Sanfav K.

Singh
Economics I
ManageriaI Economics
-
Dr. Sanjay K. Singh
ndian nstitute of Management
Lucknow
.
Course OutIine and Session PIan
Session Topics Reading
1 Managerial economics: an introduction Pindyck Chapters 1
Petersen Chapter 1
2-3 Demand, supply, price and elasticity

Pindyck Chapter 2
4-5 Theory oI consumer behaviour Pindyck Chapters 3- 4
6-7 Demand analysis and Iorecasting Petersen Chapters 4-5
Polycopy
8-10 Theory oI production and cost Pindyck Chapters 5-6
11-12 Market structures and price output
determination perIect competition and
monopoly
Pindyck Chapters 7 & 9
Petersen Chapter 12
13-15 Market structures (contd.) monopolistic
competition and oligopoly
Pindyck Chapters 11-12
16 Pricing oI Iactors oI production with
particular reIerence to the labour market
Pindyck Chapter 13
17 Economics oI inIormation asymmetry Pindyck Chapter 17
18 Competition policy and economic regulation Polycopy
19-20 Project presentation and summing up -
Note: Each topic will be supplemented by the articles given in the polycopy.
Sanfav K. Singh
Economics I
.
Readings
Textbooks:
Microeconomics by Robert S. Pindyck, Daniel L.
Rubinfeld, Prem L. Mehta, Pearson-Prentice Hall,
Seventh Edition.
Managerial Economics by H. C. Petersen and W.C.
Lewis, Prentice Hall, Fourth Edition
Reference Book:
Microeconomics: Theory and Applications by D.
Salvatore, Oxford University Press, Fourth edition.
Polycopy containing few useful articles:
.
EvaIuation (PGP)
The course wiII be graded on the foIIowing
components:
Attendance, CIass Participation, Assignments,
and Quizzes: 20%
Group Project: 20%
Mid-term Examination: 20%
End-term Examination: 40%
Sanfav K. Singh
Economics I
.
ManageriaI Economics:
An Introduction
.
Economics is the study of the allocation
of scarce resources.
. . . means that society has limited
resources and therefore cannot produce
all the goods and services people wish to
have.
Scarcity . . .
Sanfav K. Singh
Economics I
.
Economists study. . .
How people make decisions?
How people interact with each other?
1he forces and trends that affect the
economy as a whole.
.
Ten PrincipIes of Economics
1. People face tradeoffs.
Having more of one good means having less of another
Society faces tradeoffs in efficiency versus equity
You face tradeoffs in how best to allocate your time; the
choice to attend B-School rather than being in labor
force
2. People face opportunity cost (cost of something is
what you give up to get it).
What is the opportunity cost of your IIM education?
What is the opportunity cost of attending this lecture?
Undertake an activity if the benefit its opportunity cost
How People Make Decisions?
Sanfav K. Singh
Economics I
.
Ten PrincipIes of Economics
3. Rational people think at the margin (The Marginal
Principle) i.e., the relevant benefits and costs to
consider are marginal.
Marginal cost is the additional cost oI one unit increase
in an activity (MC)
Marginal beneIit is the extra beneIit resulting Irom one
unit increase in an activity (MB)
If the marginal benefit of an activity exceeds its
marginal cost, do it
If the marginal benefit of an activity is less than its
marginal cost, don`t do it
Keep doing the activity until the marginal beneIit just
equals the marginal cost
How People Make Decisions?
.
Ten PrincipIes of Economics
4. People respond to incentives.
People`s behavior may change if costs/benefits change
As petrol / diesel prices rise, people drive less, walk
more, use public transportation more often; purchase
fuel-efficient cars, .
But, sometime, government policy may have unforeseen
consequences
Do seat belts reduce auto deaths/improve auto safety?
Seat belt laws encourage drivers to drive faster, since
risk of death gets reduced (cost of poor driving falls).
There is a higher risk of accidents, but lower risk of
death if you`re in an accident and wearing your seat belt.
Although driver fatality may be reduced due to seat belt
laws, pedestrian fatality is likely to increase.
How People Make Decisions?
Sanfav K. Singh
Economics I
.
Ten PrincipIes of Economics
5. Trade can make everyone better off.
Produce and export a good in which you have a comparative
advantage (if the opportunity cost of producing that good is lower in
the country than it is in other countries).
Even if a country is having absolute advantage (or disadvantage) - the
most (or least) efficient producer of all goods, it still can benefit from
trade.
The benefits of trade do not depend on absolute advantage, rather
they depend on comparative advantage: specializing in industries
that use resources most efficiently.
The competitive advantage of an industry depends not only on its
productivity relative to foreign industry, but also on the domestic
wage rate relative to the foreign wage rate.
Therefore, an absolute productivity advantage is neither a necessary
nor a sufficient condition for having a comparative advantage.
How People Interact
.
Ten PrincipIes of Economics
6. Markets are usually a good way to organize economic
activity.
7. Governments can sometimes improve economic outcomes.
How the Economy as a Whole Works
8. The standard of living depends on a country's production.
9. Prices rise when the government prints too much money.
10. Society faces a short-run tradeoff between inflation and
unemployment.
