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Session 1
Professor David Shepherd
Reading:
Pindyck and Rubenfeld, Chapters 1 & 2
Sexton, Chapters 1, 2 & 3
What is Economics?
Key considerations
Productive resources
o Labour (L)
o Capital (K)
o Technology (A)
o Land (fixed in the background, including natural resources)
Inputs
Outputs
2.
3.
4.
Food
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F
20
40
50
Machinery
2.
3.
D
C
A
E
B
M
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Specialisation means that we have to trade with each other. The baker
supplies bread for money and then buys things that others have produced.
Absolute Advantage
Adam Smith (An Inquiry into the Nature and Causes of the Wealth of
Nations, 1776) suggested that individuals (and nations) should specialise in
the areas of activity in which they have an absolute advantage over others
The UK could grow bananas, but it is more efficient to buy them from
countries in Central America, which have an absolute advantage in
production. In exchange the UK sells goods for which it has an absolute
advantage in production
Comparative Advantage
Does it mean that the individual cant find a suitable job and must live on
benefits?
Does it mean that the nation must protect its markets from more efficient
foreign producers?
Answers..no.andno
A Numerical Example
UK: 1F costs 3M
1M costs 1/3 F
Suppose for numerical simplicity that the US and UK agree to trade food and
machinery at the rate of 1F for 1 M
The UK saves 2M by getting a unit of food from the US (it costs the
equivalent of 3M to produce 1F in the UK)
The US and the UK both gain from trade, even though the US has an
absolute advantage in both areas of production
Wage Rate
$20
Exchange Rate
Money Prices
1 = $2
1F
$20 (10)
1M
$40 (20)
1 = $2
1F
90 ($180)
1M
30 ($60)
In this case, it looks as though trade will not take place because British
machinery is more expensive than US machinery
How can we resolve this situationare there any adjustment
mechanisms to ensure that trade will take place?
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Economic Systems:
o Planned Economy
o Market Economy
o Mixed Economy
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Market Dimensions
Location - the market may or may not have a specific geographical
location
Pricethe unit price at which the product is bought and sold
Quantitythe amount of the product which is bought and sold
Timethe period of time over which the market transactions are
made
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Market Demand
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Suppose there is a fall in the prices of apples. Demand goes up, but
why?........Substitution effect and income effect
Suppose household incomes rise. How does this affect the demand for
apples? .Income effect
Suppose the price of pears goes up. How does this affect the demand for
apples?.......Substitution effect
Suppose we discover that apples are bad for our health. How does this
affect the demand for apples? Consumer preferences
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Price
P1
P2
Dx1
Dx3
Q4
Q1
Q2
Q3
Dx2
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Market Supply
Market supply is the total amount supplied by all firms operating in the
market. This depends on several factors:
o The price at which the product is sold
o Production costs and technology
o The number of firms operating in the market
Suppose that wage costs or energy costs fall. Supply goes up because
wheat production is again more profitable
Price
Sx3
Sx1
Sx2
P2
P1
B
D
A
C
Q4
Q1
Q2
Q3
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Price
Sx1
P1
Equilibrium at D=S
Dx1
Quantity (per month)
Q1
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At P1 the market is in
equilibrium with D = S at Q1
and there is no tendency for
price to change
Price
Sx1
P2
D<S
P1
P3
D>S
Dx1
Q1
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Price
P2
P1
D2
4. Equilibrium is re-established
when price rises to P2 and
demand and supply are again
in balance at Q2
D1
Q1
Q2
Q3
Quantity(per month)
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Price
S1
S2
P1
P2
Q1
Q3
Q2
END OF SESSION 1
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Business Economics
Session 2
Professor David Shepherd
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Understanding Markets
Reading:
Pindyck and Rubenfeld, Chapter 2
Sexton, Chapters 5, 6 & 7
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The demand and supply model explains how price and output are
determined and how they adjust demand or supply conditions change
For example, if demand contracts, the demand curve shifts to the left and,
other things equal, we expect price and output to fall
Or if supply expands, the supply curve shifts to the right and, other things
equal, we expect price to fall and output to rise
But usually we want to be more precise (or more detailed) and answer
questions about the quantitative magnitudes of the changes in P and Q
rather than just the qualitative directions of change
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In particular:
o Price elasticity of demand
o Income elasticity of demand
o Cross-price elasticity of demand
o Price elasticity of supply
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Suppose that consumers buy 100 units of x a week at a price of 2 per unit
and price rises by 10% to 2.20. How do consumers respond ?
