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Introductory Microeconomics ES10001 Topic 1: Introduction to Markets

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1.What is Economics? Economics is... the study of choice. More formal definition might be:.... the study of the allocation of scarce resources amongst competing users.

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1.What is Economics? Some of the key concepts in Economics can be illustrated via. the Production Possibility Frontier (PPF). Definition: The PPF shows for each level of the output of one good, the maximum amount of the other good that can be produced.

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1.What is Economics? Definition: The PPF shows for each level of the output of one good, the maximum amount of the other good that can be produced. See Figure 1

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Y X 0 5 10 15 20 25 30 5 15 10 25 20 A B C D E G F Figure 1: Production Possibility Frontier

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1.What is Economics? Points on PPF are Pareto-Efficient - unable to make one person better off without making someone worse off Economist's job is to move society to PPF (i.e. efficiency) Whereabouts on PPF is job for politicians (i.e. equity)

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2.Theories and Evidence Definition: a model (or theory) makes a series of simplifying assumptions from which it is deduced how people will behave. It is a deliberate simplification of reality. Linear example:

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y x 0 Slope = Figure 2: Linear Model Intercept

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2.Theories and Evidence N.B. = intercept; = slope Consider, for example, a total cost function, where c denotes total cost and q denotes output. i.e. Total Costs = Fixed Costs + Variable Costs Assume = 10, = 2

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Output Fixed Cost Variable Cost Total Cost q = α + βq = c 1 10 2 12 2 10 4 14 3 10 6 16 q = 10 + 2q = c

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c q 0 c = 10 + 2q 10 1 2 3 16 14 12 Figure 3: Total Cost Function

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3.Markets Definition: A market is a set of arrangements by which buyers and sellers are in contact to exchange goods or services. To understand how markets work we therefore need to examine the behaviour of buyers and sellers Otherwise known as Demand and Supply

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3.Markets Demand: Quantity of a good buyers wish to purchase at every conceivable price. Thus demand is not a particular quantity. Supply: Quantity of a good sellers wish to sell at every conceivable price. Thus supply is not a particular quantity. N.B. distinction between demand (supply) and quantity demanded (supplied).

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3.Markets Demand / Supply denotes schedule of demands / supplies at each and every conceivable price. Quantity demanded / quantity supplied defines a particular demand / supply at a particular price. Hypothesis - at high prices we have q d < q s and at low prices the converse. Moreover, at some intermediate equilibrium price, p *, the market clears.

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3.Markets We define the equilibrium price p * as the price which clears the market Thus p > (<) p * implies excess supply (demand) and in a free market the actions of buyers and sellers move p towards p *.

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p q 0 Figure 4: Market Equilibrium Demand Supply q*q* p *

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p q 0 p1p1 Excess Supply Demand Supply q d (p 1 ) q * q s (p 1 ) p * Figure 5: Price Floor

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p q 0 p1p1 Excess Demand Demand Supply q s (p 1 ) q * q d (p 1 ) p * Figure 6: Price Ceiling

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p q 0 Supply Demand p*p* pf pf q 1 q * pcpc Figure 7: Near Side is Satisfied

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4.Demand The demand curve shows the relationship between price and quantity demanded (q d ) ceteris paribus That is: (i)q d at particular price per unit; (ii)(maximum) price per unit consumers willing to pay for a particular quantity.

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4.Demand Formally q d = q d (p) Quantity demanded depends upon price Normal Demand Function (Curve)

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q p 0 Figure 8: Normal Demand Curve; q d = q d (p) 10 5

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4.Demand We can equivalently think of price depending upon the quantity consumed p d = p d (q) Inverse Demand Function

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p q 0 Figure 8: Inverse Demand Curve; p d = p d (q)

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p q 0 Figure 10: (Inverse) Demand Curve; p d = p d (q) 5 10 … quantity demanded at a particular price

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p p 0 Figure 11: (Inverse) Demand Curve; p d = p d (q) 5 10 … buyers reservation (i.e. maximum price buyer willing to pay per unit

