% Demand change = 200% PED = 200 / 50 = 4

Total Revenue = Price × Quantity 1200 = 20 × 60

P TR

100
Unit elastic

Elastic
Unit elastic

Inelastic
20 800

80
60 1200
40

0 10 20 30 40 50

0 10 20 Elastic

30 40 50 Q Inelastic

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100

Unit elastic

Elasticity, Total Revenue and Linear Demand

When the price corresponds to the elastic part of the demand line, a decrease in price leads to a
higher total revenue. When the price corresponds to the inelastic part of the demand line, a
decrease in price leads to a decline in total revenue.

P TR

Elastic
Unit elastic

Inelastic
20 800

80
60 1200
40

0 10 20 30 40 50

0 10 20 Elastic

30 40 50 Q

Inelastic
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Determinants of Price Elasticity of Demand

• The elasticity of demand for a good depends on: The closeness of substitutes
The proportion of income spent on the good The time elapsed since a price change

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Determinants of Price Elasticity of Demand

• Closeness of substitutes

 The closer the substitutes for a good or service, the more elastic is

the demand for it.

 Necessities, such as food or housing, generally have inelastic demand.

 Luxuries, such as exotic vacations, generally have elastic demand.

• Proportion of income spent on the good

• The greater the proportion of income consumers spent on a good, the larger is its elasticity of
demand.

•Time Elapsed Since Price Change

• The more time consumers have to adjust to a price change, or the longer that a good

can be stored without losing its value, the more elastic is the demand for that good.

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Class Question – Microsoft Case Study

  Microsoft has a product called Office that include Microsoft Word, Excel, PowerPoint,
Access and ...
 Why Does Microsoft sell these products as a bundle, and never sells individually?

• Any insight?

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Cross Price Elasticity of Demand

Cross Price Elasticity of Demand

• The cross price elasticity of demand is a measure of the responsiveness of demand for a good
to a change in the price of a substitute or a complement, other things remaining the same.
• The formula for calculating the cross elasticity is:

Percentage change in quantity demanded Percentage change in price of substitute or

CEP =

complement

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Cross Elasticity of Demand

• The cross elasticity of demand for a substitute is positive.

• The cross elasticity of demand for a complement is negative.

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Cross Elasticity of Demand (Smoothies)

• The demand for smoothies may increase when the price of a coffee (a substitute for smoothie)
rises.

• The demand for smoothies may decrease when the price of a salad (a complement of smoothie)
rises.

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How do firms identify rival products in the market?

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How Economic Recessions Affect Corporate Revenue?

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Income Elasticity of Demand

• The income elasticity of demand measures how the quantity demanded of a good responds to a
change in income, other things remaining the same.

• The formula for calculating the income elasticity of demand is

Percentage change in quantity demanded Percentage change in income

IED =

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Normal and Inferior Goods

  If the income elasticity of demand is greater than 1, demand is income elastic and the
good is a normal good.
 If the income elasticity of demand is greater than zero but less than 1, demand is income
inelastic and the good is a normal good.
 If the income elasticity of demand is less than zero (negative) the good is an inferior
good.

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Income Elasticity of Demand - Insights

How may a firm secure stable revenue / profits and create a safeguard against recessions?

Optimal Product Portfolio Design

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Elasticity of Supply: Market I

An increase in demand brings:

 A large rise in price

 A small increase in the

quantity supplied

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An increase in demand could bring:

A small rise in price

A large increase in the quantity supplied

••

Elasticity of Supply: Market II

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Elasticity of Supply

 The contrast between the two markets highlights the need for a measure of the
responsiveness of the quantity supplied to a price change.
 The price elasticity of supply measures the responsiveness of the quantity supplied to a
change in the price of a good when all other factors affecting supply remain the same.

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Calculating the Elasticity of Supply

The elasticity of supply is calculated by using the formula:

Percentage change in quantity supplied Percentage change in price

PES =

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•
•

Elasticity of Supply

Three cases of the elasticity of supply:

Supply is perfectly inelastic if the supply curve is vertical and the elasticity of supply is 0.

Supply is unit elastic if the supply curve is linear and passes through the origin. (Note that slope
is irrelevant.)

Supply is perfectly elastic if the supply curve is horizontal and the elasticity of supply is infinite.

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Elasticity of Supply
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Factors that Affect the Elasticity of Supply

• The elasticity of supply depends on: Resource substitution possibilities

 Availability of resources  Technology

Time frame for supply decision

• Resource Substitution Possibilities
• The easier it is to substitute among the resources used to produce a good or service, the greater
is its elasticity of supply.

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Factors that Affect the Elasticity of Supply (Continued)

•Time Frame for Supply Decision

The more time that passes after a price change, the

greater is the elasticity of supply.

 Momentary supply is perfectly inelastic. The quantity supplied immediately following a

price change is constant.

Short-run supply is somewhat elastic. Long-run supply is the most elastic.

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••

Why Price Elasticity Matters

The effects on the equilibrium price of a movement of the demand or supply curve on PED and
PES

Consider an expansion of demand for example

Price

*
P** P

Price

Relatively Elastic Supply

 *
P** P

Relatively Inelastic Supply