MEDITERRANEAN SCHOOL OF BUSINESS

COURSE: ECO 501 BUSINESS ECONOMICS

PROFESSOR: Alec Hansen, Ph.D.

DATE: April 2020

10/03/2020 SOUTH MEDITERRANEAN UNIVERSITY 1

SESSION 2
MICROECONOMICS BASICS:
DEMAND, SUPPLY, ELASTICITIES AND COSTS

2
Demand Functions
and elasticity

3
Elasticity . . .
… allows us to analyze supply and demand
with greater precision

… is a measure of how much buyers and

sellers respond to changes in market
conditions

4
THE ELASTICITY OF DEMAND
Price elasticity of demand is a measure of how much
the quantity demanded of a good responds to a
change in the price of that good

Price elasticity of demand is:

the percentage change in quantity demanded
given a percent change in the price

5
 Computing the Price Elasticity of Demand
The price elasticity of demand is computed as the
percentage change in the quantity demanded divided by
the percentage change in price.

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P ric e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e in p ric e

6
 Computing the Price Elasticity of Demand

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P ric e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e in p ric e

Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the
amount you buy falls from 10 to 8 cones, then what is your elasticity of demand?

? 7
 Computing the Price Elasticity of Demand

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P ric e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e in p ric e

Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the
amount you buy falls from 10 to 8 cones, then what is your elasticity of demand?

– 20%
Elasticity = = –2
10%

8
 Computing the Price Elasticity of Demand

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P ric e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e in p ric e

Example: If the price of an ice cream cone increases from $2.00

to $2.20 and the amount you buy falls from 10 to 8 cones, then
your elasticity of demand would be calculated as:

  ( 𝑄2 − 𝑄1 ) ( 8 − 10 ) −2
𝑄1 10 10 − 20 %
= = = =− 2
𝑃2 − 𝑃1 2.20 − 2.00 0.2 10 %
𝑃1 2.00 2

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 But what if we go the other way?

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P ric e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e in p ric e

Now the price of an ice cream cone falls back from $2.20 to $2.00
and the amount you buy increases from 8 to 10 cones, then your
elasticity of demand would be calculated as:

 ( 𝑄2 − 𝑄1 ) ( 10 − 8 ) 2
𝑄1 8 8 25 %
= = = =− 2.75
𝑃2 − 𝑃1 2.00 − 2.20 − 0.2 −9%
𝑃1 2.20 2.20

10
 The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities

The midpoint formula is preferable when calculating the price

elasticity of demand because it gives the same answer regardless of
the direction of the change.

  ( 𝑄1 − 2 )
𝑄1 + 𝑄2

𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 =

( 2 )
𝑃1 − 𝑃2
𝑃1 + 𝑃2
( 2 )

11
 The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities
Example: If the price of an ice cream cone increases from
$2.00 to $2.20 and the amount you buy falls from 10 to 8
cones, then your elasticity of demand, using the midpoint
formula, would be calculated as:

?
  ( 𝑄1 − 𝑄2 )
𝑄1 + 𝑄2
( 2 ) =¿
𝑃1 − 𝑃2
𝑃1 + 𝑃2
( 2 )

12
 The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities
Example: If the price of an ice cream cone increases from
$2.00 to $2.20 and the amount you buy falls from 10 to 8
cones, then your elasticity of demand, using the midpoint
formula, would be calculated as:

  ( 𝑄1 − 𝑄2 ) ( 10 − 8 )
𝑄 1 +𝑄 2 ( 10 +8 ) 2
( 2 )= ( 2 ) =
9
=
22 %
=− 2.33
𝑃1 − 𝑃2 2.00 − 2.20 − 0.2 − 9.5 %
𝑃1 + 𝑃2 ( 2.00 +2.20 ) 2.10
( 2 ) ( 2 )

13
 The Price Elasticity of Demand and Its Determinants

Availability of Close Substitutes

Necessities versus Luxuries
Definition of the Market
Time Horizon
Expenditure Share

14
 The Price Elasticity of Demand and Its Determinants
Demand tends to be more price elastic
• the larger the number of close substitutes
• if the good is a luxury
• the more narrowly defined the market
• the longer the time period
• The greater the expenditure share (salt versus cars)

15
Selected Short- and Long-Term Own Price Elasticities
Market Short-Term Own Long-Term Own
Price Elasticity Price Elasticity
Transportation -0.6 -1.9

Food -0.7 -2.3

Alcohol and -0.3 -0.9

tobacco
Recreation -1.1 -3.5

Clothing -0.9 -2.9

16
Types of Demand Curves
Perfectly Inelastic
• Quantity demanded does not respond to price
changes.
Perfectly Elastic
• Quantity demanded changes infinitely with any
change in price.
Unit Elastic
• Quantity demanded changes by the same
percentage as the price.
17
 Types of Demand Curves

Because the price elasticity of demand

measures how much quantity demanded
responds to the price, it is closely related to
the slope of the demand curve.

