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Chapter 2 Review of S and D Supply Curve: Shows quantity supplied at each possible price, ceteris paribus (c.p.). –Slopes upward (positive relationship) –Qs = Qs(P) –Shift S Curve if change c.p. factor –Movement along vs shift –C.P. factors: change in cost of production; change S from bad weather. –Interpret shift S curve: change willingness to supply at each price.

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Demand Curve Shows quantity demanded at each possible price, ceteris paribus (c.p.) –Slopes downward (negative relationship) –Qd = Qd(P) –Movement along versus shift. –C.P. factors: change income; change demand for related good. –Interpret shift D curve: change willingness to buy at each price.

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Substitutes and Complements Given two goods X and Y, if they are consumed together they are called complements and if one is used instead of the other, they are called substitutes. Substitutes: P x D y –When price of X , the demand for X falls. So demand for Y . –Example: beef and chicken Complements: P x D y –When price of X , its demand . So demand for Y also. –Example: bread and butter

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Market Mechanism Put Supply and Demand Together Equilibrium –Point at which Qs=Qd; –Market-clearing P; Describe re-equilibrating process by changing C.P. factor: –Increase in income causes increase in demand (shift D rightward) –At old P, Qd greater than Qs: so individuals bid up price till reach new equilibrium.

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Example of Shifts in S and D Effects of 9/11: Example 2.4 in text. Much destruction of office space; suggests shortage (lower vacancy rate) should drive up rental rates. Result was different because as supply fell, demand fell also. See Figure 2.10

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In-Class Exercise Note in text on pg. 28: –Fact: top 20% of income distribution had 40% increase in real take-home earnings; bottom 10% of distribution had decline of 10%. Consider: two separate labor markets for skilled and unskilled workers. Start in equilibrium for both; then show: –Unskilled workers: big S, small D –Skilled workers: small S, big D. –Outcome will explain observed trend: big increase in inequality in 1980s and 1990s; or, increase in working poor.

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Homework Assignment Consider the two separate markets for peanut butter and jelly. Assume that the two products are complements for consumers. –1. Sketch and describe the initial equilibrium in both markets. –2. Show the effect of new health warnings about all the fat in peanut butter in first the market for peanut butter and then in the market for jelly. –3. Draw and label completely and describe in words.

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Elasticity Definition: % Qd in response to a 1% P Or: % Qd / % P What is % ? Absolute change in variable divided by original level of variable. Ep = ( Qd/Q) / ( P/P) = (P/Q) ( Q/ P) Remember: ( Q/ P) is 1/slope. Ep = price elasticity of demand; usually negative.

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Relate Elasticities to S and D Equations Demand: Q = a – bP Supply: Q = c + dP E = (P/Q )*( Q/ P) ( Q/ P) = constant = d for supply = –b for demand. Demand: E D = -b(P*/Q*) Supply: E S = d(P*/Q*)

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More About Elasticities Elastic: Ep 1 Inelastic: Ep 1 Unitary Elastic: Ep 1 Fact: While slope is constant along a linear demand curve, elasticity is not. Fact: At top of demand curve, when P is high and Q is low, Ep is big negative number so D curve is very elastic. Fact: As move down D curve to right, Ep falls (because P is while Q is , so P/Q is ).

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Example Price Demand Supply What is P*, Q*? 2. When P=$80, what is E D ? Homework:. Textbook page 58; Exercises #1 and #2.

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Relative Elasticities Rule: the steeper the slope of the curve, the less elastic. Completely horizontal demand curve: infinitely elastic: consumers will buy as much as they can at a single P* Completely vertical demand curve: completely inelastic: consumers will buy fixed quantity, no matter what the P.

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Nearly Horizontal Demand Curve Elasticity approaches infinity: Recall: 1/slope = Q/ P If nearly flat curve: small P causes a huge Q. This is same as: huge / small , which equals a very big number. This will help you remember elasticity for completely flat versus completely vertical.

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Income Elasticity of Demand Measure responsiveness of Qd to change in income (note this is a ceteris paribus factor). E I = % in Qd resulting from a 1% in income. E I = ( Q/Q) / ( I/I) = I/Q ( Q/ I).

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Cross-Price Elasticity of Demand Measures responsiveness in Qd of one good to change in price of a related good (note this is a change in a c.p. factor). Cross-price elasticity of demand = % in Qd resulting from a 1% in the price of a related good. E Q1P2 = ( Q1/Q1) / ( P2/P2) P2/Q1 Q1/ P2. E QP 0: the two goods are substitutes. E QP 0: the two goods are complements.

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Price Elasticity of Supply Price Elasticity of Supply: Responsiveness of Qs to P. E S P = % Qs / % P = ( Qs/Qs) / ( P/P) P/Qs Qs/ P Usually positive.

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Wage Elasticity of Supply Measures responsiveness of Qs to changes in the cost of labor (a ceteris paribus factor). E S W = % Qs / % W = ( Qs/Qs) / ( W/W) W/Qs Qs/ W. Usually negative. Remember: W cost of production.

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Example Qs = P Qd = 19 – 4P 1. Find P* by setting Qs=Qd. 2. Find Q* by putting P* into either Qs or Qd. Solve for Ep of demand at equilibrium: E D P* = (P*/Q*) ( Q/ P)

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Short-Run versus Long-run Elasticities Focal point: how much time do sellers and consumers have to respond (in their Qs and Qd) to changes in price? In general: LR adjustment is more full, free adjustment so that LR elasticity is larger; BUT not true all the time. Key factors: –Durability. –Availability of substitutes –% of consumer’s budget

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Government Price Controls Key: If government sets P so that there is no single P for which Qs=Qd, then there will be a shortage or surplus. Be able to show the Qs and Qd for any price. Price ceiling: prevents price from rising above the ceiling. Price floor: prevents price from falling below floor.

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In-Class Exercise Rent control in NYC: Qd = 100 – 5P Qs = P 1. Find P* and Q*. 2. What if rent control agency sets Price ceiling at $1? –A. What is Qd? –B. What is Qs? –C. What is resulting Q sold? –D. What is # newly homeless?

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