AGB 212 Review

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AGB 212 Review
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Agenda

• Graphing Techniques
• Consumer Theory and Demand
• Producer Theory and Supply
• Elasticity
• Market Equilibrium and Welfare Analysis

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Review of Graphing Techniques

• A graph shows the relationship between two or
  more variables.
• A variable is something that can take different
  values.
• E.g., y x 2 in this equation x and y are
  variables
• Variables can be related to each other.
• In the example above if you increase x, you will
  increase y

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Review of Graphing Techniques Cont.

• In economics, the two primary types of variables
  we work with are prices and quantities.
• Prices are usually denoted by P, p, or pi.
• Quantities are usually denoted by Q, X, q, x, qi,
  or xi.
• The quantity of outputs are usually denoted by
  the different forms of q, and the quantity of
  inputs are usually denoted by the different forms
  of x.
• When talking about prices and quantities
  together, prices are graphically depicted on the
  y-axis, while quantities are graphically depicted
  on the x-axis.

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Review of Graphing Techniques Cont.
P
Q
6
Review of Graphing Techniques Cont. Equational
Mapping
P
P 10 - Q
10
10
Q
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Drawing a Line on a Graph

• If the line is linear, to graph the line it is
  best to find the x and y intercepts.
• To find the x intercept, set y equal to zero in
  the equation and solve for x.
• To find the y intercept, set x equal to zero in
  the equation and solve for y.
• It is important to remember that the slope (m) of
  the line will be equal to the rise over the run
  or more commonly seen as
• m ((y2-y1))/(x2-x1))

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Example of graphing a line

• P 20 2Q
• X-intercept 10
• Y-intercept 20
• Slope -2

P
20
P 20 2Q
Q
10
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Notes on Slopes

• A positive slope is normally associated with a
  supply curve.
• A negative slope is normally associated with a
  demand curve.
• Hence in economic terms slope has meaning.

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Consumer Theory

• There are two important pillars that consumer
  theory rests upon
• The utility function
• The budget constraint

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Consumer Equilibrium

• Consumer equilibrium is comprised of two
  concepts
• The utility function
• The budget constraint
• Consumer equilibrium can be defined as a
  consumption bundle that is feasible given a
  particular budget constraint and maximizes total
  utility.

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Changes in Equilibrium

• There are many things that can change consumer
  equilibrium.
• The major two items that we will examine that can
  change consumer equilibrium, ceteris paribus
• Income
• Price of each good
• Note Ceteris paribus means that we hold
  everything else fixed.

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Deriving Demand

• By changing the price of soda and examining the
  new equilibrium point, we can derive the demand
  curve for soda for an individual.
• Summarizing the changing equilibrium example
  gives the following demand schedule for soda

Price of Soda
Quantity Demanded of Soda
0.50 1.00 2.00
10 5 2.5
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Graphing the Demand Schedule
Price of Soda

2.00

1.00

0.50
2.5
5
10
Quantity of Soda
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Deriving Demand Cont.

• Now suppose we change the price for soda on a
  continuous basis.
• Instead of points on the graph, you would begin
  to see a curve like the following

P
Demand curve for soda
Q
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Notes on Demand Cont.

• When we derived demand, we only change the price
  of the good we were investigating and the change
  in the quantity demanded for the good.
• Prices of the other good(s) and income were held
  fixed.
• Any other variable that might affect the utility
  function were held fixed also.

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Notes on Demand Cont.

• We can mathematically represent demand for good i
  as the following
• D(pi) d(price of good i price of all other
  goods and income)

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Other Demand Determinants

• Beside the price of the good, there are three
  other major items that affect the demand curve
• Income (M)
• Prices of other goods (pj)
• Tastes and preferences
• This can either show up as a variable in the
  demand function or it can change the function
  altogether.

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How Income Affects Demand

• Remember that an increase in income shifts the
  budget curve out, while a decrease in income
  shifts the budget curve in.
• Does an increase in income imply that you will
  always increase demand for a good?
• No. It depends on whether the good is a inferior
  or normal good.

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How Price Changes of Other Goods Change Demand

• The demand curve for a particular good may shift
  if the price of another good changes.
• How the demand curve shifts will depend on
  whether the goods are substitutes, complements,
  or have no correlation.