How People Interact
Sanfav K. Singh
Economics I
.
Macroeconomics versus Microeconomics
Macroeconomics looks at the economy as a
whole and focuses on economic aggregates:
Total economic output, employment
Inflation, unemployment
Trade deficit; budget surplus/deficit
Economic growth and business cycles
Monetary policy, fiscal policy
Microeconomics focuses on the individual parts
of the economy and studies individual decision
makers and their interaction in the market
Households, firms, industries, government
.
Microeconomics helps you understand the world and
predict behavior
Why do monopolistic firms earn higher profits than
more competitive firms?
Why are airline tickets cheaper in lean season?
Can government regulation improve corporate
governance?
Microeconomics is one way of looking at the world
Thus, there is an economics of:
Health care
Sports
Housing and urban policy
Education
International Trade
Energy
Transport
Deregulation
Sanfav K. Singh
Economics I
.
What is manageriaI economics?
Applied micro-economics, but with a Iocus on
decision making
'What shall a manager do in this and that
situation?
Pricing decisions in diIIerent circumstances
Market entry, advertising, innovation, .
Organization oI the Iirm
Personnel policy, how to motivate workers .
.
Positive versus Normative
AnaIysis
Positive statements are statements
that describe the world as it is.
Called descriptive analysis
Normative statements are
statements about how the world
should be.
Called prescriptive analysis
Sanfav K. Singh
Economics I
.
The Market Forces of
SuppIy and Demand
Demand, Supply, Price
and Elasticity
.
Markets
A market is a group of buyers and sellers of
a particular good or service.
The terms supply and demand refer to the
behavior of people . . . as they interact with
one another in markets.
And economics, especially microeconomics
is about how supply and demand interact in
markets.
Sanfav K. Singh
Economics I
.
Market Types or Structures
Competitive Markets
Homogeneous product, large number of
buyers and sellers, no player has any control
on prices, no entry/exit barrier, .
Monopoly
Monopolistic Competition
Oligopoly
.
IndividuaI Demand Curve
$3.00
2.50
2.00
1.50
1.00
0.50
2 1 3 4 5 6 7 S 9 10 12 11
Price of
Ice-Cream
Cone
Quantity of
Ice-Cream
Cones
0
relationship between price and demand
Sanfav K. Singh
Economics I
.
Why does the Demand Curve SIope
Downward?
Law of Demand
Inverse relationship between price and
quantity.
Law of Diminishing Marginal Utility
Utility is the extra satisfaction that one
receives from consuming a product.
Marginal means extra.
Diminishing means decreasing.
.
Market Demand
Market demand refers to the sum of all
individual demands for a particular good or
service.
Graphically, individual demand curves are
summed horizontally to obtain the market
demand curve.
So, market demand curve is the
horizontal sum of the demand curves of
all consumers in the market.
Sanfav K. Singh
Economics I
.
Ceteris Paribus
Ceteris paribus is a Latin phrase that
means all variables other than the ones
being studied are assumed to be
constant. Literally, ceteris paribus
means ~other things being equal.
The demand curve sIopes downward
because, ceteris paribus, Iower prices
impIy a greater quantity demanded!
.
Two SimpIe RuIes for Movements vs.
Shifts
Rule One
When an independent variable changes and that
variable does not appear on the graph, the curve on
the graph will shift.
Rule Two
When an independent variable does appear on the
graph, the curve on the graph will not shift, instead
a movement along the existing curve will occur.
Let`s apply these rules to the following cases of
supply and demand!
Sanfav K. Singh
Economics I
.
Movement aIong the Curve
0
D
1
Price of
Cigarettes
per Pack
Number of Cigarettes
Smoked per Day
A movement occurs when a change
in the quantity demanded is caused
only by a change in its price, and vice
versa.
A
C
20
2.00
$4.00
12
.
Consumer Income
NormaI Good
$3.00
2.50
2.00
1.50
1.00
0.50
2 1 3 4 5 6 7 S 9 10 12 11
Price of
Ice-Cream
Cone
Quantity of Ice-
Cream Cones
0
Increase
in demand
An increase in
income...
A shiIt in the demand curve
occurs when a good's
quantity demanded changes
even though price remains
the same.
D
1
D
2
Shift in the Demand Curve
Sanfav K. Singh
Economics I
.
Consumer Income
Inferior Good
$3.00
2.50
2.00
1.50
1.00
0.50
2 1 3 4 5 6 7 S 9 10 12 11
Price of
Ice-Cream
Cone
Quantity of Ice-
Cream Cones
0
Decrease
in demand
An increase
in income...
D
1
D
2
Shift in the Demand Curve
.
Prices of ReIated Goods
Substitutes & CompIements
When a fall in the price of one good
reduces the demand for another good, the
two goods are called substitutes.
When a fall in the price of one good
increases the demand for another good,
the two goods are called complements.
Sanfav K. Singh
Economics I
.
VariabIes that affect quantity demanded
Variables that
affect Quantity
Demanded
A Change in
this Variable . . .
