Simplified Principles of Microeconomics PDF

Hazbo Skoko Simplified Principles of Microeconomics 2 Download free eBooks at bookboon.com Simplified Principles of Microeconomics 1st edition © 2015 Hazbo Skoko & bookboon.com ISBN 978-87-403-0993-5 Peer reviewed by Prof. Tim Brook PhD (math.) and El...

Hazbo Skoko Simplified Principles of Microeconomics 2 Download free eBooks at bookboon.com Simplified Principles of Microeconomics 1st edition © 2015 Hazbo Skoko & bookboon.com ISBN 978-87-403-0993-5 Peer reviewed by Prof. Tim Brook PhD (math.) and Elvira Skoko MSc (Psy.) 3 Download free eBooks at bookboon.com Simplified Principles of Microeconomics Contents Contents Introduction 9 Part 1 11 1 The structure of this book 12 2 How to read this book 13 3 Those two lines 14 3.1 Learning Objectives 14 Part 2 21 4 The First Principle: we can’t have everything we want 22 4.1 Learning objectives 22 4.2 Challenge 29 4.3 Summary 29 Aan de slag als trainee? Reageer voor 1 mei werkenbijapg.nl de grootste financiële dienstverlener in pensioen 4 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics Contents 5 The Second Principle: desire versus availability 30 5.1 Learning objectives 30 5.2 The demand side of the market 30 5.3 Conclusion 36 5.4 Challenge 37 6 The Third Principle: measuring responses 43 6.1 Learning Objectives 43 6.2 Example 1 44 6.3 Example 2 44 6.4 Example 1 again 45 6.5 Example 2 again 45 6.6 Example 3 47 6.7 Revenue and elasticity 49 5 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics Contents 7 The Fourth Principle: negotiations 56 7.1 Learning objectives 56 7.2 Competitive markets 56 7.3 Example 1 57 7.4 Example 2 57 7.5 Summary 59 7.6 Different market structures 63 7.7 PC: Perfect Competition 63 7.8 IC: imperfect competition 65 8 The Fifth Principle: costs 68 8.1 Learning objectives 68 8.2 Production factors 68 8.3 Total costs 68 8.4 Average costs 70 8.5 Marginal costs 71 8.6 Example 72 8.7 Marginal and average costs 73 Lighting, beyond illumination In 10 years 2/3 of people will be living in big cities. At Philips we focus on providing lighting beyond illumination to make these cities more livable, enjoyable and safe. #makeitmeaningful What will be your impact? www.philips.com/careers 6 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics Contents Part 3 78 9 Instead of a conclusion 79 10 About the author 80 11 Bibliography 81 12 Selected answers 82 12.1 Those two lines 82 12.2 The First Principle 82 12.3 The Second Principle 84 12.4 The Third Principle 85 12.5 The Fourth Principle 86 12.6 The Fifth Principle 87 13 Glossary 89 14 Endnotes 93 Unlock your potential eLibrary solutions from bookboon is the key eLibrary Interested in how we can help you? email [email protected] 7 Click on the ad to read more Download free eBooks at bookboon.com Dedicated to Ella Sirka and Rafael Goran Skoko 8 Download free eBooks at bookboon.com Simplified Principles of Microeconomics Introduction Introduction Several years ago a student rushed into my office without any consideration for my work or for the thoughts I had at the time. ‘Professor I hate economics, I don’t know anything about it. I have to take it for my degree and I’m scared’. She sat down on a chair and started sobbing helplessly. Economic subjects are often regarded as ‘hard, mathematical, full of formulas, dry and boring’. These are some of the descriptions you often hear when you ask students how they first perceive economic subjects. Economics class sizes are shrinking at most universities, and at some universities they have been abandoned altogether. If there are some economics subjects left in business colleges, the curriculum is adjusted to ‘please the students’ rather than to teach them about an important aspect of their daily lives. Why are economics subjects attracting such negative responses from students? Where is the problem? Is it really so hard to comprehend ‘those two lines’, the two different shapes on a graph, the famous demand and supply curves that can be used to explain almost everything in economics? This book proposes straightforward answers to these questions based on the way the subject is presented. The principles of economic theory have to be explained in terms of everyday activities. Everyday activities are, after all, what economics is all about! Yes, every day we use complicated economic laws without even noticing. This book aims to deal with these problems instead of changing the curriculum in an attempt to please the students. It uses a teaching method that has been proved to work all over the world. Economics is presented in simplified terms with real-life examples. In a few short chapters I shall explain the most important principles of microeconomics in the simplest possible terms. I have taught economics for more than two decades all over the world. In each country, with its distinct culture, customs and languages, my teaching philosophy has been the same: use simplicity, honesty, humour and show respect for differences in the learning styles of students. As the result of this approach, I have received accolades from students and heard many inspirational stories. Finally, here is one real-life example of my teaching approach. It can be described, in a nutshell, as presenting a concept in simple real-life terms, getting students to understand it, then leaving further applications for them to think about. 9 Download free eBooks at bookboon.com Simplified Principles of Microeconomics Introduction At one university I teach entrepreneurship as part of the economics syllabus. I was asked to talk about creativity. This is how the class went: Before the start of class, I had set the scene by placing objects around the room. There were balls, pieces of paper, paints, a saxophone, bottles: whatever I had been able to bring from my home. These objects would have appeared to be strategically placed but in fact they were in no particular order. The students seemed puzzled at the scene but they were making no comments when I entered the room. I introduced myself, then sat quietly at the desk apparently minding my own business, reading and making notes. During this time I was actually taking notes on what was happening in the class. During the first five minutes, the students were quiet, a bit confused about what was happening, expecting at every moment that I would start telling them how to be creative. During the next ten minutes, the students began to give up on me. They started texting under the desk, writing notes or checking their schedule for the next class. Overall they remained well behaved. During the rest of the time, the students found things to do with the objects that were scattered around the room. A few were painting; some sketched; a few were making paper planes, cutting coloured paper and gluing; some tried to play the saxophone; one student drew cartoon characters. In short, the students did whatever they liked, paying no attention to my presence whatsoever. At the end of the class I stood up and said ‘Thank you very much for your work. That was our class on creativity.’ The students turned around, putting aside whatever they were doing, and applauded. Later, of course, I spoke to them about practicalities, but not about creativity itself. (How could you teach anyone to be creative or to think?) Instead, I gave the students practical strategies to enable alternative thinking, to make themselves ready for an epiphany, to use technology, to follow their dreams, to establish a business and to employ people. Finally, I spoke to them about the five basic principles of economics to apply when establishing and running a business: the five principles discussed in this book. 10 Download free eBooks at bookboon.com  Part 1 11 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The structure of this book 1 The structure of this book This book is divided into three parts. Part 1 is the foundation for the main body of the book. It provides the visual vocabulary for the rest of the book. Part 2 is the core of the book. It deals with five essential principles of microeconomics. Part 3 contains a summary and the reference material. Part 1 The chapter ‘Those two lines’ explains a few basic concepts and how they are portrayed with one or two lines on a graph. Part 2 The first chapter in Part 2 discusses The First Principle: the economic fact of life that ‘we can’t have everything we want’. The next chapter, The Second Principle, deals with desires and availability, the economics of demand and supply. In the chapter on The Third Principle you will learn how to measure how our desires respond to changes in prices. The Fourth Principle will take you to the marketplace where those who want a product or service negotiate with those who produce or provide it. The final chapter on The Fifth Principle examines the types of costs we have to pay to produce something. In each chapter I first list the objectives of that chapter and what you will get out of it. Then I discuss the topic in simple terms, providing real-life examples. I also include exercises or questions you will need to increase your understanding of the topic. These few chapters will enable you to understand the basics of economics. They will provide a solid foundation for further studies in economics if you ever need to take a more comprehensive course. Part 3 Part 3 contains some handy reference material: the bibliography is a list of useful textbooks; the answers allow you to check your work after you have attempted the exercises in the text; the glossary explains some words that are frequently used in economics. 