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Law of Demand

• The Law of Demand states that as the price
  decreases for a good, there is a tendency for
  people to consume more of that good assuming that
  prices of other goods, income, tastes and
  preferences all are held constant.
• This implies that the demand curve slopes
  downward.

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Deriving Market Demand

• To this point we have discussed deriving consumer
  demand.
• To derive market demand for a product, you must
  sum for each price level the quantity demanded
  for the good for each individual.
• For this to be true, we must assume that the
  demand of the good of one person has no effect on
  the demand for the good of the other person.

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Deriving Market Demand Cont.
Consumer 1
Consumer 2
Market Demand
P
P
P


Q
Q
Q
1
2
3
4
5
1
2
3
4
5
1
2
3
4
5
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Consumer Surplus

• Consumer surplus is a measure of the difference
  between the amount of money a person was willing
  to pay to buy a quantity of good and the actual
  price they paid.
• This measure is used as a tool in policy
  analysis.
• Consumer surplus is represented graphically as
  the area underneath the demand curve above the
  price paid for the goods.

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Graphical Representation of Consumer Surplus
P
Consumer Surplus
p 5
q 5
Q
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Production Theory

• Dependent upon cost of inputs and the production
  function

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Graphical Representation of Cost Concepts Cont.

MC
ATC
AVC
AFC
Y
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Profit Scenario Graphically
Profit

MC
MR py
ATC
ATC
AVC
AFC
Y
Yprofit
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Firm Supply Curve

• The firms supply curve is derived from the
  firms marginal cost curve in which the supply
  curve starts at where the marginal cost curve
  meets the average variable cost curve.
• Why?

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Graphical Representation of Deriving the Supply
Curve
Firms Supply Curve


MC
S
Firms Supply Curve is the black portion of the
marginal cost curve
AVC
PAVC
PAVC
Y
YAVC
Y
YAVC
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Law of Supply

• The law of supply states that the price of a good
  or service has a direct effect on the quantity
  supplied for that good or service.
• This implies that the supply curve is upward
  sloping.
• What this law is saying is that for you to
  produce more of a good, you need to be
  compensated by a greater price.

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Notes on Firm Supply Curve

• Anything that affects the marginal cost curve
  will affect the supply curve.
• Marginal cost was dependent on variable costs and
  output.
• Hence, anything that affects your output, i.e.,
  the production function, or the variable costs
  will affect the supply curve.
• E.g., input prices, technological advances,
  weather, etc.

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Deriving Market Supply

• To derive the market supply curve you need to
  horizontally sum the quantity supplied from each
  producer at each price level.
• Another way of thinking about this is by
  imagining an auctioneer calling at a price and
  counting up how much each producer would supply
  at that price.

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Deriving Market Supply Graphically
Producer 1
Producer 2
Market Supply
P
P
P
S1
S2


5
5
5
SM
4
4
4
3
3
3
2
2
2
1
1
1
Q
Q
Q
1
2
3
4
5
1
2
3
4
5
1
2
3
4
5
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Producer Surplus

• Producer surplus, also known as economic rent,
  can be defined as the return above the firms
  variable cost of production.
• It can be viewed as the difference between the
  amount for which a good sells and the minimum
  amount necessary for the seller to be willing to
  produce the good. (Perloff)

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Producer Surplus Graphically
P
S
Producer Surplus
p
Variable Cost
q
Q
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Example for Producer Surplus

• Suppose you had a supply curve that was linear
  and could be represented by the following P 2
  Q.
• Also suppose you have a price of 10 set in the
  market.
• What is the producer surplus?

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Example for Producer Surplus Cont.

• Steps to finding producer surplus when supply is
  linear
• Calculate the quantity supplied at the price.
• Use the formula for finding the area of a
  triangle, i.e., (1/2)baseheight
• Where base can be defined as the quantity
  supplied.
• Where height can be defined as the difference
  between the price and the price when quantity
  supplied is zero, i.e., the supply equivalent of
  a choke price.

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Producer Surplus Example Cont.
Producer Surplus (1/2)baseheight .5(10-2)(8
-0) 32
P
S
10
Variable Cost
height
2
8
0
Q
base
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Elasticity

• An elasticity can be defined as a percentage
  change in one variable due to a percentage change
  in another variable.
• It is a way of measuring the sensitivity of one
  variable to another.
• We typically represent elasticity with the symbol
  ?.

