Economics Exercises: Short Run, Long Run, Elasticity Of Demand, Budget Constraints, Indifference Curves, And Rationalization Of Choice

According to the study "Gasoline Demand, Pricing Policy and Social Welfare in Saudi Arabia" Tarek N. Atalla, Anwar A. Gasim and Lester C. Hunt prepared in 2017 at the King Abdullah Petroleum Studies and Research Center, the elasticity of demand for gasoline in KSA is −0.098 in the short run and −0.150 in the long run.

• Explainwhat "short run" and "long run" 
• Explainwhat these numbers (−0.098 and −0.150)  That is, explain the concept of elasticity using these numbers as specific examples.
• Explainwhy the short run demand is more inelastic than the long run 
• Supposethat the price of gasoline  What are the consequences in terms of total revenue of the seller of gasoline? Analyze short run and long run separately.

In the graph below (see next page), we have a choice model representing Adam's consumption. Bundle A (black dot) is his optimal bundle. Red line is Adam's budget line. Blue lines are some of Adam's indifference curves – I drew them to give an idea of how Adam's preferences look like. One of the indifference curve is tangent (at bundle A) to the budget line; the optimal bundle belongs to that indifference curve.

Now, something has changed. Bundle A is not Adam's optimal bundle; now, it is bundle B (green dot) that is his optimal bundle.

There are many possible explanations of what that "something" was; i.e., many explanations of why Adam's optimal bundle has shifted from A to B. Your task is to provide one explanation.

I would like to see both graphical analysis and explanation. That is, explain in words what could have happened and graphically represent it.

In economics, this kind of exercise is called "rationalization" of choice: you are looking for explanation of Adam's behavior based on the assumption that he is behaving in a rational way. For economists like me, this is precisely what we do on daily basis in our research.

                                                    

In this exercise, you will conduct self-analysis: you will analyze yourself as a consumer.

• Thinkabout two simple but important goods that you buy every week (e.g., food items). What are these goods?
• Preparean indifference map representing your  Explain how you derived that map.

An imaginary* MBA student at MBSC recently said the following:

Even though I hate my MBA classes, I can't quit because I've spent so much money on tuition.

According to economics, this student is behaving irrationally. Explain why the behavior of this student is irrational. In particular, explain what kind of bias this student exhibits.

(a) Short run and the long run denotes the time period in economics. Flexibility is the differentiating factor between the short run and the long run. While in the short run the inputs to the production process cannot be changed, in the long run, the inputs can be changed. From the perspective of the customers also, in the short run the amount of output and choices of the product is limited (Cowell, 2018).  However, there is no fixed time period that can be considered as the short run or long run. For example, a baby crying for 7 hours continuously can be considered as a long run, while two years of operation of a company can be considered as a short run.

(b) Elasticity is the responsiveness of the quantity demanded with respect to the change in other variables such as own price, the price of a substitute, the price of complementary goods and the income of the consumer. The price elasticity of demand is basically the percentage change in the quantity demanded divided by percentage change in the price of that product.  Here these two numbers denote the price elasticity of demand for gasoline in the short run and long run. The minus sign before the figure denotes the negative relationship between the price and the quantity demanded of gasoline.  Depending on the absolute value of elasticity the demand is either elastic or inelastic (Mankiw, 2016).

The price elasticity of demand is generally denoted by e_p. When the absolute value of the e_p is more than 1, the percentage change in the quantity is more than the percentage change in the price. On the other hand, when the absolute value of the e_p is less than 1, the percentage change in quantity demanded is less than the percentage change in the price of the product.  

|e|>1 => elastic demand

|e|<1 => inelastic demand (e denotes the price elasticity)

(c) In the short run, inputs to the production are fixed and the output is not flexible. Therefore the output is flexible and the consumer has no other choice to move their consumption in the short run corresponding to a rising gasoline price. On the other hand, in the long run, inputs are changeable and hence the output is changeable too (Bauer, 2018). That allows the consumer to have more buying option and hence the demand reduces more in the long run corresponding to increase in price.

(d) The revenue of the seller is,

Quantity sold* price of gasoline

Now in the short run, the demand is inelastic. That means a proportionate increase in price is more than the reduction in quantity demanded (Ogloblin et al. 2018).

Thus, Revenue ↑↑= Quantity sold ↓* price of gasoline ↑↑

On the other hand, in the long run, the demand for gasoline is elastic. That means the proportionate reduction in demand is more than the increase in prices.

Thus, Revenue ↓↓= Quantity sold ↓↓* price of gasoline ↑

Therefore the revenue of the seller increases in the short run and decreases in the long run with the increase in the price of gasoline.

                                        

                                                          Figure 1: change in the budget line

                                                         (Source: Developed by the learner)

One of the explanations for the change in the optimum bundle can be the change in the budget line. The new budget line has pivoted to show that the price of Y has increased and the price of X has decreased (Kolmar, 2017). The intercept in the y-axis has reduced as with higher prices, less number of Y can be bought with all the budget. Similarly, due to the reduction in the price of X, the intercept has increased in X-axis. With the new budget constraints, Adam has the option to move towards a higher utility.

(a) Two important good that I buy is bread and movie tickets.

                                     

                                                                 Figure 2: The indifference map

                                                               (Source: Developed by the learner)

The indifference map is derived through the revealed preference of mine. The budget constraint is steep because of the fact that, the price of movie tickets is more than the price of bread.

In this case, the student exhibits a cognitive bias and emotion. In this case, the student has spent a lot of money on the tuition only because he loved the MBA classes. The rationality of the buyer is subject to cognitive bias, emotions and social influence (Nguyen and Wait, 2015). A rational buyer, in this case, will have no influence from the emotions and social factors. The student is bound to continue the MBA classes under behavioral economics and under the condition that he is rational if he has already spent a lot on the tuition fees.  

Reference 

Kolmar, M., 2017. Principles of Microeconomics. Springer International Publishing.

Bauer, M.J.R., 2018. Principles of microeconomics. Routledge.

Cowell, F., 2018. Microeconomics: principles and analysis. Oxford University Press.

Mankiw, N.G., 2016. Economics-Microeconomics-Principles of Microeconomics. Worth publishing Ltd.

Nguyen, B. and Wait, A., 2015. Essentials of Microeconomics. Routledge.

Ogloblin, C., Brown, J., King, J. and Levernier, W., 2018. Principles of Microeconomics (GA Southern). Galileo Publishers.