12 Download free eBooks at bookboon.com Simplified Principles of Microeconomics How to read this book 2 How to read this book Start by studying ‘Those two lines’ in the first chapter. Do not worry at this stage if there is something that does not make sense to you. Everything will become clearer as you study the five basic principles in Part 2 of the book. From time to time, as you progress through the rest of the book, come back to review the chapter on ‘Those two lines’. Throughout the book I suggest various activities for you to try. Be sure to make an honest attempt at each of these activities. Write down your answers, then compare your written answers with the answers at the end of the book. You will find many new words and phrases in this book, and also words and phrases that have special meanings in economics. I shall give you an careful explanation of each of these terms as it arises. Do not worry if you cannot remember everything the first time. On the other hand, if you are not sure of the meaning of a term, do not ignore it: check in the glossary at the end of this book, look it up in a dictionary or search for it on line. In some chapters I shall expand the discussion to round out the topic and perhaps also satisfy your curiosity. These extra sections are indicated by |a border around the text|. You may chose to skip the extra sections and focus only on the main body of the chapter. You will be equipped to study the later chapters, even without the extra material. 13 Download free eBooks at bookboon.com Simplified Principles of Microeconomics Those two lines 3 Those two lines 3.1 Learning Objectives After studying this chapter you will know how economists present many concepts using a single graph how the different directions of the lines on the graph explain different relationships how to draw a graph from a set of data. As I mentioned in the introduction, economics is about everyday activities. Everything in life has two sides to it, so too everything in economics has two sides: black-white, increase-decrease, birth-death, together-separate, head-tail and so on. Most concepts in economics can be represented by one or two lines. Economists are both rational and practical people so these lines are very useful tools for explaining certain relationships. Career opportunities for professionals. #PIONIERGEIST How our employees use their #PIONIERGEIST in their everyday work and master the tasks of the energy transformation together. Click and see! 14 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics Those two lines Consider an example. Picture a marketplace where a seller and a buyer are negotiating. For example, you could picture a vendor at a fruit market who has apples and a customer who wants to buy apples. Instead of just talking about prices and quantities, economists draw two intersecting lines. These lines represent the relationship between price and quantity. They are drawn in the area bordered by two axes. Figure 1 Economists use the convention that quantity, Q, is presented on the horizontal axis and price, P, is presented on the vertical axis. Quantities are shown in an appropriate unit such as kilograms for apples. Prices are shown in monetary units, for example dollars, pounds or euros. The point of intersection of these lines is called the equilibrium point. This is where the quantity demanded is equal to the quantity supplied. I want to show how a change in the price of apples corresponds to a change in the quantity of the apples the customer is willing to buy, so I need some data. Table 1 lists imaginary price and quantity data for the customer. Quantities in kg Prices in $ Q P 1 6 2 5 3 4 4 3 5 2 6 1 Table 1 15 Download free eBooks at bookboon.com Simplified Principles of Microeconomics Those two lines I can now mark these numbers on the axes and connect related numbers: Q=1 & P=6; Q =2 & P=5; and so on. In doing so I draw the black line showing the relationship between price and quantity. Figure 2 When there is a decrease in the price of apples, there is increase in the quantity the customer will buy. The variables price and quantity go in opposite directions, as one increases the other decreases, so their relationship is called an inverse relationship or a negative relationship. I use these terms interchangeably. (In other books, you may also see the terms opposite relationship and indirect relationship.) A defining characteristic of economics is that it is a scientific study of the behaviour of a typical, rational person. The black line shows how such a person behaves. When the price of a product decreases they buy more of it, the quantity demanded increases. Such a line in economics is called a demand curve. It does not have to be a straight line, as it is in Figure 2; it could be a curved or broken shape, as you will see when you get to Your Turn at the end of this chapter. Until now I have been talking about the behaviour of people who want a product or service and their willingness to pay a certain price for a certain quantity, the relationship between price and quantity. Furthermore, I have illustrated the inverse relationship with the black line in Figure 2: it is going downwards; a customer is willing to buy more when the price is lower. Remember, in economics you always have to consider two sides to any argument. So now, instead of thinking about the customer’s point of view, consider the seller of a product or service. Imagine yourself as a seller. How would you react to a change in price? Yes, exactly the opposite: the higher the price, the more you are willing to sell and, vice versa, the lower the price the less you are willing to sell. 16 Download free eBooks at bookboon.com Simplified Principles of Microeconomics Those two lines Reminder We can present everything in economics by a line or two on a graph. The line for the seller will look different from the line for the customer. The new line will show the opposite behaviour of a seller. Again I need some imaginary data, which I shall plot on another graph. Quantities in kg Prices in $ Q P 0 0 1 1 2 2 3 3 4 4 5 5 6 6 Table 2 From Table 2, you can see how a seller is happier when prices increase and is willing to sell more of the product with each increase in price. Again I take the numbers from the table and mark them on the axes. Then I connect related numbers: Q=1 & P=1; Q=2 & P=2; and so on. In doing so I draw the blue line in Figure 3 showing the relationship between price and quantity. When the price of a product is increased, the quantity supplied is increased. Since the variables price and quantity are going in same direction, such a relationship is called a direct relationship or a positive relationship. 17 Download free eBooks at bookboon.com Simplified Principles of Microeconomics Those two lines Figure 3 The blue line in Figure 3 shows how sellers behave. When the price of a product increases they offer more of the product for sale, the quantity supplied increases. Such a line in economics is called a supply curve. It does not have to be a straight line; it could be a curved or broken shape, as you will see when you do the exercises at the end of this chapter. JE VINDT DAT JE OOK VAN KLANTEN KUNT LEREN? VERTEL ABN AMRO zoekt trainees Bedrijven. Eigenzinnige meningen. Nieuwe ideeën. We zijn benieuwd wat jij als trainee kunt toevoegen aan de bank. En vooral: aan het succes van onze klanten. Natuurlijk staat daar tegenover dat je ook werkt aan je persoonlijke ontwikkeling. Daarom hebben we een traineeship op maat, met veel ruimte voor jouw inbreng. Nieuwsgierig geworden? Wij ook naar jou. Dus solliciteer naar het ABN AMRO- traineeship Bedrijven en vertel ons jouw ideeën op werkenbijabnamro.nl DE BANK ANNO NU 18 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics Those two lines That completes the story about the black and blue lines and how you can draw them to illustrate the behaviour of customers and suppliers. It completes the first stage of your journey towards an understanding of Simplified principles of microeconomics. Now it is time for you to do a few exercises and answer a few questions to increase your understanding of the topics I have covered so far. Your Turn Draw the graph based on these numbers: Prices in $ Quantities in kg P Q 2 3 3 5.5 4 6.5 6 7.5 9 8 Questions 1. Explain in your own words what economics is about. 2. Which type of relationship does the black line in Figure 2 represent? 3. What does vice versa mean? And why am I asking this question in book about economics? 4. Look carefully at these diagrams: Figure 4 a) Which of these graphs1 shows a negative relationship? b) Which of these figures show a quantity that remains unchanged even when the price changes? c) In which of these diagrams is the Q-P relationship positive rather then negative? 