Introduction to Markets

Today marks the start of a new textbook. The textbook that I will be using now is Intermediate Microeconomics A Modern Approach by Hal R. Varian. This is a more advanced microeconomic textbook. The reason that I am using it is very similar to the last one, basically I have it because I used it in a class. It seems to be a good textbook. It is quite a bit longer than the last textbook and so will take me longer to go through. Some of the concepts that I have gone over previously will be gone over again, either just in passing or in more detail.

The first chapter of the textbook is talking about some basic market examples. I will be following along with this example because it works very well to explain some of these economic concepts. As well, this example serves to show a very basic economic model and how it can be useful.

The example that is used is of a town that has a university. In this town there are two types of apartments, ones that are close to the university and ones that are far away. The ones that are close are considered more desirable since they allow easier access to the university. These two types of apartments will be called inner and outer apartments to make things simpler.

The focus on the model will be the market for the inner apartments. There are several assumptions that we are making in this model.

1. People who can’t find an inner apartment live in an outer apartment
2. Outer apartments price is fixed at some level
3. All apartments are identical except for location

The difference in the two prices in this model is a good example of exogenous variables and endogenous variables. The price of the outer apartments is an exogenous variable, which means that it is determined by forces outside of the model. The price of the inner apartments is an endogenous variable, which means that it is determined by forces within the model.

What will be determined with this model is:

1. The price of inner apartments
2. Who lives in the inner apartments and who lives in the outer apartments

The textbook at this point also discusses two economic principles that helps us try to explain human behaviour. The first of these is the optimization principle. This is pretty much just the maximization principle that we talked about earlier but states slightly differently. The optimization principle is that people try to choose the best patterns of consumption they can afford. The second principle that it discusses is what it calls the equilibrium principle. This is just the idea that prices adjust until the amount that is demanded of something is equal to the amount that is supplied.

The chapter has a brief description of the demand and supply curves and I really like how it is explained so I will talk about it here for a little bit. The chapter brings in the concept of the reservation price. A reservation price is the maximum price that someone would be willing to accept for a good and still buy it. In our example that would be the rent on an inner apartment.

For the moment let’s imagine that there are five people looking for apartments. The first person is willing to pay $500 for the apartment, the second person is willing to pay $490 and so on, until the last person will be willing to pay $460. These are the people’s reservation prices. The demand curve in this market then is made up of this. If the rent for an apartment is $500 then only one apartment will be rented. This means that the number of apartments that are rented will just be equal to the number of people whose reservation price is above the market price. When we plot this on a curve it looks like this.

It has steps because there are so few people in the market. When you introduce more and more people than we see the curved demand curve that we are used to.

 

After having looked at the demand curve briefly we can talk about the supply curve as well. For now we will be looking at the competitive market, which is where there are many independent landlords. We will be making a couple more assumptions here as well.

1. Consumers will have perfect information about price
2. There are no regulations or contracts
3. We are operating in the short-run.
4. Landlords have no costs

Under these conditions we can show that the equilibrium price of all the inner apartments will be the same. The easiest way to show this is to start with a situation where the prices are not all equal. In this situation there will be two prices, a high price and a low price. Under this situation what will happen is that people who are renting a place that has a high price will go to a landlord who has a low price and offer them more money than the low price but less money than the high price for a place. In this situation there will be a trade and both people will be made better off. This will continue to happen until the prices for all apartments are the same.

Since we have shown that prices will all be the same, it is time to look at why the third assumption is important. The reason that for now we will be looking at the short run is that in the short run the number of apartments will not change. This is pretty easy to imagine as it takes quite a while to build more apartments. As such the supply curve will just be a vertical line as such.

 

Using the basic information that we have so far, we have been able to come up with both a supply curve and a demand curve. In order to get our equilibrium now we will put them together.

In this graph now P* is equal to the price where the quantity demanded and the quantity supplied are equal. At this price, all consumers who are willing to pay more than P* find an apartment and the landlords are able to rent all of their apartments. Neither the consumers nor landlords have any reason to change their behaviour.

This has answered the first thing that we were looking for in our model which was to find the price. The second thing that we wanted to know was who rents which apartment. As was briefly mentioned before this is actually very simple. The people who get the inner apartments are the ones that are willing to pay the most for them. In this case everyone who is willing to pay above P*. The difference between P* and their reservation price is their consumer surplus. So apartments in the competitive will be assigned based on how much people are willing to pay.

Now that we have our model, we are able to play around with different situations and see how they affect the behaviour of the equilibrium price. In order to do this what we will do is look at two different equilibrium situations and see what the difference is. We will not worry for now about how the market moves from one equilibrium to another, what we are doing is known as comparative statics.

First we will look at what will happen when supply in the market increases.