Price Represents a movement
along the demand curve
Income Shifts the demand curve
Prices of related
goods
Shifts the demand curve
Tastes Shifts the demand curve
Expectations Shifts the demand curve
.
SuppIy Curve
$3.00
2.50
2.00
1.50
1.00
0.50
2 1 3 4 5 6 7 S 9 10 12 11
Price of
Ice-Cream
Cone
Quantity of Ice-
Cream Cones
0
The suppIy curve sIopes
upward, demonstrating that
at higher prices firms
wiII increase output
Sanfav K. Singh
Economics I
.
Market SuppIy
Market suppIy refers to the sum of aII
individuaI suppIies for aII seIIers of a
particuIar good or service.
GraphicaIIy, individuaI suppIy curves
are summed horizontally to obtain
the market suppIy curve.
.
Movement aIong the SuppIy Curve
1 5
Price of
Ice-Cream
Cone
Quantity of Ice-
Cream Cones
0
S
1.00
A
C
$3.00 A rise in the price
of ice cream cones
resuIts in a
movement aIong
the suppIy curve of
ice cream cones.
Sanfav K. Singh
Economics I
.
Shift in the SuppIy Curve
Price of
Ice-Cream
Cone
Quantity of Ice-
Cream Cones
0
S
1
S
2
S
3
Increase in
Supply
Decrease in
Supply
A shiIt in the supply curve
occurs when a good's
quantity supplied changes
even though price remains
the same.
.
VariabIes that affect quantity suppIied
Var|ab|es that
Affect 0uant|ty 8upp||ed

A 6hange |n Th|s Var|ab|e . . .
Pr|ce Represerls a rovererl a|org
lre supp|y curve
lrpul pr|ces 3r|lls lre supp|y curve
Tecrro|ogy 3r|lls lre supp|y curve
Expeclal|ors 3r|lls lre supp|y curve



Sanfav K. Singh
Economics I
.
The Market Mechanism
The market mechanism is the
tendency in a free market for price to
change untiI the market cIears
Markets cIear when quantity
demanded equaIs quantity suppIied
at the prevaiIing price
Market cIearing price - price at which
markets cIear
.
Supply
Demand
Price of
Ice-Cream
Cone
Quantity of Ice-
Cream Cones
EquiIibrium of
SuppIy and Demand
2 1 3 4 5 6 7 S 9 10 12 11 0
$3.00
2.50
2.00
1.50
1.00
0.50
Equilibrium
The curves intersect at
equiIibrium, or market-
cIearing price.
Quantity demanded
equaIs quantity
suppIied at P=$2.
Sanfav K. Singh
Economics I
.
Price of
Ice-Cream
Cone
Quantity of Ice-
Cream Cones
2 1 3 4 5 6 7 S 9 10 12 11 0
$3.00
2.50
2.00
1.50
1.00
0.50
Supply
Demand
Surplus
Excess SuppIy
When price is higher
than market cIearing
price, say,
P = $2.50 (> $ 2.0).
UnsustainabIe in free
market.
.
Excess Demand
Quantity of
Ice-Cream Cones
Price of
Ice-Cream
Cone
$2.00
0 1 2 3 4 5 7 8 9 10 11 12 13
Supply
Demand
$1.50
Shortage
When price is Iower than
market cIearing price, say,
P = $1.50 (< $ 2.0).
UnsustainabIe in free market.
Sanfav K. Singh
Economics I
.
Three Steps To AnaIyzing
Changes in EquiIibrium
Decide whether the event shifts the
supply or demand curve (or both).
Decide whether the curve(s) shift(s) to
the left or to the right.
Examine how the shift affects
equilibrium price and quantity.
.
How an Increase in Demand
affects the EquiIibrium
Price of
Ice-Cream
Cone
2.00
0 7 Quantity of
Ice-Cream Cones
Supply
Initial
equilibrium
D
1
1. Hot weather increases
the demand for ice cream...
D
2
2. ...resulting
in a higher
price...
$2.50
10
3. ...and a higher
quantity sold.
New equilibrium
Sanfav K. Singh
Economics I
.
S
2
How a Decrease in SuppIy affects
the EquiIibrium
Price of
Ice-Cream
Cone
2.00
0 1 2 3 4 7 S 9 11 12 Quantity of
Ice-Cream Cones
13
Demand
Initial equilibrium
S
1
10
1. An earthquake reduces
the supply of ice cream...
New
equilibrium
2. ...resulting
in a higher
price...
$2.50
3. ...and a lower
quantity sold.
.
D'
5'
How an increase in both Demand and
SuppIy affects the EquiIibrium
Income increases
and raw material
prices fall
Quantity increases
If the increase in D
is greater than the
increase in S price
also increases
F
Q
5
F
2
Q
2
D
F
1
Q
1
Sanfav K. Singh
Economics I
.
What determines the equiIibrium
outcome when there is a shift in both
Demand and SuppIy curves?
The reIative size and direction of the
change and
The shape of the suppIy and demand
curves
.
An exampIe: The Price of a CoIIege
Education in the US
The reaI price of a coIIege education rose 105
percent from 1970 to 2007
Increases in the costs of equipping and
maintaining modern cIassrooms, Iaboratories,
and Iibraries, aIong with increases in facuIty
saIaries, pushed the suppIy curve up.