19 Download free eBooks at bookboon.com Simplified Principles of Microeconomics Those two lines Exercise Choose a product that is on sale at your local supermarket or on a website. Collect data about the prices and quantities of this product. Draw a graph depicting their relationship. Tips When you use graphs, always label them properly. Give each graph a title and label the axes appropriately. Interpreting a graph without labels is like trying to find a can of beans on a shelf full of unlabelled cans. Reading a graph should be as easy as reading text. Plotting a point on a graph is a straightforward process. Starting from 0 on each axis, find the point on the axis that corresponds to the given value, then follow straight lines from each of these points into the space bordered by the axes until the lines meet. For example, to find the point where Q=5 & P=7: on the Q axis find 5; on P axis find 7; imagine a straight line going vertically from 5 on Q; imagine a straight line going horizontally from 7 on P; find the point where these two lines meet. Further reading Look up one of the books in the bibliography or find any substantial economics textbook. You are sure to find a chapter on graphs near the beginning of the book. There are millions of websites dealing with graphs in economics. Search for ‘graphs in economics’ and follow some of the links. 20 Download free eBooks at bookboon.com  Part 2 21 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The First Principle: we can’t have everything we want 4 The First Principle: we can’t have everything we want 4.1 Learning objectives After studying this chapter you will be able to use one of the most important concepts in economics: opportunity costs recognise the opportunity costs of your actions illustrate opportunity costs on a graph Why can’t we have everything that we want? The answer to this question is very simple: there are not enough resources to satisfy everyone’s desires. In other words, human desires may be unlimited but resources are not. 22 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics The First Principle: we can’t have everything we want This is a fact of life. There are not enough resources for everybody to have everything they want; we have to make trade-offs. That is, we usually have to make some sacrifices and choose one thing over another. For example, I would like to have a small car for around the city and another car for long distances, but I cannot afford two cars. Which one should I choose? Well, most of the time I use my car to travel around town. Therefore I will choose a small town car and do without a bigger car that would have been more convenient for long distances. You have probably experienced numerous situations where you had to choose one product or one service over another. Perhaps you chose an iPhone instead of a Samsung, or an exotic holiday instead of deposit for a house, or one perfume instead of another, or you put money into a savings account to earn interest instead of investing it in a business venture. I am sure you can think of lots of examples. When you think like an economists, you make choices by considering both the costs and benefits of each action, and then you chose the alternative that leaves you better off. You will always make sure that the benefits of your choice are greater than costs. For example, if a shop 10 km away is offering a discount on the new iPad, you may decide not to buy one at a local shop after you have worked out that the cost of travelling 20 km is less than the discount. But there is a catch! When you choose one product over another, you face not only the obvious, direct cost of that choice but also an indirect cost, the value of the missed opportunity. When you choose one product over another, along with the price of that product, you also incur the costs of missing out on the product you sacrificed. For example, if I choose to invest my money in property instead of depositing it in the bank to earn interest, apart from the price of that property, I also incurred the cost of the lost interest. And, vice versa, if I deposit money in a bank instead of buying a property, the costs of earning the interest would be the missing value of having a property in my portfolio. Another example would be if I have chosen an iPhone over a Samsung smart phone, the cost of having an iPhone includes the missing value of having a Samsung smart phone. So, when you choose one thing instead of something else, you effectively incur costs which can be expressed as the value of the missed opportunity, the value you would have had if you had chosen the alternative. These costs are called opportunity costs. They may also be called implicit costs in contrast to the out of pocket expenses, the tangible costs, which are called explicit costs. Opportunity costs are unique to economics. By contrast, an accountant will only recognise explicit costs. 23 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The First Principle: we can’t have everything we want More examples: Suppose I choose to buy a PC for $800. The opportunity costs of having the PC is the value of something else I could have used the $800 for. If the second best choice was to deposit $800 in a savings account, the opportunity costs of the PC would be the interest I would have earned on the $800 but did not. If I was not writing this chapter, I would be spending time with my family. The opportunity costs of writing this chapter is the time with my family that I have sacrificed. If I had wanted to sleep in this morning, the opportunity costs of writing this chapter would have been an hour or two of missed sleep. In short, every choice in life has opportunity costs. The world’s resources are limited, so individuals, firms and governments have to make choices about what to have, what to produce and what to fund. Every decisions involves the sacrifice of the benefits of an alternative that was not chosen. Often there are no direct outlays associated with the opportunity costs of a decision. Opportunity costs do not have to be expressed in monetary units, they may be express terms of time, satisfaction or other values. Your Turn What are your opportunity costs if you are stuck in a traffic jam on a motorway for an hour on your way to work? Questions 1. What is the opportunity cost of spending an hour reading this chapter, if the best alternative would be to earn income at $100 per hour? 2. If a company is capable of producing Product A and Product B, what are the opportunity costs for the company if it uses all its resources to produce Product A? 3. Suppose you have spent three hours searching for a new laptop and found the lowest price is $300. What are your explicit and implicit costs of buying that new laptop? Case 1 The government was tossing up between building a new hospital and buying a new ship for the navy. They do not have enough money in the budget for both, so they had to choose which project to fund. After long discussions and a vote in parliament, they have decided, by majority vote, to buy a new ship for the navy. a) What did the government sacrificed to buy the new ship for the navy? b) What could the government have done instead of buying the ship? c) What was the best alternative to buying a ship for the navy? d) What are the opportunity costs of the ship? 24 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The First Principle: we can’t have everything we want Case 2 Your friend is well known for loving to sleep in for an hour, and for having a nap for an hour each afternoon. a) What are the opportunity costs of your friend attending the morning class? b) What are the opportunity costs of your friend doing afternoon shopping? c) What are the opportunity costs of your friend watching an early morning TV show? d) What are the opportunity costs of your friend watching the comedy review in the late afternoon? Case 3 1 esaC (Case 1 the other way around) The government was tossing up between building a new hospital and buying a new ship for the navy. They do not have enough money in the budget for both, so they had to choose which project to fund. After long discussions and a vote in parliament, they have decided, by majority vote, to build a new hospital. a) What did the government sacrificed to build the new hospital? b) What could the government have done instead of building the new hospital? c) What was the best alternative to building a new hospital? d) What are the opportunity costs of building the new hospital? #daaromwerkikbijAPG Wij realiseren een zo hoog mogelijk rendement op pensioenvermogen. Ga jij ook voor resultaat en heb je oog voor duurzaamheid? Ga naar werkenbijapg.nl werkenbijapg.nl de grootste financiële dienstverlener in pensioen 25 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics The First Principle: we can’t have everything we want Reminder Earlier I said that in economics we can illustrate concepts by one or two lines in the space bordered by horizontal and vertical axes (see Figure 1 in the previous chapter). Reminder Economists are rational people, simple people (I know you are laughing now) and practical people so, whenever they can, they use graphs and other shortcuts as tools to explain concepts. Economists call these tools economic models. Economic models simplify reality by including assumptions. For example, if I want to talk about opportunity costs, I shall assume that everything else is held constant and that there is a choice between only two products. In reality, you would have to choose between lots of different products and services, but reducing it to only two products make the discussion simpler. Instead of saying ‘while everything else is held constant’ in an economic model, economist will often use the phrase ceteris paribus. I have it in mind every time I give you an example. To make the economic principles clear, I change one thing at a time, ceteris paribus. Be careful: I shall not say ceteris paribus again, you will have to say it to yourself every time I give you an