Econ 210 Exam 2

Front 1

Price elasticity of demand

Back 1

Percentage change in the amount of something demanded caused by a one-percent price change.

Front 2

Calculation of elasticity of demand

Back 2

ED = Percentage change in the quantity demanded of a good / Percentage change in the price of that good

= [(QN - QO) / ( QN + QO)] / [(PN - PO) / ( PN + PO)]

Where QN and PN are new quantity demanded and price, and QO and PO are original quantity demanded and price.

Called the mid-point formula.

Front 3

Interpretation of elasticity of demand

Back 3

Suppose ED = -2.

ED = -2 means that a one-percent increase in the price of tennis shoes caused a 2 percent decrease in quantity demanded. Conversely, if the price were to decrease by one percent, quantity demanded would increase by 2 percent.

These two situations can be generalized by saying that a one-percent change in the price of tennis shoes would cause a 2 percent change in quantity demanded.

The number -2 in this situation is also referred to as the elasticity coefficient.

Whatever the numerical value of the elasticity coefficient, it always represents the percentage amount by which quantity demanded of a good would be expected to change if the price of that good were to change by one percent.

Front 4

The use of price elasticity of demand

Back 4

Firms use price elasticities of demand to determine the effect of price changes on sales revenues.

Governments use price elasticities of demand to determine the effect of sales tax changes on tax revenues.

Front 5

Classification of demand based on price elasticity

Back 5

Perfectly inelastic demand: ED = 0

Quantity demanded remains the same regardless of the percentage change in price.

Inelastic demand: -1 < ED < 0

Percentage change in quantity demanded is less than percentage change in price.

Unitarily elastic demand: ED = -1

Percentage change in quantity demanded is equal to percentage change in price.

Elastic demand: -∞ ≠ ED < -1.

Percentage change in quantity demanded is greater than percentage change in price.

Perfectly elastic demand: ED ≈ -∞.

ED is virtually undefined, which means even a small percentage change in price can cause a very large percentage change in quantity demanded.

Inelastic, elastic, and unitarily elastic demands represent most goods and services in the real world.

Because a larger negative number is smaller than a smaller negative number but represents greater elasticity of demand (e.g., -3 vs. -2), absolute values are sometimes used instead of negative values.

When the percentage change in quantity demanded is less than a percentage change in price, demand is inelastic.

When the percentage change in quantity demanded is greater than a percentage change in price, demand is elastic.

When the percentage change in quantity demanded is equal to a percentage change in price, demand is unitarily elastic.

Front 6

Determinants of price elasticity of demand

Back 6

Substitutes - the more substitutes available for a good, the more elastic its demand is and vice versa.

Necessity vs. luxury - necessities have less elastic demand than luxuries.

Narrowly vs. broadly defined goods - goods that are narrowly defined have more elastic demand (coke) than goods that are broadly defined (e.g., food).

The larger the proportion of income spent on a good, the more elastic its demand (e.g., the demand for cars is more elastic than the demand for clothing).

The longer the time period available for making adjustments or decisions (e.g., finding substitutes or changing consumption behavior), the more elastic will be the demands for goods and services.

Front 7

Impacts of the price elasticity of demand on the relationship between price changes and total revenue

Back 7

When demand is elastic, total revenue increases in response to a price decrease because the revenue increasing effect of a percentage increase in quantity demanded dominates the revenue decreasing effect of a percentage decrease in price.

When demand is inelastic, total revenue decreases in response to a price decrease because the revenue increasing effect of a percentage increase in quantity demanded is dominated by the revenue decreasing effect of a percentage decrease in price.

When demand is unitarily elastic, total revenue does not change in response to a change in price because the effect of a percentage change in price on total revenue is offset by the effect of the corresponding percentage change in quantity demanded. Thus, when demand is unitarily elastic, price changes are revenue neutral.

Front 8

Income elasticity of demand

Back 8

Percentage change in the amount demanded of something caused by a one-percent change in consumer income.