We can see that it is pretty obvious that the price of the apartments will fall. The opposite is also true though, if supply were to decrease than prices would rise. This is a very basic and obvious change. We can also look at more complicated changes that could happen as well. The textbook uses the example of what might happen if some of the apartments were converted into condominiums. The first obvious thing that will happen is the supply of apartments will fall. However this is not necessarily the only change that will take place in the market. There is the question of who is going to buy the condos. In our model it is conceivable that the people who will buy the condos are those that are willing to pay the most for apartments, in other words people who were living in inner apartments already. If all of the people who buy condos used to live in inner apartments then there will be no change in price as both supply and demand for apartments will fall equally.

This shows that it is important not just to look at how the supply side changes but also at how the demand side changes. The reality is that most likely there will be some people who used to live in apartments that will buy condos and some people who didn’t live in apartments who buy condos. This means that prices will most likely rise for rent, but by less than people might think.

We can also look at another interesting example given in the textbook, that of a unit tax on the apartments. So now each landlord needs to pay $50 a year for each apartment. What would this do to the price of the apartments? The usual assumption that people make is that some of the tax will be paid by the landlord and some will be passed along to the consumer. However if we look at our model, keeping the assumption of the short run, we will find out that is not actually true.

It is actually fairly easy to see that prices will not actually change, the landlord will absorb the entire tax. If we look at our model, the supply curve is not changing, there are still the same number of apartments as before. The demand curve is also not changing. If neither the demand curve, nor the supply curve shift, then there will be no change in price.

From a logical point of view it is pretty easy to see this as well. Before the tax each landlord was charging the maximum price that they could to keep all of their apartments rented. After the tax, this is still the case. If the landlords try to raise the price in order to transfer some of the cost of the tax what will happen is the consumers at the margin will drop out of the market and move to outer apartments. This means that not all of the apartments will be rented and the landlords will lose money. This for now is assuming that supply is fixed and the landlords are unable to do anything else with them, it is also functioning off of the assumption that the landlords do not have any costs with the apartments. In the long run where supply can change, this will not hold true.

Now that we have done a bit of analysis of the competitive market we can look at other ways of allocating apartments and how that will change the price and who gets which apartment. Following the textbook we will look at three other ways in which we could allocate the apartments, the discriminating monopoly, the ordinary monopoly and rent control.

A monopoly could either be a single dominant landlord or it could be a number of individual landlords getting together and coordinating their actions to act as one. For this example let’s say that instead of a normal renting procedure, the landlord decides to auction off the apartments. This means that each person will be paying a different price for an apartment. This is called a discriminating monopolist. Right now for simplicity we will assume that the landlord has perfect information. That is, that he knows the reservation price for each person.

In this situation what the landlord will do then is rent out each apartment to each person at his or her reservation price. What is interesting about this is that the exact same people who got the apartments in the competitive market will get the apartments in this situation. The last person to rent an apartment in this situation will in fact be paying P*, the market equilibrium price. So people will pay more money for their apartments but the same number and same people will all rent the apartments as before.

Now let’s look at a situation with an ordinary monopoly, this means that everyone will be charged the same price. Now the landlord faces a dilemma. He can set a low price and rent out all of his apartments or he can set a higher price and rent out less apartments but he may make more money. If we use D(p) to represent the demand function, which is the number of apartments that will be demanded based on the price. Then if the monopolist sets a price P, he will rent D(P) apartments and receives a revenue of P * D(P) or PD(P). The revenue can be thought of graphically as a box, where the height of the box is P and the width of the box is D(P). The area of the box is thus the revenue. If the monopolist has no costs, than he will want to maximize revenue and so choose the biggest box that he can. As can be seen, this will not always be at the equilibrium price.

 

In fact usually in a monopoly it is best to restrict the output and charge a higher price. So in the case of the ordinary monopoly, the price will be higher and fewer apartments will be rented as compared to the competitive market.

Finally let’s look at the case of rent control. This is where the government decides on a maximum amount of rent that can be charge for an apartment. In this situation we would have an excess of demand. Which means more people want apartments than are available. This begs the question, who will end up with an apartment? As it stands our model is unable to answer this question. There are really too many factors right now that would determine this to add to our model. So people who get the apartments will depend on how much time a person spends looking around, who knows current tenants, relationship with the landlord, and many other factors.

To make things simpler let’s just make the assumption that some of the people who had inner apartments before will have them now and some people who had outer apartments before will now have inner apartments and vice versa. The same number of apartments will be rented as in the competitive market just different people will have them. At least that is the situation in the short run.

We have now discussed four different ways to allocate the apartments, competitive market, discriminating monopolist, ordinary monopolist and through rent control. So which of these is the best way to allocate the apartments? It can be difficult to define best but here we will look at the economic positions of the people involved.

