Economics of Strategy (ECON 4550) Maymester 2015 Review of Relevant Principles of Economics

Transcription

1 Economics of Strategy (ECON 455) Maymester 215 Review of Relevant Princiles of Economics Definitions and Concets: Economics is the social science that studies decision making in the face of scarcity, and the imlications of such decisions on individuals and societies. Microeconomics the branch of economics which studies how individual decision-makers behave and interact with each other (very often with a focus on how individual households and/or firms behave and interact with each other in markets). Perfectly Cometitive Market a market in which no individual buyer and no individual seller can substantially influence market rice by changing his own behavior Two rimary conditions which must be met for a market to be erfectly cometitive : i. all goods offered for sale are identical ii. there are many buyers and many sellers Primary Imlication: in erfectly cometitive markets, all buyers and all sellers are rice takers (i.e., buyers and sellers must accet the rice that market demand and market suly determine ; nobody has any market ower or control over rice ) A third condition which is assumed when discussing the Long Run dynamics of erfectly cometitive markets iii. Free Entry/Exit new firms could enter and existing firms could exit the market with relative ease and without incurring substantial costs of doing so Model of Suly and develoed to exlain how buyers and sellers interact in a erfectly cometitive market and what outcome results from their interaction with each other. The free interaction between buyers and sellers in markets results in an outcome which can be described by: i. an equilibrium of trade (amount traded) ii. an equilibrium rice (rice at which trade takes lace) Quantity ed the number of units of a good that buyers are willing and able to urchase at a articular rice the entire relationshi between the rice of a good and demanded, all other factors fixed. Law of all other factors fixed, the demanded of a good will be larger at lower rices (visually, demand curves are downward sloing).

2 Buyer s Reservation Price the maximum dollar amount a buyer is willing to give u in order to acquire an item. (The height of the demand curve at any articular illustrates the reservation rice of the buyer of that unit.) Function mathematical relation secifying demanded of a good as a function of own rice (and any other factors that are relevant for individuals urchasing decisions),,,,, Treating everything other than own rice as fixed, we have Examles: or Focus on two tyes of changes in demand i. Increase in a change in demand consistent with buyers becoming more willing to urchase a good in that demanded increases at every rice (visually a rightward shift of the demand curve) ii. Decrease in a change in demand consistent with buyers becoming less willing to urchase a good in that demanded decreases at every rice (visually a leftward shift of the demand curve) Common Determinants of : The following changes will result in an increase in demand (changing these factors in the oosite direction would result in a decrease in demand): 1. A decrease in the rice of a Comlement Good (e.g., demand for hotdogs would increase if the rice of hotdog buns were to decrease) 2. An increase in the rice of a Substitute Good (e.g., demand for Pesi would increase if the rice of Coke were to increase) 3. An increase in income (for a Normal Good most goods are normal goods) 4. A decrease in income (for an Inferior Good some goods, such as generic brands, are inferior) 5. An increased reference by consumers for the good (e.g., new study suggesting drinking 24 ounces of milk er day will reduce obesity would increase demand for milk) 6. An increase in market size (e.g., increase in oulation) 7. An exectation of higher future rices (e.g., if you have reason to susect that gasoline will cost $1 more er gallon tomorrow, would you be more likely to buy gas today?) Quantity Sulied the number of units of a good that sellers are willing and able to sell at a articular rice Suly the entire relationshi between the rice of a good and sulied, all other factors fixed. Law of Suly all other factors fixed, the sulied of a good will be larger at higher rices (visually, suly curves are uward sloing).

