Microeconomics (PGP-I)
Session 1 to Session 5
Joysankar Bhattacharya
Session One : Overview
1.Defining Microeconomics
2. Analytical tools of Microeconomics
• Constrained Optimization
• Equilibrium Analysis
• Comparative Statics
3. The Types of Microeconomic Analysis
2
Microeconomics Defined
Microeconomics studies the economic behavior
of individual decision makers, such as a
consumer, a worker, a firm or a manager.
How individual economic decision-makers
allocate scarce resources among alternate uses.
This study involves both the behavior of these
economic agents on their own and the way their
behavior interacts to form larger units, such as
markets.
3
Microeconomic Modeling
Choice vs. Alternatives
Models are like maps – using visual methods, they
simplify the process and facilitate understanding of
complex concepts. Microeconomic models need to:
 Resemble Reality
 Be Understandable
 Be an Appropriate Scale
4
Exogenous & Endogenous Variables
Defined:
Variables that have values taken as given in the analysis are
exogenous variables.
Variables whose values are
determined as a result of the model’s workings are
endogenous variables.
“How would a manager
hire the maximum possible workers on a budget of
$100?”
vs.
“How would a manager minimize the cost of hiring three workers?”
OR
“How much food and clothing should the consumer purchase in order to
maximize satisfaction on a budget of Rs. 2000 ?”
vs.
“What is the minimum level of expenditure that the consumer must receive in
order to reach a subsistence level of satisfaction?”
5
The Objective Function
Defined:
The Objective Function specifies what the
agent cares about.
• Does manager care more about
raising profits or increasing
“power”?
6
The Constraints
Defined:
Constraints are whatever limit is placed on the
resources available to the agent.
 Time
 Budget
 Other Resources
 Technical Capabilities
 The Marketplace
 Rules, Regulations, and Laws
7
The Constraint Optimization
Behavior can be modeled as optimizing the
objective function, subject to various constraints.
• Consumers
Maximize Utility
Subject to the Budget Constraint
•
Producers
Maximize Profits
Subject to
1. Consumer Demand
2. Input Costs
8
The Constraint Optimization
Behavior can be modeled as optimizing the objective
function, subject to various constraints.
Manager’s Investment Choice
• Facilities ( F ): Facilities workers cost $30
• R&D ( R ):
R&D workers cost $100
• Max N
(F,R)
• Subject to: expenditure < $250
• Where: N is the number of workers
9
The Constraint Optimization
Consumer purchases
Food (F), Clothing(C), Income (I)
Price of food (Pf), Price of clothing (Pc)
𝐹𝐶
Utility from purchases: U =
2
Max U(F,C) subject to: Pf F + Pc C < I
(F,C)
10
Fundamental Questions
Societies must answer these questions
that relate to microeconomics:
1. What goods and services will be produced and in what quantities
2. Who will produce the goods and services and how
3. Who will receive these goods and services and how will they get
them
11
Equilibrium
Defined:
Equilibrium is defined as the point where demand just
equals supply in this market (i.e., the point where the
demand and supply curves cross).
Equilibrium analysis is an analysis of
a system in a state that will continue
indefinitely as long as the exogenous
factors remain unchanged.
12
Equilibrium
Example – Sale of Coffee Beans
13
Equilibrium
Example – Sale of Coffee Beans
•
Demand (P,I)
14
Equilibrium
Example – Sale of Coffee Beans
P*
•
Demand (P,I)
Q*
17
Comparative Statics Analysis
Defined:
A Comparative Statics Analysis
compares the equilibrium state of a
system before a change in the
exogenous
variables
to
the
equilibrium state after the change.
18
Comparative Statics Analysis
19
Marginal Impact
Defined:
The Marginal Impact of a change
in the exogenous variable is the
incremental impact of the last unit
of the exogenous variable on the
endogenous variable.
20
Microeconomic Analysis
Positive Analysis (the way things are):
• Is an analysis that attempts to explain how an
economic system works
Normative Analysis (the way things should be):
• Is an analysis of what should be done
21
Microeconomic Analysis
Some Examples
• If USA lifts the prohibition on imports of Cuban cigars, the price of
cigars will fall.
• To provide revenues for public schools, taxes on alcohol and
tobacco should be raised instead of increasing income taxes.
