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Macro economics slides chapter 4

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8 просмотров11 страницMacro economics slides chapter 4

© All Rights Reserved

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2

Luxury goods and necessary goods

In general, Engel curves do not have to be straight lines. That is,

the relationship between income and consumption needs not be

linear.

If the demand for a good goes up by a greater proportion than

income, we say that it is a luxury good, and if it goes up by a

lesser proportion than income we say that it is a necessary

good.

Of course, both luxury goods and necessary goods are

normal goods.

On the other hand, we have the case of inferior good if

the demand goes down as income increases.

3

Own price effect VS. Cross price effect

Suppose that we decrease the price of good X

P

X

Y

X

As p

X

decreases, the

demand quantity for

good X increases.

In this case, we say good

X is an ordinary good.

As p

X

decreases, the

demanded quantity for

good Y decreases.

In this particular case,

good Y is a substitute

of good X.

4

Income and Substitution effects of own price

change

When the price of good X changes, the change in the

consumption of good X can be broken to two effects:

The substitution effect and the income effect.

The substitution effect is that component of the total effect

of a price change that results from the associated change

in the relative attractiveness of other goods.

The income effect is that component that results from the

associated change in real purchasing power.

To decompose the total effect we begin by asking: How

much income would the consumer need to reach his

original indifference curve?

If the consumer were given a total income of that amount, it

would undo the injury caused by the loss of purchasing

power.

5

Income and Substitution effects of own price

change

In the following example the price of shelter increases from

$6 per sq yd/wk to $24.

As a result shelter consumption decreased from 10 sq

yd/wk to 2.

How do we brake the change?

6

The Substitution and Income

Effects of a Price Change

To get the substitution

effect slide the new budget

B

1

outward Parallel to itself

until it becomes tangent to

the original indifference

curve I

0

.

The movement from A to C

reflects The substitution

effect.

The movement from C to D

reflects the income effect. It

is the reduction in shelter

that results from the loss in

purchasing power.

7

The Substitution and Income

Effects of inferior good

By contrast to the case of a normal good, the income effect in

an inferior good acts to offset the substitution effect

8

Income change: A brief review

Income changes have the effect of shifting the budget line in

a parallel fashion.

From the apparatus of indifference curves, we derive the income

expansion path, describing how the optimal consumption bundle

changes as we change the income.

If we focus onl y on good X,

then we derive the Engel

curve for the good,

describing how the optimal

consumption of good X

changes as we change the

income.

For income changes, we can

have two possible cases:

(1) the normal good case

(2) the inferior good case

9

Own price change: A brief review

Own-price changes have the effect of pivoting the budget line.

From the apparatus of indifference curves, we derive the price

offer curve, describing how the optimal consumption bundle

changes as we change the price of the good in question.

If we focus onl y on the good

whose price has changed, then

we derive the demand curve for

that good, describing how the

optimal consumption of the

good changes as we change its

price.

For own-price changes, we can

have two possible cases:

(1) the ordinary good case

(2) the Giffen good case

10

Cross price change: A brief review

good X is a

substitute

for good Y

p

Y

x

good X is a

complement

to good Y

p

Y

x

11

MARKET DEMAND MARKET DEMAND

12

Here we see how to add up individual

choices to get total market demand.

Once we have derived the market demand curve,

we will examine some of its properties, such as the

relationship between demand and revenue.

Introduction

We have seen in earlier chapters how to model individual

consumer choice.

13

From indi vidual to market demand

Let us use X

1

(p

X

, p

Y

, M

i

) to represent consumer i's demand

function for good X, and Y

i

(p

X

, p

Y

, M

i

) consumer i's demand

function for good Y.

Suppose that there are n consumers.

Then the market demand for good X, also called the

aggregate demand for good X, is the sum of these individual

demands over all consumers:

) , , ( ) ,......, , , (

1

1 i Y X

n

i

i n Y X

M p p X M M p p X

=

=

The analogous equation holds for good Y:

) , , ( ) ,......, , , (

1

1 i Y X

n

i

i n Y X

M p p Y M M p p Y

=

=

14

) , , ( ) ,......, , , (

1

1 i Y X

n

i

i n Y X

M p p X M M p p X

=

=

Since each individual's demand for each good

depends on prices and his money income:

The aggregate demand will generally depend on prices and

the distribution of incomes (M

1

, M

2

, ., M

n

).