3 Seller s Reservation Price the minimum dollar amount a seller is willing to accet in exchange for an item. (The height of the suly curve at any articular illustrates the reservation rice of the seller of that unit.) Suly Function mathematical relation secifying sulied of a good as a function of own rice (and any other factors that are relevant for individuals selling decisions),,,, Treating everything other than own rice as fixed, we have Examles: or Focus on two tyes of changes in suly (caution: do not think of the curves as shifting uward v. downward, but instead think of the shifts as leftward v. rightward ) i. Increase in Suly a change in suly consistent with sellers becoming more willing to sell a good in that sulied increases at every rice (visually a rightward shift of the suly curve) ii. Decrease in Suly a change in suly consistent with sellers becoming less willing to sell a good in that sulied decreases at every rice (visually a leftward shift of the suly curve) Common Determinants of Suly: The following changes will result in an increase in suly (changing these factors in the oosite direction would result in a decrease in suly): 1. A decrease in the cost of any factors of roduction needed to roduce the good (e.g., decrease in the wage rate aid to labor would increase suly) 2. An imrovement in technology that reduces roduction costs 3. A favorable realization of natural events (e.g., good weather for the growing of an agricultural commodity) 4. An increase in market size (e.g., increase in the number of suliers of the good) 5. An exectation of lower future rices (e.g., if a gas station owner has reason to susect the market rice will be $1 less tomorrow, they would want to unload as much gasoline as ossible today) Equilibrium a stable state for a system which will ersist as long as outside factors do not change. In the context of market equilibrium we need to identify a rice/ air that is stable in the sense that no individual buyer and no individual seller can benefit by altering their own behavior. Consumer s Surlus a measure of the benefit realized by a buyer from making a urchase, defined as the difference between the buyer s reservation rice for the item and rice aid for the item. Producer s Surlus a measure of the benefit realized by a seller from making a sale, defined as the difference between rice received for the item and the seller s reservation rice for the item.

4 Total Consumers Surlus a measure of the total gains from trade realized by all consumers in a market, defined as the difference between buyer s reservation rice and actual rice aid added over all units urchased. Total Producers Surlus a measure of the total gains from trade realized by all sellers in a market, defined as the difference between actual rice received and seller s reservation rice added over all units sold. Price Elasticity of a measure of the sensitivity of demanded to a change in rice, comuted as the ercentage change in demanded divided by the ercentage change in rice: Q % Q Q P Q P 1 (P/Q)(1/ sloe ) % P P Q P Q P P Q If the Function is secified by D ( ), then D( ) D( ) Recall that by the Law of : Q and P are of oosite sign ; D ( ) ; sloe of demand curve is negative => very negative => elastic demand => demanded is very sensitive to changes in rice (i.e., consumers adjust their urchasing behavior substantially to changes in rice) close to zero => inelastic demand => demanded is not very sensitive to changes in rice (i.e., consumers do not alter urchasing behavior much in resonse to changes in rice) is erfectly elastic if elastic if 1 unit elastic if 1 inelastic if 1 erfectly inelastic if Price Elasticity of Suly a measure of the sensitivity of sulied to a change in rice, comuted as the ercentage change in sulied divided by the ercentage change in rice. S If the Suly Function is secified by S ( ), then S( ). S( ) By the Law of Suly, S ( ), which imlies that Price Elasticity of Suly is ositive.

5 Cross-Price Elasticity of a measure of the sensitivity of demanded of a good to a change in the rice of another good, comuted as the ercentage change in demanded of the first good divided by ercentage change in the rice of the second good. Sign of Cross-Price Elasticity of for Good A with resect to the rice of Good B tells us whether the goods are comlements to or substitutes for one another: Qa, Pb Good A is a substitute for Good B Good A is a comlement to Good B Qa, Pb If for A is D D A() => A( ) B Qa, Pb B qa Income Elasticity of a measure of the sensitivity of demanded of a good to a change in consumer income, comuted as the ercentage change in demanded divided by ercentage change in income. Sign of Income Elasticity of tells us whether a good is a normal good or an inferior good: Q, Inc Normal Good Inferior Good Q, Inc D( ) I If is D () => Q, Inc I D( )