example. Reminder Resources are limited, so you frequently have to chose one alternative over another and therefore encounter opportunity costs. I shall illustrate this statement with a single line on a graph. It is like the lines in Figure 2 in the previous chapter, but this time it uses a different coordinate system. Instead of P and Q, the axes represent the quantities A and B of two alternative products. Figure 5 26 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The First Principle: we can’t have everything we want In this economic model I shall assume that there are only two alternatives: Product A and Product B. The model illustrates the trade-offs when choosing one of these products instead the another. For example, if I chose to have 7 of Product A, I cannot chose any of Product B, as you can see from the point A=7 & B=0 (and vice versa, as you can see from the point A=0 & B=7). However there are some combinations of the two products that I could chose. For example, I could choose a combination of 4 of Product A and 3 of Product B, as you can see from Point F (A=4 & B=3). Figure 5 shows all the possible combinations, from Point C to Point H on the black line: A=1 & B=6, A=2 & B=5 and so on. In addition, the black line illustrates the results of a scarcity of resources; it shows the trade-offs that the scarcity entails; it shows the opportunity costs. By choosing to have Product A, I have to sacrifice Product B. If I want to have seven Product A, I have to sacrifice seven Product B and vice versa. Moreover, every increase of one Product A entails a corresponding sacrifice of one Product B.2 In other words, the opportunity cost of having one Product A is sacrificing one Product B. The opportunity cost in this example is 1. Because of the quantities of these two products have an inverse relationship, the black line slopes downwards, which means that when either product is increased the other is decreased. Not only does any increase in Product A entail a sacrifice of Product B but also, vice versa, any increase in Product B entails a sacrifice of Product A, as you can see as you move upwards on the black line, for example from Point D to Point C. Questions Questions 4 to 8 refer to Figure 5 4. What are the opportunity costs of having Product A? 5. What are the opportunity costs of having Product B? 6. What are the opportunity costs of having one less of Product B? 7. What are the opportunity costs of having one additional Product A? 8. At the combination illustrated by Point G, how much would it costs to have five Product A? Reminder Each concept in economics has two sides. So far I have considered things from the customer’s point of view. I have shown how customers face trade-offs and therefore face opportunity costs. However, the same concept applies to companies and governments when they act as suppliers. 27 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The First Principle: we can’t have everything we want I shall illustrate the opportunity costs of a supplier using the same diagram (Figure 5), but first I need to adjust my assumptions. Instead of talking about a customer acquiring one product or another, I shall consider a firm that has to choose which combination of products to produce with the limited resources it has available. Figure 5 again 28 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics The First Principle: we can’t have everything we want The next change is that the black line is now called the production possibility frontier or PPF curve. The PPF curve shows how much of a product it is possible to produce with the available resources. The firm can produce seven Product A and no Product B, or no Product A and seven Product B, or any other combination represented by the points C to H.3 Any government, too, has to face limits to its resources. It has to choose which products to acquire, for example a navy ship or a hospital. In this case it is acting as a customer. It also has to chose which projects to fund, for example infrastructure or public goods, in which case it is acting as a supplier. 4.2 Challenge In the previous example, opportunity costs were constant (at 1). What would the PPF curve look like if there were increasing opportunity costs? Use the data in Table 3 to draw the PPF curve. A B 0 160 20 140 40 100 60 40 70 0 Table 3 4.3 Summary In this chapter I illustrated one of the facts of life: we cannot have everything we want because of there limited resources. Limited or scarce resources force us to make a choice about which products and services to acquire and which to sacrifice. Each time we make a choices, we incur implicit costs, which in economics are called opportunity costs. These are the costs of the foregone alternative. Finally, I have shown that not only customers encounter scarcity but also firms and governments. 29 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Second Principle: desire versus availability 5 The Second Principle: desire versus availability 5.1 Learning objectives After studying this chapter you will be able to make use of another important concept in economics: demand and supply recognise the actions of suppliers and customers distinguish between changes in demand and changes in the quantity demanded distinguish between changes in supply and changes in the quantity supplied 5.2 The demand side of the market Economics is all about understanding how incentives and disincentives affect typical human behaviour, how economic humans might behave in an everyday situation. Suppose you have been buying one 300 ml bottle of water for $6 every day. One morning you find that the price has gone down to $5, so you are enticed to buy two bottles. The next morning the price of water goes down to $4 and you are tempted to buy three bottles. As the price goes down even further, you buy more and more, as you can see in Table 4. Finally, when the price goes down to $1 you buy six bottles.4 Prices in $ Quantities in units P Q 6 1 5 2 4 3 3 4 2 5 1 6 Table 4: demand schedule Now think about it the other way round. Every day you have been buying six 300 ml bottles of water for $1 each. One morning you find the price has gone up to $2, so you are only willing to buy five bottles. The next morning the price goes up to $3 and you decide you can only afford four bottles at that price. For the sake of argument again, suppose the price goes up to $4 and you buy three bottles; when the price is $5 you buy two bottles. Finally, when the price reaches $6 you buy one only bottle. 30 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Second Principle: desire versus availability As you know by now, you can illustrate this behaviour as a line on a graph. Whenever you can replace human judgement by a formula or a graph, you should at least consider it (Kahneman, 2012, p. 233). The numbers for you as a customer (Table 4) just happen to be the same as those for the supplier I discussed in the previous chapter (Figure 5), but in this case the axes represent Quantity, Q, and Price, P, instead of Product A, and Product B. Figure 6 A move downwards towards 0 on the P axis in Figure 6 is equivalent to a reduction in the price. You can see that if the price goes down the customer is enticed to buy more of the product and, vice versa, if the price goes up the customer will reduce the quantity demanded. As always, I connect the related Q and P points: Point C (Q=1 & P=6), Point D (Q=2 & P=5) and so on. The resulting black line is the demand curve. This demand curve shows how a typical, rational customer would behave in the market situation I described above. The curve is downward sloping, which indicates an inverse relationship between the price and quantity. Questions Questions 1–4 are based on Figure 6, which illustrates your willingness to pay for a certain item. 1. How much you are willing to pay for three items? 2. If the price is $3, how many items will you buy? 3. How many items would you take if they were free? 4. If the price is $7, how many items would you buy? 31 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Second Principle: desire versus availability To summarise, when the price goes down you are more willing to buy more of a product and, vice versa, when the price goes up you reduce the quantity you demand. This principle is called the Law of Demand. The Law of Demand states that there is an inverse relationship between the price and quantity. When the price is incr easing, the quantity demanded is decreasing and vice versa. The Law of Demand explains the behaviour of customers when they are faced with changing prices. So far I have discussed the behaviour of a customer when the price of the product changes. In Figure 6, the demand curve shows that when the price changes the quantity demanded changes in the opposite direction. For example, going down the demand curve from Point C to Point D, you can see that when the price goes down from $6 to $5, the quantity demanded goes up from one unit to two units. Going in the opposite direction from Point F to Point E, you can see that when the price goes up from $3 to $4, the quantity demanded goes down from four units to three units. It might seem like just a number but it means a whole lot more to us. MASTERS IN FINANCE RANKED 3RD WORLDWIDE BY FINANCIAL TIMES 2016 Master in Finance Choose the option that fits your profile and discover an innovative methodology of learning at the forefront of global financial education for over 35 years. Boost your career with a highly international and interactive environment in HIGH FINANCIAL one of the best Business Schools in the World. PROFILE CLASS MASTER IN MASTER IN ADVANCED GLOBAL MASTER EXECUTIVE MASTER OPTIONAL TRIPS FINANCE FINANCE IN FINANCE IN FINANCE TO LONDON, NEW YORK & GHANA Format: FULL-TIME Format: FULL-TIME Format: BLENDED Format: BLENDED GLOBAL ALUMNI Av. experience: 1 YEAR Av. experience: 5 YEARS Av. experience: 12 YEARS Av. experience: 10 YEARS NETWORK Intake: SEPTEMBER Intake: APRIL Intake: OCTOBER Intake: SEPTEMBER www.ie.edu/mif [email protected] 32 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Second Principle: desire versus availability Remember When the price of a product or a service changes, the QUANTITY DEMANDED changes in the opposite direction, which is illustrated by a MOVEMENT ALONG the demand curve. When you observe movements up or down the demand curve, you know there are changes in the quantity demanded. Changes in the quantity demanded caused by changes in the price of a product are represented graphically by movement along the demand curve. Don’t get confused Movement along the demand curve is caused by changes in the price of the product and corresponding changes in the quantity demanded. Questions 5. What does movement along the demand curve illustrate? 