But, to know the distribution of incomes, we need a lot of data.

So, it is sometimes convenient to think of the aggregate

demand as the demand of some " representative " representative

consumer" consumer" who has an income that is just the sum of all

individual incomes.

15

The representative consumer

It is convenient to ignore income distribution issues and

think of the aggregate demand as the demand of some

" representative consumer" who has an income that is just

the sum of all individual incomes.

The aggregate demand function will change from:

to:

=

=

=

n

i

i

i Y X

n

i

i Y X

M M where

M p p x M p p X

1

1

1 1

), , , ( ) , , (

Under this

representative

consumer

assumption, the

aggregate demand

in the economy is

just like the

demand of some

individual who

faces prices (p

X

,p

Y

)

and has income M.

That is, the distribution of income does

not matter! Only the sum matters.

) , , ( ) , , (

1

i Y X

n

i

i Y X

M p p X M p p X

=

=

16

= =

=

n

i

i i Y X

n

i

i Y X

M M where M p p X M p p X

1 1

), , , ( ) , , (

If we hold constant the aggregate income M and p

2

:

) , ( M p p X

Y X

p

X

X

aggregate demand

curve for good 1

) , ( M p p X

Y X

Note that the demand

curve is drawn holding

all other prices and

incomes fixed.

If income and other

prices change, the

aggregate demand

curve will shift.

17

p

X

X

aggregate demand

curve for good X

) , ( M p p X

Y X

For example, if goods X and Y are substitutes, then

we know that increasing p

Y

will tend to increase the

demand for good X whatever its price.

This means that

increasing the price of

good Y will tend to shift

the aggregate demand

curve for good X outward.

On the other hand, if

goods X and Y are

complements, increasing

the price of good Y will

shift the aggregate

demand curve for good X

inward.

good X and

good Y are

substitutes

18

p

X

X

aggregate demand

curve for good X

) , ( M p p X

Y X

If good X is a normal

good, there will be an

inward shift in the

demand curve.

Now, suppose that there is a reduction in the income.

On the other hand, if

good X is an inferior

good, the demand curve

will shift out.

good X is a

normal good

19

The inverse demand function

We can look at the aggregate demand curve as giving us

quantity as a function of price: direct demand function, q(p).

This function measures what the quantity demanded would

have to be if the price is at the level p.

Al ternativel y, we can look at the aggregate demand curve as

giving us price as a function of quantity: inverse demand

function, p(q).

This function measures what the market price for the good

would have to be for q units of it to be demanded.

20

Elasticity

q q p po m = ( , ) It is often of useful to have a

measure of how " responsive"

demand is to a change in own

price.

p

q

aggregate demand for the

good in question

The first idea that springs to mind is to use the inverse of the

slope of a demand curve as a measure of responsiveness.

After all, the definition of

the slope of a demand

curve is the change in

price divided by change in

quantity demanded:

p

q

q

p

curve demand of slope

=

p

q

curve demand

of slope the of inverse

=

So, the inverse of the slope of a

demand curve looks like a measure

of demand responsiveness.

21

Well, it is a measure of responsiveness - but it suffers

one major drawback: It depends on the units in which

we measure price and quantity.

For example, if we measure demand in gallons rather

than in quarts, the slope becomes four times bigger, and

hence, one over slope becomes four times smaller.

It is convenient to consider a unit-free measure of

demand responsiveness.

Economists have chosen to use a measure known as

elasticity elasticity.

q

p

curve demand of slope

=

p

q

curve demand

of slope the of inverse

=

22

Own price elasticity of demand

The own-price elasticity of demand, , is defined to be

the percentage change in quantity demanded divided by

the percentage change in own price.

A 10 percent increase in

price is the same percentage

increase whether the price is

measured in American

dollars or English pounds.

