Elasticity of Demand and Indifference Curves

• Using what you have just learned about indifference curves and budget lines, explain how this might change your thinking about an every day task.

Economic thinking is very useful.  We would do well to remember the lessons we learn here in our everyday lives.  Indifference curves and budget lines, for instance, provide a conceptual way of thinking about the trade-offs we all make between various bundles of goods.  When I shop, for instance, I certainly try to maximize my total utility for the money I spend.  I have to make a decision about how much of one or some goods I am willing to sacrifice to buy, for instance, a case of soda, a high-dollar snack, or a big tub of ice cream.  

Perhaps a better example might be features on a new car.  I want all the bells and whistles, but can't afford them.  So I make an ad-hoc indifference curve in my mind between something like heated seats and an upgraded sound system.  If there are unheated fabric seats, heated fabrics, unheated leather, and heated leather; and if there are basic sound, upgraded sound, and premium sound, and an increase in one necessarily decreases the other, I might settle on upgraded sound and heated fabric seats.

However, sense my budget line doesn't actually touch all that many indifference curves, my marginal rates of substitution tend to apply to things like "with my budget, if I buy this energy drink at the store, is it worth it to sacrifice buying a beer after work?"  

You could apply indifference curves and budget lines to other decisions involving limited resources.  If my budget line represents the time I have for two different tasks, and I can perform one task better only at the expense of quality in the other task, I will try to set the marginal increases in quality in each task equal to the ratio of their respective time intensities; MQualX/Time = MQualY/Time.

• What are some factors that effect the price elasticity of demand?

There are three important factors:

• Availability of Substitutes
• Two goods are substitutes in consumption if an increase in price in one good increases the quantity demanded of the other good.  A good with many reasonable substitutes is price elastic because consumers will quickly buy the substitute after (even a ) small increase in price.  This is the most important determiner.
• Percentage of Consumer budget
• If a good takes up a relatively small amount of a consumer's budget, it will be more likely to be price inelastic because even a large change in the price is small relative to total money available.  A large purchase, like a computer, is more price elastic than the purchase of a jump drive
• Time period of adjustment
• Over time, for most goods, price elasticity of demand will tend to "normalize' over longer periods of time.  For instance, a good that is price-inelastic in the short term may find that its quantity demanded slowly falls after a price increase, even though the increase had little effect on quantity demanded initially.  Also, perhaps the opposite is true: a price elastic good that may have seen its quantity demanded rise/fall after a price decrease/increase might see quantity demanded move back to its original level over time as consumers (and the market) adjust to the new price.

• What type of price elasticity of demand does a Rolls-Royce exhibit.  How might having a knowledge of the concept of price elasticity of demand help your business as a high end auto manufacturer?

I would guess that a luxury good like a RR is relatively price-inelastic around the normal asking price for a RR.  But it depends on the model to an extent: the ultra-high-end, $500,000 model might be sold for $550K or $600K will only small changes in quantity demanded (but you couldn't just charge $1000K).  Moving down in price, however, would move toward greater dominance of the quantity effect as more consumers were able to afford the car.  

A more important determiner in this case is the availability of substitutes.  A wealthy playboy might choose a different car (a new Bentley) over the RR if it was a good amount cheaper.  Or, since wealthy people are sometimes crazy, he might by the RR simply because it's more expensive!  

As a manufacturer, I might try to construct indifference curves for various target-market incomes that made trade-offs between features I thought were important to my market: hugely powerful engine and performance vs overall comfortability of the experience (lots of amenities, noise insulation, more comfortable suspension, all of which add weight).  I would try to balance those qualities where the budget line of my target buyer is the tangent line to that indifference curve.

Reflections

Phillip Miller, ECO post one

• What did you learn in this module's readings that surprised you?
• The most interesting things I read concerned optimization and marginal analysis.  Also, I enjoyed the treatment of economic vs accounting profit.  I've taking courses that mentioned it before, but this text had a great explanation.
• Explain the difference between price taking and price setting firms.  Give an example of your experience with each.  Discuss the characteristics of the four market structures discussed in your text. 
• A price-taking firm is one that has no market power, operates in a competitive environment, and has the price of its good determined by market forces.  Such markets exist where consumers view competing products as identical and have no reason to pay more.  A price-setting firm is one with a degree of market power who can change its prices without losing all of its customers.  
• We all interact with these firms: to an extent, entry-level products from toe-nail clippers to value-menu burgers have their prices determined by the market.  And firms like Apple and Google operate in oligopolies, and they have some leverage, and strategic incentive, to manipulate their prices relative to their competitors.
• A monopoly is relatively rare these days but occurs when there are large barriers to entry, there are no real competitors, there are no close substitutes to the product, and the firm can charge almost whatever it wants.  Monopolistic competition occurs when there are many, relatively small firms competing who produce differentiated products but are not protected by substantial barriers to entry.  Monopolistic competitors are price-setters because product differentiation bestows a degree of market power.  Pure competition is similar to monopolistic competition except that perfect competitors don't have the market power necessary to set their own price: they are price-takers.  An oligopoly exists when there are only a few large firms supplying a market.  Their business decisions affect each other greatly, and is therefore the most complicated structure to analyze. 
• Discuss how you, or a business, "thinks at the margin" or uses marginal analysis to operate on a daily basis.  ie. give examples of what it means to optimize and how optimization problems are prevalent in your life. 
• I learned "thinking at the margin" a long time ago from a science teacher in high school.  He showed me exactly what our text has explained: that sunk, fixed, and average costs are irrelevant to the decision to do something "one more time."  He emphasized that whatever I had already invested - time, money - the only that that mattered was if "producing" another unit would raise my benefits over my total costs.  This applies, for example, to an essay: sure, I could write another section, go over it one more time, or find someone to proof-read it, but that extra effort might not pay off in an improved grade.
• Concerning optimization, I use calculus-based optimization language in my daily job.  My job is always constrained by time, resources, and physical capability.  I must decide, with the time and effort I have, how much a given piece of furniture needs to be protected, the amount of preparation - like putting blankets, moving objects - required to move the piece, etc.  If I am late to the next appointment, I've failed, just as I've failed if I damaged the piece but arrived on time.  Some pieces, like pine, are lightweight and require little in the way of protection.  Others demand a third person be present for the move.