Topics in Demand and Supply Analysis

Elasticity of demand and elasticity of supply

measures how sensitive quantity demanded or supplied is to changes in the independent variables that affect them. Elasticity is a general measure of how sensitive one variable is to any other variable, and it is expressed as the ratio of percentage changes in each variable: %Δy/%Δx.

Average product of labor (APL)

measures the productivity of an input (in this case, labor) on average and is calculated by dividing total product by the total number of units for the given input that is used to generate that output.

For inferior goods

an increase in income causes consumers to buy less, not more, and if their incomes fall, they buy more, not less. "Inferior" does not imply anything at all about the quality of the good; it is simply used to refer to a good for which an increase in income causes some people to buy less of it.

Variable costs

are all costs that fluctuate with the level of production and sales. This relationship between cost and productivity also holds with average variable cost.

As the firm grows in size, economies of scale and a lower ATC can result from the following factors:

- Increasing returns to scale, which is when a production process allows for increases in output that are proportionately larger than the increase in inputs. - Having a division of labor and management in a large firm with numerous workers, which allows each worker to specialize in one task rather than perform many duties, as in the case of a small business (as such, workers in a large firm become more proficient at their jobs). - Being able to afford more expensive, yet more efficient equipment and to adapt the latest in technology that increases productivity. - Effectively reducing waste and lowering costs through marketable byproducts, less energy consumption, and enhanced quality control. - Making better use of market information and knowledge for more effective managerial decision making. - Obtaining discounted prices on resources when buying in larger quantities.

The factors that can lead to diseconomies of scale, inefficiencies, and rising costs when a firm increases in size include the following:

-Decreasing returns to scale, which is when a production process leads to increases in output that are proportionately smaller than the increase in inputs. -Being so large that it cannot be properly managed. -Overlapping and duplication of business functions and product lines. -Higher resource prices because of supply constraints when buying inputs in large quantities.

The benefits from increased productivity are as follows:

-lower business costs, which translate into increased profitability; -an increase in the market value of equity and shareholders' wealth resulting from an increase in profit; and -an increase in worker rewards, which motivates further productivity increases from labor.

Breakeven Analysis

A firm is said to break even if its TR is equal to its TC. It can also be said that a firm breaks even if its price (AR) is exactly equal to its ATC, which is true under conditions of perfect and imperfect competition. Of course, the goal of management is not just to break even but to maximize profit. However, perhaps the best the firm can do is cover all of its economic costs.

Relationships between the average total cost (ATC), average variable cost (AVC), average fixed cost (AFC), and marginal cost (MC) curves in the short run

As output quantity increases, AFC declines because TFCs are spread over a larger number of units. Both ATC and AVC take on a bowl-shaped pattern in which each curve initially declines, reaches a minimum average cost output level, and then increases after that point. The MC curve intersects both the ATC and the AVC at their minimum points—points S and T. When MC is less than AVC, AVC will be decreasing. When MC is greater than AVC, AVC will be increasing.

Would additional unit increase profit?

Clearly, profit would be increased (or losses reduced) if the additional revenue from that next unit were greater than the additional cost. So, a profit-seeking firm should increase Q if MR > MC. Conversely, if the additional unit added more to cost than to revenue, the firm should reduce output because it would save more in cost than it would lose in revenue. Only if the additional cost were exactly equal to the additional revenue would the firm be maximizing its profit. There is another condition (called a second-order condition) necessary for profit maximization: At the level of output at which MR = MC, MC cannot be falling. This condition is fairly intuitive. If MC is falling with additional output, MPL would be rising. (Recall that SMC = w/MPL) If one additional hour of labor input causes MC to fall, the firm would want to add that hour and continue adding labor until SMC becomes positively sloped. We can sum up the profit-maximization decision for an operating firm as follows: Produce the level of output such that (1) MR = MC and (2) MC is not falling.