6. Which factor causes changes in the quantity demanded? 7. What causes an upward movement along the demand curve, and what causes a downward movement along the demand curve? Aside ‘Whether you think you can or you think you can’t, you’re probably right.’ ‘If you fail to plan, you plan to fail.’ Shortcut I know this shortcut may seem confusing at first, but it can help you to remember the idea: ΔP ⇒ ΔQd ⇒ Movement along The Greek capital letter delta, Δ, means a change, so ΔP means a change in Price and ΔQd means a change in Quantity demanded. You can read the shortcut as: A change in price causes a change in the quantity demanded, which implies a movement along the demand curve. I am sure you need a break after that! Try listening to Everybody Hurts by the band R.E.M. 33 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Second Principle: desire versus availability Reminders The Law of Demand states that when the price is increased, the quantity demanded is decreased and vice versa: there is an inverse relationship between price and quantity. When the price of a product or service changes, the QUANTITY DEMANDED changes in the opposite direction, which is illustrated by MOVEMENT ALONG the demand curve. A change in price causes a changes in the quantity demanded, which is illustrated by a movement along the demand curve. So far I have only discussed the behaviour of customers when there is a change in the price of the product itself. I shall go on to consider what else might affect your desire for a particular product or service, for example cans of Coke, but first I shall use some imaginary figures to plot the demand curve. 34 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Second Principle: desire versus availability Figure 7: demand for Coke Point F, for example, shows that you are willing to buy four cans of Coke at $3 each. If the price changes upwards, the quantity demanded goes down and vice versa, which is seen as movement along the demand curve. There is nothing new so far, but now things get a bit more complicated… You notice that the price of a can of Pepsi in the same market is $1.50. For the price of one can of Coke you could get two cans of Pepsi. Consequently, it is reasonable to expect that you will reduce your demand for Coke. (No, I did not say ‘quantity demanded’; I was talking about the demand itself, and you will see why in a moment.) I assume here that you are one of a number of customers. I also assume that customers do not have a preference for one brand over the other, in which case the alternative product, Pepsi, is call a substitute. With these assumptions I can say that customers will buy cans of Coke only when the substitute, Pepsi, is not available at a lower price. What will happen to the demand curve in this case? Instead of moving along the curve to indicate a change in price, I have to change the demand curve itself to show the change in demand. 35 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Second Principle: desire versus availability Figure 8: shifts in demand for Coke The dotted black line in Figure 8 is the original demand curve for Coke. The solid red line shows the new, reduced demand for Coke when the alternative, Pepsi, is cheaper. The solid green line shows the opposite case when a can of Pepsi costs $3 and a can of Coke costs $1.50, and there is a corresponding increase in the demand for Coke. This example shows that non-price factors can cause a shift in the demand curve. Non-price factors are everything except the price of the product itself, they may include the price of substitutes, customer preferences, income, the number of customers, climate change and many other influences. 5.3 Conclusion A change in the price of a product cause a movement along the demand curve, while all other non-price factors cause the demand curve to shift. Shortcuts ΔP ⇒ ΔQd ⇒ Movement along demand ΔnonP ⇒ ΔD ⇒ Shift in demand 36 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Second Principle: desire versus availability Questions 8. What is the difference between a movement along the demand curve and a shift in the demand curve? 9. If the weather influences the demand for a product, how would that be represented on a graph? 10. If the price of a product changes, what changes will you observe in the demand curve? 11. You want to buy a ball but you cannot afford it because your income is limited. How would that situation be reflected in the demand curve for the ball? 12. What can cause movement along a demand curve? 13. What is the difference between a change in demand and a change in the quantity demanded? How is this illustrated on a demand curve? 14. What does the Greek capital letter delta (Δ) mean? 15. What factors can cause shifts in the demand curve? 5.4 Challenge Is it possible to have both a change in the quantity demanded and a shift of the demand curve at the same time? 37 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Second Principle: desire versus availability Availability: the supply side of the market Earlier I talked about customers; in this section I shall switch to thinking as a supplier. In any market, supply represents the other side of the coin to demand. You will find it much easier to master the discussion of supply if you have already mastered the demand side. To understand the supply side, you take almost everything you learnt about the demand side and turn it upside down. You have already seen how customers dislike price increases and how this dislike is reflected in reductions in the quantity demanded. On the other hand, suppliers like to see an increase in the price of their product, and their liking is reflected in an increase in the quantity supplied. When the price of a product goes up, more of that product is made available in the market. Example Now suppose you have been selling one 300 ml bottle of water for $1 every day. One morning you find that the price has gone up to $2, so you are enticed to sell two bottles. The next morning the price of water goes up to $3 and you are tempted to sell three bottles. As the price goes up even further, you offer more and more for sale, as you can see in Table 5. Finally, when the price goes up to $6 you sell six bottles.5 Prices in $ Quantities in units P Q 1 1 2 2 3 3 4 4 5 5 6 6 Table 5: supply schedule In short, when the price of a product goes up, you are willing to supply more of it and, vice versa, when the price goes down you are willing to supply less. Remember Whenever you can replace human judgement by a formula or a graph, you should at least consider it (Kahneman, 2012, p. 233). With that advice in mind, I shall plot the data from Table 5 on a graph. 38 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Second Principle: desire versus availability Figure 9: supply curve The blue line in Figure 9 shows how you behave as a supplier. Such a line in economics is called a supply curve. When the price increases you offer more for sale, the quantity supplied increases. This is called The Law of Supply. The Law of Supply states that there is the direct relationship between price and quantity. When the price is increasing, the quantity supplied is increasing. The Law of Supply describes the behaviour of suppliers when they are faced with changing prices. Suppliers have to decide how many products they are willing to supply at any given market price. These decisions are represented by the points on the supply curve. As you can see from the blue line in Figure 9, when the price is $1 you are willing to supply 1 unit of the product to the market, but if the price is increased to $2 you will supply 2 units of the product and so on. Remember When the price of the product or service changes the QUANTITY SUPPLIED changes in the same direction, which is illustrated by MOVEMENT ALONG the supply curve. When you observe a movement up or down the supply curve, you know there is a change in the quantity supplied. When a change in the price of a product causes a change in the quantity supplied, it results in a movement along the supply curve. 