The demand curve shifted to the right as a Iarger
percentage of a growing number of high schooI
graduates decided that a coIIege education was
essentiaI.
Sanfav K. Singh
Economics I
.
Market for CoIIege
Education
The supply curve for a
college education shifted
up as the costs of
equipment, maintenance,
and staffing rose.
The demand curve shifted
to the right as a growing
number of high school
graduates desired a
college education.
As a result, both price and
enrollments rose sharply.
An exampIe: The Price of a CoIIege
Education in the US
.
Another exampIe: The Price of
Copper
Consumption of copper has increased
about a hundredfoId from 1880 through
2002
The Iong term reaI price for copper has
remained reIativeIy constant
Increased demand as worId economy
grew
Decreased production costs increased
suppIy
Sanfav K. Singh
Economics I
.
5
2002
D
2002
D
100
5
100
5
150
D
150
Long-kun Foth o|
Fr|ce ond Consumpt|on
Quont|ty
Fr|ce
Another exampIe: The Price of
Copper
.
EIasticity and Its
AppIication
Sanfav K. Singh
Economics I
.
EIasticity . . .
. is percentage change in one variabIe with respect
to percentage change in another variabIe.
Economists want to compare appIes and oranges aII
the time.
Is oiI market demand more price sensitive than wheat
demand? (no)
Is the Iabor suppIy of women more wage sensitive
than the Iabor suppIy of men? (yes)
EIasticities aIIow economists to quantify the
differences among markets without standardizing the
units of measurement (it does not matter how we
measure the price or the quantity in different markets).
.
Price EIasticity of Demand
Price eIasticity of demand is the percentage
change in quantity demanded given a percent
change in the price.
P = the current price of a good
Q = the quantity demanded at that price
P = small change in the current price
Q = small change in the quantity demanded
Price Elasticity of Demand = (Percentage Change
in Quantity) / (Percentage Change in Price)
Price Elasticity of Demand = ((Q/Q)/(P/P)) =
dlnQ/dlnP (from the calculus).
Sanfav K. Singh
Economics I
.
Computing the Price EIasticity of Demand
price in change Percentage
demanded quatity in change Percentage
demand of elasticity Price =
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:
2
10
20
100
00 . 2
) 00 . 2 20 . 2 (
100
10
) 10 8 (
=

percent
percent
.
Computing the Price EIasticity of
Demand Using the Midpoint FormuIa
Although the exact formula for calculating an
elasticity is useful for theory, in practice economists
usually calculate an approximation called the
symmetric midpoint formula elasticity.
This is also called arc elasticity (is the elasticity of one
variable with respect to another between two given points).
Formula used for this is a bit different from that of point
elasticity.
)J2] P )J[{P P {P
)J2] Q )J[{Q Q {Q
= Demand of Elasticity Price
1 2 1 2
1 2 1 2
+
+
Sanfav K. Singh
Economics I
.
Computing the Price EIasticity of Demand
Example: f 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 the your elasticity of demand, using the midpoint
formula, would be calculated as:
32 . 2
5 . 9
22
2 / ) 20 . 2 00 . 2 (
) 00 . 2 20 . 2 (
2 / ) 8 10 (
) 10 8 (
=

=
+

percent
percent
)J2] P )J[{P P {P
)J2] Q )J[{Q Q {Q
= Demand of Elasticity Price
1 2 1 2
1 2 1 2
+
+
Arc elasticity value is different from point elasticity value because point
elasticity is for an infinitesimally small change in price and quantity. The
point elasticity can be approximated by calculating the arc elasticity for a
very short arc, e.g., 0.01% change in price.
.
Ranges of EIasticity
Inelastic Demand
Percentage change in price is greater than
percentage change in quantity demand.
(Absolute value of ) price elasticity of demand
is less than one.
Elastic Demand
Percentage change in quantity demand is
greater than percentage change in price.
(Absolute value of) price elasticity of demand
is greater than one.
Sanfav K. Singh
Economics I
.
PerfectIy IneIastic Demand
- EIasticity equaIs 0
0uant|ty
Pr|ce
4
$5
0emand
100
2. ...|eaves the quant|ty demanded unchanged.
1. An
|ncrease
|n pr|ce...
.
IneIastic Demand
- EIasticity is Iess than 1
0uant|ty
Pr|ce
4
$5
1. A 257
|ncrease
|n pr|ce...
0emand
100 90
2. ...|eads to a 107 decrease |n quant|ty.
Sanfav K. Singh
Economics I
.
Unit EIastic Demand
- EIasticity equaIs 1
0uant|ty
Pr|ce
4
$5
1. A 257
|ncrease
|n pr|ce...
0emand
100 75
2. ...|eads to a 257 decrease |n quant|ty.
.
EIastic Demand
- EIasticity is greater than 1
0uant|ty
Pr|ce
4
$5
1. A 257
|ncrease
|n pr|ce...
0emand
100 50
2. ...|eads to a 507 decrease |n quant|ty.
