Question

Answer the following questions with short paragraphs. Use economic reasoning to defend it. Make sure to answer all parts!

How does the price elasticity of supply/demand relate to opportunity cost? Provide an example of how a change in opportunity cost could change the price elasticity of supply/demand in a market!

Answer 1

Let's first look at the own price elasticity of a product. If there are two substitutable products x and y, and a certain quantity of x (say Q) is bought at price (say P), it implies that the customer finds Q units of x yielding higher utility to them at this price P. If they buy any more than Q, the extra units aren't worth the money due to diminishing marginal utility, and perhaps an additional unit product y (when quantity of x is Q) is more worthwhile than an additional unit of product x beyond Q. So the customer is comparing the opportunity cost (in terms of additional utility from y) when deciding whether to buy more of product x. Now assume that the price of x goes up, implying that for the new price they woudl pay for x, they could potnetially get more utility if they shift some of their purchase from x to y. This is because relatively speaking the opportunity cost has come down with an increase in x's price. The quantum of shift of purchase from x to other goods (elasticity) depends on, among other thigns, availability of the alternatives to x. The more there are alternatives, the more will be elasticity of demand for x.

Now for the second part of the question: Assume that it is the price of y that changes (say goes down) but x's price remains unchanged. Similar to above, the opportunity cost of x has come down (actually not just relatively) and hence some quantity will shift from x to y. This is a case of opportunity cost changing (for real) in the market.