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ELEC15- Engineering Economics & Finance Day 4 Session 3: Microeconomics-2

ELEC15- Engineering Economics & Finance Day 4 Session 3: Microeconomics-2. Dr. Wilton W.T. Fok Room CYC703 Tel: 2857 8490. Content. 3.1 Money 3.2 Government Policies 3.3. Supply and Demand Fundamentals 3.4. Supply and Demand Shifts and Movements 3.5. Case Studies: Oil Price

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ELEC15- Engineering Economics & Finance Day 4 Session 3: Microeconomics-2

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  1. ELEC15- Engineering Economics & FinanceDay 4Session 3: Microeconomics-2 Dr. Wilton W.T. Fok Room CYC703 Tel: 2857 8490

  2. Content • 3.1 Money • 3.2 Government Policies • 3.3. Supply and Demand Fundamentals • 3.4. Supply and Demand Shifts and Movements • 3.5. Case Studies: Oil Price • 3.6. Effects of Supply Demand Curve Shifts • 3.7 Exceptions • 3.8. Macroeconomic uses of demand and supply • 3.9. Price Elasticity • 3.10 Factors affecting price elasticity • 3.11 Calculating Elasticity • 3.12 Perfect elasticity and Perfect inelasticity • 3.13 Other Elasticity • 3.14 Types of Market Structures • 3.15 Game Theory • 3.16 Summary of Microeconomics

  3. 3.9 Price Elasticity of demand • It is useful to know how the quantity demanded or supplied will change when the price changes. This is known as the price elasticity of demand and the price elasticity of supply. • If a monopolist decides to increase the price of their product, how will this affect their sales revenue? If a government imposes a tax on a good, thereby increasing the effective price, how will this affect the quantity demanded? Will the increased unit price offset the likely decrease in sales volume? $

  4. 3.9 Price Elasticity of demand • Price elasticity of demand • An elasticity that measures the nature and degree of the relationship between changes in quantity demanded of a good and changes in its price.

  5. 3.9 Price Elasticity of demand • For all normal goods, a price drop results in an increase in the quantity demanded by consumers. • The demand for a good is relatively inelastic when the quantity demanded does not change much with the price change. • Goods and services for which no substitutes exist are generally inelastic.

  6. 3.9 Price Elasticity of demand • Example • Demand for an antibiotic is highly inelastic when it alone can kill an infection resistant to all other antibiotics. • Rather than die of an infection, patients will generally be willing to pay whatever is necessary to acquire enough of the antibiotic to kill the infection.

  7. 3.9 Price Elasticity of demand • Necessities and Inelasticity • Inelastic demand is commonly associated with "necessities," although there are many more reasons a good or service may have inelastic demand other than the fact that consumers may "need" it.

  8. 3.9 Price Elasticity of demand • Substitution and Elasticity • Substitution serves as a much more reliable predictor of elasticity of demand than “necessity” • E.g: Few substitutes for oil and gasoline exist • demand for these goods is relatively inelastic. • However, products with a high elasticity usually have many substitutes. • E.g.: Potato chips are only one type of snack food out of many others, such as corn chips or crackers, and predictably, consumers have more room to turn to those substitutes if potato chips were to become more expensive. Vs

  9. 3.10 Factors affecting price elasticity • Factors affecting price elasticity • Availability of Substitutes • The good is habit forming or obligatory • The proportion of the consumer's income • Duration of the demand shortage

  10. 3.10 Factors affecting price elasticity • 3.10.1 Availability of Substitutes • Easily substitutable goods will enable buyers to switch to an alternative good and thus such goods will exhibit greater elasticity than goods that do not have substitutes available • It is important to understand that a given good is in essence unique and thus the comparability of the available substitutes in terms of quality to the original good is an important sub-variable. • The better the substitutes can replace the original good in terms of desirability, affordability, practicality etc. the more elastic the good will become.

  11. 3.10 Factors affecting price elasticity • 3.10.1 Availability of Substitutes • Example • A driver used to use the Western Harbour Tunnel could switch to use the Central Harbour Tunnel if the Western Harbour Tunnel fares rise. • However, it may be inconvenient and longer journey time and thus will form part of his consideration before switching the route • It may take a certain price difference before he chooses this option representing the substitute's quality.