Sanfav K. Singh
Economics I
.
PerfectIy EIastic Demand
- EIasticity equaIs infinity
0uant|ty
Pr|ce
0emand
$4
1. At any pr|ce
above $4, quant|ty
demanded |s zero.
2. At exact|y $4,
consumers w|||
buy any quant|ty.
3. At a pr|ce be|ow $4,
quant|ty demanded |s |nf|n|te.
.
Price EIasticity of Demand
Therefore,
The steeper the demand curve, the more
inelastic the demand for the good becomes.
The flatter the demand curve, the more
elastic the the demand for the good becomes.
Two extreme cases of demand curves:
Perfectly inelastic demand vertical
Perfectly elastic demand horizontal
Sanfav K. Singh
Economics I
.
P
r
i
c
e
Elasticity along
demand curve as one
moves toward the
quantity axis
$10
9
8
7
6
5
4
3
2
1
0 1 2 3 4 5 6 7 8 9 10
E
d
=
E
d
= 1
E
d
= 0
Quantity
Elasticity along a Linear Demand Curve
E
d
< 1
E
d
> 1
(perfectly elastic)
(elastic)
(unitary elastic)
(inelastic)
(perfectly inelastic)
.
Determinants of
Price EIasticity of Demand
Necessities versus Luxuries
Availability of Close Substitutes
Definition of the Market
Time Horizon
Personal Income
Sanfav K. Singh
Economics I
.
Determinants of Price EIasticity of Demand
Demand tends to be more elastic
if the good is a luxury.
the longer the time period (n general, consumers take time
to adjust consumption habits and more substitutes are usually
available in the long run).
the larger the number of close substitutes.
the more narrowly defined the market.
This is because, in narrowly defined markets, close
substitutes are more likely to exist.
For example, market for camel cigarettes vs. market for all
cigarettes. The demand for camel cigarettes is likely to be
relatively more elastic.
the lower is personal income (Those in poverty have little
money and are likely to be relatively more responsive to price
changes.).
.
Determinants of Price EIasticity of Demand
Demand tends to be more inelastic
f the good is a necessity.
f the time period is shorter.
The smaller the number of close substitutes.
The more broadly defined the market
(because very few close substitutes exist for broadly
defined market).
The higher is personal income (Perhaps the
elasticity of demand decreases with income. That is
because the wealthy have so much money that they
are relatively insensitive to price changes.).
Sanfav K. Singh
Economics I
.
Is the Iong run eIasticity higher than
short run eIasticity for aII the goods?

5k

Lk
No.
Although it is true for most of the
goods.
For example, gasoline demand is
relatively more elastic in the long
run. Why?
n the long run, people tend to drive
smaller and more fuel efficient cars.
But what about automobiles?
Quont|ty o| goso||ne
Fr|ce
.
D
5k
D
Lk
When car price increases, initially, people
may put off immediate car purchase.
n the long run, older cars must be replaced.
n fact, if goods are durable, then when price
increases, consumers choose to hold on to the
good instead of replacing it.
But in the long run, older durable goods will
have to be replaced.
So, for durable goods, demand is more elastic
in the short run.
Demand eIasticity for cars in the short
run and Iong run
Quont|ty o| cors
Fr|ce
Sanfav K. Singh
Economics I
.
Demand for GasoIine
Demand for AutomobiIes
.
Demand EIasticity and TotaI
Revenue
If E
d
is elastic (E
d
> 1), a rise in price
lowers totaI revenue
If E
d
is inelastic (E
d
< 1), a rise in price
increases totaI revenue
If E
d
is unit elastic (E
d
= 1), a rise in price
Ieaves totaI revenue unchanged.
Sanfav K. Singh
Economics I
.
A
P
r
i
c
e
EIastic Demand
E
d
> 1
Quantity
$10
8
6
4
2
0
1 2 3 4 5 6 7 8 9
Elasticity and Total Revenue
C
B
K
J
Lost
revenue
Gained
revenue
.
A
P
r
i
c
e
IneIastic Demand
E
d
< 1
Quantity
$10
8
6
4
2
0
1 2 3 4 5 6 7 8 9
Elasticity and Total Revenue
C
H
B
G
Lost
revenue
Gained
revenue
Sanfav K. Singh
Economics I
.
P
r
i
c
e
Elastic range E
d
> 1
E
d
= 1
nelastic range
E
d
1
Q
0 Quantity
(a)
0 0
Quantity
(b)
How Total Revenue Changes
Along a Linear Demand Curve
Q
0
T
o
t
a
l

r
e
v
e
n
u
e
.
EIasticity and Revenue
For a Iinear dd
curve, P = a -
bQ, revenue wiII
be maximum
when P = a/2
i.e., price
eIasticity of
demand = -1.
Sanfav K. Singh
Economics I
.
Income EIasticity of Demand
Income eIasticity 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.
Elasticity of demand wrt income,
.
Income EIasticity - Types of Goods -
Normal Goods
ncome Elasticity is positive.
Necessity Goods
ncome Elasticity is positive but less than 1.
Luxury or Superior Goods
ncome Elasticity is more than 1.