Income effect (based on purchasing power )

Consider a consumer spending all of her "money income" on a given combination of goods and services. Now suppose the price of something she was regularly purchasing falls while her money income and the prices of all other goods remain unchanged. Economists refer to this as an increase in purchasing power or real income. For most goods and services, consumers tend to buy more of them when their income rises.

Why is productivity important?

Cost-minimization and profit-maximization behavior dictate that the firm strives to maximize productivity—for example, produce the most output per unit of input or produce any given level of output with the least amount of inputs.

The graph of the inverse demand function is called

Demand curve. The demand curve represents the highest quantity willingly purchased at each price as well as the highest price willingly paid for each quantity. The slope of the demand curve is measured as the change in price, P, divided by the change in quantity, Q (ΔP/ΔQ, where Δ stands for "the change in").

Economic profit

Economists define profit differently than do accountants. Economic profit is defined as the difference between total revenue (TR) and total economic costs. Accounting profit is the difference between TR and total accounting cost. TR is the same from both an accounting standpoint and an economic standpoint; it is derived by multiplying the selling price per unit of output by the number of units: TR = (P)(Q). The difference between the two measures of profit, therefore, lies in an understanding of economic cost (also called "opportunity cost," which is defined in detail in the next section).

Quasi-fixed cost

Fixed costs may stay the same over a given range of production but can change to another constant level when production moves outside of that range. The latter is referred to as a quasi-fixed cost, although it remains categorized as part of TFC. Examples of fixed costs are debt service, real estate lease agreements, and rental contracts.

How consumers' purchases of a good respond to changes in consumer income.

For most goods and services, an increase in income would cause consumers to buy more; these are called normal goods. But that does not hold true for all goods: There are goods that consumers buy less of when their income rises and goods that they buy more of when their incomes fall. These are called inferior goods.

Short Run and Long Run Decisions to Operate or Not

Given the relationships between TR, TVC, and TFC, Exhibit 22 summarizes the decisions to operate, shut down production, or exit the market in both the short run and the long run. The firm must cover its variable cost to remain in business in the short run; if TR cannot cover TVC, the firm shuts down production to minimize loss. The loss would be equal to the amount of fixed cost. If TVC exceeds TR in the long run, the firm will exit the market to avoid the loss associated with fixed cost at zero production. By exiting the market, the firm's investors do not suffer the erosion of their equity capital from economic losses. When TR is enough to cover TVC but not all of TFC, the firm can continue to produce in the short run but will be unable to maintain financial solvency in the long run.

There is a relationship that always holds for average and marginal costs:

If MC is less than average cost, average cost must fall, and if MC is greater than average cost, average cost must rise.

Normal good: substitution and income effect together

If a good is normal, a decrease in price will result in the consumer buying more of that good. Both the substitution effect and the income effect are at play here: -A decrease in price tends to cause consumers to buy more of this good in place of other goods—the substitution effect. -The increase in real income resulting from the decline in this good's price causes people to buy even more of this good when its price falls—the income effect.

The Shutdown Decision

In the long run, if a firm cannot earn at least a zero economic profit, it will not operate because it is not covering the opportunity cost of all of its factors of production, labor, and capital. In the short run, however, a firm might find it advantageous to continue to operate even if it is not earning at least a zero economic profit. Sunk costs must be ignored in the decision to continue to operate in the short run. As long as the firm's revenues cover at least its variable cost, the firm is better off continuing to operate. If price is greater than AVC, the firm is not only covering all of its variable cost but also a portion of fixed cost. Economists refer to the minimum AVC point as the shutdown point and the minimum ATC point as the breakeven point.