Thus, measuring

increases in percentage

terms keeps the

definition of elasticity

unit-free.

q

p

p

q

p

p

q

q

p

p

q

q

p in

q in

100

100

%

%

23

=

%

%

in q

in p

% in q associated with 1% in p

=

30%

5%

in q

in p

6% in q associated with 1% in p

curve demand the of slope the q

p

q

p

p

q

Note

1

*

:

=

=

The own-price elasticity can be expressed as

the ratio of own price to quantity multiplied by

the inverse of the slope of the demand curve.

24

= =

%

%

in q

in p

q

q

p

p

p

q

q

p

The sign of the elasticity of demand is

generally negative, since demand

curves invariabl y have a negative slope.

- 2 or - 3

It is tedious to keep referring to a price elasticity of minus

something-or-other, so it is common in verbal discussion to refer

to price elasticities of 2 or 3, rather than -2 or -3.

To avoid confusion, we will keep

the signs straight in the

discussion by referring to the

absolute value of elasticity.

2 3 or

25

A 1%increase in the price of the good will cause

a 0.5%reduction in the demand quantity.

= - 0.5

= 05 .

Good X

= - 1.5

= 15 .

A 1% increase in the price of th good will cause

a 1.5% reduction in the demand quantity.

Good Y

Which of the two goods is more own-price elastic?

Good Y is more own-price elastic. The absolute value

of its own price elasticity is larger than that of good X.

26

OWN-PRICE: Elastic VS. Inelastic

A 1%increase in the price of the good will cause

a 0.5%reduction in the demand quantity.

= - 0.5

= 05 .

This good is own-price inelastic.

= - 1.5

= 15 .

A 1% increase in the price of the good will cause

a 1.5% reduction in the demand quantity.

This good is own-price elastic.

= - 1.0

= 10 .

A 1% increase in the price of the good will cause

a 1% reduction in the demand quantity.

The elasticity is unitary.

27

If a good has an own-price elasticity of demand greater than

1 in absolute value we say that it has an elastic demand.

If a good has an own-price elasticity of demand less than 1

in absolute value we say that it has an inelastic demand.

If a good has an own-price elasticity of demand of exactly 1

in absolute value we say that it has unit elastic demand.

The own-price elasticity of demand for an ordinary good is

a negative number because the demand curve is

downwardl y sloped.

However, the own-price elasticity of demand for a Giffen

good is a positive number because, in this case, the

demand curve is upwardly sloped.

28

elastic

inelastic

unitary

0

- infinity

+ infinity

-1

own-price elasticity

ordinary good

Giffen good

q

p

ordinary good

q

p

Giffen good

29

= =

p

q

q

p

p

q the slope of the demand curve

*

1

p

q

p

q

slope = - 0

slope = - infinity

elasticity = - infinity elasticity = - 0

Perfectl y Elastic Perfectl y Inelastic

The flatter the demand curve is, the more own-price

elastic is the demand.

30

p

q

p

q

flatter

steeper

That is, the flatter the demand curve is, the more

room there is for the quantity to adjustment.

The flatter the demand curve is, the more own-price

elastic is the demand.

31

Elasticity and close substitutes

Take our example of red pens and blue pens. Suppose that

everyone regards them as perfect substitutes. Then, red pens

and blue pens must sell for the same price.

Now think what would happen to the demand for red pens if

their price should rise, and the price of blue pens stays

constant.

Clearly the demand for red pens would drop to zero.

In other words, the demand for red pens is very elastic.

This is because it has a perfect substitute.

The own-price elasticity of demand for a good depends to

a large extent on how many close substitutes it has.

p

q

32

So what?

If a good has many close substitutes, we would expect that its

demand curve would be very responsive to its price changes.

That is, its demand would be very own-price elastic.

On the other hand, if there are few close substitutes for a good,

its demand curve would be very unresponsive to its price

changes.

That is, its demand would be very own-price inelastic.

33

Example: Own price elasticity of a LINEAR

DEMAND CURVE

Consider the linear demand curve: q = a - b p

p

q

1/slope = - b

If q = 0:

?

0 = a - b p

p = a / b

a/b

If p = 0:

? q = a

a

34

p

q

=

b

p

a bp

When p = 0, the own-price

elasticity of demand is zero.

