Price, Income and Cross-Price Elasticities of
==
Demand
Elasticity of demand is measured as a ratio of percentage change in quantity demanded
to a percentage change in other variables.
Own-price elasticity
Own-price elasticity of demand is usually always negative.
If |own price elasticity| > 1, then demand is elastic.
If |own price elasticity| < 1, then demand is inelastic.
If own price elasticity = -1, then demand is unit, or unitary, elastic.
Income elasticity
If income elasticity > 0, then the good is a normal good.
If income elasticity < 0, then the good is an inferior good.
Cross price elasticity
If cross price elasticity > 0, then the related good is a substitute.
If cross price elasticity < 0, then the related good is a complement.
A demand function for chairs is as follows:
At current average prices, a chair costs $50, a table costs $100 and a stool costs $30.
Average income is $5,000. Calculate the income elasticity of demand for chairs.
Solution:
Substitute current values for the independent variables (except income)
The slope of income is 0.05
For an income of $5,000; Qchairs = 306
Factors impacting the own price elasticity of demand for a product include:
Substitutes: If the number of substitutes for this product is high, then elasticity will
be high.
Portion of total budget: If the portion of total budget spent on this product is high,
then elasticity will be high.
Time horizon: If the time horizon we consider is long, then elasticity will be high.
This is because consumers will have enough time to respond to changes in the
price of this product.
Discretionary (optional) versus non-discretionary (necessary): If the product is
discretionary rather than non-discretionary, then the elasticity will be high.
Elasticity of demand is measured as a ratio of percentage change in quantity demanded
to a percentage change in other variables.
Own-price elasticity
Own-price elasticity of demand is usually always negative.
If |own price elasticity| > 1, then demand is elastic.
If |own price elasticity| < 1, then demand is inelastic.
If own price elasticity = -1, then demand is unit, or unitary, elastic.
Income elasticity
If income elasticity > 0, then the good is a normal good.
If income elasticity < 0, then the good is an inferior good.
Cross price elasticity
If cross price elasticity > 0, then the related good is a substitute.
If cross price elasticity < 0, then the related good is a complement.
A demand function for chairs is as follows:
At current average prices, a chair costs $50, a table costs $100 and a stool costs $30.
Average income is $5,000. Calculate the income elasticity of demand for chairs.
Solution:
Substitute current values for the independent variables (except income)
The slope of income is 0.05
For an income of $5,000; Qchairs = 306
Factors impacting the own price elasticity of demand for a product include:
Substitutes: If the number of substitutes for this product is high, then elasticity
will be high.
Portion of total budget: If the portion of total budget spent on this product is
high, then elasticity will be high.
Time horizon: If the time horizon we consider is long, then elasticity will be high.
This is because consumers will have enough time to respond to changes in the
price of this product.
Discretionary (optional) versus non-discretionary (necessary): If the product is
discretionary rather than non-discretionary, then the elasticity will be high.
Concept 23: Aggregate Supply Curve
The aggregate supply curve shows the positive relationship between GDP and the
price level
In the very short run, companies change output to some degree without
changing prices.
In the short run input prices are fixed so businesses expand real output when
output prices increase.
In the long run aggregate supply is perfectly inelastic (vertical) and represents
the potential GDP which is the full-employment level of economic output.
Shifts in the SRAS are cause by changes in input prices, expectations about the future,
changes in business tax rates, changes in subsidies, currency exchange rates.
Shifts in the LRAS are caused by changes in labor supply, availability of natural
resources, stock of physical capital, changes in productivity and technology
Concept 18: Substitution and Income
Effects
Substitution effect
When a good’s price falls, due to substitution effect consumers buy more of this
good as compared to other goods for which the prices have remained the same.
Substitution effect is always positive.
Income effect
When a good’s price falls, real income rises.
If the good is a normal good, the income effect will be positive and more of this
good will be purchased.
If the good is an inferior good, the income effect will be negative and less of this
good will be purchased.
Giffen goods
Giffen goods are highly inferior for which the negative income effect outweighs
the positive substitution effect.
Therefore even though price falls, the quantity demanded still decreases.
Giffen goods have a positively sloped demand curve (which means that as price
decreases the quantity demanded also decreases).
Veblen goods
Veblen goods are “high status” goods.
If price increases, this makes the goods even more desirable and quantity
demanded increases.
