Indifference curves and budget constraints

Customer indifferene curve
Convex curves that do not intersect and are based on assumptions that:

• More is preferable to less
• Goods are substitutable.
• Marginal utility of a good falls as more of it is consumed.
• Infinite no. of indifference curve.
• The higher the indifference curve, the greater the utility
  

Budget constraint (for money economy)
Straight line that defines combinations of the goods that an individual can afford. Point of tangency between budget constraint and highest obtainable indifference curve is optimal level of consumer satisfaction. ( consumption opportunity constraint for barter economy)

Increase in income shifts the budget constraint line to right, while the substitution effect rotates the budget constraint line.

Elasticity of Supply

Elasiticity of supply measures the responsieness of the quantity supplied to changes in price.

Elasiticity of supply= % change in quantity supplied /%change in price (%∆Qs / %∆P).

Determinants:

• Availability of substitutes for resources inputs: If the resources inputs are rare and unique, the elasticity is lower.
• Length of the production process: if the producer can change the supply quickly (eg electricity), momentary supply is elastic, otherwise it is inelastic (eg orange).
• Production spare capacity: More spare capacity, more ability to increase the supply and thus the elasticity.
• Storage capacity of the merchants: Higher level of stocks gives more flexibility and higher elasticity.
• Time elapsed since price change: Supply is normally more elastic in the long run than in the short run for produced goods as spare capacity and more capital equipment can be utilised in long run while only labor can be increased in short run.
• Goods that have no labor component and are not produced are said to be "fixed" in supply and do not respond to price changes.

Income elasticity of demand

A measure of the relationship between a change in income and a change in quantity of a good demanded:

Income elasticity = % change in quantity demanded / % change in income.

Interpretations from the value of Income elasticity
If 0-1
Necessities, e.g. bread

If greater than 1
Luxury goods

If smaller than 0
Inferior goods, e.g. bus travel

Notes:

• During a period of increasing income, demand for luxury products tends to increase at a higher rate than the demand for necessities.
• Inferior goods has negative value of income elasticity while normal goods has positive one.

Cross elasticity of demand

A measure of the responsiveness in the quantity demand of one good when a change in price takes place in another good (eg substitute good or complement).

Cross elasticity
= % change in quantity demanded of good X / % change in price of good Y
= (ΔQx/ ΔPy)[(PX1+PX2)/(QX1+QX2)]

Interpretations from the value cross elasticity
If +ve,
Two goods are substitute, e.g. ice-cream and frozen yogurt

If –ve,
Two goods are complement, e.g. autos and gosaline

Price elasticity of demand

A measure of the responsiveness of the quantity demanded of a good to a change in its price. The greater the extent to which demand falls as price rises, the greater the price elasticity of demand.

Price elasticity = % Δ Qd / % ΔP
Where:
% Δ = change in value/ average value

Interpretations:
Price elasticity in absolute value
If ∞
Perfectly inelastic, any change in price do not affect the quantity demanded. The demand curve is in vertical.

If greater than 1
Elastic, a small change in price accompanied by a large change in quantity demanded.

If smaller than 1
Inelastic, a large change in price accompanied by a small change in quantity demande

If =0
Perfectly elastic, a small rise in price reduce the quantity demanded to zero. The demand curve is in horizontal


Notes:

• The price elasticity of demand faced by an individual firm is higher than that faced by the entire industry.
• The price elasticity of demand tends to increase in the long run.
• Slope of demand curve is not equal to the elasticity (higher pice is more elastic than lower price)
• Increase in price will drecrease revenue (revenue = PxQ) for elastic goods and increase revenue for inelastic goods.

Determinants of elasticity:

• Availability of substitutes
• Share of budget spent on product (If represents a small portion, it is more inelastic)
• Effect of time (less elastic in short run and more elastic in long run)
  

Demand and consumer choice

Principles behind Consumer Choice

• Limited income versus unlimited desires necessitates choices.
• Make rational choices to achieve goals.
• Can substitute between “like” goods.
• Make decisions based on less than perfect information.
• Law of Diminishing Marginal Utility: the additional utility derived eventually declines as
  consumption of a good increases.
  

Consumer Behavior in making Choices

• Consumer will continue to consume the goods until the marginal utility of consuming the good
  just equals the price of the good.
  

Consumer Demand Curve:

• Diminishing Marginal Utility implies that the amount demanded by the consumer falls as the
  price of a good rises.

Note:

• Income effect and substitution effect are associated with change in price.