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Why Use Elasticity?

• It gives us the ability to gauge the sensitivity
  of one variable due to another variable at a
  single point.
• It is a unit-free measure which gives us the
  ability to cross compare different items.
• Suppose you wanted to ask the following question
  Which industry would be more affected by a price
  increase?
• To answer this question we would need a basis of
  comparison.
• The concept of elasticity gives us this basis.

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Point Elasticity

• Point elasticity can be defined as (?Y/Y)/(?X/X)
  
• (?Y/ ?X)(X/Y)
• Where ?Y y2-y1, ?X x2-x1, X and Y are equal
  to the corresponding point you are examining for
  the elasticity.

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Classifying Elasticity

• In many cases with elasticity, the following
  holds
• If the absolute value of elasticity (?) is
  greater than one, the point you are investigating
  is said to be elastic.
• If the absolute value of elasticity (?) is equal
  to one, the point you are investigating is said
  to be unitary elastic.
• If the absolute value of elasticity (?) is less
  than one, the point you are investigating is said
  to be inelastic.

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Own-Price Elasticity of Supply

• Own-price elasticity of supply ?s can be defined
  as the percentage change in quantity supplied due
  to a percentage change in price of the good.
• ?s ( ? Qs)/( ? P)
• Two definition
• Own-price point elasticity of supply
• Own-price arc elasticity of supply

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Own-Price Point Elasticity of Supply
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Own-Price Point Elasticity Interpretation

• If the value of own price elasticity is greater
  than one, the elasticity is said to be elastic,
  i.e., ?s gt 1.
• At an elastic point, we know that a 1 change in
  price will cause a greater than 1 change in
  quantity supplied.
• If the value of own price elasticity is equal to
  one, the elasticity is said to be unitary
  elastic, i.e., ?s 1.
• At a unitary elastic point, we know that a 1
  change in price will cause a 1 change in
  quantity supplied.

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Own-Price Point Elasticity Interpretation Cont.

• If the value of own price elasticity is less than
  one but greater than or equal to zero, the
  elasticity is said to be inelastic, i.e., 0 ? ?s
  lt 1.
• At a inelastic point, we know that a 1 change in
  price will cause less than a 1 change in
  quantity supplied.

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Notes on Own-Price Elasticity of Supply

• The more elastic a supply curve is, the flatter
  it is.
• The less elastic a supply curve is, the steeper
  it is.
• The more elastic the supply curve is, the greater
  the effect on the total revenue due to a price
  change.

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Notes on Own-Price Elasticity of Supply Cont.

• The less elastic the supply curve is, the lower
  the effect on the total revenue due to a price
  change.
• Due to the Law of Supply, the own-price
  elasticity of supply should be positive and bound
  at its lower end by zero.

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Graphical View of Elasticities of Supply
Elastic Supply Curve
Inelastic Supply Curve
P
P
S
S
Q
Q
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Extreme Cases

• A perfectly elastic supply curve implies that
  supply is a horizontal line.
• A perfectly inelastic supply curve implies that
  the supply curve is a vertical line.

Perfectly Inelastic
P
Perfectly Elastic
P
Q
Q
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Own-Price Elasticity of Demand

• Own-price elasticity of demand for good i can be
  defined as the percentage change in quantity
  demanded of good i divided by the percentage
  change in the price of good i.
• This elasticity measures the sensitivity of
  quantity demanded due to a change in its price.

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Own-Price Point Elasticity of Demand Defined
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Own-Price Point Elasticity Interpretation

• If the absolute value of own price elasticity is
  greater than one, the elasticity is said to be
  elastic, i.e., ?p gt 1.
• At an elastic point, we know that a 1 change in
  price will cause a greater than 1 change in
  quantity demanded.
• If the absolute value of own price elasticity is
  equal to one, the elasticity is said to be
  unitary elastic, i.e., ?p 1.
• At a unitary elastic point, we know that a 1
  change in price will cause a 1 change in
  quantity demanded.

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Own-Price Point Elasticity Interpretation Cont.

