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Unformatted text preview: FUNDAMENTALS OF FUNDAMENTALS MANAGERIAL MANAGERIAL ECONOMICS ECONOMICS 9th Edition By Mark Hirschey Demand Analysis and Estimation and Chapter 5 Chapter 4 OVERVIEW Utility Theory l Indifference Curves l Budget Constraints l Individual Demand l Optimal Consumption l Demand Sensitivity Analysis: Elasticity l Price Elasticity of Demand l Price Elasticity and Marginal Revenue l Price Elasticity and Optimal Pricing Policy l Cross-price Elasticity of Demand l Income Elasticity of Demand l l utility Chapter 5 KEY CONCEPTS principle l nonsatiation l indifference l ordinal utility l cardinal utility l utility function l utils l market baskets l marginal utility l law of diminishing marginal utility l indifference l substitutes l perfect curves l complements substitutes l perfect complements l budget constraint l income effect l substitution effect l price-consumption curve l income-consumption curve l Engle curve l normal goods l inferior goods l optimal market basket l revealed preference l marginal rate of substitution l consumption path l Assumptions About Consumer Preferences Preferences l Utility Theory l Utility functions relate well-being to consumption. consumption. More is better. l Consumers rank-order desirability of products. products. l Marginal utility shows added benefit of a small increase in consumption. of l l Law of Diminishing Marginal Utility l Marginal utility is usually positive, MU>0. Marginal Marginal utility eventually declines for everything. everything. l Basic Characteristics l Indifference Curves l Perfect substitutes are products that satisfy the same need, e.g., that car models. car Higher indifference curves are better. better. l Indifference curves do not intersect. intersect. l Indifference curves slope downward. downward. l Indifference curves are concave to origin. origin. l Perfect complements are products consumed together, products e.g., cars and tires. e.g., l Basic Characteristics l Budget Constraints l Effects of Changing Income and Prices Prices l Show affordable combinations of X and Y. and l Slope of –PX/PY reflects relative prices. prices. l Income and Substitution Effects Budget increase (decrease) causes parallel outward (inward) causes shift. shift. l Relative price change alters budget slope. slope. Income effect changes overall consumption. consumption. l Substitution effect alters relative consumption. consumption. l l Price-consumption curve shows consumption impact of price consumption changes. changes. l Individual Demand l Income-consumption curve shows consumption impact of income consumption changes. changes. l Reflects movement along demand curve. l Engle curves plot income and consumption. consumption. l Reflects shift from one demand curve to another. another. Normal good consumption rises with income. income. l Inferior good consumption falls with income (rare). income l Marginal Rate of Substitution (MRS) (MRS) l Optimal Consumption MRSXY = -MUX/MUY and equals indifference curve slope. indifference l MRSXY shows tradeoff between X and Y consumption, holding utility and constant. constant. l MRSXY diminishes as substitution of X for Y increases. of PX/PY = MUX/MUY, or l MUX/PX = MUY/PY. l l Utility maximization requires l l Elasticity measures sensitivity. sensitivity. Point elasticity shows sensitivity of Y to small small changes in X. changes l Demand Sensitivity Demand Sensitivity Analysis: Elasticity εX = ∂Y/Y ÷ ∂X/X. ∂X/X. l Arc elasticity shows sensitivity of Y to big big changes in X. changes l EX = (Y2–Y1)/(Y2+Y1) ÷ (X2-X1)/ (X2+X1). l Price Elasticity Formula l Price Elasticity of Price Elasticity of Demand Point price elasticity, εP = ∂Q/Q Point ∂Q/Q ÷ ∂P/P. l In all cases, εP < 0 . In l Price Elasticity and Total Revenue Revenue l Price cut increases revenue if │εP│> 1. l Revenue constant if │εP│= 1. Revenue l Price cut decreases revenue if │εP│< 1. Price Elasticity and l Elasticity Varies along Demand Curve Demand l Marginal Revenue Marginal Revenue As price rises, so too does │εP│. l As price falls, so too does│εP│. l Price Elasticity and Price Changes Changes MR > 0 if │εP│> 1. MR l MR = 0 if │εP│= 1. MR l MR < 0 if │εP│< 1. MR l Price Elasticity and Optimal Pricing Policy l Optimal Price Formula l MR and εP are directly related. MR l MR = P/[1+(1/ εP)]. MR l Optimal P* = MC/[1+(1/ εP)]. Optimal l Determinants of Price Elasticity Elasticity l Cross­price Elasticity of Demand l Essential goods have low│εP│. l Nonessential goods have high│εP│. high│ Cross-price elasticity shows demand sensitivity to changes in demand other prices. other l εPX = ∂QY/QY ÷ ∂PX/PX. ∂Q l Substitutes have εPX > 0. Substitutes E.g., Coke demand and Pepsi E.g., Coke Pepsi prices. prices. l Complements have εPX < 0. Complements l E.g., Coke demand and Fritos E.g., Coke Fritos prices. prices. l Independent goods have εPX = 0. Independent l E.g., Coke demand and car prices. E.g., Coke l l Income elasticity shows demand sensitivity to changes in income. sensitivity l Income Elasticity of Demand Demand εI = ∂Q/Q ÷ ∂I/I. l Normal goods have εI > 0. Normal Noncyclical normal goods have 0 < εI < 1, e.g., candy. l Cyclical normal goods have εI > 1, Cyclical e.g., housing. e.g., l l Inferior goods have εI < 0. Inferior l Very rare. ...
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