39 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Second Principle: desire versus availability Don’t get confused A movement along the supply curve is caused by a change in the price of the product and the corresponding change in the quantity supplied. Questions 16. What does movement along the supply curve illustrate? 17. Which factor causes changes in the quantity supplied? 18. What causes upward movements along the supply curve and what causes downward movement along the supply curve? Shortcut ΔP ⇒ Δ Qs ⇒ Movement along supply The Greek capital letter delta, Δ, means a change, so ΔP means a change in Price and ΔQs means a change in Quantity supplied. You can read the shortcut as: A change in price causes a change in the quantity supplied, which implies a movement along the supply curve. 40 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Second Principle: desire versus availability Reminders The Law of Supply states that when the price is increased, the quantity demanded is increased: there is a direct relationship between price and quantity. When the price of a product or service changes, the QUANTITY SUPPLIED changes in the same direction, which is illustrated by MOVEMENT ALONG the supply curve. A change in price causes a changes in the quantity supplied, which is illustrated by a movement along the supply curve. So far I have only discussed the behaviour of suppliers when there is a change in the price of the product itself. I shall now consider what else might affect your willingness to supply a particular product or service. You may have noticed a number of suppliers of the same product, not just your company. If there are more firms producing the same or similar products, there may be an oversupply in the market. In this case, increased competition may cause you to reduce supply. In the current digital age, new technology is being introduced to enable cheaper production methods. Lower production costs for product will increase the supply of that product. For example, new software used to be delivered on a CD or DVD. I am sure you remember that. Now software licences are offered on line and new software is downloaded directly to your computer, tablet or smart phone. This cuts the supplier’s production costs, increases productivity and increases supply. Reductions in the supplier’s input costs also increase supply. The expectations of suppliers can also affect supply. For example, if news of a new version of Apple’s iPhone is leaked to the media, Samsung might reduce the price of their smart phones to increase their sales before the new iPhone is released. What would happen to your supply curve in Figure 9 in any of these cases? The supply will be increased or decreased depending which of these factor apply and how they influence supply. 41 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Second Principle: desire versus availability Figure 10: shifts in supply In Figure 10 the dashed blue line is the original supply curve and the solid red line represents a new, reduced supply. This reduction in supply could have been caused by increased competition or by increased input prices making the production more expensive. The solid green line represents a new, increased supply. An increase in supply could have been caused by reduced input prices or by increased productivity. Non-price factors can cause a shift in the supply curve. Non-price factors are everything except the price of the product itself, they may include the number of suppliers, technological advances, input prices, taxes, supplier expectations and many other influences. Conclusion A change in the price of a product cause a movement along the demand curve, while all other non- price factors cause the supply curve to shift. Shortcuts ΔP ⇒ Δ Qs ⇒ Movement along supply ΔnonP ⇒ ΔD ⇒ Shift in supply Your Turn Answer questions 8, 9, 10, 12, 13 and 15 again, but this time replace demand with supply throughout the questions. By now you are probably humming ‘We don’t need no education’ from Pink Floyd’s Another Brick in the Wall. If so, always remember the words from The Police, ‘Every breath you take…I’ll be watching you’ 42 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Third Principle: measuring responses 6 The Third Principle: measuring responses 6.1 Learning Objectives After studying this chapter you will know how to use the concept elasticity of demand measure customers’ responsiveness to price changes differentiate between elasticity of demand, elasticity of supply and elasticity of income. In the previous chapter you saw how customers and suppliers react when the price of a product changes and also how they respond to other factors. You saw that customers react negatively to price increases but suppliers react positively to price increases. When the price increases, customers reduce the quantity demanded but suppliers increase the quantity supplied. The relationship between price and quantity is negative for customers and positive for suppliers. 43 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Third Principle: measuring responses Sometimes you will need to measure the magnitude of these responses. For example, as a company’s senior economist you may be asked to prepare a report on whether to increase or decrease the price of a product in order to increase the company’s revenue. Unless you know how to measure the magnitude of customer responses, you can only guess which way to adjust the price. You know that customers react negatively to an increased price, so if you increase the price some of your customers will switch to the competition. In this case you might decrease the company’s revenue instead of increasing it. In contrast, if you decrease the price you will get more customers to buy your product, but an increased customer base may not be enough to offset the decrease in price. In that case, too, you might decrease the company revenue. You need to know how to make accurate measurements of customer responses to changes in price. 6.2 Example 1 Every week you buy petrol for your car at $1 per litre. You wake up one Monday morning to the sound of the the radio news and you are immediately worried by an announcement of a 20% increase in the price of petrol. That means the price will now be $1.20 per litre. You could decide to drive only on weekends, reducing your petrol consumption by 15% from the current 100 litres per week. In the opposite situation, if prices go down by 20% to $0.80, would you jump up out of the bed, singing your favourite tune, and calculate how much you will save on petrol every week? 6.3 Example 2 Every morning you buy a packet of chewing gum for $1. One day you read that the price of a packet is about to go up by 20%. You might react to this news by reducing consumption by 80%. In these examples I have illustrated some possible reactions of a customer to price changes. In the first case, the 15% reduction in consumption was proportionally smaller than the 20% price change; in the second case, the 80% reduction in consumption was drastically larger than the 20% price change. In this section I shall discuss the relative size of changes in the price and in the quantity demanded. In other words I shall examine the percentage by which the quantity demanded falls when the price rises by a certain percentage. Economists use the concept of price elasticity of a product or service to measure sensitivity of quantity demanded. Elasticity is a measure of the proportional change in the quantity demanded compared to the proportional change in price. Algebraically, elasticity of demand is the ratio of the percentage change in quantity to the percentage change in price. It is normally expressed as a fraction: 44 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Third Principle: measuring responses percentage change in quantity demanded elasticity of demand is percentage change in price in short where Ed is the elasticity of demand; %ΔQd is the percentage change in the quantity demanded; %ΔP is the percentage change in the price. 6.4 Example 1 again In the first example, the original price of petrol, P0, was $1.00 and the new price, P1, was $1.20, so The original quantity of petrol, Q0, was 100 L and the new quantity, Q1, was 85 L so There is a negative relationship between the price and the quantity demanded, which is why there is a negative sign in %Δqd = -15%. However, economists drop the negative sign when calculating elasticity of demand, so This means there is a 0.75 percent change in the quantity demanded for each one percent change in the price. In other words, if the price is increased by 1%, the quantity of demand decreases by 0.75%. Economists understand the negative relationship between price and quantity demanded, so they express the elasticity of demand as 0.75, not -0.75. 