6 5 Market Equilibrium What rices are stable? : rice Suly Excess Suly at a rice of $5: sulied (of 75) is greater than demanded (of 15) [i.e., more sellers than buyers ] => downward ressure on rice 3 2 Excess at a rice of $2: demanded (of 15) is greater than sulied (of 4) [i.e., more buyers than sellers ] => uward ressure on rice D(5)=15 S(2)=4 D(3)=S(3)=55 S(5)=75 D(2)=15 Is a high rice of H 5 stable? At this rice: buyers are willing and able to buy 15 units, while sellers are willing and able to sell 75 units. Since sulied is greater than demanded, there is excess suly. 6 of the sellers who would like to sell the item for $5 are not able to find buyers each of these sellers would have an incentive to instead accet $49.99 (and sell the item for one cent less, as oosed to not selling the item) => downward ressure on rice. Any rice for which there is excess suly is not stable. Is a low rice of L 2 stable? At this rice: buyers are willing and able to urchase 15 units, while sellers are willing and able to sell 4 units. Since demanded is greater than sulied, there is excess demand. 65 of the buyers who would like to urchase the item for $2 are not able to find sellers each of these buyers would have an incentive to instead offer $2.1 (and buy the item for one cent more, as oosed to not buying the item) => uward ressure on rice. Any rice for which there is excess demand is not stable Only stable rice is at the intersection of the demand curve and the suly curve. Only at this rice do we have ( demanded)=( sulied). At * 3 : buyers are willing and able to urchase 55 units and sellers are willing and able to urchase 55 units (no excess demand ; no excess suly ). Further, all those otential buyers that don t make a urchase at this rice do not want to make a urchase at this rice. Likewise, all those otential sellers that don t make a sale at this rice do not want to make a sale at this rice. Nobody has anything to gain by changing their behavior => Stable Outcome. Market Equilibrium occurs at the intersection of suly and demand: equilibrium rice is * 3 and equilibrium is q * 55.

7 Imact of Change in on Market Equilibrium: High Price rice Suly Low Price (B) (A) Low Quantity High Quantity Increase in demand (for whatever reason): shift from (B) to (A) => increase equilibrium rice, increase equilibrium. Decrease in demand (for whatever reason): shift from (A) to (B) => decrease equilibrium rice, decrease equilibrium. Imact of Change in Suly on Market Equilibrium: High Price rice Suly (A) Suly (B) Low Price Low Quantity High Quantity Increase in suly (for whatever reason): shift from Suly (A) to Suly (B) => decrease equilibrium rice, increase equilibrium. Decrease in suly (for whatever reason): shift from Suly (B) to Suly (A) => increase equilibrium rice, decrease equilibrium.

8 A motivation for defining Price Elasticity of Note that the insights on how equilibrium rice and equilibrium change as a result of a change in demand or change in suly are simly directional insights and tell us nothing about magnitude For examle, a decrease in suly will lead to a decrease in equilibrium and an increase in equilibrium rice. These directional insights follow from the Law of. To see why, consider the decrease in suly below: Uer Bound on New P rice Suly (new) Suly (initial) Initial P Lower Bound on New Q Initial Q While the directional changes in rice/ follow from the Law of, the magnitudes of the changes deend uon how sensitive demanded is to rice. For the decrease in suly under consideration: i. there will be a big increase in rice but a small decrease in demanded is not very sensitive to rice ii. there will be a small increase in rice but a big decrease in demanded is very sensitive to rice (See the illustrations of these two cases rovided on the following age.) Thus, it is useful to have a measure of how sensitive demanded is to changes in own rice. Price elasticity of demand is defined to be this measure.

9 ( A motivation for defining Price Elasticity of continued) If demanded is very unresonsive to changes in rice, this decrease in suly: results in a big increase in equilibrium rice results in a small decrease in equilibrium rice Suly Uer Bound (new) on New P New P Initial P Suly (initial) Lower Bound on New Q New Q Initial Q If demanded is very resonsive to changes in rice, this decrease in suly: results in a small increase in equilibrium rice results in a big decrease in equilibrium rice Suly Uer Bound (new) on New P New P Suly (initial) Initial P Lower Bound on New Q New Q Initial Q

10 Equilibrium Price serves to define the slit of total gains from trade between buyers and sellers at the market equilibrium outcome: rice Total Consumers Surlus ( green area ) Suly *=3 Total Producers Surlus ( urle area ) q*=55

