Elasticity Consumer Theory

Managerial Economics (ECO200)

Rahul Singh AMSOM, rahul.singh@ahduni.edu.in

September 2, 2021
Elasticity Consumer Theory

Elasticity of Demand

Income Elasticity of Demand

I ∆Q
Income Elasticity of Demand = ×
Q ∆I
Cross Price Elasticity of Demand
Pother ∆Q
Cross Price Elasticity of Demand = ×
Q ∆Pother
Elasticity Consumer Theory

Elasticity

Calculate the price elasticity of demand at Price=1,5,10.

(POLL)
Demand Curve
25
Qd =
P
Elasticity Consumer Theory

Elasticity and Revenue: Applications

The Ministry of Health, GOI has sought your advice on policy

related to controlling the sale of cigarettes in the black market
during lockdown. The ministry is concerned that the sharp
increase in prices will have a negative effect on the health of
smokers with low incomes as they may reduce expenditures on
essential goods like food, medicines and personal hygiene
products. The Economic advisor to the ministry proposes that
all government resources should be used to enforce lock down
rules and shut down the illegal black market that are
operating all over the city. The government has also started
an advertisement campaign focusing on the health risks
attached to smoking and highlighting the increased risk of
hospitalization for Covid-19 infected smokers. (POLL)
Elasticity Consumer Theory

Elasticity and Revenue: Applications

One side effect of illegal drug use is crime → Users often turn
to crime to finance their habit
Let’s examine two policies designed to reduce illegal drug use
and see what effects they have on drug-related crime.
Interdiction
Education spending
Elasticity Consumer Theory

Elasticity and Revenue: Applications

Interdiction
Elasticity Consumer Theory

Elasticity and Revenue: Applications

education
Elasticity Consumer Theory

Elasticity and Revenue

Marginal Revenue ⇒ Extra revenue from selling an additional

unit of the good ⇒ What can we say about the sign of
marginal revenue?
Elasticity Consumer Theory

Elasticity and Revenue

Marginal Revenue ⇒ Extra revenue from selling an additional

unit of the good ⇒ What can we say about the sign of
marginal revenue?
What is the relationship between Price Elasticity of Demand
and Change in Revenue ⇒ If we increase quantity will the
revenue increase/decrease?
Elasticity Consumer Theory

Elasticity and Revenue

Marginal Revenue ⇒ Extra revenue from selling an additional

unit of the good ⇒ What can we say about the sign of
marginal revenue?
What is the relationship between Price Elasticity of Demand
and Change in Revenue ⇒ If we increase quantity will the
revenue increase/decrease?
Hint → Derive the expression for marginal revenue from total
revenue and represent it in terms of elasticity!
Elasticity Consumer Theory

Elasticity and Revenue

Marginal Revenue ⇒ Extra revenue from selling an additional

unit of the good ⇒ What can we say about the sign of
marginal revenue?
What is the relationship between Price Elasticity of Demand
and Change in Revenue ⇒ If we increase quantity will the
revenue increase/decrease?
Hint → Derive the expression for marginal revenue from total
revenue and represent it in terms of elasticity!
What is the implication of this relationship for managers?
Elasticity Consumer Theory

Consumer Behavior

What is the Consumer’s Problem? Discuss!

Elasticity Consumer Theory

Consumer Behavior

What is the Consumer’s Problem? Discuss!

Consumer Behavior
Consumer Preferences over consumption bundles
Elasticity Consumer Theory

Consumer Behavior

What is the Consumer’s Problem? Discuss!

Consumer Behavior
Consumer Preferences over consumption bundles
Budget Constraints
Elasticity Consumer Theory

Consumer Behavior

What is the Consumer’s Problem? Discuss!

Consumer Behavior
Consumer Preferences over consumption bundles
Budget Constraints
Consumer Choice
Elasticity Consumer Theory

Consumer Behavior

What is the Consumer’s Problem? Discuss!