  12. 3.10 Factors affecting price elasticity • 3.10.1 Availability of Substitutes • Example • If the cost of butter rises significantly consumers can choose to consume margarine instead • But a shop who makes and sells butter cookies will not have this option and thus the Price Elasticity of Demand will thus be far more inelastic in the latter case.

  13. 3.10 Factors affecting price elasticity • 3.10.1 Availability of Substitutes • Example • A driver faced with rising petrol bills may opt to switch to using the train. • However an airline company has no choice but to absorb rising fuel costs and will according have a much more inelastic demand curve for the essentially the same good. No choice!

  14. 3.10 Factors affecting price elasticity • 3.10.2. The good is habit forming or obligatory • Addictive drugs, whether psychologically addictive or physically addictive, and other goods where dependency plays a key role will naturally exhibit inelastic properties. • At aggregate level, rising costs of such goods are unlikely to reduce demand significantly. • Classic examples of such goods would be alcohol and tobacco.

  15. 3.10 Factors affecting price elasticity • 3.10.2. The good is habit forming or obligatory • Governments often place taxes on these types of goods, namely alcohol, tobacco and fuel because of their highly inelastic demand since consequently such goods are assured revenue generators for the treasury. • Tax rate for fuel gases is over 40% in Hong Kong!

  16. 3.10 Factors affecting price elasticity • 3.10.3. The proportion of the consumer's income • Goods which typically make up a small proportion of people's income will exhibit inelastic qualities. • Conversely, goods which form a large proportion of people's income will cause greater responses in demand to comparable % increases or decreases in price. • Example • If cinema ticket costs rise by 20%, decreases in demand are unlikely to be pronounced. • However a 15% drop in a "luxury" good such as a car or LCD Television changes in demand are likely to be relatively greater.

  17. 3.10 Factors affecting price elasticity • 3.10.4. Duration of the demand shortage • Generally the greater the shortage period, the more possible it may be for a good to be replaced with a substitute. • Example: Home • A gas user faced with rising gas bills will unlikely be able to switch to electric alternatives overnight due to possibly contractual tie-ins and time needed to change a stove to electric hob for example. • However over 3 months, a switch is far more viable and the Price Elasticity of Demand will be accordingly more elastic. • Likewise, prices are dynamic. • Over short time periods, prices of substitutes maybe static • Over longer periods, the price of substitutes may drop, making them more appealing. ?

  18. 3.11 Calculating Elasticity • Definitions • Linear Elasticity • is the % change in one variable divided by the % change in another variable • Arc elasticity • calculates the elasticity over a range of values • Point elasticity • uses differential calculus to determine the elasticity at a specific point)

  19. 3.11. Calculation of Elasticity • 3.11.1 Linear Elasticity • The formula used to calculate the coefficient of price elasticity of demand for a given product is • This simple formula has a problem, however. • It yields different values for Ed depending on whether Qd and Pd are the original or final values for quantity and price.

  20. 3.11 Calculating Elasticity • 3.11.1 Linear Elasticity • Example • If the price moves from $1.00 to $1.05, and the quantity supplied goes from 100 pens to 102 pens, the slope is 2/0.05 or 40 pens per dollar. What’s the price elasticity? • Since the elasticity depends on the percentages: • Percentage increment in Quantity of pens =(102-100)/100= 2% • Percentage increment in price =(1.05-1.00)/1.00=5% •  Price elasticity of supply is 2/5 = 0.4

  21. 3.11 Calculating Elasticity • 3.11.2. Arc Elasticity • Elasticity figure you come up with is different depending on what you use as the start point and what you use as the end point. • When we looked at Price Elasticity of Demand we calculated the price elasticity of demand when: • price went from $9 to $10 and • demand went from 150 to 110 Elasticity = (∆Q/Q)/(∆P/P) = (-40/ 150) / (1/ 9) = - 2.4 P 10 9 Q 1000 0 110 150

  22. 3.11 Calculating Elasticity • 3.11.2. Arc Elasticity • But what if we calculated what the price elasticity of demand when we started at $10 and went to $9? So we'd have: • By filling in the values we wrote down, we get: Elasticity = (∆Q/Q)/(∆P/P) = [150 - 110] / 110= -3.636 [9 - 10] / 10 • Obviously 3.6 is a lot different from 2.4 •  this way of measuring price elasticity is quite sensitive to which of your two points you choose as your new point, and which you choose as your old point. • Arc elasticities are a way of removing this problem. P 10 9 Q 1000 0 110 150