The landlords definitely end up in the best position if they are able to act as discriminating monopolists. This would maximize their revenue. Similarly the rent controlled situation is probably the worst for them.

The situation with the tenants is a little more complicated. Under the discriminating monopolist they will definitely be paying more money than under any of the other systems. However under the ordinary monopolist less people will get inner apartments than under the other systems. Finally under rent control some tenants will be better off, those who have inner apartments that otherwise would have had outer apartments. However the tenants who now have outer apartments but would have had inner apartments under the other systems are now made worse off. This shows that it is very difficult to determine which the best way is. One way that economists try to do this is to use the idea of Pareto efficiency.

If we are able to make some people better off without making anyone else worse off, we have a Pareto improvement. If we have a situation when we are unable to make any Pareto improvements, we say that the situation is Pareto efficient.

One way to think of Pareto efficiency in terms of our model is to look at the following situation. Suppose that who gets which apartment is decided by lottery. We then allow tenants to sublet their apartments to other people. If there are two people, person A that is assigned an inner apartment that he has a reservation price of $200 for, and there is person B that is assigned an outer apartment but has a reservation price of $300 for an inner apartment, then there is room for a Pareto improvement.

If person A trades apartments with person B, and person B pays person A some amount of money, both people are made better off, and no one is made worse off. In our model, what is important is that the people who have the highest reservation prices are the ones that get the inner apartments. This is because if people with low reservation prices get them, than there can be voluntary trade that makes both parties better off. Before we talked about efficiency as being when all gains from trade are maximize. We can see now that when all voluntary trades have been carried out, the situation will be Pareto efficient.

We can now use the idea of Pareto efficiency to look at our four ways of allocating the apartments. If we start with the competitive market we can see that since all voluntary trade is carried out, the situation is Pareto efficient.

If we look at the discriminating monopolist we can actually see that this is also Pareto efficient. The exact same people as in the competitive market get the apartments, and no one can be made better without making someone else worse off.

If we look at the ordinary monopolist we will see that this is not a Pareto efficient outcome. The reason for this is that all the apartments are not rented. As such the landlord could make more profit by renting a vacant apartment to another person at any positive price. Now the monopolist would only be able to do this if the other tenants were alright with people paying different prices. However as soon as that is the case we have a discriminating monopoly and not an ordinary monopoly. As such the ordinary monopoly is not Pareto efficient.

Finally we can look at rent control. We can immediately see that this is not Pareto efficient. If we look back to our example of person A and person B we can see why. Under rent control some people will have high reservation prices but be unable to get inner apartments. If we allowed voluntary trade then people would be able to trade and make at least one person better off, without making any one else worse off.

Everything that we have been talking about so far has been in the short run. However we do have to take a quick look at the long run as well because this is what will determine the supply. In the long run, supply of apartments will depend on how profitable it is for landlords to rent apartments as such, each situation will change the supply in the long run.

For today we have covered the simple model of apartments. The important idea of Pareto efficiency was introduced as well. Today was my first time introducing diagrams and I will try to go back over time and add more diagrams to my other posts.

Market supply and demand

This post will be about the competitive firm, and market supply and demand curves.

By competitive economists refer to a highly stylized set of conditions that describe a certain market structure. First, all firm are price takers. A price taking firm is one that has no impact on its price, in part because it is so small relative to the size to the market. Second, all competitive firms ignore their rivals and make output decisions based only on prices. Finally there is no strategic behaviour on the part of firms.

To say that the firm is a price taker is to say that as far as the firm is concerned its demand curve is just flat and equal to the price. The price for the product is determined in the market for it, and the firms simply take the price as given and assume they can sell all they want at that price.

Elasticity of demand for the price taking firm is assumed to be infinity. In other words if they tried to sell for any more, no one would buy and if they tried to sell for any less, everyone would come knocking down their door to try to buy from them.

When the firm considers the market price as its demand curve, then the demand curve is also equal to the marginal and average revenue for the firm. Marginal revenue is the change in total revenue divided by a change in output. Average revenue is the total revenue divided by the total output.

The profit maximizing level of output is when the marginal cost is equal to the price. Profit is equal to the total revenue minus the total cost. Since we are going to assume that all variable costs are avoidable and all fixed costs are sunk then the rent a firm earns is equal to the total revenue minus the variable costs.

Rent is equal to the sunk costs of the firm in equilibrium and rent is just the amount of money that could be taken away and the firm would continue to produce at the same level of output.