• If telephone companies are allowed to offer cable TV service, the
price of both types of service will fall.
• Government subsidies to farmers are too high and should be phased
out over the next decade.
• If the tax on cigarettes is increased by 50 cents per pack, the
equilibrium price of cigarettes will rise by 30 cents per pack.
22
Session Two: Overview
1. Consumer Preferences and the Concept of Utility
3. The Utility Function
• Marginal Utility and Diminishing Marginal Utility
4. Indifference Curves
5. The Marginal Rate of Substitution
6. The Budget Constraint
7. Consumer Choice
23
Objective
• Our aim is to understand the consumer decisionmaking process that generates demand functions for
goods and services
• It is important to know how changes in various prices,
changes in income distribution, and changes in the
‘attribute mix’ of a product will affect demand
Rationality assumption
• Every consumer has well-defined preferences over
goods and services, and given his/her constraints
(prices and incomes), (s)he chooses a commodity
bundle that maximizes his/her well-being
Consumer Preferences
Consumer Preferences tell us how the consumer would
rank (that is, compare the desirability of) any two
combinations or allotments of goods, assuming these
allotments were available to the consumer.
These allotments of goods are referred to as baskets or
bundles. These baskets are assumed to be available for
consumption at a particular time, place and under particular
physical circumstances.
26
Consumer Preferences
Preferences are complete if the consumer can rank any
two baskets of goods (A preferred to B; B preferred to
A; or indifferent between A and B)
Preferences are transitive if a consumer who prefers
basket A to basket B, and basket B to basket C also
prefers basket A to basket C
A  B; B  C = > A  C
27
Consumer Preferences
Preferences are monotonic if a
basket with more of at least one
good and no less of any good is
preferred to the original basket.
28
Types of Ranking
Students take an exam. After the exam, the students are ranked
according to their performance. An ordinal ranking lists the
students in order of their performance (i.e., A did best, B did
second best, C did third best, and so on). A cardinal ranking
gives the mark of the exam, based on an absolute marking
standard (i.e., A got 80, B got 75, C got 74 and so on).
29
The Utility Function
The three assumptions about preferences allow us to represent
preferences with a utility function.
Utility function
– a function that measures the (maximum) level of satisfaction
a consumer receives from any basket of goods and services.
– assigns a number to each basket so that more preferred
baskets get a higher number than less preferred baskets.
30
The Utility Function
• An ordinal concept: the precise magnitude of the number that
the function assigns has no significance.
• Utility not comparable across individuals.
• Any transformation of a utility function that preserves the
original ranking of bundles is an equally good representation of
preferences. e.g. U = y vs. U = y + 2 represent the same
preferences.
31
Marginal Utility
Marginal Utility of a good Y
• additional utility that the consumer gets from
consuming a little more of Y
• i.e. the rate at which total utility changes as the
level of consumption of good Y rises
• MUy =
𝜕𝑈
𝜕𝑌
• slope of the utility function with respect to Y
32
Diminishing Marginal Utility
The principle of diminishing marginal utility
states that the marginal utility falls as the
consumer consumes more of a good.
33
Diminishing Marginal
Utility
34
Marginal Utility
The marginal utility of a good, X, is the additional
utility that the consumer gets from consuming a little
more of X when the consumption of all the other
goods in the consumer’s basket remain constant.
• U(X, Y) : Utility Function
•
𝜕𝑈
𝜕𝑋 (Y held constant)
= MUX
•
𝜕𝑈
𝜕𝑌 (X held constant)
= MUY
35
Marginal Utility
Example of U(B) and MUB
U(B) = 10B – B2
MUB = 10 – 2B
B
1
2
4
6
8
10
B2
1
4
16
36
64
100
U(B) MUB
9
8
16
6
24
2
24
-2
16
-6
0
-10
36
Marginal Utility
U(B) = 10B – B2
MUB = 10 – 2B
37
Marginal Utility
Example of U(B) and MUB
• The point at which he should stop consuming
hotdogs is the point at which MUB = 0
• This gives B = 5.
• That is the point where Total Utility is flat.
• Beyond B=5, the utility is diminishing.
