Price Elasticity of Supply PDF

BM1704 PRICE ELASTICITY OF SUPPLY AND CONSUMER BEHAVIOR Price Elasticity of Supply According to a journal Economics Online, price elasticity of supply (PES) measures the responsiveness of quantity supplied to a change in price. The following equation can be used to cal...

BM1704 PRICE ELASTICITY OF SUPPLY AND CONSUMER BEHAVIOR Price Elasticity of Supply According to a journal Economics Online, price elasticity of supply (PES) measures the responsiveness of quantity supplied to a change in price. The following equation can be used to calculate PES: 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑜𝑜𝑜𝑜 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 (𝐸𝐸𝐸𝐸) = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 %∆𝑄𝑄𝑄𝑄 (𝑄𝑄𝑄𝑄2 − 𝑄𝑄𝑄𝑄1)/𝑄𝑄𝑄𝑄1 𝐸𝐸𝐸𝐸 = = %∆𝑃𝑃 (𝑃𝑃2 − 𝑃𝑃1)/𝑃𝑃1 Where: 𝑄𝑄𝑠𝑠 2 = Current quantity supplied 𝑄𝑄𝑠𝑠 1= Previous quantity supplied 𝑃𝑃2 = Current price 𝑃𝑃1= Previous price Values of Elasticity Price elasticity coefficient Supply elasticity Less than 1 Inelastic 0 Perfectly inelastic 1 Unitary More than 1 Elastic ILLUSTRATION: Consider a producer of organic juice. On the first month of the production, he sold 1,500 bottles at the price of ₱120. Positive feedback from consumers encouraged him to supply 2,500 bottles the following month at the price of ₱180. Calculate the price elasticity of supply. Price (P) Quantity Supplied (Qs) 120 1,500 180 2,500 SOLUTION: %∆𝑄𝑄𝑄𝑄 (𝑄𝑄𝑄𝑄2 − 𝑄𝑄𝑄𝑄1)/𝑄𝑄𝑄𝑄1 𝐸𝐸𝐸𝐸 = = %∆𝑃𝑃 (𝑃𝑃2 − 𝑃𝑃1)/𝑃𝑃1 05 Handout 1 *Property of STI Page 1 of 4  BM1704 (2,500 − 1,500)/1,500 = (180 − 120)/120 0.67 = = 1.34 0.50 KEYPOINTS: The supply is elastic based on the computed amount of 134%. Indifference Curves Assumptions of Consumer Theory Optimization – First, we assume that all individuals make consumption decisions with the goal of maximizing their total satisfaction from consuming various goods and services. In consumer theory, we will not allow consumers to either spend less than their income (no saving is allowed) or to spend more than their incomes (no borrowing is allowed). Information – The basic model of consumer theory seeks to explain how consumers make their purchasing decisions when they are completely informed about all things that matter. Specifically, the consumer is expected to know all the products and services available, as well as the corresponding utilities each product brings. It is also assumed that consumers know the prices of the goods and their income during the time period in question. Bundling – Consumer theory requires that consumers can rank (or to order) various combinations of goods and services according to the level of satisfaction associated with each combination. These combinations of goods are called consumption bundles. Two (2) important assumptions must be made about how consumers rank goods: o Complete – For any given pair or consumption bundles, consumers must be able to rank the bundles according to the level of satisfaction they would enjoy from consuming the bundles. A consumption bundle would be ranked higher than another bundle if it offers more utility. If two (2) bundles give a consumer the exact same amount of utility, they would have the same ranking, and the consumer is said to be indifferent to them. When a consumer can rank all conceivable bundles of commodities, the consumer’s preferences are said to be complete. o Transitive – This assumption means that the consumer’s choices are consistent in the following way: If Bundle A is preferred to Bundle B, and Bundle B is preferable to Bundle C, then it follows that Bundle A is preferred over Bundle C. Consumer preferences must be transitive, otherwise inconsistent preferences would undermine the ability of consumer theory to explain or predict the bundles consumers will choose. It also prevents consumers from being caught in a perpetual cycle where they never make a choice. Non-satiation – This concept assumes that consumers would always prefer to have more of the good, rather than less. It also implies that if Bundle A has more goods than Bundle B, Bundle A would be preferred. Indifference Curve - This is a set of points representing different combinations of goods and services, each of which providing an individual with the same level of utility. 