= 0

When q = 0, p = a/b and the

own-price elasticity of demand

is (negative) infinity.

=

At what value of price is the

price elasticity of demand

equal to -1?

a/b

a

q = a - bp

bp a

p

b

q

p

b

p

q

q

p

= =

=

b

slope p

q

= =

1

= 0 =

??? 1 =

35

p

q

=

b

p

a bp

= 0

=

a/b

a

1 =

p b a

p

b

Well, let's set the elasticity to -1:

Solve the above for p:

b

a

p

2

=

= 0 =

??? 1 =

Substitute the solution for p to

the demand equation to find

the associated q:

2

a

q =

a

b 2

a

2

= 1

36

p

q

= 0

=

a/b

a

a

b 2

a

2

= 1

Except in special cases,

the magnitude of price

elasticity changes as one

moves along the demand

curve.

In other words, the magnitude

of price elasticity changes as

price changes.

= ( ) p

37

Evaluating own price elasticity at a sample point

Since the elasticity coefficient may vary along a demand

curve, It is not technically correct to say that the demand

for a commodity is own-price elastic or inelastic.

That is, demand may be own-price elastic or

inelastic only within some range of the data.

In making empirical computations, a common procedure

is to evaluate own-price elasticity of demand at the mean

of the data.

q

p

p

q

*

=

where are the price

and quantity demanded, evaluated

at the mean of the data.

q and p

38

250 , 20 , 4

, 5 , 3 , 2 Q

: are variables the of means sample The

beef

= = =

= = =

SPPD M P

P P

chicken

pork beef

Write down the formula for own-price elasticity of demand for beef.

Compute the own-price elasticity of demand for beef (evaluating

at the sample means). Is the demand elastic or inelastic? Is

beef an ordinary good or a Giffen good?

Suppose that the price of beef is projected to decrease by 2% next

month, what would be the percentage change in Q

beef

(demand)?

social and

demographic

variables

SPPD M P P P

chicken pork beef

01 . 0 04 . 0 01 . 0 03 . 0 5 . 0 01 . 0 Q

: products beef for equation demand following the Consider

beef

+ + + + =

income

39

PUT YOUR ANSWERS HERE

75 . 0

2

3

5 . 0

,

=

=

=

beef

beef

beef

beef

P Q

Q

P

P

Q

beef beef

5 . 0 =

beef

beef

P

Q

The coefficient associated with

P

beef

in the demand equation.

A 1% increase in P

beef

will be accompanied by a 0.75%

decrease in Q

beef

(demand).

The demand is inelastic, and beef is an ordinary good.

If P

beef

is to drop by 2%, Q

beef

will increase by 1.5%.

[(-2%) * (-0.75) = 1.5%]

40

Own price elasticity and industry revenue

Revenue is the price of a good times the

quantity sold of that good: R = p q

You are the only seller in the market and are thinking about

raising the price. What would happen to your revenue?

p q R

? or

It depends on how responsive the demand is to the price change.

If the demand drops a lot

due to the price increase,

revenue will fall.

If the demand drops only a little

due to the price increase,

revenue will increase.

This suggests that the direction of change in revenue has

something to do with the own-price elasticity of demand.

41

Change in industry revenue

R = p q

Let the price change to:

p p +

Let the quantity change to:

q q +

We have a new revenue of:

R p p q q

p q q p p q p q

new

= + +

= + + +

( ) ( )

Subtracting R from R

new

we have:

R q p p q p q = + +

42

R q p p q p q = + +

For small values of and , the last term can safel y

be neglected.

p q

a small number times

another small number

Thus, the expression for the change in revenue

can be approximated by:

q p p q R +

That is, the change in revenue is roughl y equal to the

original quantity times the change in price plus the original

price times the change in quantity.

43

R = p q

R q p p q p q = + +

q p p q R +

price

quantity

The original price and

quantity are p and q,

respectivel y.

p

q

Thus, the original

revenue is pq.

original

revenue, pq

When the price

increases, we add a

rectangular area on the

top of the box, which

is:

q p

p p +

q p

44

price

quantity

p

q

p p +

To reflect the

quantity

reduction, we

need to subtract

an area on the

side of the box,

which is: p q

q q +

original

revenue, pq

p q

The leftover part,

p q

is the little square

in the corner of

the box.

p q

This leftover part will be

very small relative to

the other magnitudes.