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4.Demand Usually, we presume that q d depends negatively on (own) price, but this is not always the case (i.e. Giffen goods) Note: Movements Along:Arise as a result of changes in own price. Shifts In: Arise when anything else changes. Consider the latter

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4.Demand What are these other things that might bring about a shift in the demand curve To answer that question, we need to look behind the demand curve and drop our assumption of ceteris paribus – that other things remain equal. Consider each in turn

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4. Demand Four factors that might not remain equal: (1)Price of Related Goods (2)Consumer Incomes (3)Tastes (4)Tax

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4. Demand Price of Related Goods Example: A rise in price of butter would: Decrease quantity of butter demanded by consumers; Increase demand for margarine at each and every price of margarine; Decrease demand for bread at each and every price of bread.

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4. Demand That is: Butter & margarine are substitutes for one another Butter & bread are complements for one another Note: Pairs of goods; most goods are substitutes.

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p Margarine q Margarine 0 Figure 12: Substitutes (Rise in p Butter )

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p Bread q Bread 0 Figure 13: Complements ( Rise in P Butter )

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4. Demand Consumer Income A normal good is a good for which demand increases when incomes rises A inferior good is a good for which demand falls when income rises.

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p Private Transport q Private Transport 0 Figure 14: Normal Good (Increase in Income)

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p Public Transport q Public Transport 0 Figure 15: Inferior Good (Increase in Income)

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4. Demand Tastes Consumer tastes or preferences regarding array of potential consumables. Shaped by custom, attitude, advertising.

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4. Demand Tax Consider purchase tax (e.g. VAT) Consumer liable for £x tax per unit purchased Thus, imposition of tax will reduce consumers reservation price for the good Note: Unit / Ad Valorem

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p 0 q Figure 15: (Unit) Purchase Tax

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p 0 q tax Figure 16: (Unit) Purchase Tax

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p 0 10 q Figure 17: (Unit) Purchase Tax 5 3 t = £2

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5.Supply The Supply Curve Shows the relationship between price and quantity supplied ceteris paribus; That is: Quantity supplied at particular price per unit; Minimum price per unit suppliers willing to accept for particular quantity.

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p q 0 Figure 18: (Inverse) Supply Curve

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p q 0 5 10 … quantity supplied at a particular price Figure 19: (Inverse) Supply Function ; p s = p s (q)

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p q 0 5 10 … sellers reservation price (i.e. minimum price seller wiling to accept per unit) Figure 20: (Inverse) Supply Function ; p s = p s (q)

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5.Supply Behind the supply curve (ceteris paribus) Four factors: (1)Technology; (2)Input Costs; (3)Government Regulation; (4)Tax.

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5.Supply Technology Improvement in technology shifts supply curve to the right Intuition? Producers willing to supply higher quantity at each and every price

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Figure 21: Technological Advance q 0 p

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5.Supply Costs If these fall then supply curve will shift to right for the same reason. Government Regulation Adverse technological change - i.e. safety / environmental regulations will shift supply curve to the left.

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p q 0 Figure 23: Government Regulation

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5.Supply Tax Consider unit sales tax Seller liable for £x tax per unit sold Thus, imposition of tax will increase sellers reservation price for the good

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p 0 q Figure 24: (Unit) Sales Tax

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p 0 q tax Figure 25: (Unit) Sales Tax

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p 0 q Figure 26: (Unit) Sales Tax t = £2 11 9 10

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6. Linear Demand / Supply Demand Recall - the demand curve shows: quantity demanded at particular price per unit. (maximum) price per unit consumers willing to pay for particular quantity

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6. Linear Demand / Supply Formally q d = q d (p) Assume demand curves are linear - i.e. straight lines. Thus: q d (p) = a - bp

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6. Linear Demand / Supply That is, when p = 0, individuals demand a maximum number of units of the good q d (0) = a - b·0 = a Simplistic, but useful, assumption

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p q 0 a a/b Figure 27: Linear Demand Curve

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p q 0 Figure 28: Non-Linear Demand Curve pdpd

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6. Linear Demand / Supply Now consider slope b The slope of the demand curve tells us how quantity demand changes in response to a change in price Formally

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6. Linear Demand / Supply (1) (2) (3) = (2) - (1) (3)

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p q 0 a p0p0 p1p1 q 0 q 1 E 0 E 1 Figure 29: Slope of Demand Curve a/ba/b

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p q 0 a p0p0 p1p1 q 0 q 1 Figure 30: Slope of Demand Curve E 0 E 1 a/ba/b

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6. Linear Demand / Supply Now consider two demand curves (4) where i = x, y. Thus: (4a) (4b)

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6. Linear Demand / Supply It must be the case that: (5) If b y > b x then Demand curve y has a bigger slope than demand curve x But … it is flatter!!!