• If the absolute value of own price elasticity is
  less than one but greater than or equal to zero,
  the elasticity is said to be inelastic, i.e., 0 ?
  ?p lt 1.
• At a inelastic point, we know that a 1 change in
  price will cause less than a 1 change in
  quantity demanded.

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Example of Calculating Point Elasticity

• When calculating a point elasticity we know that
  the elasticity ?p is equal to (?Q/?P)(P/Q)
• Where ?Q/?P is the inverse of the slope of the
  demand curve at the price-quantity point P,Q.
• Hence for our example ?Q/?P -1 along the whole
  function.
• Why?

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Special Cases

• A perfectly elastic demand curve implies that
  demand is a horizontal line.
• A perfectly inelastic demand curve implies that
  the demand curve is a vertical line.

Perfectly Inelastic
P
Perfectly Elastic
P
Q
Q
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Equilibrium

• An equilibrium is said to exist if there is no
  tendency to move away from a certain point once
  that point has been established.

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Market Equilibrium

• Market equilibrium is defined as the price
  quantity relationship where the quantity supplied
  at a particular price is equal to the quantity
  demanded at that price.
• This equilibrium price is denoted by p, and the
  equilibrium quantity is denoted q.
• Market equilibrium is found by setting the supply
  curve equal to the demand curve.

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Example of Market Equilibrium

• Suppose you had a supply relationship which could
  be represented by the following Ps 2 Qs
• Where Ps is the price of the supplied good and Qs
  is the quantity supplied.
• Also, suppose you had a demand relationship which
  could be represented by the following Pd 10 -
  Qd
• Where Pd is the price of the good demanded and Qd
  is the quantity demanded.

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Example of Market Equilibrium Cont.

• To find market equilibrium you can either set Pd
  Ps and solve in terms of a general Q or you can
  set Qd Qs and solve in terms of a general P.
• Remember the Pd Ps and Qd Qs at equilibrium.

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Example of Market Equilibrium Cont.

• Ps 2 Qs
• Pd 10 Qd
• Set Ps Pd and let Qs Qd Q
• This implies 2 Q 10 Q
• This implies 2Q 8
• This implies Q 4 q
• This implies Ps Pd P 6 p

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Example of Market Equilibrium Cont.
P
S Ps 2 Qs
10
6
D Pd 10 - Qd
2
Q
4
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Total Economic Surplus

• Total economic surplus can be defined as the
  summation of producer surplus and consumer
  surplus.
• Examining economic producer surplus, consumer
  surplus, and economic surplus can give the
  legislative body a tool for analyzing policy
  changes.

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Total Economic Surplus Graphically
P
Consumer Surplus
S
Total Economic Surplus
p
D
Producer Surplus
q
0
Q
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Welfare Analysis

• Welfare analysis is when you examine what happens
  to the economic surplus when a policy change
  occurs.
• These policy changes may cause demand, supply, or
  both to change, thus having an effect on the
  market.

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Example of Welfare Analysis

• Suppose you have a tax put on an input you use
  for your farm.
• This will affect the supply curve adversely.
• Initially the consumer surplus was 1 2 3
• Initially the producer surplus was 4 5

P
S2
1
S1
p2
2
3
p1
4
5
D1
Q
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Example of Welfare Analysis Cont.

• After the tax, consumer surplus was 1 2
• After the tax, producer surplus was 4
• Net loss to society, i.e., the adverse change in
  economic surplus is 3 5

P
S2
1
S1
p2
2
3
p1
4
5
D1
Q
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Market Disequilibrium

• Market disequilibrium is said to exist when
  market price is above or below the market
  clearing equilibrium where supply meets demand.
• There are two major types of market
  disequilibrium
• Market Surplus
• Market Shortage

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Market Surplus

• A market surplus exists when at the market price
  quantity supplied (Qs) is greater than quantity
  demanded (Qd), i.e., Qs Qd gt 0 .
• This occurs when market price is above
  equilibrium price.

P
Surplus
S
pm
p
D
Qs
Qd
Q
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Market Shortage

• A market shortage exists when at the market price
  quantity demanded (Qd) is greater than quantity
  supplied (Qs), i.e., Qd Qs gt 0 .
• This occurs when market price is below
  equilibrium price.

P
S
p
pm
D
Shortage
Qs
Qd
Q