  23. After: To calculate an arc-elasticity, we use the following formula: DemandNEW – DemandOLD ½ ( DemandOLD + DemandNEW ) This formula takes an average of the old quantity demanded and the new quantity demanded on the denominator. 3.11 Calculating Elasticity • 3.11.2. Arc Elasticity • When calculating Arc Elasticities, the basic relationships stay the same. So when we're calculating Price Elasticity of Demand we still use the basic formula: Elasticity = % Change in Quantity Demanded % Change in Price Before DemandNEW - DemandOLD DemandOLD

  24. 3.11 Calculating Elasticity • 3.11.2. Arc Elasticity • We will get the same answer (in absolute terms) by choosing $9 as old and $10 as new, as we would choosing $10 as old and $9 as new. • When we use arc elasticity we do not need to worry about which point is the starting point and which point is the ending point. This benefit comes at the cost of a more difficult calculation. P 10 9 Q 1000 0 110 150

  25. 3.11 Calculating Elasticity • 3.11.2. Arc Elasticity • Example: PriceOLD=9 PriceNEW=10 DemandOLD=150 DemandNEW=110 • We will get a percentage change of: (110 – 150) = -40/ (260x ½) = -0.3707 (150 + 110)x ½ • So we get a percentage change of -0.3707 (or -37% in percentage terms). • If we swap the old and new values, the denominator will be the same, but we will get +40 in the numerator instead, giving us an answer of the 0.3707. • When we calculate the percentage change in price, we will get the same values except one will be positive and the other negative. DemandNEW – DemandOLD ½ ( DemandOLD + DemandNEW )

  26. 3.11 Calculating Elasticity • 3.11.3 Point-price elasticity Elasticity,  = (% change in Quantity) (% change in Price) = (∆Q/Q)/(∆P/P) = (P ∆Q)/(Q ∆P) = (P/Q)(∆Q/∆P) Point Elasticity = lim (P/Q)(∆Q/∆P) = ∆0 • Note: • In the limit (or "at the margin"), "(∆Q/∆P)" is the derivative of the demand function with respect to P.  >1  Elastic  <1  Inelastic P • = (∆Q/Q) (∆P/P) Q 1000 0 40 80

  27. 3.11 Calculating Elasticity • 3.11.3 Point-price elasticity • Example • Given a demand curve (Q = 1000 - 0.6P ) determine the point price elasticity of demand at P = 80 and P = 40 • Step 1: obtain the derivative of the demand function when it's expressed Q as a function of P. • Step 2: next apply the above equation to the sought ordered pairs • At P = 40 = -0.6(40/976) = -0.02 • At P = 80 = -0.6(80/952) = -0.05 -0.6 P 976 952 Q 1000 0 40 80

  28. 3.11 Calculating Elasticity • 3.11.4. Total Revenue Test • It is a means for determining whether demand is elastic or inelastic. • If  price  Total revenue, (Pt A B) • then demand can be said to be inelastic, since the increase in price does not have a large impact on quantity demanded. • If  price   total revenue, (Pt.B C) • then demand can be said to be elastic, since the increase in price has a large impact on quantity demanded. P C B A Q 1000 Area under the demand curve is the revenue

  29. 3.11 Calculating Elasticity • 3.11.4. Total Revenue Test • Examples: • 1. Product A currently sells for $10. The seller decides to increase the price to $15, but finds that he ends up making less money. • This is because he is selling fewer of the product due to the increased price, and his total revenue has fallen. The demand for this product must be elastic. • 2. Product A currently sells for $10. The seller decides to increase the price to $15, and finds that his revenue ends up increasing. • The demand for this product must be inelastic.