R q p p q p q = + +

q p p q R +

q p

45

So, there are two main effects on the revenue when one

increases the price:

Positive Effect: q p

p q Negative Effect:

Why is this second effect negative? q < 0

When will the net result of these two effects be positive? That

is, when will an increase in the price be followed by an increase

in the revenue?

Two effects on revenues

q p p q R +

46

R q p p q = +

??? 0 when will is, That > + q p p q

Divide the expression by

p

q p

q

p

+ >

0

q

q

p

q

q

p

+ >

0

p

q

q

p

> 1 > 1

< 1

0

- infinity

+ infinity

-1

inelastic

47

The revenue will increase as the price is increased if the

own-price elasticity of demand is less than 1 is absolute

value. That is, if the demand is own-price inelastic.

Inelastic:

p q

R

The revenue will decrease as the price is increased if

the own-price elasticity of demand is greater than 1 is

absolute value. That is, if the demand is own-price

elastic.

Elastic:

p q

R

If the price elasticity is unitary, what would happen to

the revenue when price increases?

48

Demand is Own

Price Inelastic:

p q

Demand is Own

Price Elastic:

p q

Quantity is not responsive to the price change.

inelastic

demand

Quantity is responsive to the price change.

elastic

demand

NOW, THE OTHER SIDE OF THE MIRROR:

IS THE PRICE RESPONSIVE TO A CHANGE IN

QUANTITY? [PRICE FLEXIBILITY]

Price is responsive to the quantity change. flexible

price

Price is not responsive to the quantity change.

inflexible

price

49

Marginal revenue and own price elasticity

Marginal Revenue is the additional

revenue to an additional unit of output.

M R

R

q

R p q q p = +

M R

p q q p

q

p q

p

q

p

q p

p q

+

= + = +

1

50

M R p

q p

p q

+

term inside the

brackets?

Nope, it's not elasticity. It is the reciprocal of elasticity.

q p

p q

p q

q p

= =

1 1

M R p +

1

1

MR p +

1

1

05 .

To avoid confusion due

to the fact that own-price

elasticity is a negative

number, we rewrites the

expression as:

M R p

1

1

MR p

1

1

05 .

51

If the demand is inelastic, then marginal

revenue is negative. So, revenue

decreases as you increase output.

p p R M 3

25 . 0

1

1 =

price is flexible

If the demand is unitary, then marginal

revenue is zero. So, revenue does not

change as you increase output.

0

0 . 1

1

1 =

p R M

price flexibility is unitary

If the demand is elastic, then marginal

revenue is positive. So, revenue

increases as you increase output.

M R p

1

1

p p R M 5 . 0

0 . 2

1

1 =

price is not flexible

52

Both sides of the mirror

If the demand is inelastic,

revenue decreases as you

increase output.

If the demand is inelastic,

revenue increases as you

increase price.

If the demand is unitary,

revenue does not change as

you increase output.

If the demand is unitary,

revenue does not change

as you increase price.

If the demand is elastic,

revenue increases as you

increase output.

If the demand is elastic,

revenue decreases as you

increase price.

53

Income elasticity

The income elasticity of demand is used to describe how the

quantity demanded responds to a change in income:

income elasticity of demand =

% change in quantity demanded

% change in income

m

in q

in income

q

q

m

m

q

q

m

m

= =

%

%

100

100

m

in q

in m

m

q

q

m

=

%

%

54

m

in q

in m

m

q

q

m

=

%

%

in income leads to an increase in demand.

0 >

m

q

The income elasticity of demand is positive.

Further, we say the good is a luxury good if its

income elasticity of demand is greater than 1.

An inferior good is one for which an increase in

income leads to a decrease in demand.

0 <

m

q

The income elasticity of demand is negative.