Predicting Demand Elasticity

If there are close substitutes for the good, then if its price rises even slightly, a consumer would tend to purchase much less of this good and switch to the less costly substitute. If there are no substitutes, however, then it is likely that the demand is much less elastic. In general, if consumers tend to spend a very small portion of their budget on a good, their demand tends to be less elastic than if they spend a very large part of their income. This example leads to another characteristic regarding price elasticity. For most goods and services, the long-run demand is much more elastic than the short-run demand. For example, if the price of gasoline rises, we probably would not be able to respond quickly to reduce the quantity we consume. In the short run, we tend to be locked into modes of transportation, housing and employment location, and so on. With a longer adjustment period, however, we can adjust the quantity consumed in response to the change in price by adopting a new mode of transportation or reducing the distance of our commute. Knowing whether the good or service is seen to be discretionary or non-discretionary helps to understand its sensitivity to a price change. Faced with the same percentage increase in prices, consumers are much more likely to give up their Friday night restaurant meal (discretionary) than they are to cut back significantly on staples in their pantry (non-discretionary). The more a good is seen as being necessary, the less elastic its demand is likely to be.

Substitutes

In economics, if the cross-price elasticity of two goods is positive, they are substitutes, irrespective of whether someone would consider them "similar."

Law of demand

In general, economists believe that as the price of a good rises, buyers will choose to buy less of it, and as its price falls, they buy more.

Own-price, income, and cross-price elasticity formulas

In our example, at a price of €1.48, the own-price elasticity of demand is -0.20; a 1% increase in the price of gasoline leads to a decrease in quantity demanded of about 0.20% (Equation 10). Because the absolute value of the own-price elasticity is less than one, we characterize demand as being inelastic at that price. The income elasticity of demand is 0.26 (Equation 11): A 1% increase in income would result in an increase of 0.26% in the quantity demanded of gasoline. Because that elasticity is positive (but small), we would characterize gasoline as a normal good. The cross-price elasticity of demand between gasoline and automobiles is −0.84 (Equation 12): If the price of automobiles rose by 1%, the demand for gasoline would fall by 0.84%. We would, therefore, characterize gasoline and automobiles as complements because the cross-price elasticity is negative. The magnitude is quite small, however, so we would conclude that the complementary relationship is weak.

Giffen goods

In theory, it is possible for the income effect to be so strong and so negative as to overpower the substitution effect. In such a case, more of a good would be consumed as the price rises and less would be consumed as the price falls.

Income Elasticity of Demand

Income elasticity of demand is defined as the percentage change in quantity demanded %ΔQd divided by the percentage change in income (%ΔI), holding all (x)other things constant. Although own-price elasticity of demand will almost always be negative, income elasticity of demand can be negative, positive, or zero. Positive income elasticity means that as income rises, quantity demanded also rises. Negative income elasticity of demand means that when people experience a rise in income, they buy less of these goods, and when their income falls, they buy more of the same good. Goods with positive income elasticity are called "normal" goods. Goods with negative income elasticity are called "inferior" goods. Typical examples of inferior goods are rice, potatoes, or less expensive cuts of meat. For normal goods, a rise in income would shift the entire demand curve upward and to the right. For inferior goods, however, a rise in income would result in a downward and leftward shift in the entire demand curve.

Sunk costs

It cannot be avoided, no matter what the firm does. Sunk costs must be ignored in the decision to continue to operate in the short run.

Substitution effect (based on price)

On its own, the substitution effect suggests that when the price of something falls, consumers tend to purchase more of that good. The substitution effect says that if the price of a good falls, the consumer will substitute more of this good in the consumption bundle and buy less of some other good. The substitution effect is true for both normal and inferior goods.

Understanding Economies and Diseconomies of Scale

Rational behavior dictates that the firm select an operating size or scale that maximizes profit over any time frame. The short run is the time period during which at least one of the factors of production, such as technology, physical capital, and plant size, is fixed. The long run is defined as the time period during which all factors of production are variable. Additionally, in the long run, firms can enter or exit the market based on decisions regarding profitability. The long run is often referred to as the "planning horizon" in which the firm can choose the short-run position or optimal operating size that maximizes profit over time. The firm is always operating in the short run but planning in the long run.