05 Handout 1 *Property of STI Page 2 of 4  BM1704 Characteristics of an Indifference Curve: Indifference curves are downward sloping – The consumer obtains utility from both goods. When more of one good (Good X) is added, some of the other good (Good Y) is taken away to maintain the same level of utility. Indifference curves are convex – A convex shape means that as consumption of Good X is increased relative to consumption of Y, the consumer is willing to accept a small reduction in Y for an equal increase in X in order to stay at the same level of utility. Indifference curves are also bowed towards the origin, because consumers prefer a bit of everything rather than a lot of just one thing. Other Concepts in Consumer Theory Marginal utility – This is the additional utility that comes from consuming one more unit of a good, holding constant the amounts of all other goods consumed. Economists typically assume that as the consumption of a good increases, the marginal utility from an additional unit of a good diminishes. For points on a given indifference curve, all combinations of good yield the same amount of utility, so ∆𝑈𝑈 is 0 for all changes in X and Y that would keep the consumer on the same indifference curve. Keep in mind that total utility and marginal utility cannot be plotted on the same graph. Utility is ∆𝑈𝑈 measured in 𝑈𝑈, while is often called utils, while marginal utility is measured in , where y ∆𝑦𝑦 represents the product. Marginal rate of substitution – This is a measure of the number of units of Y that must be given up per unit of X added to maintain a constant level of utility. Expressed mathematically, the ∆ 𝑌𝑌 marginal rate of substitution is. If the marginal rate of substitution is 2, it means that the ∆ 𝑋𝑋 consumer is willing to give up two (2) units of Y for each unit of X added. The marginal rate of substitution diminishes along an indifference curve. Budget Constraints The budget constraint restricts consumer behavior by forcing the consumer to select a bundle of goods that is affordable. It defines the set of consumption bundles that a consumer can purchase with a limited amount of income. The Budget Line This is the line showing all bundles of goods that can be purchased at given prices if the entire income is spent. ∆ 𝑌𝑌 The slope of the budget line, , indicates the amount of Y that must be given up if one more unit ∆ 𝑋𝑋 of X is purchased. For every additional unit of X purchased, the consumer must spend P50 more on good X. To continue meeting the budget constraint, P5 less must be spent on good Y. The relationship between income (𝑀𝑀) and the amount of goods X and Y that can be purchased can be expressed as: 𝑀𝑀 = 𝑃𝑃𝑥𝑥 𝑋𝑋 + 𝑃𝑃𝑦𝑦 𝑌𝑌 Where: 𝑃𝑃𝑥𝑥 represents the price of the good X, and 𝑃𝑃𝑦𝑦 represents the price of good Y. 05 Handout 1 *Property of STI Page 3 of 4  BM1704 If the consumer chooses to spend all his/her income on good X, the equation will become: 𝑋𝑋 = 𝑀𝑀⁄𝑃𝑃𝑋𝑋 If the consumer chooses to spend all his/her income on good Y, the equation will be: 𝑌𝑌 = 𝑀𝑀⁄𝑃𝑃𝑦𝑦 Utility Maximization When analyzing consumer choice, we want to find the bundle of goods that: Maximize satisfaction Allows the consumer to live within the budget constraint The maximizing bundle must satisfy two (2) conditions: It must be on the budget constraint; and It must give the consumer the most preferred combination. Two (2) applications of the indifference curves: Gifts and gift certificates - People usually prefer gift certificates as presents rather than gifts of one type of good. Income and leisure: workers Corner solutions References Baye, M., & Prince, J. (2013). Managerial economics and strategy, 8e. New York : McGraw HIll. Bentzen, E., & Hirschey, M. (2016). Managerial economics. Hampshire: Cengage Learning. Cross Elasticity Demand. (n.d.). Retrieved from Investopedia : http://www.investopedia.com/terms/c/cross-elasticity-demand.asp. Economics Online. (n.d.). Price elasticity of supply. Retrieved on August 7, 2019, from https://www.economicsonline.co.uk/Competitive_markets/Price_elasticity_of_supply.html. Graham, R. (2013). Managerial economics for dummies. New Jersey: John Wiley & Sons. Thomas, C., & Maurice, S. (2015). Managerial economics: Foundations of business analysis and strategy. New York: McGraw Hill Education. 05 Handout 1 *Property of STI Page 4 of 4