38
Indifference Curves
An Indifference Curve or Indifference Set: is the set
of all baskets for which the consumer is indifferent
- shows all combinations of consumption along which
an individual is indifferent
An Indifference Map : Illustrates a set of indifference
curves for a consumer
39
Indifference Curves
1)Indifference curves have negative slope (Monotonicity)
2)Indifference curves do not cross (Transitivity)
3)Each basket lies
(Completeness)
on
only
one
indifference
curve
40
Indifference Curves
41
Indifference Curves
Suppose that B preferred to A.
But … by definition of IC,
B indifferent to C
A indifferent to C => B indifferent
to C by transitivity.
And thus a contradiction !!
42
Indifference Curves
U = xy2
.
for U  144
x
8
4
3
1
y
4.24
6
6.93
12
xy2
143.8
144
144.07
144
43
Indifference Curves
Example: Utility
and the single
indifference curve.
Indifference Curve for U = xy2
14
12
10
8
y
6
U = 144
4
2
0
0
1
2
3
4
5
6
7
8
9
X
44
Marginal Rate of Substitution
The marginal rate of substitution: is the maximum rate at which the
consumer would be willing to substitute a little more of good X for a
little less of good Y;
It is the increase in good X that the consumer would require in
exchange for a small decrease in good Y in order to leave the
consumer just indifferent between consuming the old basket or the
new basket;
It is the rate of exchange between goods X and Y that does not affect
the consumer’s utility;
It is the negative of the slope of the indifference curve:
MRSx,y =
−
𝒅𝒀
𝒅𝑿
(for a constant level of
preference)
45
Marginal Rate of Substitution
46
Convex Indifference Curves
Quantity of Pepsi
14
MRS=6
A
8
1
4
3
B
MRS=1
Indifference
curve
1
0
2
3
6
7
Quantity of Pizza
At point A, the consumer has
little pizza and much Pepsi,
so he requires a lot of extra
Pepsi to induce him to give
up one of the pizzas: The
marginal rate of substitution
is 6 cans of Pepsi per pizza.
At point B, the consumer has
much pizza and little Pepsi,
so he requires only a little
extra Pepsi to induce him to
give up one of the pizzas:
The marginal rate of
substitution is 1 can of Pepsi
per pizza.
47
Marginal Rate of Substitution
MUx(dX) + MUy(dY) = 0 …along an IC
Mux
MUy
= −
𝑑𝑌
𝑑𝑋
=
MRSx,y
Positive marginal utility implies the indifference curve
has a negative slope (implies monotonicity)
Diminishing marginal rate of substitution implies the
indifference curves are convex to the origin (implies
averages preferred to extremes)
48
Marginal Rate of Substitution
Implications of this substitution:
• Indifference curves are negatively-sloped, bowed out
from the origin, preference direction is up and right
• Indifference curves do not intersect the axes
49
Indifference Curves
Averages preferred to extremes =>
indifference curves are bowed toward
the origin (convex to the origin).
50
Indifference Curves
y
Example: Graphing Indifference
Curves
Preference direction
IC2
IC1
x
51
Key Definitions
Budget Set:
• The set of baskets that are affordable
Budget Constraint:
• The set of baskets that the consumer may purchase
given the limits of the available income.
Budget Line:
• The set of baskets that one can purchase when
spending all available income.
PxX + PyY = I
Y = I/Py – (Px/Py)X
52
The Budget Constraint
Assume only two goods available: X and Y
• Price of X: Px ; Price of Y: Py
• Income: I
Total expenditure on basket (X,Y): PxX + PyY
The Basket is Affordable if total expenditure
does not exceed total Income:
PXX + PYY ≤ I
53
A Budget Constraint Example
Y
I/PY
Budget line = BL1
•
-PX/PY
•C
•
I/P
X
X
54
A Budget Constraint Example
Y
Shift of a budget line
If income rises, the budget line shifts parallel
to the right (shifts out)
If income falls, the budget line shifts parallel
to the left (shifts in)
BL2
BL1
X
55
A Budget Constraint Example
Y
Rotation of a budget line
If the price of Y rises, the budget
line gets flatter and the vertical
intercept shifts in (BL2 )
BL1
If the price of Y falls, the budget
line gets steeper and the vertical
intercept shifts out (BL1 )
BL2
X
56
Consumer Choice
Assume:
 Only non-negative quantities
 "Rational” choice: The consumer chooses
the basket that maximizes his satisfaction given
the constraint that his budget imposes.