Front 9

Calculation of income elasticity of demand

Back 9

EI = Percentage change in the quantity demanded of a good / Percentage change in consumer income

= [(QN - QO) / ( QN + QO)] / [(IN - IO) / ( IN + IO)]

Where QN and IN are new quantity demanded and consumer income, and QO and IO are original quantity demanded and consumer income.

Front 10

Interpretation of income elasticity of demand

Back 10

Suppose EI = 1.

EI = 1 means that a one-percent increase in per capita consumer income caused a one-percent increase in quantity demanded.

Conversely, if per capita consumer income were to decrease by one percent, quantity demanded would decrease by one percent.

Front 11

Normal goods

Back 11

Normal goods: Goods whose demands increase when consumer income increases and vice versa.

Most goods are normal, such as milk, new cars, vacation, air travel, and restaurant foods.

Front 12

Inferior goods

Back 12

Inferior goods: Goods whose demands decrease when consumer income increases and vice versa.

Examples include used cars, bus travel, fast foods, and rental apartments.

Front 13

Cross-price elasticity of demand

Back 13

The percentage change in the quantity demanded of a good caused by a one-percent change in the price of another good.

Front 14

Calculation of cross-price elasticity of demand

Back 14

EXY =
Percentage change in the quantity demanded of good X / Percentage change in the price of good Y

= [(QNX - QOX) / ( QNX + QOX)] / [(PNY - POY) / ( PNY + POY)]
where QNX and QOX are new quantity and original quantity demanded of good X , and PNY and POY are new price and original price of good Y.

Front 15

Interpretation of cross-price elasticity of demand

Back 15

ECP = 0.43 means that a one-percent decrease in the price of Pepsi caused a 0.43 percent decrease in the quantity demanded of Coke.

Conversely, if the price of Pepsi were to increase by one percent, quantity demanded of Coke would increase by 0.43 percent.

Front 16

Substitute goods

Back 16

If the demand for one good increases as a result of an increase in the price of another good and vice versa, the two goods are substitutes.

Examples include Coke and Pepsi, chicken meat and turkey meat, butter and margarine, and wheat bread and rye bread.

Front 17

Complimentary goods

Back 17

If the demand for one good decreases as a result of an increase in the price of another good and vice versa, the two goods are complements.

Examples include milk and cereal, bread and meat slices, wine and cheese, and tennis balls and tennis rackets.

Front 18

Production process

Back 18

The conversion of inputs into output(s) using a specific process or technology.

Front 19

Short run

Back 19

The time period in which at least one input is fixed in quantity.

Front 20

Long run

Back 20

The time period in which all inputs are variable in quantity.

Front 21

Fixed inputs

Back 21

Inputs whose quantities used remain fixed regardless of the quantity of output produced.

Examples include land, buildings, machinery, and management or long-term contractual labor.

Front 22

Variable inputs

Back 22

Inputs whose quantities used vary depending on the quantity of output produced.

Examples include raw materials, wage or temporary labor, and utility.

Front 23

Total product in the short run

Back 23

(TP or Q) - The total quantity of output produced from a specific total amount of an input or a combination of inputs.

Front 24

Average product in the short run

Back 24

(AP) - The amount of output per unit of an input. AP = Q/Qi, where Q is total quantity of output and Qi is the total quantity of an input used to produce Q.

Front 25

Marginal product in the short run

Back 25

(MP) - The amount by which total output (Q) changes when the quantity of an input is changed by one additional unit. MP = ΔQ/ΔQi, where Δ represents a change in quantity.

Front 26

The law of diminishing marginal product

Back 26

• Given a set of fixed inputs, as larger and larger quantities of a variable input are used to increase output, each additional unit of the variable input eventually generates smaller and smaller quantity of additional output.
• The reason is that the fixed inputs become increasingly limited in proportion to the variable input, thereby decreasing the productivity of the additional units of the variable input.

Front 27

Total cost in the short run

Back 27

(TC) - The sum of all the costs incurred in producing a specific total quantity of output (Q).

TC = Total Fixed Cost (TFC) + Total Variable Cost (TVC)

Front 28

Average cost in the short run

Back 28

(AC) - Cost per unit of output.