Short- and Long-Run Cost Curves

Recall that when we addressed the short-run cost curves of the firm, we assumed that the capital input was held constant. That meant that the only way to vary output in the short run is to change the level of the variable input—in our case, labor. If the capital input—namely, plant and equipment—were to change, however, we would have an entirely new set of short-run cost curves, one for each level of capital input. The short-run total cost includes all the inputs—labor and capital—the firm is using to produce output. For reasons discussed earlier, the typical short-run total cost (STC) curve might rise with output, first at a decreasing rate because of specialization economies and then at an increasing rate, reflecting the law of diminishing marginal returns to labor. Total fixed cost (the quantity of capital input multiplied by the rental rate on capital) determines the vertical intercept of the STC curve. At higher levels of fixed input, TFC is greater but the production capacity of the firm is also greater. The long-run total cost curve is derived from the lowest level of STC for each level of output because in the long run, the firm is free to choose which plant size it will operate. This curve is called an "envelope curve." In essence, this curve envelopes—encompasses—all possible com- binations of technology, plant size, and physical capital. For each STC curve, there is also a corresponding short-run average total cost (SATC) curve and a corresponding long-run average total cost (LRAC) curve, the envelope curve of all possible short-run average total cost curves. The shape of the LRAC curve reflects an important concept called economies of scale and diseconomies of scale.

The law of demand states

That if nothing changes other than the price of a particular good or service itself, a decrease in that good's price will tend to result in a greater quantity of that good being purchased. Simply stated, it is the assumption that a demand curve has negative slope; that is, where price per unit is measured on the vertical axis and quantity demanded per time period is measured on the horizontal axis, the demand curve is falling from left to right.

sunk cost

The money spent in the past on the firm's plant and equipment is what economists call a "sunk cost."

Revenue under Conditions of Perfect and Imperfect Competition

The difference between the two manifests itself in the slope of the demand curve facing the firm. If the environment of the firm is perfectly competitive, it must take the market price of its output as given, so it faces a perfectly elastic, horizontal demand curve. In this case, as we saw previously, the firm's MR and the price of its product are identical. Additionally, the firm's average revenue (AR), or revenue per unit, is also equal to price per unit. However, a firm that faces a negatively sloped demand curve must lower its price to sell an additional unit, so its MR is less than price (P). These characteristics of MR are also applicable to the TR functions. Under conditions of perfect competition, TR (as always) is equal to price times quantity: TR = (P)(Q). But under conditions of perfect competition, price is dictated by the market; the firm has no control over price. As the firm sells one more unit, its TR rises by the exact amount of price per unit. Under conditions of imperfect competition, price is a variable under the firm's control, and therefore price is a function of quantity: P = f(Q), and TR = f(Q) × Q. For simplicity, suppose the firm is monopolistic and faces the market demand curve, which we will assume is linear and negatively sloped. Because the monopolist is the only seller, its TR is identical to the total expenditure of all buyers in the market.

Expand Own-price elasticity of demand

The first term, ΔQ/ΔP, which is the inverse of the slope of the demand curve, remains constant along the entire demand curve. But the second term, P/Q, changes depending on where we are on the demand curve. At very low prices, P/Q is very small, so demand is inelastic. But at very high prices, Q is low and P is high, so the ratio P/Q is very high and demand is elastic.

Inverse demand function

The inverse demand function views price as a function of quantity. The price can't be negative.

The quantity of a good that consumers are willing to buy depends on a number of different variables.

The price, consumers' incomes, their tastes and preferences, and the prices of other goods that serve as substitutes or complements are just a few of the other variables that influence consumers' demand for a product or service. Economists attempt to capture all these influences in a relationship called the demand function.

Demand function

The signs of the coefficients on gasoline price (negative) and consumers' income (positive) reflect the relationship between those variables and the quantity of gasoline consumed. It is expressed the quantity demanded of some good as a function of several variables, one of which was the price of the good itself (the good's "own-price").