Consumer’s Problem:
Max U(X,Y)
Subject to: PxX + PyY < I
57
Interior Consumer Optimum
(an optimum at which the consumer purchases both commodities
(X > 0 , Y > 0)
Y
B
Preference Direction
•
•
Optimal Choice (interior solution)
IC
C
0
•
BL
X
58
Interior Optimum
Interior Optimum: The optimal consumption basket is
at a point where the indifference curve is just tangent to
the budget line.
Tangency
Equal Slope
MUx
Px
MRSx,y =
=
MUy
Py
“The rate at which the consumer would be willing to
exchange X for Y is the same as the rate at which they
are exchanged in the marketplace.”
59
Equal Slope Condition
MUx
MUy
=
Px
Py
“At the optimal basket, each good gives
equal bang for the buck”
Now, we have two equations to solve for two unknowns
(quantities of X and Y in the optimal basket):
1.
MUx
MUy
=
Px
Py
2. PxX + PyY = I
60
•Consumer’s optimal basket.
•Thus, we can tell – for a given income and prices of
other goods – how much a consumer will demand of
X for a given price of X.
•We can find different amounts of X demanded by
changing the price of X(PX) and determining how
much of X the consumer will demand – prices of other
goods and income are held constant.
61
Price Consumption Curves
Y (units)
The price consumption curve for
good x can be written as the
quantity consumed of good x for
any price of x.
PY = 4
I = 40
10
Price Consumption Curve
•
•
•
PX = 1
PX = 2
PX = 4
0
XA=2
XB=10
XC=16
20
X (units)
62
Price Consumption Curves
The Price Consumption Curve of Good X:
Is the set of optimal baskets for
every possible price of good x,
holding all other prices and
income constant.
63
Individual Demand Curve
PX
Individual
Demand Curve
For X
PX = 4
•
PX = 2
PX = 1
XA
•
XB
•
XC
U increasing
X
64
Change in Income & Demand
The income consumption curve of
good X is the set of optimal baskets
for every possible level of income.
65
Income Consumption Curve
66
Engel Curves
The income consumption curve for
good X also can be written as the
quantity consumed of good X for any
income level. This is the individual’s
Engel Curve for good X. When the
income
consumption
curve
is
positively sloped, the slope of the
Engel Curve is also positive.
67
Engel Curves
I
Engel Curve
“X is a normal good”
92
68
40
0
10
18
24
X
68
Definitions of Goods
• If the income consumption curve shows that the consumer
purchases more of good X as her income rises, good X is a
normal good.
• Equivalently, if the slope of the Engel curve is positive, the
good is a normal good.
• If the income consumption curve shows that the consumer
purchases less of good X as her income rises, good X is an
inferior good.
• Equivalently, if the slope of the Engel curve is negative, the
good is an inferior good.
69
Impact of Change in the Price of a Good
•If price of a good falls – consumer substitutes
into the other good to achieve the same level of
utility
•When price falls – purchasing power increases
the consumer can buy the same amount and still
have money left
70
Impact of Change in the Price of a Good
Pizza-Pepsi Story
• Reduction in price of Pepsi
• Now that the price of Pepsi has fallen, I get more Pepsi for
every Pizza that I give up. Because Pizza is now relatively more
expensive, I should buy less Pizza and more Pepsi (Substitution
Effect, change in consumption on the same IC with a different
MRS )
• Now that Pepsi is cheaper, my income has greater purchasing
power. I am, in effect, richer than I was. Because I am richer, I
can buy both more Pizza and more Pepsi (Income Effect,
change in consumption that results from the movement to a
higher IC)
71
Impact of Change in the Price of a Good
• Substitution Effect: Change in relative
price affects the amount of good that is
bought as consumer tries to achieve the same
level of utility
• Income Effect: Consumer’s purchasing
power changes and affects the consumer in a
way similar to effect of a change in income
72
The Substitution Effect
• As the price of X falls, all else constant, good X
becomes cheaper relative to good Y
•This change in relative prices alone causes the
consumer to adjust his/ her consumption basket.
• This effect is called the substitution effect.