18
 The Price Elasticity of Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0

Price
Demand

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

19
Copyright©2003 Southwestern/Thomson Learning
 The Price Elasticity of Demand

(b) Inelastic Demand: Elasticity Is Less Than 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 90 100 Quantity

2. . . . leads to a 10.5% decrease in quantity demanded.

20
 The Price Elasticity of Demand

(c) Unit Elastic Demand: Elasticity Equals 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 80 100 Quantity

2. . . . leads to a 22% decrease in quantity demanded.

21
Copyright©2003 Southwestern/Thomson Learning
 The Price Elasticity of Demand

(d) Elastic Demand: Elasticity Is Greater Than 1

Price

$5

4 Demand
1. A 22%
increase
in price . . .

0 50 100 Quantity

2. . . . leads to a 67% decrease in quantity demanded.

22
 The Price Elasticity of Demand

(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Price

1. At any price
above $4, quantity
demanded is zero.
$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

0 Quantity

23
 Total Revenue

Price

$4

P × Q = $400
P
(revenue) Demand

0 100 Quantity

Q 24
Copyright©2003 Southwestern/Thomson Learning
 How Total Revenue Changes When Price Changes: Inelastic
Demand

Price Price
An Increase in price from $1 … leads to an Increase in
to $3 … total revenue from $100 to
$240

$3

Revenue = $240
$1
Revenue = $100 Demand Demand

0 100 Quantity 0 80 Quantity

25
Copyright©2003 Southwestern/Thomson Learning
 How Total Revenue Changes When Price Changes: Elastic Demand

Price Price

An Increase in price from $4 … leads to a decrease in

to $5 … total revenue from $200 to
$100

$5

$4

Demand
Demand

Revenue = $200 Revenue = $100

0 50 Quantity 0 20 Quantity

26
Copyright©2003 Southwestern/Thomson Learning
 Cross-Price Elasticity
Cross-price elasticity: A measure of the responsiveness of the demand
for a good to changes in the price of a related good
Formula: the percentage change in the quantity demanded of one good
divided by the percentage change in the price of a related good.
◦ The cross-price elasticity is positive whenever goods are substitutes.
◦ The cross-price elasticity is negative whenever goods are complements.

27
28
 Income Elasticity of Demand
Income elasticity of demand measures how
much the quantity demanded of a good
responds to a change in consumers’ income
It is computed as the percentage change in the
quantity demanded divided by the percentage change
in income

29
 Computing Income Elasticity

P e rc e n ta g e c h a n g e
in q u a n tity d e m a n d e d
In c o m e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e
in in c o m e

30
 Income Elasticity
Types of Goods
• Inferior Goods E < 0
• Normal Goods E > 0
• Luxury Goods E > 1

Higher income raises the quantity demanded for normal goods but lowers
the quantity demanded for inferior goods

31
 Income Elasticity
Goods consumers regard as necessities tend to be income inelastic
• Examples include food, fuel, clothing, utilities, and medical services

Goods consumers regard as luxuries tend to be income elastic

• Examples include sports cars, furs, and expensive foods

32
Advertising Elasticity
The advertising elasticity of demand for good X is the
percentage change in the consumption of X that results
from a given percentage change in advertising spent on
X

33
Uses of Elasticities
Pricing
Impact of changes in competitors’ prices
Impact of economic booms and recessions
Impact of advertising campaigns
And lots more…

34
Cost Functions

35
Review of COST Functions
The production function reflects Technology
• What is the relationship between input quantity and output quantity?
For example, consider
• Water and cereal yield
• Fertilizer and cereal yield
• Time and # of exams graded
What can we say about the shape of the curve?

36
A production function
Wheat
plateau
decreasing output

decreasing returns

Increasing returns

no returns
Water

If you are a farmer, in what region of the production

curve would you expect to maximiize your profit?

37
Optimal amount of input
There are two possibilities depending on the relative prices of water and wheat
• If wheat is nearly worthless and water extremely precious… then you use no water at
all and produce no wheat.
• If wheat is sufficiently valuable relative to water… then you produce at least the
quantity at the inflection point (take advantage of all increasing returns) and at most
the maximum output.
Clearly, the profit-maximizing input-output combination will be in the
decreasing-returns-to-scale region.