Suppose demand falls by 20% from 100 to 80. Price elasticity is then
calculated as 20%/10%= 2. The percentage change in quantity is
greater than the percentage change in price and demand is classified as
elastic
Now suppose that demand falls by only 5%, from 100 to 95. Price elasticity
is calculated as 5%/10% = 0.5. The percentage change in quantity is
smaller than the percentage change in price and demand is classified as
inelastic
Note, if demand falls from by 10%, from 100 to 90, elasticity is 10%/10%
= 1. In this case, the percentage change in demand is the same as the
percentage change in price and demand is said to be unit elastic, meaning
that it is neither elastic nor inelastic.
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Price Inelastic
40% / -20% = 2
-20%
10
10
100
140
+40%
100
110
+10%
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36
Q 0 so p
a
elastic region
p = -1
a/2
Inelastic region
P 0 so p 0
0
a/2b
a/b
Q
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dQ / Q
dQ
P
dP / P
dP
Q
1
a/2
b
a / 2b
1
b 1
b
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Q
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More inelastic
D2
D1
40
12
10
10
100
q
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p
s1
s2
p1
p3
p2
d1
q1
q2
q3
d2
Q (per period)
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Timedemand is likely to be more elastic in the long run than the short
run, because buyers have more time to find substitutes and alter behaviour
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Price Elastic: if price falls (from 10 to 8) buyers spend more and the total
revenue earned from the sale of the product rises from 1000 to 1120
(from 10 100 to 8 140). Demand is responsive to the price change
and the revenue lost by selling units more cheaply is more than offset by
the revenue gained from selling more units. The reverse is true for a price
rise..total business revenue falls
Price Inelastic: if price falls, total revenue falls from 1000 to 880.
Because demand is not responsive to price, the revenue gained from the
sale of extra units does not offset the revenue lost by selling units more
cheaply. The reverse is true for a rise in price..total business revenue
rises.
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Inelastic Demand
Elastic Demand
10
8
10
Revenue
lost
Revenue
lost
Revenue
gained
Revenue
gained
100
140
100
110
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i = Q/Q I/I
If incomes rise by say 5% and the demand for product x rises by 10%,
income elasticity is 5%/10% = 2
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Cross-Price Elasticity
The impact on demand arising from changes in the prices of other goods
can also be expressed in elasticity terms
cp= Q x / Q x P y /P y
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Preference Elasticity ?
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Market supply is the total quantity supplied by all of the firms operating in
the market
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s
12
+20%
12
+20%
10
10
100
110
+10%
100
140
+40%
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12
+20%
10
10
100
40
100
+ 0%
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s1
p2
s2
p3
p1
d1
q1 q2
q3
d2
Q (per period)
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Market adjustments take place over time and the longer the period of time
considered, the greater the potential responsiveness of demand and supply
The longer the period of time under consideration, the more elastic
demand is likely to be, because consumers can adjust their behaviour and
switch to alternative products
The longer the period of time under consideration, the more elastic supply
is likely to be, because new firms can enter the market and existing firms
can adjust their capacity, or leave the market
This implies that price and output adjustment may change over time, as
demand and supply responses change
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The short run is a period during which the number of firms operating in the
market is fixed and each firm operates with fixed capital capacity and a
given technology
In the short run, firms can alter production by employing more or fewer
people. Supply can therefore change, but only within the constraints of
existing capacity and technology
The long run is a period during which existing firms can alter capacity,
technology may change and new firms can enter the industry
In the long run, larger adjustments in production can occur and supply is
more elastic than in the short run
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2. A technological innovation in
farming increases supply. How are
farm incomes affected?
S1
S2
p1
p2
p3
d1
q1 q3 q2
d2
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Elastic Demand
Tax
Tax
S
S
P2
P3
P1
P1
D
q2 q1
q3
q1
q
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END OF SESSION 2
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