Sticky Goods
ncome Elasticity is zero.
Inferior Goods
ncome Elasticity is negative.
Higher income raises the quantity demanded
for normal goods but lowers the quantity
demanded for inferior goods.
Sanfav K. Singh
Economics I
.
Cross Price EIasticity of Demand
Elasticity measure that looks at the impact a
change in the price of one good has on the
demand of another good.
Elasticity of demand of product A wrt Price of
product B,
Positive Goods are Substitutes
Negative Goods are Complements
Zero Goods are ndependent
.
Price Elasticity of Supply
The price elasticity of supply measures the
reIationship between change in quantity
suppIied and a change in price and
is defined as the percentage change in
quantity suppIied divided by the percentage
change in price.
Sanfav K. Singh
Economics I
.
Price EIasticity of SuppIy
The value of price elasticity of supply is positive, because an
increase in price is likely to increase the quantity supplied in the
market.
Demand curve
.
Price EIasticity of SuppIy
When supply is
relatively inelastic a
change in demand
affects the price more
than the quantity
supplied.
When supply
is perfectly
inelastic, a
shift in the
demand curve
has no effect
on the
equilibrium
quantity
supplied
{supply of
tickets for
sports
venues}.
When supply
is perfectly
elastic a firm
can supply
any amount at
the same
price. Firm
can supply at
a constant
unit cost and
has no
capacity
constraint. A
change in
demand alters
the
equilibrium
quantity but
not the
market
clearing price.
When supply is
relatively elastic a
change in demand can
be met without a
significant change in
market price.
Sanfav K. Singh
Economics I
.
Determinants of the Price EIasticity of SuppIy
SPARE CAPACTY
f there is plenty of spare capacity, the firm should be able to
increase output quite quickly without a rise in costs and
therefore supply will be elastic.
STOCKS
f stocks (or inventories) of raw materials, components and
finished products are high then supply will be elastic.
EASE OF FACTOR SUBSTTUTON
f capital and labour resources are occupationally mobile
then the elasticity of supply for a product is likely to be
higher.
TME PEROD
Supply is likely to be more elastic, the longer the time period
a firm has to adjust its production. n the short run, the firm
may not be able to change its factor inputs.
.
An AppIication of EIasticity Concept:
Prices of BraziIian Coffee
Why are coffee prices very volatile?
Most of the world's coffee is produced in
Brazil
Changing weather conditions affect the
crop of coffee, thereby affecting price
Price following bad weather conditions is
usually short-lived
n long run, prices come back to original
levels, all else equal
Sanfav K. Singh
Economics I
.
Prices of BraziIian Coffee
.
Demand and supply are more elastic in the
long run
n the short run, supply is completely inelastic
Weather may destroy part of the fixed
supply, decreasing supply
Demand is relatively inelastic as well
Price increases significantly whenever supply
gets reduced due to bad weather
An AppIication of EIasticity Concept:
Prices of BraziIian Coffee
Sanfav K. Singh
Economics I
.

0
5

0
Quont|ty
Fr|ce
A freeze or drought
decreases the suppIy
of coffee
5'

1
Price increases
significantIy due to
ineIastic suppIy and
demand

1
Prices of BraziIian Coffee in the short run
.
Understanding and Predicting the Effects of
Changing Market Conditions: An ExampIe of
Copper Market
After reaching a level of about $1.00 per pound in 1980, the
price of copper fell sharply to about 60 cents per pound in
1986.
Worldwide recessions in 1980 and 1982 contributed to the
decline of copper prices.
Why did the price increase sharply in 20052007?
First, the demand for copper from China and other Asian
countries began increasing dramatically.
Second, because prices had dropped so much from 1996
through 2003, producers closed unprofitable mines and cut
production.
Sanfav K. Singh
Economics I
.
Copper prices are shown in both nominal (no adjustment for inflation) and real
(inflation-adjusted) terms. n real terms, copper prices declined steeply from the
early 1970s through the mid-1980s as demand fell. n 19881990, copper prices
rose in response to supply disruptions caused by strikes in Peru and Canada but
later fell after the strikes ended. Prices declined during the 19962002 period but
then increased sharply during 20052007.
Copper Prices, 1965-2007
Understanding and Predicting the Effects of
Changing Market Conditions: An ExampIe of
Copper Market
.
8upply, Demand, and 8upply, Demand, and 8upply, Demand, and 8upply, Demand, and
Governmen Governmen Governmen Government Policies t Policies t Policies t Policies
In a free, unreguIated market system, market
forces estabIish equiIibrium prices and
exchange quantities.
One of the things government can do is to
set price controIs when the market price is
seen as unfair to either buyers or seIIers.
Sanfav K. Singh
Economics I
.
Price CeiIings and Price FIoors
Price CeiIing
A IegaIIy estabIished maximum price at which a
good can be soId. (Fee charged by private
engineering coIIeges, say, in UP)
You can't charge more than the set price.
Price FIoor
A IegaIIy estabIished minimum price at which a good
can be soId. (Price Supports for wheat, sugarcane,
etc.)
You can't charge Iess than this price.
.