• The substitution effect always is negative(in
direction).
73
Impact of Change in the Price of a Good
Definition: As the price of X falls, all else
constant, purchasing power rises. As the price
of X rises, all else constant, purchasing power
falls.
This is called the income effect of a change in
price.
The income effect may be positive (normal
good) or negative (inferior good).
74
Y
Clothing
The Substitution and Income Effects
• Initial Basket
• Final Basket
• Decomposition
Basket
BLd
A
C
B
U2
U1
BL1
XA
XB
XC
BL2
X
Food
The Substitution and Income Effects
76
The Substitution and Income Effects
77
Giffen Goods – Income and Substitution Effects
78
Giffen Goods
If a good is so inferior that the net effect of a price
decrease of good X, all else constant, is a decrease in
consumption of good X, good X is a Giffen good.
For Giffen goods, demand does not slope down.
When might an income effect be large enough to offset
the substitution effect?
The good would have to represent a very large
proportion of the budget.
A Giffen good has to be an inferior one, but the
converse is not necessarily true.
79
Individual Demand Curve
 The consumer is maximizing utility at every point along the
demand curve
As the price of X falls, it causes the consumer to move down
and to the right along the demand curve as utility increases in that
direction.
The demand curve is also the “willingness to pay” curve – and
willingness to pay for an additional unit of X falls as more X is
consumed.
80
The Market Demand Function
Defined:
The Market Demand Function tells us
that the quantity of a good all
consumers in the market are willing to
buy is a function of various factors.
81
Market Demand as the Sum of Individual Demands
Catherine’s demand
+
Price of
Ice-Cream
Cones
$3.00
Nicholas’s demand
$3.00
$3.00
DNicholas
2.50
2.50
2.00
2.00
2.00
1.50
1.50
1.50
1.00
1.00
1.00
0.50
0.50
0.50
0
1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones
0
Market demand
Price of
Ice-Cream
Cones
Price of
Ice-Cream
Cones
DCatherine
=
1 2 3 4 5 6 7
2.50
0
DMarket
2 4 6 8 10 12 14 16 18
Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones
82
The Market Demand Curve
Defined:
The Market Demand Curve plots the
aggregate quantity of a good that consumers
are willing to buy at different prices,
holding constant other demand drivers such
as prices of other goods, consumer income,
quality.
83
The Law of Demand
Defined:
The Law of Demand states that the
quantity of a good demanded decreases
when the price of this good increases.
84
Demand Curve Rule
Defined:
A move along the demand curve for a
good can only be triggered by a change in
the price of that good.
Any change in another factor that affects
the consumers’ willingness to pay for the
good results in a shift in the demand
curve for the good.
85
Shifts of the Demand Curve
The Demand Curve shifts when factors other than own
price change
 If the change increases the willingness of consumers to
acquire the good, the demand curve shifts right
 If the change decreases the willingness of consumers to
acquire the good, the demand curve shifts left
86
The Demand for Cars
We always graph P on vertical axis and Q on horizontal axis, but
we write demand as Q as a function of P… If P is written as
function of Q, it is called the inverse demand.
Markets defined by commodity, geography, time.
87
Market Supply
Tells us that the quantity of a good
supplied by all producers in the market
depends on various factors
Plots the aggregate quantity of a good that
producers are willing to sell at different
prices.
88
Market Supply as the Sum of Individual Supplies
Ben’s supply
Price of
Ice-Cream
Cones
Jerry’s supply =
+
Price of
Ice-Cream
Cones
Market supply
Price of
Ice-Cream
Cones
SBen
$3.00
$3.00
2.50
2.50
2.50
2.00
2.00
2.00
1.50
1.50
1.50
1.00
1.00
1.00
0.50
0.50
0.50
SJerry
0 1 2 3 4 5 6 7
0 1 2 3 4 5 6 7
Quantity of
Ice-Cream Cones
Quantity of
Ice-Cream Cones
$3.00
SMarket
0 2 4 6 8 1012141618
Quantity of
Ice-Cream Cones
89
The Law of Supply
Defined:
The Law of Supply states that the
quantity of a good offered increases when
the price of this good increases.
90
Supply Curve Rule
Defined:
A move along the supply curve for a good
can only be triggered by a change in the
price of that good.