6.5 Example 2 again In the second example, the original price of chewing gum, P0, was $1.00 and the new price, P1, was $1.20, so There was an 80% reduction in the quantity demanded: 45 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Third Principle: measuring responses There is a negative relationship between the price and quantity demanded, which is why there is a negative sign in %ΔQd = -80%. However, economists drop the negative sign when calculating elasticity of demand, so The elasticity of demand is four. There is a four percent change in the quantity demanded for each one percent change in the price. In other words, if the price is increased by 1% the quantity of demand decreases by 4%. There is a logic behind dropping the minus sign. Elasticity is a measure of sensitivity to change. Something can be more or less sensitive, or even completely insensitive, but there is no such thing as negative sensitivity. The minus sign would only be there for the sake of mathematical correctness, indicating the negative relationship between price and quantity demanded. From now on I shall drop the negative sign without mentioning it. 46 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Third Principle: measuring responses 6.6 Example 3 Suppose P0 = $1, P1 = $1.20, Q0 = 10 and Q1 = 8. Then These three values, 0.75, 4 and 1, illustrate three types of price elasticity. If the elasticity is less than one, economists say the demand is inelastic; if the elasticity is greater than one, they say the demand is elastic; if the elasticity is equal to one, they say the demand has unit elasticity. Ed < 1 ⇒ inelastic demand Ed > 1 ⇒ elastic demand Ed = 1 ⇒ unit elasticity Even though it is a straight line, the black line in Figure 11 is a demand curve that illustrates different elasticity in different parts of the curve. Figure 11: elasticity of demand Going down this line, from left to right, the demand curve displays a range of values for elasticity. From $40 to down to $20, the demand is elastic; at $20 there is unit elasticity; further down, the demand is an inelastic. 47 Download free eBooks at bookboon.com  Simplified Principles of Microeconomics The Third Principle: measuring responses Recall that the price elasticity of demand is a ratio of percentage changes. At the upper end of the demand curve, quantities demanded are lower and prices are higher, so a small percentage change in price can cause a large percentage change in quantity. For example, if the price is increased from $30 to $35, the quantity demanded is reduced from 10 to 5. Putting these numbers into the formula for price elasticity, confirms that demand is elastic towards the top of the curve. The opposite will happen towards the other end of the curve. A price increase from $5 to $10 would cause a reduction in quantity demanded from 35 to 30. In that case, %Δ𝑄𝑄 16% 0.16 Ed = %Δ𝑃𝑃𝑑𝑑 ≈ 50%≈ 0.32100% < 1, which which confirms that confirms that demand demand is inelastic is inelastic towards towards theofbottom the bottom of the curve. the curve. Apart from these three types of elasticity, there is a theoretical possibility of Apart from perfectly these three elastic demandtypesor of perfectly elasticity, there is a theoretical inelastic demand. possibility of perfectly elastic demand or perfectly inelastic demand. Figure 12: price elasticity of demand a) perfectly inelastic demand b) perfectly elastic demand A completely vertical section Figure 12: price elasticityof a demand curve would represent perfectly of demand inelastic demand. For example, a medication might be so important to its consumers A completelythat thesection vertical quantity demanded, of a demand Q0 , would curve would be perfectly represent the same regardless inelastic demand.ofFor example, price. a medication might be so important to its consumers that the quantity demanded, Q , would be the 0 Insame regardless contrast, of price. a completely flat section would represent perfectly elastic demand. For example, a product would have perfectly elastic demand if the quantity demanded In contrast, was theoretically a completely infinite flat section when would the price represent was perfectly $100, elastic but reduced demand. to zero For example, a product aswould soonhave as the price went up to $100.01. perfectly elastic demand if the quantity demanded was theoretically infinite when the price was $100, but reduced to zero as soon as the price went up to $100.01. Revenue and elasticity I began this chapter by asking you to imagine that you were advising a firm how to increase its revenue. You have to decide whether to increase or decrease the price of the firm’s product. You now need to apply your knowledge about elasticity of demand to tackle this problem. The total revenue (or just the revenue) is the 48 total amount of money a firm gets from the sale of its products or services. Download For example, free eBooks a firm sold 100 units of a at bookboon.com product at $5 each. To get the revenue from these sales, multiply the quantity sold by the sale price. The total revenue, TR , in this case is $500. Simplified Principles of Microeconomics The Third Principle: measuring responses 6.7 Revenue and elasticity I began this chapter by asking you to imagine that you were advising a firm how to increase its revenue. You have to decide whether to increase or decrease the price of the firm’s product. You now need to apply your knowledge about elasticity of demand to tackle this problem. The total revenue (or just the revenue) is the total amount of money a firm gets from the sale of its products or services. For example, a firm sold 100 units of a product at $5 each. To get the revenue from these sales, multiply the quantity sold by the sale price. The total revenue, TR, in this case is $500. TR = P × Q = $5 ×100 = $500. To show how revenue can be linked to elasticity, I shall consider three separate cases: elastic demand, inelastic demand and unit elasticity. This e-book is made with SETASIGN SetaPDF PDF components for PHP developers www.setasign.com 49 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Third Principle: measuring responses Figure 13: elastic demand Ed > 1 As you saw earlier, the flatter the demand curve, the more elastic the demand is. In Figure 13, when the price was decreased from $10 to $4, the quantity demanded was increased from 3 to 20. Comparing these proportional changes, you find that the price is elastic: The total revenue, TR, is calculated by multiplying the number of units sold by their price, P × Q. In addition, you know from geometry that you get the area of a rectangle by multiplying its height by its width. For example, the area of the rectangle, H, below the curve is calculated as P × Q = 4 × 20 = 80. Therefore the total revenue at any point on the demand curve is equal to the area of the rectangle under the curve at that point. Now compare the revenue at the original price, the area of K, with the revenue at the reduced price, the area of H. The original revenue was P × Q = 10 × 3 = 30 and the new revenue is P × Q = 4 × 20 = 80. Revenue has increased by $50. When demand is elastic, a reduction in the price will result in an increase in the revenue and, vice versa, an increase in the price will result in a decrease in revenue. There is a negative relationship between price and revenue. 50 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Third Principle: measuring responses Ed > 1: P reduced ⇒ TR increased In contrast, when demand is inelastic, there is a positive relationship between price and revenue. Ed < 1: P reduced ⇒ TR decreased Figure 14: inelastic demand Ed < 1 From Figure 14 you can see that the new revenue, H, is smaller than the original revenue, K. Finally, when there is unit elasticity of demand there is no change in the total revenue. In this case H = K. Ed = 1: P reduced ⇒ TR unchanged Figure 15: unit elasticity Ed = 1 51 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Third Principle: measuring responses Questions 1. What does elasticity mean? 2. If the proportional change of quantity demanded is larger than the proportional change in price, which type of elasticity is this? 3. If the proportional changes in quantity demanded and price are equal, which type of elasticity is this? 4. Explain in your own words why the price elasticity of demand always has a negative sign. 5. If you found the price elasticity of demand was 3, how would you interpret it?6 52 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Third Principle: measuring responses Further discussion Before I go any further I need to clarify two points. First, why do you have to use percentages when calculating elasticity? The answer is that elasticity would otherwise be a ratio of two different units of measurement. Price is expressed in monetary units while quantity may be expressed in kilograms, litres, metres or any other convenient unit. It makes sense algebraically for the units in a ratio to be the same. Economists avoid this problem by using percentages to calculate elasticity because a percentage is a unit-less measure.6 Secondly, when you measure a change, you move along the demand curve from the Point A to Point B, but you could also calculate the change by moving in the opposite direction from B to A. One way would represent an increase in price, the other way would represent a decrease in price. The distance on the graph is the same in each case, but the algebraic formula will give a different value for the elasticity. Suppose, for example, that in going from Point A to Point B you observe an increase in price from $5 to $10. This is a 100% increase in price. However, going the other way, a decrease from $10 to $5 its a decrease of 50%. I shall illustrate this anomaly by returning to Example 1 where a increase in the price of petrol caused a fall in the quantity demanded. In this example, the original price of petrol, P0, was $1.00 and the new price, P1, was $1.20, so The original quantity of petrol, Q0, was 100 L and the new quantity, Q1, was 85 L so ∴ Going the opposite way, a decrease in the price of petrol caused an increase in the quantity demanded. In this case, the original price of petrol, P0, is $1.20 and the new price, P1, is $1.00, so The original quantity of petrol, Q0, is 85 L and the new quantity, Q1, is 100 L so ∴ As you can see, the price elasticity of demand comes out as 0.75 when you use an increasing price, and that means demand is inelastic. However, when you deal with the same change in the other direction, the price elasticity comes out as 1.06, and that means demand is elastic. To avoid this anomaly and calculate a more precise value for elasticity, you can use average changes in price and quantity. The formula for elasticity becomes so elasticity of demand is 0.89. This more precise value means that demand for petrol is inelastic. 