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p q 0 p0p0 p1p1 Figure 31: Slope of Demand Curve

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6.Linear Demand / Supply Recall, we generally write the normal demand function but draw the inverse demand function And if b y > b x then 1/b y < 1/b x Such that the inverse demand function (i.e. the one we draw) is flatter

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6. Linear Demand / Supply The inverse demand curve maps the consumers reservation price schedule i.e. as quantity increases consumers are willing to pay less per unit - diminishing marginal utility. Also, it tells us the maximum price consumers are willing to pay for the first unit of the good p d (0) = a/b

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6. Linear Demand / Supply Supply Recall, supply curve shows Quantity producers willing/able to supply at particular price per unit. (Minimum) price per unit sellers willing to accept for particular quantity.

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6. Linear Demand / Supply q s = q s (p) Linear form: (1) q s = c + dp or (2)

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7.Equilibrium Equilibrium Assuming linear demands and supplies we can solve for the equilibrium prices and quantities in the market q d = a - bp q s = c + dp

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7. Equilibrium Recall, there is a particular price vis. the equilibrium price, p *, at which the market clears q d (p * ) = q s (p * ) or q d (p * ) = a - bp * = c + dp * = q s (p * )

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7. Equilibrium

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Consider the following example: Thus

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7. Equilibrium Such that: Substituting equilibrium price, p *, into the demand and supply functions yields equilibrium quantity q d (p * ) =20 – 4p * = 8 + 2p * = q s (p * )

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7. Equilibrium

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or: such that:

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8. Elasticity Measuring the price responsiveness of demand Consider problem of seller who want to maximise sales revenue. R = p*q But q = q(p) and p = p(q); i.e. q depends upon p and p depends upon q Thus trade off!

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8. Elasticity Revenue increases if price is raised ceteris paribus; but we cannot assume ceteris paribus Strategy: (i) sell few goods at high unit price; or (ii) sell many goods at low unit price Optimal choice depends upon price responsiveness of demand

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8. Elasticity We could simply look at the slope of the demand curve Recall two individuals, x and y, where: And b y > b x such that individual y is more responsive to a change in price than individual x.

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p q 0 p0p0 p1p1 Figure 32: Slope of Demand Curve

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8. Elasticity Slope is OK but: (i) It is unit dependent i.e. £, £, quantity of laptops, bottles of wine (ii) Does not convey relative strength of change i.e. price cut from £100 to £99 increases demand by same amount as cut from £2 to £1

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8. Elasticity Better concept Elasticity of Demand Definition: The (price) elasticity of demand is the percentage change in the quantity of a good demanded divided by the corresponding percentage change in its price.

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8. Elasticity Example: Price rises from £10 to £12 and demand falls from 50 units to 30 units then: E = (-40%) / (20%) = -2 In words: A 1% rise in price will lead to a 2% fall in demand. N.B. For simplicity, we usually ignore the minus sign and define E as a positive number.

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8. Elasticity Thus: Define:

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8. Elasticity Thus: Recall our linear model:

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8. Elasticity (1) (2) (3) = (2) - (1) (3)

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8. Elasticity Thus: Such that

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8. Elasticity Note: E is a number and as such it is unit dependent E conveys the relative strength of changes in price and demand Along a linear demand curve, slope (i.e. b) is constant but elasticity [i.e. b(p/q)] varies.