  30. 3.11 Elasticity and revenue • 3.11.4. Total Revenue Test • A set of graphs shows the relationship between demand and total revenue. • In the elastic range (|| > 1), • Elasticity  Revenue  • Price   Revenue  • In the inelastic range (|| < 1), • Elasticity  Revenue  • Price   Revenue  Area under the demand curve is the revenue elastic range Inelastic range elastic range,  decreasing

  31. 3.12 Perfect elasticity and Perfect inelasticity • 3.11.4. Total Revenue Test • When the price elasticity of demand for a good is inelastic (|| < 1), • the % change in quantity is smaller than that in price. •  when the price is raised, the total revenue of producers rises, and vice versa. • When the price elasticity of demand for a good is elastic (|| > 1), • the % change in quantity demanded is greater than that in price. • Hence, when the price is raised, the total revenue of producers falls, and vice versa. • When the price elasticity of demand for a good is unit elastic (or unitary elastic) (|| = 1), • the % change in quantity is equal to that in price.

  32. 3.12 Perfect elasticity and Perfect inelasticity • Example - Find out the optimal pricing that maximize revenue: • Given a demand curve. • Determine the optimal price that maximize revenue Revenue, R = Price x Qty R = P x (1000-50P) = 1000P-50P2 Maximum when dR/ dP = 0 dR/dP = 1000 - 2x50P dR/dP =0  P = 10 Q = 1000 - 50P P 20 10 Q = 1000 - 50P 0 500 1000 Q Mid Point is the Optimal Point!

  33. 3.12 Perfect elasticity and Perfect inelasticity • 3.12.1 Perfectly elastic ( is infinity) • Any increase in the price, no matter how small, will cause demand for the good to drop to zero. •  when the price is raised, the total revenue of producers falls to zero. • The demand curve is a horizontal straight line. • Example • A banknote is the classic example of a perfectly elastic good; nobody would pay $10.01 for a $10 note, yet everyone will pay $9.99 for it. $ Demand curve 10.01 10.00 9.99 Qty

  34. 3.12 Perfect elasticity and Perfect inelasticity • 3.12.2 Perfectly inelastic demand( = 0) • Changes in the price do not affect the quantity demanded for the good. • The demand curve is a vertical straight line • Example • Human heart for someone who needs a transplant; neither increases nor decreases in price affect the quantity demanded • No matter what the price A person will pay for one heart but only one • Nobody would buy more than the exact amount of hearts demanded, no matter how low the price is. $ Demand curve Qty

  35. 3.12 Perfect elasticity and Perfect inelasticity • 3.12.3. Perfectly Inelastic Supply (Vertical supply curve ) • An example of perfectly inelastic supply, or zero elasticity, is represented as a vertical supply curve • When demand D1 is in effect, the price will be P1. • When D2 is occurring, the price will be P2. • Notice that at both values the quantity is Q. Since the supply is fixed, any shifts in demand will only affect price.

  36. 3.12.3 Perfectly Inelastic Supply) When demand D1 is in effect, the price will be P1. When D2 is occurring, the price will be P2. Notice that at both values the quantity is Q. Since the supply is fixed, any shifts in demand will only affect price. 3.12 Perfect elasticity and Perfect inelasticity

  37. 3.12 Perfect elasticity and Perfect inelasticity • 3.12.3 Perfectly Inelastic Supply • It is sometimes the case that a supply curve is vertical • e.g. that is the quantity supplied is fixed, no matter what the market price. • Example: • The Solar Energy received on earth is fixed. No matter how much someone would be willing to pay for an additional watt, the extra cannot be created. • Also, even if no one wanted all the land, it still would exist. • Solar Energy therefore has a vertical supply curve, giving it zero elasticity (i.e., no matter how large the change in price, the quantity supplied will not change). • Many other nature resources are similar However, the supply of solar energy panel are not because it involves manufacturing cost

  38. 3.13. Other Elasticity • Other Elasticity in relation to other variables • Price elasticity of supply • Income elasticity of demand • Cross elasticity of demand

  39. 3.13 Other Elasticity • 3.13.1. Price elasticity of supply • Definition • A numerical measure of the responsiveness of the quantity supplied of product X to a change in price of product X alone. • It is measured as the % change in supply that occurs in response to a % change in price. • Example • If, in response to a 10% rise in the price of a good, the quantity supplied increases by 20%, the price elasticity of supply would be 20%/10% = 2. $ Supply Curve 10% 20% Q

  40. 3.13 Other Elasticity • 3.13.1. Price elasticity of supply • In the short term: • The supply quantity can be different from the amount produced, as manufacturers will have stocks which they can build up or run down. • In the long run: • However, quantity supplied and quantity produced are synonymous.

