Government-Set Prices (Price Floor and Price Ceiling) and Elasticity:
Governments sometimes intervene in markets, in response to dissatisfaction from some groups in society, by instituting price ceilings or price floors. This intervention can have unintended—and sometimes harmful—consequences.
Elasticity measures the sensitivity of one variable to a change in some other variable. The rate of change is not a desirable measure of sensitivity because it does not take into account the relative size of the changes occurring. Elasticity is a better measure of sensitivity because it does take the relative size of the changes into account.
Price elasticity of demand measures the sensitivity of quantity demanded to a change in price. The greater the absolute value of this number, the more sensitive quantity demanded is to price. Demand can be classified as inelastic, unitary elastic, or elastic. A special case of inelastic demand is perfectly inelastic demand, shown by a vertical demand curve. A horizontal demand curve shows perfectly elastic demand—a special case of elastic demand.
A straight line demand curve can be used to show that elasticity changes as we move along a demand curve. This happens because elasticity is generally not a characteristic of a demand curve, but rather is a measure of price sensitivity for a particular price change along that curve.
When demand is price inelastic, total revenue moves in the same direction as price. When demand is price elastic, total revenue moves in the opposite direction as price. When demand is unitary elastic, total revenue remains the same as price changes.
Two key determinants of price elasticity of demand are the availability of substitutes and the importance of the good in the buyer’s budget.
Besides price elasticity of demand, there are two other important demand elasticities. Income elasticity of demand measures the sensitivity of quantity demanded to a change in income. Income elasticity of demand is positive for normal goods and negative for inferior goods. Additionally, income elasticity is positive but less than 1 for economic necessities and is greater than 1 for economic luxuries. Cross-price elasticity of demand measures the sensitivity of quantity demanded of one good to a change in the price of a second good. Cross-price elasticity of demand is positive if the two goods are substitutes, and is negative if the two goods are complements.
Price elasticity of supply measures the responsiveness of quantity supplied to a change in the price of the good itself. Supplly can be elastic, unitary elastic, or inelastic. Price elasticity of supply varies with the ease of modification of product lines, with how broadly the good is defined, and with the time horizon considered.
Taxes enable governments to provide public services, correct income and wealth distribution inequities, and discourage use of particular goods. A tax on a particular good or service is called an excise tax. An excise tax shifts the market supply curve upward by the amount of the tax. The burden of an excise tax is determined by the elasticity of demand and supply.
The importance of the concept of elasticity is highlighted with several extended examples. The first—in the body of the chapter—discusses the market for illegal drugs. A key fact—the demand for drugs is price inelastic—explains why policies that restrict drug supply (rather than demand) leads to undesirable side-effects. Mass transit and oil crises are also discussed. Another example—in the Using the Theory section—shows how price and income elasticities help us understand the variability of farmers’ incomes.
Consumer Choice
Consumer Choice 5 analyzes choices faced by consumers and takes two approaches to analyzing the decisions of individual households.
In one approach, the concept of marginal utility together with the budget constraint explains how an individual chooses the best combination of different goods or services. Generally, this theory of consumer behavior explains how an individual chooses between any two alternatives.
A budget constraint identifies which combinations of goods and services a consumer can afford with a limited budget, at given prices. Changes in income will cause the budget constraint to shift, while a change in a price will cause the budget constraint to rotate.
Utility is the satisfaction that a consumer gets from consuming goods or services. Marginal utility is the increment in utility an individual gets from an additional unit of a good. The law of diminishing marginal utility states that the marginal utility of a thing to anyone diminishes with every increase in the amount one already has.
The concept of utility helps us to characterize peoples’ preferences. In our theory of consumer choice, we focus on the assumptions that people have preferences, that preferences are transitive, and that marginal utility is positive. A consumer will maximize utility by choosing the point on the budget line where marginal utility per dollar is the same for both goods.
Goods can be classified as normal or inferior depending on how the consumer responds to changes in income. When price changes, and the budget line rotates, we can distinguish two separate effects on the consumer: the substitution effect and the income effect. In the case of a normal good, these two effects work together to support the law of demand; in the case of an inferior good, the two effects oppose each other. Still, even when goods are inferior, we expect the law of demand to hold: price increases virtually always cause consumers to decrease the quantity demanded.