Extremes of Price Elasticity

There are two special cases in which linear demand curves have the same elasticity at all points: vertical demand curves and horizontal demand curves. In the first case, the quantity demanded is the same, regardless of price. There is no demand curve that is perfectly vertical at all possible prices, but it is reasonable to assume that, over some range of prices, the same quantity would be purchased at a slightly higher price or a slightly lower price. Thus, in that price range, quantity demanded is not at all sensitive to price, and we would say that demand is perfectly inelastic in that range. In the second case, the demand curve is horizontal at some given price. It implies that even a minute price increase will reduce demand to zero, but at that given price, the consumer would buy some large, unknown amount. This situation is a reasonable description of the demand curve facing an individual seller in a perfectly competitive market, such as the wheat market. At the current market price of wheat, an individual farmer could sell all she has. If, however, she held out for a price above market price, it is reasonable to believe that she would not be able to sell any at all; other farmers' wheat is a perfect substitute for hers, so no one would be willing to buy any of hers at a higher price. In this case, we would say that the demand curve facing a seller under conditions of perfect competition is perfectly elastic.

Own-price elasticity of demand

This equation expresses the sensitivity of the quantity demanded to a change in price. Edpx is the good's own-price elasticity and is equal to the percentage change in quantity demanded divided by the percentage change in price.

Complements

Typically, these goods tend to be consumed together as a pair, such as gasoline and automobiles or houses and furniture. When automobile prices fall, we might expect the quantity of autos demanded to rise, and thus we might expect to see a rise in the demand for gasoline.

Defining Economies of Scale and Diseconomies of Scale

When a firm increases all of its inputs in order to increase its level of output (obviously, a long-run concept), it is said to scale up its production. Scaling down is the reverse— decreasing all of its inputs in order to produce less in the long run. Economies of scale occur if, as the firm increases its output, cost per unit of production falls. Graphically, this definition translates into a LRAC curve with a negative slope. Diseconomies of scale occur if cost per unit rises as output increases. Graphically, diseconomies of scale translate into an LRAC curve with a positive slope. Exhibit 25 depicts several SATC curves, one for each plant size, and their envelope curve, the LRAC curve, representing diseconomies of scale.

TVC has a direct relationship with quantity.

When quantity increases, TVC increases; when quantity decreases, TVC declines. At zero production, TVC is always zero. Variable cost examples are payments for labor, raw materials, and supplies. The change in TVC declines up to a certain output point and then increases as production approaches capacity limits.

Elasticity interpretation

When the magnitude (ignoring algebraic sign) of the own-price elasticity coefficient has a value of less than one, demand is said to be inelastic. When that magnitude is greater than one, demand is said to be elastic. And when the elasticity coefficient is equal to negative one, demand is said to be unit elastic, or unitary elastic. <1 = ineslastic >1 = elastic -1 = unit elastic

Veblen goods

With some goods, the item's price tag itself might drive the consumer's preferences for it. Thorstein Veblen posited just such a circumstance in his concept of conspicuous consumption. According to this way of thinking, a consumer might derive utility out of being known by others to consume a so-called high-status good, such as a luxury auto- mobile or a very expensive piece of jewelry. Importantly, it is the high price itself that partly imparts value to such a good. These are called Veblen goods, and they derive their value from the consumption of them as symbols of the purchaser's high status in society; they are certainly not inferior goods. It is argued that by increasing the price of a Veblen good, the consumer would be more inclined to purchase it, not less.

economic loss

a condition in which revenues fall short of total opportunity cost.

Giffen goods and veblen goods

a decrease (increase) in price may result in a decrease (increase) in the quantity demanded. These unusual cases are called Giffen goods and Veblen goods.