Any change in another factor that affects
the producers’ willingness to offer for the
good results in a shift in the supply curve
for the good.
91
The Law of Supply
The Supply Curve shifts when factors other than own price change
 If the change increases the willingness of producers to
offer the good at the same price, the supply curve shifts right
 If the change decreases the willingness of producers to
offer the good at the same price, the supply curve shifts left
92
Market Equilibrium
• Market Equilibrium
• is a price such that, at this price, the quantities demanded and
supplied are the same.
• is a point at which there is no tendency for the market price
to change as long as exogenous variables remain unchanged.
Demand and supply curves intersect at equilibrium
93
Example: Market Equilibrium for Cranberries
Qd = 500 – 4p
Qs = -100 + 2p
p = price of cranberries (dollars per barrel)
Q = demand or supply in millions of barrels per year
The equilibrium price of cranberries is calculated by equating demand to supply:
Qd = Qs … or…
500 – 4p = -100 + 2p
…solving
p* = $100
Plug equilibrium price into either demand or supply to get equilibrium quantity:
Q* = 500 – 4(100) = 100 units
94
Market Equilibrium for Cranberries
Q* = 100
95
Excess Demand/Supply
Excess Demand: A situation in which the quantity demanded
at a given price exceeds the quantity supplied.
Excess Supply: A situation in which the quantity supplied at a
given price exceeds the quantity demanded.
If there is no excess supply or excess demand, there is no
pressure for prices to change and thus there is equilibrium.
When a change in an exogenous variable causes the demand
curve or the supply curve to shift, the equilibrium shifts as
well.
96
Excess Demand/Supply
Excess supply
when price is $5
Price (dollars
per bushel)
S
5.00
E
4.00
3.00
Excess demand
when price is $3
8
9
D
11 13 14
Quantity (billions of bushels per year)
97
Shifts in Demand, Supply Unchanged
Demand Increases:
P Q
98
Shifts in Supply, Demand Unchanged
Supply Decreases:
PQ
99
Three Steps
 Decide whether the event shifts the supply curve, the
demand curve, or, in some cases, both curves.
 Decide whether the curve shifts to the right or to the
left.
 Use the supply-and-demand diagram
• Compare the initial and the new equilibrium.
• Effects on equilibrium price and quantity.
100
Consumer Surplus
• The individual’s demand curve can be seen as the
individual’s willingness to pay curve.
• On the other hand, the individual must only
actually pay the market price for (all) the units
consumed.
• Consumer Surplus is the difference between what
the consumer is willing to pay and what the
consumer actually pays.
101
Consumer Surplus
Definition: The net economic benefit to the
consumer due to a purchase (i.e. the willingness to
pay of the consumer net of the actual expenditure on
the good) is called consumer surplus.
The area under an ordinary demand curve and
above the market price provides a measure of
consumer surplus
102
Demand Curve
• The demand curve measures how many people would
want to by the commodity at any particular price
• The demand curve slopes down; as the price of the
commodity decreases more people will be willing to
buy.
• If there are many people and their reservation prices
differ only slightly from person to person, the demand
curve would slope smoothly downward
How the Price Affects Consumer Surplus
(a) Consumer Surplus at Price P1
Price
Price
P1
(b) Consumer Surplus at Price P2
A
A
Consumer
surplus
Initial
consumer
surplus
C
P1
Additional consumer surplus
to initial consumers
C
Consumer surplus
to new consumers
B
B
F
P2
0
Q1
Quantity
E
D
Demand
0
Q1
Demand
Q2
Quantity
Initial price P1, Quantity Q1, Consumer surplus is the area ABC.
New lower price P2, Quantity Q2,
Consumer surplus rises and becomes ADF.
Increase : 1) from initial buyers BDEC and 2)from new buyers CEF
104
Consumer Surplus
Consumer Surplus and Demand
Consumer Surplus Generalized
For the market as a whole, consumer
surplus is measured by the area under the
demand curve and above the line
representing the purchase price of the
good.
Here, the consumer surplus is given by
the yellow-shaded triangle and is equal to
1/2 × ($20 − $14) × 6500 = $19,500.
Applying Consumer Surplus
When added over many individuals, it measures the aggregate
benefit that consumers obtain from buying goods in a market.