The market demand curve is the horizontal summation of the individual demand curves of every consumer in the market.
In some circumstances, our model of consumer choice will not work well, at least not without some modification. Problems that complicate these basic models of consumer behavior are uncertainty, imperfect information, borrowing or saving, unselfish behavior, and judging quality by price.
A broader challenge to our model of consumer choice has emerged from a new subfield of economics known as behavioral economics. Behavioral economics tries to incorporate the approaches of psychology and sociology to answer economic questions. It incorporates notions about people’s actual thinking process in making decisions, and points out that such behavior by large groups of people can alter a market’s equilibrium.
Indifference curve analysis as a second approach to consumer theory, and can be read in place of the approach in the body of the chapter. The main difference between this approach and the approach developed in the body of the chapter is that indifference curve analysis does not use the concept of marginal utility. It is able to come to the same conclusions as the marginal utility approach, but with fewer and less restrictive assumptions.
An indifference curve represents all combinations of two categories of goods that make the consumer equally well off. Consumers are assumed to prefer “more” to “less” of every good, so that any point on a higher indifference curve is preferred to any point on a lower one. The marginal rate of substitution between two goods along any segment of an indifference curve is the absolute value of the indifference curve’s slope along that segment. It tells how much of one good must be traded for the other good in order to keep the consumer indifferent to the change. A consumer’s indifference map is the complete set of her indifference curves.
The optimal combination of goods for a consumer is that combination on the budget line at which the indifference curve has the same slope as the budget line. We can also use indifference curve analysis to derive the individual’s demand curve.
Production and Costs
A business firm is an organization that specializes in production. Production is the process of combining inputs to make outputs. Firms sell outputs to receive revenue. Profit is what remains after costs are deducted from revenue.
Production is usually organized within firms, rather than entirely through markets, to take advantage of further gains from specialization, lower transactions costs, and risk reduction from diversification. These gains lead to lower costs and reduced risks. Lower costs allow firms to charge lower prices, which attract customers, and to pay higher wages, which attract employees. Reduced risks also attract potential owners. Bigger is not always better, however. There are problems associated with “bigness,” and limits on firm expansion.
For each different combination of inputs, the production function tells us the maximum quantity of output a firm can produce over some period of time. It is useful to categorize firm decisions into long-run decisions and short-run decisions. The long run is a time horizon long enough for a firm to vary all of its inputs. In the short run, at least one of the firm’s inputs cannot be varied.
In the short run, a firm looks for the least-cost combination of variable inputs needed to produce a given amount of output. In the case of a single variable input (labor), the amount needed is determined by the production function. Total product is the maximum quantity of output that can be produced from a given combination of inputs. The marginal product of labor is the additional output produced when one more worker is hired. The relationship between these two concepts is important to master, in order to understand a firm’s short-run behavior.
The law of diminishing (marginal) returns states that as we continue to add more of any one input, holding the other inputs constant, marginal product will eventually decline.
Firms face both explicit and implicit costs. Implicit costs include the opportunity cost of the owner’s resources (including his or her time) used within the firm.
A sunk cost is a cost previously paid, or one that must be paid, regardless of one’s current decisions. Sunk costs should be ignored when making current decisions.
There are no fixed inputs or fixed costs in the long run. In the long run, the firm uses the least-cost combination of all inputs. U-shaped long-run average total cost curves show economies of scale, constant returns to scale, and diseconomies of scale. These concepts are defined and explained.
The shape of the LRATC curve plays an important role in the number of sellers in the market. The output level at which the LRATC first hits bottom is known as the minimum efficient scale (MES) for the firm. We can use the MES to predict how many firms will serve a market. Mergers may occur if firms realize that they are too small to take advantage of the market’s MES. When market conditions are stable for long periods of time, we’d expect that firms would have already expanded to exploit economies of scale. So a sudden merger wave is usually set off by some change in the market. Two examples of market changes are covered—government policy changes in the banking industry in the 1990s, and changes in the market for personal computers that led to the 2002 merger of Hewlett Packard and Compaq.