Veblen goods also have a positively sloped demand curve (which means that as
price increases the quantity demanded also increases).
Concept 20: Perfect Competition,
Monopolistic Competition, Oligopoly &
Perfect Monopolistic
Oligopoly Monopoly
competition competition
Number of firms Many firms Many firms Few firms Single firm
Barriers to entry Very low Low High Very high
Nature of
Very close Substitutes but Very close substitutes
substitute No good substitutes
substitutes differentiated or differentiated
products
Nature of Price, marketing & Price, marketing &
Price only Advertising
competition features features
Pricing power None Some Some to significant Significant
Demand curve for Perfectly elastic Downward sloping,
Downward sloping Downward Sloping
the firm (Horizontal) yet elastic
Example Rice market Soap Aircraft manufacturers Utility companies
Firms are
Branding creates
Overall market interdependent, i.e.
differentiation in May be regulated by
Key points supply and demand, they must consider
otherwise very similar the government.
determine the prices. actions and reactions
products.
of each other.
Monopoly
Concept 22: Gross Domestic Product
(GDP)
Gross domestic product refers to the market value of all final goods and services
produced in a country over a specific time period, usually one year; government
transfers and goods/services without market value are not included.
There are two approaches to calculate GDP:
The income approach computes GDP as the total income earned by
households, businesses and the government in the country during a time period.
The expenditure approach
Can be computed through the sum-of-value-added approach where
GDP is calculated by summing the additions to value created at each
stage of production & distribution
Can be computed through the value-of-final-output approach where
GDP is calculated by summing the values of all final goods and services
produced during the period
The expenditures approach can also be stated as:
GDP = C + I + G + (X – M)
where:
C = consumption spending,
I = business investments (includes capital equipment and inventories),
G = government purchases,
X = exports,
M = imports
Theoretically, the GDP derived from the two methods should match. Practically, there
are some discrepancies due to measurement issues.
Concept 23: Aggregate Supply Curve
The aggregate supply curve shows the positive relationship between GDP and the
price level
In the very short run, companies change output to some degree without
changing prices.
In the short run input prices are fixed so businesses expand real output when
output prices increase.
In the long run aggregate supply is perfectly inelastic (vertical) and represents
the potential GDP which is the full-employment level of economic output.
Shifts in the SRAS are cause by changes in input prices, expectations about the future,
changes in business tax rates, changes in subsidies, currency exchange rates.
Shifts in the LRAS are caused by changes in labor supply, availability of natural
resources, stock of physical capital, changes in productivity and technology
=============================================
===================Concept 24: Business
Cycle
Business cycles refer to the fluctuation in economic activity where the real GDP and
unemployment vary through time. The four stages of the business cycle are: expansion,
peak, contraction and trough.
Business cycle characteristics
Trough:
GDP growth rate changes from negative to positive.
High unemployment rate and a moderate or declining inflation.
Increasing production to meet the pickup in sales with more flexible methods like
overtime or increasing utilization levels.
Housing activity starts to pick up coupled with an increase in consumer spending.
Expansion:
GDP growth rate increases.
Reduction in unemployment rate as hiring rises.
Inflation may begin to rise.
Increasing production needs are met with investments and labor force additions.
Housing demand leads to a rise in construction activity.
Import increases as the domestic GDP increases.
Peak:
GDP growth rate decreases.
Unemployment rate decreases but firms cut back on hiring.
Business and consumer confidence declines, slowing the growth rates in
investments and consumer spending.
Inflation rate increases.
Contraction (Recession):
GDP growth rate is declining.
Unemployment rate increases as firms cut back on production.
Inflation decreases with a lag.
Decline in consumer and business confidence lowers the investment and
consumer spending.
Housing activity starts to decline.
Import decreases as the domestic GDP decreases.
-----------------------------================================================
Concept 25: Theories of The Business
Cycle
Theory Causes of Business Cycles Recommended Policy
No action is necessary; wages and prices
adjust through demand-supply characteristics
Neoclassical Changes in technology. pulling or pushing the economy form
expansion or recession level to its full-
employment level.
Shifts in AD due to changes in business
expectations can lead to over or under
Authorities should use fiscal and/or monetary
investments.
Keynesian policy to shift the AD curve directly to get the
Downward sticky wages prevent a self- GDP to its full employment level.
recovery from contraction (SRAS curve is slow
to move down).