11 Price Elasticity of Functional Examles: 1. (linear demand) =>, so that: b D ( ) D( ) a b At (horizontal intercet): a a At (vertical intercet): a a b a a As increases: b (the numerator of ) increases, while a b (the denominator of ) decreases => becomes more negative 1 1 b a b 2b a a a b 2b Along any linear demand curve, demand is: Elastic along the to half of the curve; Inelastic along the bottom half of the curve; Unit Elastic exactly halfway down the curve Perfectly Inelastic at the horizontal intercet; Perfectly Elastic at the vertical intercet Value of elasticity always gets closer to zero as one moves down the curve Elasticity takes on every ossible value between and at some oint along the curve rice a b a 2 b Perfectly Elastic Elastic Unit Elastic Inelastic Perfectly Inelastic a 1 a 2 2., so that: b1 b ba ba b b b a a As a result, this functional form of demand is referred to as a constant elasticity demand function

12 Real World Estimates of Price Elasticity of : Good: Estimated : Breakfast Cereal -.31 Cigarettes -.17 Theatre/Oera tickets -.18 Wine and Brandy Beer and Malt Beverages Ice Cream Pork -.45 Cheese Beef -.65 Chicken -.65 Cigars Movie tickets -.87 Airline Travel (business) Coca-Cola Airline Travel (leisure) Pesi Cola Restaurant Meals Green Peas -2.8 Lexus LS Ford Escort Inelastic Elastic Real World Estimates of Cross-Price Elasticities: Cross-Price Elasticity of for with resect to the rice of. Chicken beef = (.12) [chicken is a substitute for beef] Beef chicken = (.2) [beef is a substitute for chicken] Nissan Sentra Ford Escort = (.78) [Nissan Sentra is a substitute for Ford Escort] Ford Escort Lexus LS4 = (.1) [value of essentially zero imlies that Ford Escort is neither a substitute for nor a comlement to Lexus LS4] Coca-Cola Pesi Cola = (.52) [Coca-Cola is a substitute for Pesi Cola] Pesi Cola Coca-Cola = (.64) [Pesi Cola is a substitute for Coca-Cola] Real World Estimates of Income Elasticities: Good: Estimated Income Elasticity: Peaches 1.43 Pesi Cola 1.38 Ales 1.32 Coca-Cola.58 Milk.5 Eggs.44 Butter.37 Potatoes.15 Margarine -.2 Flour -.36 Normal Goods Inferior Goods

13 Multile Choice Questions: 1. Since the end of Aril, there has been an increase in both the rice and traded of #5 San Diego Chargers Jerseys. Which of the following would have led to this observed change in the market outcome for this good? A. An increase in suly. B. A decrease in suly. C. An increase in demand. D. A decrease in demand. 2. Albert is considering urchasing a new basketball. His reservation rice as a buyer of this item is r b 35. Walmart is selling basketballs for 18. If Albert buys a basketball from Walmart he would realize a Consumer s Surlus of: A. (35) (18) = (17). B. (18) () = (18). C. (35) () = (35). D. (18) + (35) = (53). 3. Economics is A. the social science that studies the allocation and transfer of ower in decisionmaking, systems of governance, and the effects of ublic olicy in a society. B. the art of communicating financial information about a business entity to stakeholders, such as emloyees, managers, shareholders, and customers. C. the social science that studies decision making in the face of scarcity, and the imlications of such decisions on individuals and societies. D. the social science that studies human mental functions and behavior, with a focus on henomena such as ercetion, cognition, ersonality, and interersonal relationshis. 4. The Law of states that A. all other factors fixed, the demanded of a good will be greater when its rice is lower. B. it should be against the law for firms to not suly goods which consumers demand. C. an increase in demand is visually illustrated by a rightward shift of the demand curve. D. More than one (erhas all) of the above answers is correct. 5. Price Elasticity of A. rovides a measure of the sensitivity of demanded to a change in rice, defined as the sloe of the demand curve at its steeest oint. B. is negative in value, as a direct consequence of the Law of. C. rovides a measure of the sensitivity of demanded to a change in rice, defined as the ratio of ercentage change in demanded to ercentage change in rice. D. More than one (erhas all) of the above answers is correct.

