Eco200 6-8

Elasticity Consumer Theory
Managerial Economics (ECO200)
Rahul Singh AMSOM, rahul.singh@ahduni.edu.in
September 2, 2021
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
Calculate the price elasticity of demand at Price=1,5,10.

(POLL)
Demand Curve
25
Qd =
P
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)
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
Interdiction
education
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?

marginal revenue?
What is the relationship between Price Elasticity of Demand
and Change in Revenue ⇒ If we increase quantity will the
revenue increase/decrease?

marginal revenue?
Hint → Derive the expression for marginal revenue from total
revenue and represent it in terms of elasticity!

marginal revenue?
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?
Consumer Behavior
What is the Consumer’s Problem? Discuss!

Consumer Behavior

Consumer Behavior
Consumer Preferences over consumption bundles
Consumer Behavior

Consumer Behavior
Budget Constraints
Consumer Behavior

Consumer Behavior
Budget Constraints
Consumer Choice
Consumer Behavior

Consumer Behavior
Budget Constraints
Consumer Choice
Given their preferences and limited income, choose
combination of goods to maximize “satisfaction” → Optimal
Choice
Implications for demand!
Consumer Preferences
Basket or Bundle → Each bundle specifies quantities of

various goods.

various goods.
Consumers decide over different bundles!

various goods.
Consumers decide over different bundles!
Assumptions on Preferences
Completeness!
Transitivity!
More is Better than Less
Assumptions on Preferences
Indifference Curves
A curve on which the consumer is indifferent between

consuming any two bundles
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!
Indifference Curves
Indifference Maps
Indifference Maps are sets of indifference curves that describe

a consumers preferences.
Indifference Maps
Indifference Maps are sets of indifference curves that describe

a consumers preferences.
From comparing across bundles → Simplified to comparing
ICs.
Indifference Maps
Indifference Maps
Shape of Indifference Curves

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.
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.
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.

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.
Draw the indifference curves for perfect substitutes and

perfect compliments.

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

Utility Function

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

value.
A higher utility value means more satisfaction/happiness.
Utility Function

value.
Useful to rank bundles.
Utility Function

value.
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!
Utility Function
Below are examples of a utility function
u =x +y
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)
Utility Function
How can we draw Indifference curve from the Utility function!

Utility Function

Draw indifference curve for u=6!
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!
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?
Marginal Utility

of a good.
∆U
MUx =
∆X
Marginal Utility

of a good.
∆U
MUx =
∆X
∆U
MUy =
∆Y
POLL
Marginal Utility and MRS
MRS is given by:

∆Y MUx
MRSxy = =−
∆X MUy
Break the change into two changes.


First, I give up ∆Y units of Y
∆U1 = MUy ∆Y

∆U1 = MUy ∆Y
Second, I get ∆X units of X
∆U2 = MUx ∆X

∆U1 = MUy ∆Y
∆U2 = MUx ∆X
Total Change in Utility
∆U = ∆U1 + ∆U2

∆U1 = MUy ∆Y
∆U2 = MUx ∆X
Total Change in Utility
∆U = ∆U1 + ∆U2
But we are on an indifference curve, so ∆U = 0!

⇒ MUy ∆Y + MUx ∆X = 0
⇒ MUy ∆Y + MUx ∆X = 0
∆Y MUx
⇒ =−
∆X MUy
MUx
⇒ MRSxy = −
MUy

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Elasticity Consumer Theory

Managerial Economics (ECO200)

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

Income Elasticity of Demand

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

Elasticity and Revenue: Applications

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

Elasticity and Revenue: Applications

Elasticity and Revenue: Applications

Elasticity and Revenue: Applications

Elasticity and Revenue

Marginal Revenue ⇒ Extra revenue from selling an additional

Elasticity and Revenue

Marginal Revenue ⇒ Extra revenue from selling an additional

Elasticity and Revenue

Marginal Revenue ⇒ Extra revenue from selling an additional

Elasticity and Revenue

Marginal Revenue ⇒ Extra revenue from selling an additional

What is the Consumer’s Problem? Discuss!

What is the Consumer’s Problem? Discuss!

What is the Consumer’s Problem? Discuss!

What is the Consumer’s Problem? Discuss!

What is the Consumer’s Problem? Discuss!

Basket or Bundle → Each bundle specifies quantities of

Basket or Bundle → Each bundle specifies quantities of

Basket or Bundle → Each bundle specifies quantities of

A curve on which the consumer is indifferent between

A curve on which the consumer is indifferent between

Indifference Maps are sets of indifference curves that describe

Indifference Maps are sets of indifference curves that describe

Shape of Indifference Curves

Marginal Rate of Substitution

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

Marginal Rate of Substitution

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

Shape of Indifference Curves

Assumption: MRS decreases with increasing values of good x.

Shape of Indifference Curves

Assumption: MRS decreases with increasing values of good x.

Shape of Indifference Curves

Assumption: MRS decreases with increasing values of good x.

Shape of Indifference Curves

Draw the indifference curves for perfect substitutes and

Shape of Indifference Curves

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

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

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

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

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

Below are examples of a utility function

Below are examples of a utility function

How can we draw Indifference curve from the Utility function!

How can we draw Indifference curve from the Utility function!

How can we draw Indifference curve from the Utility function!

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

Marginal Utility → Increase in utility from an additional unit

Marginal Utility → Increase in utility from an additional unit

Marginal Utility → Increase in utility from an additional unit

Marginal Utility and MRS

MRS is given by:

Marginal Utility and MRS

Break the change into two changes.