Consumer Behavior
Consumer Preferences over consumption bundles
Budget Constraints
Consumer Choice
Given their preferences and limited income, choose
combination of goods to maximize “satisfaction” → Optimal
Choice
Implications for demand!
Elasticity Consumer Theory

Consumer Preferences

Basket or Bundle → Each bundle specifies quantities of

various goods.
Elasticity Consumer Theory

Consumer Preferences

Basket or Bundle → Each bundle specifies quantities of

various goods.
Consumers decide over different bundles!
Elasticity Consumer Theory

Consumer Preferences

Basket or Bundle → Each bundle specifies quantities of

various goods.
Consumers decide over different bundles!
Elasticity Consumer Theory

Assumptions on Preferences

Completeness!
Transitivity!
More is Better than Less
Elasticity Consumer Theory

Assumptions on Preferences
Elasticity Consumer Theory

Indifference Curves

A curve on which the consumer is indifferent between

consuming any two bundles
Elasticity Consumer Theory

Indifference Curves

A curve on which the consumer is indifferent between

consuming any two bundles
All bundles on an indifference curve give the same level of
satisfaction!
Elasticity Consumer Theory

Indifference Curves
Elasticity Consumer Theory

Indifference Maps

Indifference Maps are sets of indifference curves that describe

a consumers preferences.
Elasticity Consumer Theory

Indifference Maps

Indifference Maps are sets of indifference curves that describe

a consumers preferences.
From comparing across bundles → Simplified to comparing
ICs.
Elasticity Consumer Theory

Indifference Maps
Elasticity Consumer Theory

Indifference Maps
Elasticity Consumer Theory

Shape of Indifference Curves

Elasticity Consumer Theory

Marginal Rate of Substitution

The MRS of good X for good Y → Maximum amount of

good Y that a person is willing to give up to obtain one
additional unit of good X.
Elasticity Consumer Theory

Marginal Rate of Substitution

The MRS of good X for good Y → Maximum amount of

good Y that a person is willing to give up to obtain one
additional unit of good X.
The MRS of food for clothing. Discuss!
Formula
Change in quantity of good Y ∆Y
MRSx,y = =
Change in quantity of good X ∆X
On the Indifference curve!
We assume we are calculating the MRS of x axis good for y
axis good.
Elasticity Consumer Theory

Shape of Indifference Curves

Assumption: MRS decreases with increasing values of good x.

Elasticity Consumer Theory

Shape of Indifference Curves

Assumption: MRS decreases with increasing values of good x.

Discuss!
As more of good x is consumed, consumer will prefer to give
up fewer units of good y.
Elasticity Consumer Theory

Shape of Indifference Curves

Assumption: MRS decreases with increasing values of good x.

Discuss!
As more of good x is consumed, consumer will prefer to give
up fewer units of good y.
The additional satisfaction that a consumer gets from another
unit of x will diminish.
Elasticity Consumer Theory

Shape of Indifference Curves

Draw the indifference curves for perfect substitutes and

perfect compliments.
Elasticity Consumer Theory

Shape of Indifference Curves

Elasticity Consumer Theory

Utility Function

A way to assign numerical values to the level of satisfaction.

Elasticity Consumer Theory

Utility Function

A way to assign numerical values to the level of satisfaction.

The utility function is a formula that takes the bundle
(quantities of each good) as input and gives us the utility
value.
Elasticity Consumer Theory

Utility Function

A way to assign numerical values to the level of satisfaction.

The utility function is a formula that takes the bundle
(quantities of each good) as input and gives us the utility
value.
A higher utility value means more satisfaction/happiness.
Elasticity Consumer Theory

Utility Function

A way to assign numerical values to the level of satisfaction.

The utility function is a formula that takes the bundle
(quantities of each good) as input and gives us the utility
value.
A higher utility value means more satisfaction/happiness.
Useful to rank bundles.
Elasticity Consumer Theory

Utility Function

A way to assign numerical values to the level of satisfaction.