14 6. If there is an increase in the rice of a good (with Suly fixed), then Total Producers Surlus will A. increase. B. decrease. C. remain unchanged. D. None of the above answers are necessarily correct (since more information is needed in order to answer this question). 7. Which of the following could never lead to an increase in the demand for tacos? A. an increase in the rice of burritos (a substitute good). B. a decrease in the rice of Coca-Cola (a comlement good). C. a decrease in the rice of tacos. D. None of the above answers are correct (since each scenario could ossibly lead to an increase in the demand for tacos). 8. A seller s reservation rice A. refers to the maximum dollar amount a buyer is willing to ay for an item. B. refers to the minimum dollar amount a seller is willing to accet for an item. C. is visually illustrated by the vertical distance between the demand curve and the suly curve. D. More than one (erhas all) of the above answers is correct. 9. Suose that demand for carrots is inelastic at all rices. If rice were to increase by 1%, then demanded would A. also increase by exactly 1%. B. decrease, but by less than 1%. C. decrease by more than 1%. D. remain unchanged. 1. At the market equilibrium outcome A. Total Producers Surlus is tyically ositive, while Total Consumers Surlus is tyically equal to zero. B. Total Consumers Surlus is tyically ositive, while Total Producers Surlus is tyically equal to zero. C. both Total Consumers Surlus and Total Producers Surlus must be ositive, and must be equal in value to each other. D. both Total Consumers Surlus and Total Producers Surlus are tyically ositive, but need not be equal in value to each other. 11. The for Milk A. refers to the entire relationshi between the rice of milk and the that consumers are willing and able to urchase, all other factors fixed. B. refers to the amount of milk that eole choose to urchase at the revailing market rice. C. is the only thing that is relevant for determining the equilibrium rice of milk. D. is determined in large art by the behavior of sellers in the market for milk.

15 12. refers to a measure of the benefit realized by a buyer from making a urchase, defined as the difference between the buyer s reservation rice for the item and rice aid for the item. A. Consumer s Surlus B. Producer s Surlus C. Equilibrium Price D. Excess 13. Suose that the income elasticity of demand for eggs is equal to.44. If consumer income were to increase, then the equilibrium rice for eggs would and the equilibrium of eggs would. A. increase, increase B. decrease, decrease C. increase, decrease D. decrease, increase For questions 14 and 15, consider a market in which demand is given by the linear function illustrated below: rice 1 25, 14. At a rice of 5 the value of rice elasticity of demand is. A. (5)/(12,5) = (.4) B. 1 C. 5 D. None of the above answers are correct, since the exact value of rice elasticity of demand at this rice cannot be determined from the given information. 15. If rice were to decrease from 4. 2 to 3. 95, then the value of rice elasticity of demand would A. increase (i.e., get closer to zero in value). B. decrease (i.e., get further from zero in value). C. remain unchanged at a value of (1) both before and after the decrease in rice. D. None of the above answers are correct, since the grah does not convey enough information to be able to determine how the value of rice elasticity will change as a result of this rice decrease.

16 16. Excess refers to a situation in which A. consumer income is sufficiently high, so that rice has no imact whatsoever on consumer urchasing decisions. B. rice is sufficiently high, so that demanded is equal to zero. C. rice is such that demanded is greater than sulied. D. a roduct is of such low quality that nobody would want it (even if it were being given away for free). 17. In a erfectly cometitive market, A. there are many sellers and many buyers of the good. B. consumers view the roducts sold by different sellers to be quite heterogeneous (i.e., different from each other), so that in the end consumers base their urchasing decisions on many factors above and beyond rice. C. in the Long Run it is tyically assumed that there is Free Entry and Exit, which means that new firms could enter the market or existing firms could exit the market with relative ease and without incurring substantial costs from doing so. D. More than one (erhas all) of the above answers is correct. Problem Solving or Short Answer Questions: 1, 1. Consider a market in which demand is given by the demand function D( ) and suly is given by the function S ( ) 5 1, 5 (for 3 ). 1A. Determine the numerical value of demanded and sulied at each of the following rices: 5, 8, and 1. 1B. Is there Excess, Excess Suly, or neither at each of the three rices considered in art (1.a)? Exlain. 1C. Based uon your answers thus far (without any further calculations), can you determine a range in which the equilibrium rice in this market must lie? Exlain. 2. Consider a market in which demand is given by the demand function D( ) 5, 625 and suly is given by the suly function S ( ) , 5 (for 2 ). 2A. Is there Excess, Excess Suly, or neither at a rice of 3? Exlain. 2B. Grahically illustrate the equilibrium outcome in this market. 2C. Numerically determine the values of equilibrium rice and equilibrium in this market.