55

Inferior good

normal good

0

- infinity

+ infinity

1

luxury good

Income Elasticity

q

p

income increase

inferior good

q

p

income increase

normal good / luxury good

56

EVALUATING INCOME ELASTICITY AT A SAMPLE

POINT

In making empirical computations, a common procedure

is to evaluate income elasticity of demand at the mean of

the data.

q

m

m

q

m

*

=

where are the

income and quantity demanded,

evaluated at the mean of the

data.

q and m

57

250 , 20 , 4

, 5 , 3 , 2 Q

: are variables the of means sample The

beef

= = =

= = =

SPPD M P

P P

chicken

pork beef

Write down the formula for income elasticity of demand for beef.

Compute the income elasticity of demand for beef (evaluating at

the sample means). Is beef a normal good or an inferior good?

Suppose that income is projected to decrease by 2% next

month, what would be the percentage change in Q

beef

(demand)?

SPPD M P P P

chicken pork beef

01 . 0 04 . 0 01 . 0 03 . 0 5 . 0 01 . 0 Q

: products beef for equation demand following the Consider

beef

+ + + + =

income

social and

demographic

variables

58

PUT YOUR ANSWERS HERE

4 . 0

2

20

04 . 0

,

=

=

=

beef

beef

P Q

Q

M

M

Q

beef beef

04 . 0 =

M

Q

beef

The coefficient associated with

M in the demand equation.

A 1% increase in M will be accompanied by a 0.4% increase

in Q

beef

(demand)

Beef is a normal good.

If M is to drop by 2%, Q

beef

will decrease by 0.8%.

[(-2%) * (0.4) = -0.8%]

59

LET'S GENERALIZE OUR NOTATIONS

q p

inq

in p

p

q

q

p

=

%

%

q m

in q

in m

m

q

q

m

=

%

%

60

m

in q

in m

m

q

q

m

=

%

%

P

Q

P

Q

Q

P

P

Q

Cross price elasticity of with

respect to

Q

P

61

Two goods are substitutes if their cross-price

elasticity is positive.

Two goods are complements if their cross-price

elasticity is negative.

Two goods are independent if their cross-price

elasticity is zero.

m

in q

in m

m

q

q

m

=

%

%

P

Q

P

Q

Q

P

P

Q

62

complements

substitutes

0

- infinity

+ infinity

1

Cross-Price Elasticity

Independent goods

1

q

1

p

p

2

increase

goods 1 and 2 are complements

1

q

1

p

p

2

increase

goods 1 and 2 are substitutes

63

Evaluating cross price elasticity at a sample point

In making empirical computations, a common procedure

is to evaluate cross-price elasticity of demand at the mean

of the data.

Consider the cross-price elasticity of demand for good 1

with respect to a change in the price of good 2:

1

2

2

1

*

2 1

q

p

p

q

p q

=

where are the price

of good 2 and quantity of good 1,

evaluated at the mean of the

data.

1 2

q and p

64

250 , 20 , 4

, 5 , 3 , 2 Q

: are variables the of means sample The

beef

= = =

= = =

SPPD M P

P P

chicken

pork beef

Write down the formula for the cross-price elasticity of demand

for beef with respect to pork price.

Compute the cross-price elasticity (evaluating at the sample

means). Are beef and pork substitutes or complements?

Suppose the price of pork is projected to decrease by 2% next

month, what would be the percentage change in Q

beef

(demand)?

SPPD M P P P

chicken pork beef

01 . 0 04 . 0 01 . 0 03 . 0 5 . 0 01 . 0 Q

: products beef for equation demand following the Consider

beef

+ + + + =

income

social and

demographic

variables

65

PUT YOUR ANSWERS HERE

075 . 0

2

5

03 . 0

,

=

=

=

beef

pork

pork

beef

P Q

Q

P

P

Q

beef beef

03 . 0 =

pork

beef

p

Q

The coefficient associated with

P

pork

in the demand equation.

A 1% increase in P

pork

will be accompanied by a 0.075%

increase in Q

beef

(demand).

Beef and pork are substitutes.

If P

pork

is to drop by 2%, Q

beef

will decrease by 0.15%.

[(-2%) * (0.075) = -0.15%]

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