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8. Elasticity E > 1: Demand is Elastic 1% rise in p leads to a more than 1% fall in q d E < 1:Demand is Inelastic 1% rise in p leads to a less than 1% fall in q d E = 1:Demand is Unit Elastic 1% rise in p leads to same 1% fall in q d

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8. Elasticity Recall our linear function with p = p 0 and q = q 0. where is this equal to 1? i.e. find the (p, q) at which E = 1

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8. Elasticity Thus, solve E for

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8. Elasticity Such that:

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p q 0 Figure 33: Elasticity of Demand

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8. Elasticity Point and Arc Elasticities So far - point elasticities If considering responsiveness over a range of prices / quantities then arc elasticity is more appropriate

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8. Elasticity Define: Thus:

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p q 0 p0p0 p1p1 q 0 q 1 Figure 34: Arc Elasticity of Demand

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8. Elasticity Arc elasticity between, e.g., p 0 and p 1 (q 0 and q 1 ) is equivalent to point elasticity at: Or:

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8. Elasticity Determinants of Elasticity Ultimately a matter of tastes - how essential is the good; how much do individuals want it. Also time; more elastic in long run as consumers can substitute away. Most important consideration is the ease with which consumers can substitute another good that fulfils approximately the same function

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8. Elasticity Applications of Elasticity Determining price and quantity the maximises revenue. Seller can choose either how many goods to sell or the price at which to sell them, but not both. i.e: R = p*q

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8. Elasticity Consider effect of cut in price on Revenue (R) (i) R falls because sell fewer goods at lower p; (ii) R rises because sell more goods at higher p. Thus trade off! Question: Where is trade off optimised?

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8. Elasticity Recall: If E > 1 then a 1% cut in p will lead to a more than 1% increase in q d Thus R will rise since increase in q d dominates fall in p Conversely if E < 1.

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8. Elasticity Strategy If E > 1 then cut price to increase revenue. If E < 1 then raise price to increase revenue. Optimum point is where E = 1 From this point, an x% change in p leads to same x% change in q, such that revenue is unchanged

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8. Elasticity This point occurs half-way down the demand curve at and Rectangle below demand curve at this point is biggest rectangle possible under the demand curve. And since the rectangle represents sales revenue, then this is where sales revenue is maximised.

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p q 0 Maximum Revenue Figure 35: Elasticity of Demand

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8. Elasticity Example:

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8. Elasticity Strategy If E > 1 then cut price to increase revenue. If E < 1 then raise price to increase revenue. Optimum point is where E = 1 From this point, an x% change in p leads to same x% change in q, such that revenue is unchanged

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8. Elasticity Thus, a producer could do no better than to put 10 units of the good onto this market. This is interesting! Had the producer gone to market with 12 goods, it would have been in his interest to destroy two of them! Intuitive??????

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8. Elasticity Cross Price Elasticity Define: Cross price elasticity of demand for good i with respect to changes in price of good j equals % change in quantity of good y demanded divided by corresponding % change in price of good j i.e.

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8. Elasticity E ij > 0Increase in p j leads to fall in q i thus i and j are substitutes for one another E ij < 0Increase in p j leads to fall in q i thus i and j are complements for one another

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8. Elasticity Income Elasticity Define:Income elasticity of demand for a good is % change in quantity demanded divided by corresponding % change in income (M). E M > 0: 1% increase in M leads to rise in demand thus the good is normal E M < 0: 1% increase in M leads to fall in demand thus good is inferior

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8. Elasticity We can distinguish: E M > 1 Luxuries 0 < E M < 1Necessities

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9. Final Comments Free markets are one way for society to solve the basic economic questions of what, how, and for whom to produce. We have begun to see how the market allocates scarce resources amongst competing users. The market will decide:

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9. Final Comments How much of a good is produced By finding price that equates demand and supply. For whom a good is produced Good is purchased by all those willing to pay at least equilibrium price By whom a good is produced Good is supplied by all those willing to supply at equilibrium price What goods are produced Through the supply curve

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9.Final Comments N.B. We will also see later in the course that the market can tell us how goods are produced! In conclusion, we should note that societies may not like the answers that the market provides. Free markets do not produce enough food for everyone to go without hunger; or enough medical care to treat all the sick.

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