Price CeiIings
Two outcomes are possibIe when the
government imposes a price ceiIing:
The price ceiIing is not binding if set above
the equiIibrium price.
The price ceiIing is binding if set below the
equiIibrium price, Ieading to a shortage.
Binding means that there is an economic
impact.
Sanfav K. Singh
Economics I
.
A Price Ceiling That Is Binding...
$3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
2
Demand
Supply
Equilibrium
price
Price
ceiling
Shortage
125
Quantity
demanded
75
Quantity
supplied
.
A Price Ceiling That Is Not Binding...
$4
3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
Demand
Supply
Price
ceiling
Equilibrium
price
100
Equilibrium
quantity
Sanfav K. Singh
Economics I
.
Effects of Price CeiIings
A binding price ceiIing creates ...
shortages because Q
D
> Q
S
.
ExampIe: LPG shortage
nonprice rationing
ExampIes: Long Iines, Discrimination
by seIIers, etc.
.
Price FIoors
When the government imposes a
price fIoor, two outcomes are
possibIe.
The price fIoor is not binding if set
below the equiIibrium price.
The price fIoor is binding if set above
the equiIibrium price, Ieading to a
surpIus.
Sanfav K. Singh
Economics I
.
A Price Floor That Is Not Binding...
$3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
100
Equilibrium
quantity
Equilibrium
price
Demand
Supply
Price
floor
2
.
A Price Floor That Is Binding...
$3
Quantity of
Ice-Cream
Cones
0
Price of
Ice-Cream
Cone
Equilibrium
price
Demand
Supply
Price floor $4
120
Quantity
supplied
S0
Quantity
demanded
Surplus
Sanfav K. Singh
Economics I
.
Effects of a Price FIoor
A binding price fIoor causes . . .
a surpIus because Q
S
>Q
D
.
ExampIes: The minimum wage,
agricuIturaI price supports, ..
.
The Minimum Wage
Quantity of
Labor
0
Wage
Equilibrium
wage
Labor
demand
Labor
supply
A Free Labor Market
Equilibrium
employment
Sanfav K. Singh
Economics I
.
Minimum
wage
The Minimum Wage
Quantity of
Labor
0
Wage
Labor
demand
Labor
supply
Quantity
supplied
Quantity
demanded
Labor surplus
{unemployment)
A Labor Market with a
Minimum Wage
.
What are some potentiaI
impacts of taxes?
Taxes are used to raise
money for the government.
Taxes discourage market
activity.
When a good is taxed, the
quantity soId is smaIIer.
Buyers and seIIers share
the tax burden.
But who bears the greater
burden-tax incidence.
Sanfav K. Singh
Economics I
.
3.00
Quantity of
Ice-Cream Cones
0
Price of
Ice-Cream
Cone
100 90
$3.30
Price
buyers
pay
D
1
D
2
Equilibrium
with tax
Supply, S
1
Equilibrium without tax
Impact of a 50 Tax Levied on Buyers...
2.S0
Price
sellers
receive
Price
without
tax
Tax {$0.50)
Demand Iunction, P a bQ where P price per unit charged
by sellers and paid by buyers.
P0.5 a bQ P (a-0.5) bQ, where buyers pay P0.5 per
unit, out oI which, sellers get P, and the government gets 0.5.
.
3.00
Quantity of
Ice-Cream Cones
0
Price of
Ice-Cream
Cone
100 90
S
1
S
2
Demand, D
1
Impact of a 50 Tax on Sellers...
Price
without
tax
2.S0
Price
sellers
receive
$3.30
Price
buyers
pay
Equilibrium without tax
A tax on sellers
shifts the
supply curve
upward by the
amount of the
tax {$0.50).
Tax {$0.50)
Equilibrium
with tax
Supply Iunction, P a bQ where P price per unit received.
P-0.5 a bQ P (a0.5) bQ, where buyers pay P per unit,
out oI which, sellers get P-0.5, and the government gets 0.5.
Sanfav K. Singh
Economics I
.
The Incidence of Tax
The incidence of a tax refers to who bears the burden
of a tax.
In what proportions is the burden of the
tax divided?
How do the effects of taxes on seIIers
compare to those Ievied on buyers?
The answers to these questions depend
on the eIasticity of demand and the
eIasticity of suppIy.
.
Elastic Supply, Inelastic Demand...
Quantity 0
Price
Demand
Supply
Tax
1. When supply is more
elastic than demand...
2. ...the
incidence of the
tax falls more
heavily on
consumers...
3. ...than on
producers.
Price without tax
Price buyers pay
Price sellers receive
Sanfav K. Singh
Economics I
.
Inelastic Supply, Elastic Demand...
Quantity 0
Price
Demand
Supply
Price without tax
Tax
1. When demand is more
elastic than supply...
2. ...the
incidence of
the tax falls more
heavily on producers...
3. ...than on consumers.
Price buyers pay
Price sellers receive
.
ELASTICITY AND TAX INCIDENCE
So, how is the burden of the tax
divided?
The burden of a tax faIIs more heaviIy
on the side of the market that is Iess
eIastic.
