ECON_CH 5 & 6

Elasticity of Demand

• Elasticity is a measure of the responsiveness of demand to changes in price or other influential factors.
• The formula for price elasticity of demand is: %change in quantity demanded / %change in price.
• Elasticity is a general concept used to quantify the response in one variable when another variable changes.

Determinants of Demand

• Availability of substitutes: the more substitutes available, the more elastic the demand.
• Luxuries versus necessities: luxury goods tend to have relatively elastic demand, while necessities have inelastic demand.
• The time dimension: in the longer run, demand is likely to become more elastic.

Income Elasticity of Demand

• Income elasticity of demand is a measure of the responsiveness of demand to changes in income.
• The formula is: %change in quantity demanded / %change in income.

Point Elasticity

• Point elasticity is a measure of elasticity that uses the slope measurement.
• The formula is: ΔQ / Q1 ÷ ΔP / P1.

Elasticity and Total Revenue

• Total revenue is the product of price and quantity: TR = P × Q.
• When price increases, quantity demanded decreases, and vice versa.
• When demand is inelastic, a price increase increases total revenue, but a price cut reduces total revenue.
• When demand is elastic, a price increase reduces total revenue, but a price cut increases total revenue.

Types of Elasticity

• Perfectly inelastic demand: quantity demanded does not respond at all to a change in price.
• Perfectly elastic demand: quantity demanded drops to zero at the slightest increase in price.

Graphical Representation

• The graph shows the relationship between the demand curve and the elasticity of demand.
• Point elasticity changes along a demand curve.
• The slope of the demand curve is not a useful measure of responsiveness.

Household Behavior and Consumer Choice

• The chapter focuses on understanding household decisions in the product market and labor market.
• The concept of constrained choice is a central theme in this analysis.

Assumptions

• Two key assumptions are made:
  • Perfect knowledge: households possess knowledge of product qualities and prices, and firms have all available information regarding wages, capital costs, technology, and output prices.
  • Perfect competition: an industry structure where many firms produce virtually identical products, and no firm is large enough to control prices.

Firm and Household Decisions

• Households demand output in output markets and supply labor and capital in input markets.
• Figure II.1 illustrates the circular flow diagram, which excludes the government and international sectors for simplicity.

Understanding the Microeconomy and the Role of Government

• The chapter lays the foundation for understanding how the economy works, with a focus on household behavior and firm decisions.

Saving and Borrowing

• Changes in interest rates affect household behavior in capital markets.
• Empirical evidence suggests that saving tends to increase as the interest rate rises.

Key Concepts

• Budget constraint: the limit on a household's spending based on its income and prices.
• Choice set or opportunity set: the set of goods and services a household can afford to buy.
• Financial capital market: the system where suppliers of capital (households) and demanders of capital (firms) interact.
• Homogeneous products: undifferentiated outputs that are identical to or indistinguishable from one another.
• Labor supply curve: a curve showing the quantity of labor supplied at different wage rates.
• Law of diminishing marginal utility: the idea that the additional utility gained from consuming one more unit of a good decreases as the quantity consumed increases.
• Marginal utility (MU): the additional utility gained from consuming one more unit of a good.
• Perfect competition: an industry structure where many firms produce virtually identical products, and no firm is large enough to control prices.
• Perfect knowledge: the assumption that households possess knowledge of product qualities and prices, and firms have all available information regarding wages, capital costs, technology, and output prices.
• Real income: the purchasing power of a household's income.
• Total utility: the total satisfaction gained from consuming a certain quantity of a good.
• Utility: the satisfaction gained from consuming a good or service.
• Utility-maximizing rule: the principle that households make decisions to maximize their overall satisfaction.

Chapter Overview

• Chapters 6-8 focus on household and firm decision making in simple, perfectly competitive markets.
• Chapters 9-11 analyze how firms and households interact in output markets and input markets to determine prices, wages, and profits.
• Chapter 12 discusses market imperfections and the role of government.
• Chapters 13-19 cover noncompetitive market structures, externalities, public goods, uncertainty, and income distribution.