Economic costs

are the sum of total accounting costs and implicit opportunity costs. A firm whose revenue is equal to its economic costs is covering the opportunity cost of all of its factors of production, including capital. A firm whose revenue is equal to its economic costs is covering the opportunity cost of all of its factors of production, including capital. Economists would say that such a firm is earning normal profit, but not positive economic profit. It is earning a rate of return on capital just equal to the rate of return that an investor could expect to earn in an equivalently risky alternative investment (opportunity cost).

Microeconomics classifies private economic units into two groups:

consumers (or households) and firms. These two groups give rise, respectively, to the theory of the consumer and the theory of the firm as two branches of study.

Macroeconomics

deals with aggregate economic quantities, such as national output and national income, and is rooted in microeconomics

Theory of the consumer

deals with consumption (the demand for goods and services) by utility- maximizing individuals (i.e., individuals who make decisions that maximize the satisfaction received from present and future consumption).

Microeconomcis

deals with markets and decision making of individual economic units, including consumers and businesses.

Theory of the firm

deals with the supply of goods and services by profit-maximizing firms.

Two important considerations of any firm are

its level of profitability and whether to continue to operate in the current environment.

Increasing marginal returns

in which marginal product—the productivity of each additional unit of a resource—increases as additional units of that input are employed. Initially, a firm can experience increasing returns from adding labor to the production process because of the concepts of specialization and division of labor. As more workers are added, employees can specialize, become more adept at their individual functions, and realize an increase in marginal productivity. But after a certain output level, the law of diminishing marginal returns becomes evident. When more and more workers are added to a fixed capital base, the marginal return of the labor factor eventually decreases because the fixed input restricts the output potential of additional workers. Marginal returns are directly related to input productivity, a measure of the output per unit of input.

Normal profit

is also considered to be a fixed cost because it is a return required by investors on their equity capital regardless of output level.

Summary on own-price elasticity of demand

is likely to be greater (i.e., more sensitive) for items that have many close substitutes, occupy a large portion of the total budget, are seen to be optional instead of necessary, or have longer adjustment times.

Marginal revenue (MR)

is the additional revenue the firm realizes from the decision to increase output by one unit per time period. That is, MR = ΔTR/ΔQ. If the firm is operating in what economists call a perfectly competitive market, it is one of many sellers of identical products in an environment characterized by low or non-existent barriers to entry. Under perfect competition, the firm has no pricing power because there are many perfect substitutes for the product it sells. If it were to attempt to raise the price even by a very small amount, it would lose all of its sales to competitors. On the other hand, it can sell essentially any amount of product it wants without lowering the price below the market price.

opportunity cost

is the forgone benefit that would have been derived by an option not chosen.

The firm's marginal cost

is the foundation of the firm's ability and willingness to offer a given quantity for sale, and its costs depend on both the productivity of its inputs and their prices.

Marginal cost (MC)

is the increase to total cost resulting from the firm's decision to increase output by one additional unit per time period: MC = ΔTC/ΔQ. Economists distinguish between short-run marginal cost (SMC) and long-run marginal cost (LMC). Labor is variable over the short run, but the quantity of capital cannot be changed in the short run because there is a lead time required to build or buy new plant equipment and put it in place. In the long run, all inputs are variable. SMC is essentially the additional cost of the variable input, labor, that must be incurred to increase the level of output by one unit. LMC is the additional cost of all inputs necessary to increase the level of output, allowing the firm the flexibility of changing both labor and capital inputs in a way that maximizes efficiency. Understanding MC is aided by recalling that cost is directly related to input prices and inversely related to productivity. For example, if the wage rate were to rise, cost would also rise. If labor were to become more productive, cost would fall. This relationship can be captured in an expression that relates SMC to wage rate (w) and MPL: SMC = w/MPL.

The total cost of production (TC)

is the number of hours of labor multiplied by the wage rate plus the number of machine hours multiplied by the rental rate of machines: TC = (w)(L) + (r)(K). The total cost is just the cost of all the firm's inputs. It is not a cost function, however, which is a relationship between the cost of production and the flow of output.