The incidence of a tax does not
depend on whether the tax is Ievied on
buyers or seIIers.
Sanfav K. Singh
Economics I
.
ELASTICITY AND ITS APPLICATION:
A Case Study of The Times Newspaper
There are Iour major national newspapers in UK:
The Times, Guardian, Dailv Telegraph, and
Independent.
They sell around 2.5 million copies daily.
In September 1993, The Times unilaterally lowered
its price by one-third Irom 45 pence to 30 pence.
Initially all the major competing newspapers kept their
prices constant as iI nothing had happened. Only later did
a price war break out.
.
A Case Study of The Times Newspaper
Price
(in pence)
Avg. daily sales Percentage
change (mid-
point Iormula)
Price Sales
Pre-
Sept. 93
Post-
Sept. 93
Pre-
Sept. 93
Post-
Sept. 93
1he 1imes
45 30 376836 448962 -40(30-
45)*100/((
4530)/2)
17.5
Cuardian
45 45 420154 401705 0 -4.5
Daily
1elegraph
45 45 1037375 1017326 0 -1.95
Independent
50 50 362099 311046 0 -15.2
Changes in the demand for newspapers
2196464 2179039
Sanfav K. Singh
Economics I
.
price elasticity of demand of 1he 1imes -17.5/40
-0.44
What will happen to the revenue of 1he 1imes
after price reduction?
It`ll obviously go down (inelastic demand). Daily sales
revenue of 1he 1imes fell from 169,576 to 134,689.
Remember, revenue will increase with reduction in
price only when absolute value of price elasticity of
demand is greater than 1.
The competing papers suffered, and the
Independent suffered most (15.2 loss of sales).
Independent was the closest substitute for the 1he
1imes (cross elasticity of demand +0.38).
A Case Study of The Times Newspaper
.
A Case Study of The Times Newspaper
Applying demand and supply concepts
Each newspaper sells all the copies that are
demanded at the price that it sets.
So, supply curve for each newspaper is horizontal (the
elasticity of supply is effectively infinite at the set price).
What will be the effect of 1he 1imes' price cut both
on 1he 1imes and on the Independent?
Aote: Since each newspaper is a distinct product, there is
no industry supply curve. Each supplier simply sets a price
and lets demand determine its sales.
Sanfav K. Singh
Economics I
.
A Case Study of The Times Newspaper
Demand for 1he 1imes and the Independent
Movement along the curve ShiIt oI the curve
.
A Case Study of The Times Newspaper
Since demand is inelastic for newspapers in the UK, it was
a good strategy for rival newspapers not to reduce their
prices.
Although the Independent suffered a daily loss of revenue a
little over 25000, it would have lost more by cutting its
price.
But, why 1he 1imes persisted with its price drop?
Increase in advertising revenue (which depends on
circulation) could be one of the important reasons.
Increase in daily advertising revenue should be more than
35000 (which is drop in sales revenue) to make price cut
profitable.
Sanfav K. Singh
Economics I
.
A Case Study of The Times Newspaper
Predatory pricing (charge a low price to force the rivals out
of business) could be another reason.
The Independent was indeed in financial difficulty before 1he
1imes' price cut announcement.
Since Independent was the closest substitute, predatory pricing can`t
be ruled out.
However, the Independent was taken over by the Mirror group,
which had more financial resources. Later it was sold to an Irish
newspaper group.
Therefore, if 1he 1imes had been following a predatory pricing
strategy, it failed.
Another possibility - 1he 1imes' manager might have
expected that its demand elasticity would increase over
time (that is, sales will increase at greater rate in the long-
run).
.
A Case Study of The Times Newspaper
Indeed, The Times did continue to increase its market
share.
In June 1994 the Telegraph reacted to The Times
growing market share by cutting its price, and the
Independent Iollowed.
The Times reduced its price Iurther, although prices
settled down at slightly higher levels soon aIter.
By July 1998 The Times price was 35p while other three
major papers were at 45p.
By July 1998 The Times sales were 800,000, almost double
what was in early 1994. In contrast, the Independent`s sales
were just 210,000, less than 60 .(long run elasticity ...)
Sanfav K. Singh
Economics I
.
A Case Study of The Times Newspaper
Market share oI major newspapers was virtually
unchanged during the next 5 years.
During mid-2002, sales oI The Times were running
just over 700,000 daily, the Guardian at just under
400,000, the Independent at about 220,000 and the
Telegraph just over 1 million.
From 2002 onwards, The Times has to compete not
only with other newspapers but also with the internet
and 24 hours news channels.
.
A Case Study of The Times Newspaper
Now, strategy to gain market share may be diIIerent than just
price cut (value added services, bundling and tying, etc.).
However, the aggressive pricing strategy adopted by The Times
in the early 1990s does appear to have had a very long lasting
eIIect on the sales pattern oI the UK newspapers.
The changes in the sales pattern established in the mid-1990s
are still evident, even though the price war is over. (In early
2007, The Times was priced at 65p while others at 70p.)
Think of a network good, once vou gain the market, vou can
continue to be market leader (unless product becomes
obsolete).
Sanfav K. Singh
Economics I
.
THANKS