  41. 3.13 Other Elasticity • 3.13.1. Price elasticity of supply • Determinants of the price elasticity of supply are: • Storage capacity of the firms • if they have more goods in stock they will be able to respond to a change in price quicker); • Production spare capacity • the more spare capacity there is in the industry the easier it should be to increase output if the price goes up; • Number of producers • Length of the production process • Time period and the factor immobility • the ease of resources to move into the industry

  42. 3.13. Other Elasticity • 3.13.2. Income elasticity of demand • To measure how would the demand for a good change if income increased or decreased • Example • How much would the demand for a luxury car increase if average income increased by 10%? • If it is positive, this increase in demand would be represented on a graph by a positive shift in the demand curve. At all price levels, more luxury cars would be demanded. Income elasticity of demand good X = % change of good X in quantity demand % change of income

  43. 3.13. Other Elasticity • 3.13.2. Income elasticity of demand • Normal good • income elasticity of demand +ve • Income  Demand  • Inferior good • income elasticity of demand –ve • Income  Demand  • Luxury good • income elasticity of demand >1 • Demand increase faster than income increase • Necessity good • income elasticity of demand <1 • Demand increase slower than income increase Demand Income Demand Income Demand Income Demand Income

  44. 3.13. Other Elasticity • 3.13.3 Cross elasticity of demand • It measures the responsiveness of the quantity demanded of a good to a change in the price of another good. • This is often considered when looking at the relative changes in demand when studying complement and substitute goods. • Complement goods are goods that are typically utilized together, where if one is consumed, usually the other is also. • E.g. Bread and Butter, Coffee and Milk, Fuel and Car; Computers and Software • Substitute goods are those where one can be substituted for the other, and if the price of one good rises, one may purchase less of it and instead purchase its substitute.

  45. 3.13. Other Elasticity • 3.13.3 Cross elasticity of demand • Cross elasticity of demand is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. • Exercise • If, in response to a 10% increase in the price of fuel, the quantity of new cars demanded decreased by 20%, What is the cross elasticity of demand? A) 2.0 B) 0.5 C) -0.5 D) -2.0 Cross elasticity of demand = % change of good i in quantity demand % change of good j in price Ans: (D) -2.0

  46. 3.14 Types of Market Structures • Basic Market Structures • There are four types of Market Structures • Perfect Competition • Considerable no of Similar Firms • Monopoly • One Firm • Oligopoly • Few Firms • Monopolistic Competition • Many Firms show product differentiation

  47. 3.14 Types of Market Structures • 3.14.1 Perfect Competition • Large number of small and alike firms • Sell similar (identical) products • Buyers & sellers accessible to market information • Low barrier to open or to close a firm • Basically price competition until marginal profit is zero. • Example • Almost non-existent. • Close examples: Fruit & vegetable market.

  48. 3.14 Types of Market Structures • 3.14.2 Monopoly • A monopoly is the case of a single supplier that can adjust the supply or price of a good at will. • The profit-maximizing monopolist is modeled as adjusting the price so that its profit is maximized given the amount that is demanded at that price. • This price will be higher than in a competitive market. • Monopoly power achieved by: • Patent, • Statute, • Large capital/structure • Extremely high barrier for new entrants • e.g. CLP in Kowloon/N.T., HEC in HK

  49. 3.14 Types of Market Structures • 3.14.2 Monopoly • But when there is only one seller, then the competition will be zero. • If point A is the point of maximum profit, then the seller shall produce that quantity. • And the supply curve shall move upward (anti-clockwise) • i.e. The seller does not have to produce point B yet enjoying the price of point A. A B Price rise for the same amount of qty

  50. 3.14 Types of Market Structures • 3.14.3 Oligopoly • Oligopoly is a market with so few suppliers that they must take account of their actions on the market price or each other. • Few firms produce all or most of outputs • Large capital investments or other natural factors that prevent new entrants • Supply curve moves anti-clockwise but not to the extent of a monopoly. • Example: • Oil industry; Supermarkets; Network Providers Oligopoly Monopoly

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