Average variable cost (AVC)

is the ratio of total variable cost to total output: AVC = TVC/Q. Again, if labor's wage rises, AVC also rises; but if labor were to become more productive, AVC falls. This relationship is captured by the expression AVC = w/APL.

Economics

is the study of production, distribution, and consumption and can be divided into two broad areas of study: macroeconomics and microeconomics.

Total cost (TC)

is the summation of all costs, where costs are classified on the basis of whether they are fixed or variable.

Total fixed cost (TFC)

is the summation of all expenses that do not change as the level of production varies.

Total variable cost (TVC)

is the summation of all variable expenses; TVC rises with increased production and falls with decreased production. At zero production, TC is equal to TFC because TVC at this output level is zero. The curve for TC always lies parallel to and above the TVC curve by the amount of TFC.

Own price

is used by economists to underscore that the reference is to the price of a good itself and not the price of some other good.

The cost of producing anything depends on

the amount of inputs, or factors of production (these terms are synonymous), and the input prices. Examples of factors of production are employee hours, machine hours, raw materials, and so on. For simplicity, economists typically concentrate on only two inputs, labor and capital. The labor input is simply employee time, and it is measured as labor hours per time period, such as per week or per month. We denote labor hours as L. If a firm is using two laborers per week and each laborer works 35 hours per week, then L equals 70 labor hours per week. We denote hours of capital as K. If the firm is using three machines and each one is used for 12 hours per week, then K equals 36 machine hours per week. Accordingly, the respective input prices would be the wage rate per labor hour (we use w to denote wage rate) and the rental rate per machine hour (we use r to denote the rental rate per machine hour).

The fundamental model of the private-enterprise economy is

the demand and supply model of the market.

Economies and diseconomies of scale can occur at the same time

the impact on long-run average total cost (LRAC) depends on which dominates. If economies of scale dominate, LRAC decreases with increases in output. The reverse holds true when diseconomies of scale prevail. There may be a range of output over which LRAC falls (economies of scale) and then a range over which LRAC might be constant, followed by a range over which diseconomies of scale prevail. The minimum point on the LRAC curve is referred to as the minimum efficient scale. The minimum efficient scale is the optimal firm size under perfect competition over the long run. Theoretically, perfect competition forces the firm to operate at the minimum point on the LRAC curve because the market price will be established at this level over the long run. If the firm is not operating at this least-cost point, its long-term viability will be threatened.

Cross-Price Elasticity of Demand

the price of another good might also have an impact on the demand for that good or service, and we should be able to define an elasticity with respect to the other price (Py) as well. y indicates some other good. For some pairs of goods, X and Y, when the price of Y rises, more of good X is demanded; the cross-price elasticity of demand is positive. Those goods are referred to as substitutes. Alternatively, two goods whose cross-price elasticity of demand is negative are said to be complements.

Elasticity and Total Expenditure

what happens to price times quantity when price falls? Recall that elasticity is defined as the ratio of the percentage change in quantity demanded to the percentage change in price. So if demand is elastic, a decrease in price is associated with a larger percentage rise in quantity demanded. Although each unit of the good has a lower price, a sufficiently greater number of units are purchased so that total expenditure (price times quantity) would rise as price falls when demand is elastic. If demand is inelastic, however, a given percentage decrease in price is associated with a smaller percentage rise in quantity demanded. Consequently, when demand is inelastic, a fall in price brings about a fall in total expenditure. In summary, when demand is elastic, price and total expenditure move in opposite directions. When demand is inelastic, price and total expenditure move in the same direction.

The cost function C = f(Q)

where (Q) denotes the flow of output in units of production per time period. Two things could cause the cost of producing any given level of output to fall: Either the price of one or both inputs could fall or the inputs themselves could become more productive and less of them would be needed (e.g., a worker is more productive when fewer hours of labor are needed to produce the same output).