UTILITY AND ELASTICITY

Microeconomics, as opposed to macroeconomics, analyzes the economy from the bottom up, by analyzing the economic decisions and tendencies of individuals and businesses. A crucial concept in understanding microeconomics is that of utility. Utility is how much a product pleases people. Marginal utility is how much every incremental quantity of a product pleases. Marginal utility decreases. For example, you eat fried chicken. The first piece's marginal utility is 5, the next piece's is 4, and so on. Marginal utility tends to drop as the number of products consumed increases. (If you eat too much, you'll get to a point at which it's going to make you sick.) Utility would be the total utility. Demand and price is related to this marginal utility, not total utility. High marginal utility brings a high cost.

Consumers choose what products they want to buy by comparing something's price and its utility. They tend to pick the product that has the highest marginal utility to price ratio. In other words, they will pick the product that gives them the biggest bang for the buck; they pick the product that gives them the greatest satisfaction for every unit of money spent. This is the principle of rational choice. Remember that marginal utility decreases though. Thus, for example, you would want to buy an exotic car sometime rather than buy the regular car you keep buying at some point even though the exotic car is only marginally better (all cars can take you where you want to go). In real life, people vary what they consume. They vary the amount of products they consume so that, in the end, the marginal utility of all those products end up being equal.

The elasticity of demand is the ratio of (percent change in quantity)/(percent change in price). Remember that based on the law of demand, quantity demanded is inversely related to price. Thus, elasticity is never positive, because when if price goes up, quantity must go down, and when quantity goes up, price must come down. However, for purposes of comparison, we will express elasticity of demand as a positive number.

Elasticity is a way of determining changes in revenue. Revenue made from selling goods or services is calculated by multiplying the quantity of that good or service sold to the average price of each one sold. Elasticity tells us whether revenue will go up, go down, or remain constant when we change prices. To find how revenue will change, we first plot a demand curve, plotting our current location on the demand curve. Then we will plot our target point, the point where we want to move the price to. Then, we will know the percentage change of each and thus we will know elasticity. When elasticity is 1, there is no change in revenue. When elasticity is greater than 1, there is a decrease in revenue. When elasticity is less than 1, there is an increase in revenue. The most important determinant of the elasticity of demand at any poing is the availability of substitutes. When people have more choices, they are less likely to pay a high price when they can just go buy something else that would serve the same purpose and provide the same satisfaction.

In microeconomics, we also analyze patterns in supply. In supply, as in demand, there is elasticity of supply. The elasticity of supply is the ratio of (percent change in quantity supplied)/(percent change in price). Elasticity in supply, as in demand, is applied to a supply curve. However, elasticity in supply is a positive number as supply is directly related to price. Supply is also not nearly as simple as demand. Supply involves the production process. Somethings like cars and houses are not just simply supplied. They are just simply bought, but the supply of most of today's products involves a complicated and technologically sophisticated production process.

The production process involves decisions being made by firms who supply things to the consumer. These decisions can be split into long-term and short-term decisions. Long-term decisions are overall goals, and they can be anything (what does your firm plan to make?). Short-term decisions are constrained by the long-term decision. Short and long-term do not refer to a predefined time period but to how many options the supplier has. Long-term decisions involve all possible options of production while short-term decisions are confined to a few options of production. These questions occupy every company: how much of each resource to produce how much of each product? Production can be measured as the amount of output for each unit of input.

Fig 3.1.1-Production Function

As you can see, the average production is continually declining. In production, we have the terms average production and marginal production. Average production, of course, is just the output per input. Marginal production is the additional production you get for each unit of input you add. Average production declines because marginal production declines drastically after a certain point. At a certain point, the facilities you have just can not handle any more inputs and the extra inputs go to waste inefficiently. This explains why average production ends up declining after a certain point, when too many inputs are put in a system that can not efficiently handle all of them.

All production and thus supply involves costs. Costs is central to economics. It is important to distinguish between fixed costs and variable costs. Fixed costs are constant costs that can not change. Variable costs are costs that you can alter at any time: the work force you maintain, for example. There is also average fixed cost(AFC), average variable cost(AVC), average total cost(ATC), and marginal cost(MC). Average fixed, variable, and total costs are just the amount of those costs spent on each unit of output. Marginal cost is the extra cost paid for each extra unit of output.

Fig 3.1.1-Costs of production

As shown in this graph, ATC, AVC, and MC all go down and then up as quantity of output increases while AFC gets ever smaller and closer to zero as quantity produced increases. This is because at first, the production capabilities of technology can easily handle the amount of goods produced and so every new bit of output incurs little cost, but as more and more things are produced, stresses are put on production capabilities and inefficiency results. However, fixed costs are always declining because these costs (like machines and facilities) do not have a problem of varying efficiency. They just do what they can do.