The utility function is a formula that takes the bundle
(quantities of each good) as input and gives us the utility
value.
A higher utility value means more satisfaction/happiness.
Useful to rank bundles.
Ordinal vs Cardinal Utility → We focus on ordinal
Ordinal → Utility Values are used only to order bundles based
on preferences → Magnitude of changes in utility values
across bundles have no meaning!
Elasticity Consumer Theory

Utility Function

Below are examples of a utility function

u =x +y
Elasticity Consumer Theory

Utility Function

Below are examples of a utility function

u =x +y

u = x 0.5 y 0.5
Calculate utility for bundle A (x=4 and y=9); and bundle B
(x=12 and y=3). (POLL)
Elasticity Consumer Theory

Utility Function

How can we draw Indifference curve from the Utility function!

Elasticity Consumer Theory

Utility Function

How can we draw Indifference curve from the Utility function!

Draw indifference curve for u=6!
Elasticity Consumer Theory

Utility Function

How can we draw Indifference curve from the Utility function!

Draw indifference curve for u=6!
6 = x 0.5 y 0.5 = xy 0.5
⇒ xy = 36

(1,36), (36,1), (6,6), (4,9),(9,4),(3,12),(12,3) all lie on this

IC! Draw!
Elasticity Consumer Theory

Marginal Utility

Marginal Utility → Increase in utility from an additional unit

of a good.
x=1,y=1 → x=2,y=1 → Increase in utility?
Elasticity Consumer Theory

Marginal Utility

Marginal Utility → Increase in utility from an additional unit

of a good.
x=1,y=1 → x=2,y=1 → Increase in utility?
∆U
MUx =
∆X
x=1,y=1 → x=1,y=2 → Increase in utility?
Elasticity Consumer Theory

Marginal Utility

Marginal Utility → Increase in utility from an additional unit

of a good.
x=1,y=1 → x=2,y=1 → Increase in utility?
∆U
MUx =
∆X
x=1,y=1 → x=1,y=2 → Increase in utility?
∆U
MUy =
∆Y
POLL
Elasticity Consumer Theory

Marginal Utility and MRS

MRS is given by:

∆Y MUx
MRSxy = =−
∆X MUy
Elasticity Consumer Theory

Marginal Utility and MRS

Break the change into two changes.

Elasticity Consumer Theory

Marginal Utility and MRS

Break the change into two changes.

First, I give up ∆Y units of Y

∆U1 = MUy ∆Y
Elasticity Consumer Theory

Marginal Utility and MRS

Break the change into two changes.

First, I give up ∆Y units of Y

∆U1 = MUy ∆Y

Second, I get ∆X units of X

∆U2 = MUx ∆X
Elasticity Consumer Theory

Marginal Utility and MRS

Break the change into two changes.

First, I give up ∆Y units of Y

∆U1 = MUy ∆Y

Second, I get ∆X units of X

∆U2 = MUx ∆X

Total Change in Utility

∆U = ∆U1 + ∆U2
Elasticity Consumer Theory

Marginal Utility and MRS

Break the change into two changes.

First, I give up ∆Y units of Y

∆U1 = MUy ∆Y

Second, I get ∆X units of X

∆U2 = MUx ∆X

Total Change in Utility

∆U = ∆U1 + ∆U2
Elasticity Consumer Theory

Marginal Utility and MRS

But we are on an indifference curve, so ∆U = 0!

Elasticity Consumer Theory

Marginal Utility and MRS

But we are on an indifference curve, so ∆U = 0!

⇒ MUy ∆Y + MUx ∆X = 0
Elasticity Consumer Theory

Marginal Utility and MRS

But we are on an indifference curve, so ∆U = 0!

⇒ MUy ∆Y + MUx ∆X = 0

∆Y MUx
⇒ =−
∆X MUy
MUx
⇒ MRSxy = −
MUy