17 3. Consider the market for chicken sou. Suose that for this good, the following estimated values of elasticity have been determined: (Price Elasticity of for chicken sou) = (.7132) (Cross-Price Elasticity of for chicken sou with resect to the rice of tomato sou) = (.2451) (Cross-Price Elasticity of for chicken sou with resect to the rice of cell hone service) = (.2) (Income Elasticity of for chicken sou) = (.3619) Based uon these estimated values, answer the following questions. 3A. Is for chicken sou elastic or inelastic? Clearly exlain (making secific reference to at least one of the numerical values above to suort your answer). 3B. How does demand for chicken sou deend uon the rice of cell hone service? Clearly exlain (making secific reference to at least one of the numerical values above to suort your answer). 3C. Would an increase in consumer income lead to an increase or decrease in demand for chicken sou? Clearly exlain (making secific reference to at least one of the numerical values above to suort your answer). 3D. Suose the rice of tomato sou decreased. Clearly exlain how the equilibrium rice and equilibrium of chicken sou would change (again, making secific reference to at least one of the numerical values above to suort your answer). 4. Consider a market in which demand is given by the linear demand function D( ) 24, 3,. 4A. Determine the numerical value of Total Consumers Surlus at a rice of 6. 4B. Suose rice in this market were to decrease from 6 to 5. Determine the change in the numerical value of Total Consumers Surlus resulting from this decrease in rice. 5. Consider a market in which demand is given by the non-linear demand function D( ) 1, A. Determine whether demand is Elastic, Inelastic, or Unit Elastic at each of the following rices: $64, $1, $121, and $225. 5B. Determine a value of rice (to two decimal laces) at which demand is Unit Elastic.

18 6. Suose that demand for Good is D(,, I) I. 26 Y Y (where denotes the rice of Good, Y denotes the rice of Good Y, and I denotes er caita consumer income in the market for Good ). 6A. Derive a general exression for Price Elasticity of for Good. 6B. Derive a general exression for Cross-Price Elasticity of for Good with resect to the rice of Good Y. Based uon this exression, Good aear to be a substitute for or comlement to Good Y? Exlain. 6C. Derive a general exression for Income Elasticity of for Good. Based uon this exression, does Good aear to be a normal good or an inferior good? Exlain. Answers to Multile Choice Questions: 1. C 2. A 3. C 4. A 5. D 6. A 7. C 8. B 9. B 1. D 11. A 12. A 13. A 14. B 15. A 16. C 17. D Answers to Problem Solving or Short Answer Questions: 1, 1A. Quantity demanded at each of the given rices is: D ( 5) 2,, 5 1, 1, D ( 8) 1,25, and D ( 1) 1,. Likewise, sulied at 8 1 each rice is: S ( 5) (5)(5) 1,5 1,, S ( 8) (5)(8) 1,5 2, 5, and S ( 1) (5)(1) 1,5 3,5. 1B. At a rice of 5 there is Excess, since D( 5) 2, 1, S(5). At a rice of 8 there is Excess Suly, since D( 8) 1,25 2,5 S(8). At a rice of 1 there is Excess Suly, since D( 1) 1, 3,5 S(1).