AC = TC/Q

Front 29

Marginal cost in the short run

Back 29

(MC) - The amount by which TC changes when the quantity of output (Q) changes by one additional unit.

MC = ΔTC/ΔQ.

Front 30

Costs in the short run equations

Back 30

Given TC = TFC+TVC,
TC/Q = TFC/Q + TVC/Q
AC = AFC + AVC, where AFC = Average Fixed Cost = TFC/Q and AVC = Average Variable Cost = TVC/Q

Given TC = TFC + TVC,
TFC = TC - TVC
TVC = TC - TFC

Given AC = AFC + AVC,
AFC = AC - AVC
AVC = AC - AFC

Front 31

Explicit costs

Back 31

Out-of-pocket costs of resources not owned by the firm. For example, hired labor wages, material costs, rents, utility costs, license fees, and taxes.

Front 32

Implicit costs

Back 32

Costs of resources owned by the firm. For example, cost of owner’s time spent on the business, cost of funds supplied by the owner, and costs of buildings or equipment supplied by the owner.

Front 33

Economic costs

Back 33

The sum of explicit and implicit costs. Economic costs include all the costs and are equal to total costs.

Front 34

Relationship between productivity and costs in the short run

Back 34

Productivity and costs are inversely related.

When AP is increasing, AC decreases; when AP is maximum, AC is minimum; and when AP is decreasing, AC increases.

When MP is increasing, MC decreases; when MP is maximum, MC is minimum; and when MP is decreasing, MC increases.

Front 35

Production and costs in the long run

Back 35

Because all inputs are variable in the long run, production is more flexible. Flexibility in production makes it possible to reduce the cost of production to the level that may not be normally possible in the short run. Thus, firms may achieve higher level of efficiency in the long run than in the short run.

Front 36

Relationship between plant size and returns to scale

Back 36

• In the long run, plant size is variable, even though it is fixed in the short run.
• As the plant size is increased, it will involve increases in the quantities of inputs used.
Returns to scale refers to the impact of an increase in plant size on the output.

Increasing Returns to Scale - Output increases by a larger percentage than the increase in plant size.

Decreasing Returns to Scale - Output increases by a smaller percentage than the increase in plant size.

Constant Returns to Scale - Output increases by the same percentage as the increase in plant size.

Front 37

Relationship between returns to scale and long-run average cost

Back 37

Returns to scale and long-run average cost are inversely related.

With increasing returns to scale, long-run average cost decreases as the plant size increases. This is called economies of scale.

With decreasing returns to scale, long-run average cost increases as the plant size increases. This is called diseconomies of scale.

With constant returns to scale, long-run average cost does not change as the plant size increases. This is called constant economies of scale.

Front 38

Characteristics of perfectly competitive markets

Back 38

Large number of firms.

Each firm small relative to the market.

Homogeneous or identical products.

Easy entry into the market.

Front 39

Pricing behavior of firms in a perfectly competitive market

Back 39

The price charged by a perfectly competitive firm is determined by market demand and market supply.

Firms in perfect competition are price takers because each firm is small relative to the market and goods are perfect substitutes for one another.

A firm in a perfectly competitive industry must take the market price because if it tried to increase its price above the market price, it may lose all customers as they would buy from other sellers.

On the other hand, if a perfectly competitive firm charges a price lower than the market price, the firm will make less profit than it could at the market price. Thus, it would not make economic sense for the firm to charge a price lower than the market price.

Front 40

Relationship between price and marginal revenue for firms in a perfectly competitive market

Back 40

For perfectly competitive firms, MR is always equal to P because each firm can sell its product as much as it wants to without reducing the price.

TR = PQ
MR =
ΔTR/ΔQ = Δ(PQ)/ΔQ = PΔQ/ΔQ = P

Front 41

General rule for determining optimal output for firms in any market and its application to firms in a perfectly competitive market

Back 41

For firms operating in any market, optimal output occurs where MR = MC when MC is increasing.

For firms operating in perfectly competitive markets, this rule can be modified as P = MC when MC is rising because MR = P at all levels of output.