38
Economic optimization
Output maximization and profit maximization are different problems with
different solutions
Relative to profit-maximization, output-maximization requires much additional
input for only a small increase in output. Since the large quantity of additional
input may cost more than the value of additional output, profits fall
Without loss of generality, we can henceforth focus our attention to production
function with decreasing returns to scale only
The simpler graph on the next slide is all we need

39
A simpler production function
output

decreasing returns

input

40
From production to cost function
output total cost
5 20

4.5 18

4 16

3.5 14

3 12

2.5 10

2 8

1.5 6

1 4

0.5 2

0 0
0 2 4 6 8 10 12 14 16 18 20 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
input input 41
Average cost functions
Average Total Cost = ATC = TC/Q
Average Fixed Cost = AFC = FC/Q
Average Variable Cost = AVC = VC/Q
Note that ATC = AFC + AVC
AFC is downward sloping
AVC is upward sloping
ATC is U-shaped

42
Average cost functions
$

ATC
AVC

AFC
Q
43
MC and ATC
The Marginal Cost curve intersects the ATC curve at the ATC’s minimum.
Intuition: if your latest grade is above your GPA, then your GPA will go up; if
your latest grade is below your GPA, you GPA will go down
By the same token,
if MC>ATC, then ATC must be upward-sloping
if MC<ATC, then ATC must be downward-sloping

44
MC and ATC
$

MC

ATC

Q
45
MC and ATC
$

dATC/dQ < 0 dATC/dQ > 0

MC < ATC MC > ATC

MC

ATC

Q
46
Comparing two technologies
Suppose you are in the $ TC
lawn care business and
start out with a small
push-mower. Its purchase
price is your fixed cost
and your labor is your
variable cost. The total
cost curve is shown in
red. Acres of mowed
lawn (Q)
The corresponding ATC
is shown here. ATC

Q 47
Comparing two technologies
Your business expands as $ TC
you get new clients. Should
you buy a riding mower? It’s
significantly more expensive
to buy, but requires less labor
time per acre. Its TC is
shown in black.

Acres of mowed
The corresponding ATC is lawn (Q)
also shown here in black. The
point of intersection ATC
determines the switching
point, the level of output at
which it makes sense to
upgrade in order to save cost.
Q 48
Economies of scale
But there may be increasing returns to scale or economies of scale:
◦ This means that when inputs to an industry increase at a certain rate, output increases at a faster rate
◦ A larger scale is more efficient: the cost per unit of output falls as a firm or industry increases output

7-49
Relationship of Input to Output for a Hypothetical Industry

What is the Average Labor

Input per Unit of Output?

7-50
Economies of Scale and Market Structure
Economies of scale could mean either that larger firms or a larger industry would be more
efficient
◦ External economies of scale occur when cost per unit of output depends on the size of the industry.
◦ Internal economies of scale occur when the cost per unit of output depends on the size of a firm.

7-51
Economies of Scale and Market Structure (cont.)
Both external and internal economies of scale are
important causes of international trade
They have different implications for the structure of
industries
◦ An industry where economies of scale are purely external will
typically consist of many small firms and be perfectly
competitive
◦ Internal economies of scale result when large firms have a cost
advantage over small firms, causing the industry to become
imperfectly competitive

7-52
The Theory of External Economies (cont.)
1. Specialized equipment or services may
be needed for the industry, but are only supplied by other firms if the industry is large and
concentrated.
◦ For example, Silicon Valley in California has a large concentration of silicon chip
companies, which are serviced by companies that make special machines for
manufacturing silicon chips.
◦ These machines are cheaper and more easily available there than elsewhere.

7-53
The Theory of External Economies (cont.)
2. Labor pooling: a large and concentrated industry may attract a pool of workers, reducing
employee search and hiring costs for each firm.
3. Knowledge spillovers: workers from different firms may more easily share ideas that
benefit each firm when a large and concentrated industry exists.

7-54
External Economies Before Trade

7-55
Trade and Prices

7-56
The Importance of Established Advantage

7-57
The Learning Curve

7-58
CASE STUDY: Lille Tissages
Review the cost table:
Which items can be classified as FC
and which ones as AC?
First assume all info is correct and reliable
Then question assumptions using common sense and take into account any
potential uncertainty

Come prepared to discuss case on Thursday

59