19 1C. Based uon the answers thus far, we can infer that the unique equilibrium rice must be above 5 (since there is Excess at this rice) but below 8 (since there is Excess Suly at this rice). 2A. At 3 there is Excess, since D ( 3) 5, (625)(3) 31, 25 is greater in value than S ( 3) (875)(3) 17,5 8, 75. 2B. rice 8 * 2 q* 2C. Numerically, the equilibrium rice is the unique rice for which D( ) S( ). For the secified functions, we have: 5, ,5 5, 1,5 17,5 67,5 1,5 * 67,5 45 1,5 From her it follows that the equilibrium is: * * * q D( ) S( ) D(45) S(45) 21,875 3A. Under current market conditions, demand for chicken sou is Inelastic. This follows directly from observing that the Price Elasticity of for chicken sou is (.7132), which is between ( 1) and () in value (and therefore falls within the range for inelastic demand. 3B. Note that the Cross Price Elasticity of for chicken sou with resect to the rice of cell hone service is (.2). While this estimated value is technically negative, it is essentially equal to zero. (Taken at face value, this estimate would suggest that a 1% increase in the rice of cell hone service would lead to a.2% decrease in the of chicken sou consumed.) Further, there is no intuitive reason to susect that demand for chicken sou would be deendent uon consumers urchasing decisions in the market for cell hone service. Thus, the reasonable conclusion to reach is that demand for chicken sou does not deend uon the rice of cell hone service. 3C. Observe that the Income Elasticity of for chicken sou is (.3619), which is negative. This negative value imlies that consumer income and urchases of chicken

20 sou are negatively related to one another that is, chicken sou is an inferior good, one for which demand decreases following an increase in consumer income. 3D. Observe that the Cross Price Elasticity of for chicken sou with resect to the rice of tomato sou is (.2451). This ositive value imlies that chicken sou is a substitute for tomato sou. Therefore, if the rice of tomato sou were to decrease, it follows that demand for chicken sou would decrease. A decrease in demand for chicken sou will lead to a decrease in the equilibrium rice of chicken sou and a decrease in the equilibrium of chicken sou. 4A. in this market is as illustrated below: 8 rice 6 5 a b c 6, 9, 24, At a rice of $6 Total Consumers Surlus is equal to area (a). Since the demand function is a linear function, area (a) is a triangle. In general, the area of any triangle is equal to one half of base times height. This triangle has a base of 6,-=6, and a height of 8-6=2. Therefore, its area (and the value of Total Consumers Surlus) is $6,. 4B. As rice decreases from $6 to $5, Total Consumers Surlus increases by area (b) lus area (c). Area (b) is a rectangle (with base of 6, and height of 1), while area (c) is a triangle (since demand is given by a linear function with base of 3, and height of 1). Thus, area (b) has an area of 6,, while area (c) has an area of 1,5. It follows that the resulting increase in Total Consumers Surlus is equal to $7, A. Recognizing that for D( ) 1, 625 we have D ( ), and alying 2 the general formula for Price Elasticity of, it follows that: ,. At a rice of $64,. 5, 2, 1,25 2, 1, , imlying that demand is inelastic. At a rice of $1,

21 , , imlying that demand is inelastic. At a 2, 1,25 1 7, ,875 rice of $121, 1. 1, imlying that demand is elastic. 2, 1, , ,375 At a rice of $225, 7. 5, imlying that demand is 2, 1, ,25 elastic B. is Unit Elastic only at the rice for which 1. Solving 2, 1,25 for, we see that this is true only for: 625 2, 1, 25 1,875 2, 2, , , A. We are given the Function D(,, I) I. 26 Elasticity of for Good is generally equal to this formula, we have: Y Y. Price D( ). Alying D( ) ( )(.72) Y I Y I 6B. We are given the Function of D(,, I) I. 26 Y Y for Good. Cross-Price Elasticity of for Good with resect to the rice of D( ) Y Good Y is generally equal to Q, P. Alying this formula, we have: Y Y D( ) ( )(.12) Y Q, P Y I.12. Y Y I Since this elasticity is always ositive, it follows that Good is a substitute for Good Y under all market conditions. D(,, I) I. Y Y for Good. Income Elasticity of for Good is generally equal to D( ) I Q, Inc. Alying this formula, we have: I D( ) 6C. We are given the Function of 26 ( )(.26) I Q, Inc Y I Y I Since this elasticity is always ositive, it follows that Good is a normal good under all market conditions.