In addition to Keynesian beliefs, this theory
Same as Keynesian (use fiscal and/or
believes other factors of production are also
New Keynesian monetary policy to shift the AD curve directly
downward sticky, presenting additional
to get the GDP to its full employment level).
barriers to self-recovery.
Monetary authorities should follow policies of
Inappropriate changes in money supply
Monetarist steady, predictable growth rate of money
growth rate.
supply.
Policymakers shouldn’t keep interest rates at
Austrian Government intervention in economy. artificially low levels. Markets should be
allowed to self-correct.
Policymakers shouldn’t try to counteract
business cycles, as expansions and
New Classical (RBC contractions are rational market reactions to
Changes in technology and external shocks.
Theory) external shocks. Theory assumes that
individuals and firms try to maximize their
utility functions.
Concept 26: Unemployment
Unemployment types
Frictional unemployment is caused by the time lag necessary to match
employees seeking work with employers seeking their skills.
Structural unemployment is caused by long-run changes in the economy that
eliminate some jobs and require workers to gain new skills to be capable of the
available jobs.
Cyclical unemployment is caused by changes in the business cycle.
Measures of unemployment
To be considered unemployed, a person must be actively searching for work.
Labor force includes employed and unemployed people.
Participation ratio (Activity ratio) = Labor Force / working-age population
(Age group: 16 – 64).
Unemployment rate is the percentage of labor force that is unemployed;
unemployment rate = unemployed people / labor force.
Discouraged workers are those who are available for work but are neither
employed nor actively seeking employment.
They are not considered in the labor force, not counted as unemployed.
With better job prospects in an expansion, these workers start actively
seeking work. This adds to the labor force and makes the unemployment
ratio a lagging indicator of business cycle.
Underemployed individual is a person who is employed at a low-paying job
despite being qualified for a significantly higher-paying one or works part time
despite his preference for full time work.
Concept 28: Inflation Measures
Laspeyres index is the most common type of index; which uses a constant basket of
goods and services. The three factors that cause the index to biased upwards are:
New goods: Older goods are replaced by newer goods that are initially more
expensive.
Quality changes: Quality improvements can cause the increase in basket price
without any inflation.
Substitution: Consumers prefer substitute products.
Paasche index uses the current weights of basket to derive the base year basket price
while determining the rate of change. It is used to address the issue arising from
substitution.
Fischer index is a geometric mean of Laspeyres and Paasche index.
Compute the Paasche index for the following simple basket of goods:
Base period Current period
Item Base period price Current pric
quantity quantity
Apparel 100 25.00 105 30.00
Burgers 50 3.50 40 4.50
Gasoline 80 2.00 95 3.50
Books 65 4.00 50 3.00
Solution:
Base period:
Apparel=105*25=2,625
Burgers=40*3.5=140
Gasoline=95*2=190
Books=50*4=200
Cost of basket=3,155
Current period:
Apparel=105*30=3,150
Burgers=40*4.5=180
Gasoline=95*3.5=332.5
Books=50*3=150
Cost of basket=3,812.5
Paasche index={{3,812.5}\over {3,155}}*100=121
Concept 30: Roles and Objectives of
Central Banks
Roles of central bank
Supply currency: Central banks have the sole authority to supply money.
Banker to government and other banks: Central banks provide banking services
to the government and other banks in the country.
Regulate risk and supervise payment system: Central banks regulate the risk
standards in the banking systems and monitor the payment system to ensure
smooth transactions.
Lender of last resort: Central banks can print money when the need arises.
Repository of gold and foreign exchange reserves: Holds a country’s gold and
foreign exchange reserves.
Conducts monetary policy: Central bank controls the money supply in an
economy.
Objectives of central bank
Control inflation (primary objective): A controlled inflation level promotes price
stability which is conducive to a stable economic development.
Exchange rate stability: Countries that have their domestic currency pegged to
another currency must make an effort to match its inflation rate with that
country.
Full employment: Take measures that move the economy to its full potential
level of employment.
Sustainable positive economic growth.
Moderate long-term interest rates.
Concept 31: Tools Used to Implement
Monetary Policy
The three tools available to central banks to control the money supply are:
Policy rates
Borrowing from central bank:
Banks can borrow from central bank to meet shortfall in reserves at a rate called
discount rate or refinancing rate or repo rate. This is facilitated
through repurchase agreements.