53 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Third Principle: measuring responses Price elasticity of supply Remember there is a positive relationship between price and quantity supplied, in contrast to the negative relationship between price and quantity demanded. The negative relationship between price and quantity demanded means there is always a negative sign in the result when you calculate elasticity of demand, even though economists drop the negative sign. The positive relationship between price and quantity supplied means you always get a positive result when you calculate the price elasticity of supply, so there is no negative sign to drop. Apart from that, the interpretation is very similar. You calculate the elasticity of supply, Es, using the percentage change in the quantity supplied, %Δ Qs. For example This result means that for each percent increase in price, the quantity supplied would increase by 0.14 percent. And, vice versa, for each 1% decrease in price, the quantity supplied would decrease by 0.14%. Income elasticity The next type of elasticity is a measure of the relationship between the quantity demanded and a customer’s income. Income elasticity, Ei, relates a change in quantity, %Δ Qd, to a change in income, %ΔI, rather than to a change in price: Elasticity of income can be positive or negative depending on whether there is a positive or negative relationship between quantity and income. It is positive if the quantity demanded increases whenever income increases. In that case the product in question is called a normal product or a normal good7. Otherwise, if the quantity decreases whenever income increases, the elasticity of income is negative and the product is called an inferior product or an inferior good. Cross price elasticity The last type of elasticity I shall mention is cross price elasticity. It is like the price elasticity of demand except that it considers the changes in the quantity demanded of one product in response to changes in the price of another product. Cross price elasticity, Ec, is the ratio of the percentage change in the quantity of Product 1, %ΔQ1, to the percentage change in the price of Product 2, %ΔP2: For each one percent change in the price of Product 1, the quantity demanded of Product 2 changes by Ec percent. For example, suppose This means that for each 7% increase in the price of Coke the quantity demanded of Pepsi increases by 1%, or for each 1% increase in the price of Coke, the quantity demanded of Pepsi increases by 0.14%. In cross price elasticity, the sign of the calculated result is very important. A positive value for Ec indicates a positive relationship between Q1 and P2; a negative value indicates a negative relationship. If their cross price elasticity is positive, products are called substitutes; if their cross price elasticity is negative, products are called complements. In the previous example cross price elasticity was 0.14, which is positive, so Coke and Pepsi are substitute products. If you calculate the cross price elasticity of coffee and sugar it might come out as a negative number because coffee and sugar go together. In that case coffee and sugar would be classified as complementary products. 54 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Third Principle: measuring responses Questions7 5. If you found the price elasticity of demand was 3, how would you interpret it? 6. If you found the price elasticity of supply was 3, how would you interpret it? 7. If you found that income elasticity was 3, how would you interpret it? 8. If the cross-price elasticity of two products is positive what can you conclude about these products? 9. If the cross-price elasticity of two products is negative what we can conclude about these products? 10. Explain the difference between price elasticity of demand and price elasticity of supply. Site of ENGINEERS, UNIVERSITY production GRADUATES & SALES PROFESSIONALS Junior and experienced F/M Total will hire 10,000 people in 2014. Why not you? Are you looking for work in process, electrical or other types of engineering, R&D, sales & marketing or support professions such as information technology? We’re interested in your skills. Join an international leader in the oil, gas and chemical industry by applying at www.careers.total.com Copyright : Total/Corbis More than 700 job openings are now online! Site of reflexion 55 Click on the ad to read more Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Fourth Principle: negotiations 7 The Fourth Principle: negotiations 7.1 Learning objectives After studying this chapter you will know how to make use of the concepts market and market forces recognise the point where demand and supply quantities are equal identify different market structures Until now I have discussed each of ‘Those two lines’ separately: demand and supply. In this chapter I shall bring them together. Using demand and supply together, you can illustrate how markets work efficiently, and you can apply economic theory to many areas of the real life. First I shall describe markets and market forces. Then I shall bring them together in a balance of demand and supply. 7.2 Competitive markets Markets are places where customers meet suppliers. These are not only physical places like the local fresh food market or the local stock exchange but also cyberspace markets like eBay or NASDAQ. The behaviour of customers in a market is represented by the demand curve and the behaviour of suppliers is represented by the supply curve. A competitive market is one where customers and suppliers negotiate the price and quantity based on their respective goals, free from coercion and outside interference. Suppliers want to sell their product at the highest possible price, while customers want to buy the product at the lowest possible price. When these two opposing market forces meet, buyer and seller have to negotiate until they agree on a price and a quantity. In other words, they have to find the price and the quantity at which both the customer is willing to buy and the supplier is willing to sell. These agreed figures are called the market clearing price and the market clearing quantity. In short, they have to negotiate until the quantity demanded and the quantity supplied are equal. This is represented by the equilibrium point on the graph, the point of intersection of the demand and supply curves. 56 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Fourth Principle: negotiations 7.3 Example 1 Imagine you are at a fairground where, apart from the usual fun activities, there is a tug-of-war. On one side there are customers and on the other side there are suppliers. Each side is trying to pull the other over a line in the middle. After several attempts by each side to overpower the other, they settle at one point where neither side can pull the other any further. At that point they have equal strength, they are in balance, they are at the point of equilibrium. 7.4 Example 2 One morning you want to buy a kilo of tomatoes from a supplier at the local fresh produce market. The ticket price is $6 per kilogram but you think the price is too high. You negotiate a price reduction which the supplier will accept, but the supplier will only accept it if you agree to buy more tomatoes. You settle on a price of $3.50 per kilo for 3.5 kg of fresh tomatoes. Because you and the supplier have reached the point of equilibrium, these are the market clearing price and the market clearing quantity for tomatoes on this occasion. Figure 16 shows this market negotiation process graphically by plotting demand and supply curves together in one coordinate system. Figure 16: the market for tomatoes 57 Download free eBooks at bookboon.com Simplified Principles of Microeconomics The Fourth Principle: negotiations The market price for tomatoes started at $6 per kilo and, at that price, there were 6 kg of tomatoes on offer. This is the quantity supplied at Point B. However, at that price there was only demand for one kilo of tomatoes, the quantity demanded at Point A. The quantity supplied was greater than the quantity demanded. At $6 per kilo there was a surplus of 5 kg of tomatoes, which is represented by the distance from Point A to Point B. Later the price was reduced to $5. At this price suppliers were willing to supply 5 kg but there was still an oversupply of tomatoes. There was a surplus of 3 kg which is represented by the distance from Point C to Point F.8 Further negotiations lead to the next iteration of the price: $4 per kilo with 4 kg as the quantity supplied. Finally the customers and suppliers settled on a price of $3.50 and a quantity of 3.5 kg where the quantity demanded is equal to quantity supplied. They reached the point of equilibrium. Now imagine that things had gone in the opposite direction. Suppose the morning star