Consumer Surplus
G = .5(10-3)(28) = 98
H+I= 28 +2 = 30
CS2 = .5(10-2)(32) = 128
106
Network Externalities
• If one consumer's demand for a good changes with the number of
other consumers who buy the good, there are network externalities.
Network Externalities
• Bandwagon effect: A positive network externality that refers to the
increase in each consumer’s demand for a good as more consumers
buy the good.
• Snob effect: A negative network externality that refers to the
decrease in each consumer’s demand as more consumers buy the good.
Bandwagon effect
D60
PX
Bandwagon Effect:
• (increased
quantity
D30
20
10
demanded when more
consumers purchase)
•
A
•
B
Pure
Price
Effect
•
C
Market Demand
Bandwagon Effect
60
Snob Effect
PX
Snob Effect:
Market Demand
• (decreased
quantity
demanded when more
consumers purchase)
•
A
900
•
•
C
B
D1000
D1300
Snob Effect
Pure Price Effect
X (units)
Price Elasticity
Elasticity
- Measure of the responsiveness of quantity
demanded or quantity supplied
- To a change in one of its determinants
Price elasticity of demand
How much the quantity demanded of a good
responds to a change in the price of that good
111
Price Elasticity
Price elasticity of demand
Percentage change in quantity demanded divided by
the percentage change in price
Elastic demand
Quantity demanded responds substantially to
changes in price
Inelastic demand
Quantity demanded responds only slightly to
changes in price
112
Price Elasticity
Defined:
The Price Elasticity of Demand is the percentage
change in quantity demanded brought about by a
one-percent change in the price of the good.
p
Q/Q
Q
Q,P= (
) = (
)( )
p
Q
p/p
113
Price Elasticity
• Slope is the ratio of absolute changes in quantity
and price. (= Q/P).
• Elasticity is the ratio of relative (or percentage)
changes in quantity and price.
114
Price Elasticity
• When a one percent change in price leads to a greater than
one-percent change in quantity demanded, the demand curve
is elastic.
• When a one-percent change in price leads to a less than
one-percent change in quantity demanded, the demand curve
is inelastic.
• When a one-percent change in price leads to an exactly onepercent change in quantity demanded, the demand curve is
unit elastic.
115
Elasticity – Linear Demand Curve
Qd = a – bP
Where:
• a and b are positive constants
• P is price
• b is the slope
• a/b is the choke price(price at which
quantity demanded falls to zero)
Re-writing, we have:
P = a/b – (1/b)Q
Elasticity is:
εQ,P = (
ΔQ P
P
)( ) = − b( )
ΔP Q
Q
Elasticity falls from 0 to - along the linear demand curve, but slope
is constant.
Example: Calculate elasticity when P = 30 and Qd = 400 – 10P
Answer: εQ,P = -3 “elastic”
116
Elasticity – Linear Demand Curve
P
a/b
Q,P = -
Elastic region
a/2b
•
Q,P
= -1
Inelastic region
Q,P = 0
0
a/2
a
Q
117
Price Elasticity
Value of ε
0
Demand Curve
Classification
Meaning
Perfectly Inelastic Quantity Demanded is
Demand
completely insensitive to Price
Between 0
and -1
Inelastic Demand
-1
Unitary Elastic
Demand
% change in Quantity
Demanded is equal to %
change in Price
Elastic Demand
Quantity Demanded is
relatively sensitive to Price
Relatively
Flatter
Perfectly Elastic
Demand
Any increase(decrease) in
Price results in Quantity
Demanded decreasing
(increasing)to zero(infinity)
Horizontal
Between -1
and - 
-
Quantity Demanded is
relatively insensitive to Price
Vertical
Relatively
Steeper
Mid-Point of
Linear Demand
118
Price Elasticity and Total Revenue
• Total Revenue (TR) = P × Q
P
Q
• Demand is elastic
• Fall in Q > Rise in P
TR falls
• Demand is inelastic
• Fall in Q < Rise in P
TR rises
119
Paradox of Public Policy
• New hybrid of wheat – increase production per
acre 20%
Supply curve shifts to the right
Higher quantity; lower price
Demand – inelastic
Total revenue falls
Paradox of public policy
Induce farmers not to plant crops
120