A lower repo rate increases money supply and encourages lending, this lowers
interest rates.
On the other hand, a higher repo rate decreases money supply and reduces
lending, this increases interest rates.
Interbank lending:
Banks can lend to each other overnight loan reserves at a rate called federal
funds rate (for US banks).
Fed uses open market operations to move it to the targeted rate.
Open market operations
Central bank buys securities →Investors and banks get cash →increases banks
excess reserves → increases money supply and encourages lending →lowers
interest rates.
Central bank sells securities → Investors and banks pay cash → lowers bank
excess reserves → decreases money supply and reduces lending → increases
interest rates.
Frequently used in US.
Reserve requirements
Represents the deposits to be maintained to meet withdrawal limits.
Increase in reserve requirement →decreases money supply and reduces lending
→increases interest rates.
Decrease in reserve requirement →increases money supply and encourages
lending → decreases interest rates.
Concept 33: Fiscal Policy Tools
Fiscal policy tools include::
Spending tools:
Current expenditure: On-going spending on goods and services by government.
For e.g. salaries of government personnel, national defense expenditure etc.
Transfer payments: Primarily aimed at redistributing wealth. For e.g.
unemployment insurance benefits, social security etc.
Capital expenditure: Government spending on infrastructure projects to boost
economic productivity. For e.g. bridges, road networks etc.
Revenue tools:
Direct taxes: Taxes levied on wealth and income. Includes income taxes,
corporate taxes, wealth taxes capital gains taxes etc.
Indirect taxes: Taxes levied on goods and services. Includes sales taxes, value-
added taxes, excise taxes etc.
Advantages and disadvantages of fiscal policy
Advantages:
Indirect taxes can be implemented swiftly and start generating revenue for the
government immediately without incurring additional costs.
Indirect taxes like VAT can influence spending behavior instantly and can be
used to discourage consumption of sin products like alcohol and tobacco.
Disadvantages:
Implementation of changes in direct taxes and transfer payments policies is time
consuming, thereby delaying the impact of the fiscal policy.
Capital expenditure projects like road construction have long gestation periods;
delaying the impact of the fiscal policy.
Concept 34: Types of Trading Blocs and
Regional Trading Agreements
Free-Trade Area: All barriers to import and export of goods and services
among member countries are removed. For e.g. North American Free Trade
Agreement (NAFTA).
Customs Union: Free-trade area + all member countries adopt a common set
of trade restrictions with non-members.
Common Market: Customs union + all barriers to the movement of labor and
capital goods among member countries are removed.
Economic Union: Common market + member countries establish common
institutions and economic policy. For e.g. European Union (EU).
Monetary Union: Economic union + member countries adopt a single currency.
For e.g. European Zone.
Cross rate is the exchange rate between two currencies derived from their exchange
rate with a common third currency.
Consider the following exchange rates:
Spot rate Expected spot rate
USD/EUR 1.3690 1.3457
CHF/USD 0.9164 0.9020
USD/GBP 1.5160 1.5100
Determine the following:
1. CHF/EUR cross rates.
2. GBP/EUR cross rates.
3. CHF/GBP cross rates.
4. Does EUR appreciate/depreciate against CHF and by how much.
5. The strongest currency over the next year.
Solution:
[Link] rate:
CHF/EUR=CHF/USD*USD/EUR=0.9164*1.3690=1.2546
Expected spot rate: CHF/EUR=CHF/USD*USD/EUR=0.9020*1.3457=1.2138
[Link] rate: GBP/EUR=GBP/USD*USD/EUR=(1/1.5160)1.3690=0.9030
Expected spot rate: GBP/EUR=GBP/USDUSD/EUR=(1/1.5100)1.3457=0.8912
[Link] rate: CHF/GBP=CHF/USDUSD/GBP=0.9164*1.5160=1.3893
Expected spot rate: CHF/GBP=CHF/USD*USD/GBP=0.9020*1.5100=1.3620
As the quoted rate for CHF/EUR drops from 1.2546 to 1.2138, the EUR depreciates
relative to CHF.
Percentage depreciation in EUR relative to CHF = (1.2138/1.2546 — 1) = -3.25\%
From the change in quoted exchange rates we can see that USD strengthens relative to
both EUR and GBP.
Whereas USD depreciates relative to CHF.
Hence, the strongest currency is CHF.