As long as firms cover the variable costs the firm stays in business, when it comes time to reinvest in capital if the firm still cannot meet its expenses then it will go out of business. The shutdown point of a business is when it will just stop producing, this is if it is unable to meet its variable costs and is shown at the minimum of the average variable cost curve. The breakeven point is where the firm will be operating at a loss but will still keep producing goods. The breakeven point is at the minimum of the average cost curve. The firm supply curve is the marginal cost curve above the shutdown point.

Anything that changes fixed costs will shift the average cost curve but not the marginal cost curve or the average variable cost curve. Anything that changes the variable costs of the firm will shift the average cost, average variable cost, and the marginal costs of the firm. The margin cost curve depends on three things, the level of output, price of the inputs, and the productions function.

When calculating the economic profits of a firm we have to remember that the total costs used in the calculations include both the opportunity cost and the sunk costs. In equilibrium each firm must earn 0 economic profit.

In order to reach this conclusion we assume that all firms are identical in every respect and no firm has any sunk costs. Under the conditions the marginal cost and average variable cost of all firms would be identical. When firms see there is a profit to be made they enter the market, when they do this they increase the supply of goods available and this lowers the equilibrium price of the good. This process happens until all firms in the industry earn zero profits.

In market equilibrium the marginal value of the consumer equals the marginal cost of the producer. Different things can cause shifts in supply and demand. Increases in demand lead to movements along the supply curve which leads to an increase in equilibrium price and an increase in equilibrium quantity. Increase in supply leads to movements along the demand curve which leads to an increase in equilibrium quantity and a decrease in equilibrium price.

Equilibrium occurs at the intersection of supply and demand because at that quantity all consumers have equal marginal value and therefore have no incentives to trade, and all firms have equal marginal costs and therefore have no incentive to shift production. Prices and quantities are determined by the intersection of supply and demand.

Taxes also have an impact of supply and demand. A one dollar per unit tax raises price by less than one dollar as long as the demand curve is not perfectly inelastic. A per unit tax increase the equilibrium price by less than the amount of the tax and creates a deadweight loss. Who pays the tax depends on the elasticity of demand. Lower elasticities lead to consumers paying a larger fraction of the tax.

This has been a short summary of basic supply and demand.

Exchange in the Market

June 12, 2013

This post will only be discussing chapter 6. Chapter 7 and 8 go together and so I have left them for tomorrow. Chapter 6 is all about exchange in the market without production.

In market exchange we use demand curves and supply curves to figure out the information that we want to know, for now we will just start with more information on the demand side. A key feature to remember is that the height of the demand curve is just equal to the marginal value.

In order to determine the price when dealing with two individuals in the market that are trading with each other, what we look at is their respective marginal values. To get the market price we take one of the demand curves and we rotate it on the vertical axis. Then we impose it over the other person’s demand curve and the price is where the two demand curves intersect.

Once we have determined the price and have the graph we can analyze it to find what each person’s respective surplus is. From before the person who is buying is the consumer and the consumer surplus is equal to the total value they are willing to pay minus the total expenditure which is what they actually pay. The person who is selling has what is called the seller’s surplus and this is equal to the total revenue minus their total value.

When we add up the consumer surplus and the seller’s surplus we get what is called the gains from trade. When we have voluntary trade with no outside influence then the gains from trade are maximized. This idea is so important that economists call it the Theorem of exchange which states that all gains from trade are exhausted at the margins. What this means is that in equilibrium there are no gains to be found from increasing or decreasing the quantity traded. When we have an exchange where all gains from trade are maximized we call this efficient.

Most of the time though we do not talk about individual demand curves but instead talk about market demand curves. The market demand is just the aggregate demand of all people in the market. It is important to remember that the market demand is more elastic than individual demand.

Market demand is more elastic than individual demand because of a couple of reasons. To explain this first we need to talk about why market demand is downward sloping. Market demand is downward sloping for two reasons, the first is that when the price of a good falls, everyone who is in the market buys more. The second reason is that when the price falls marginal individuals who were indifferent to buying at higher prices now enter the market when the price is lower. The first of these effects is call the intensive margin and the second of these effects is called the extensive margin. It is these two things that make the market demand more elastic than the individual demand.

In order to show how extensive margins work we can talk about something special called unit demand curves. Unit demand curves are used to goods that you would only buy one of such as a house. These are a special demand function that simply tells us the total value a customer has for the first unit of a commodity.

A market demand curve using the aggregate of individual unit curves looks the same as it does for goods with downward sloping individual demand curves. The reason for this is that as the price drops people are entering the market. In the aggregate of the unit demand curve this is just the only market change at work.

For now when we talk about market supply we are going to simplify it by only using a vertical line. So that market supply is the same no matter the price. Obviously this is a large oversimplification but for now it will suit our purposes. Now to find the market quantity and price we simply look for the intersection of the supply and demand curves. If the price is greater than the intersection there will be a surplus of supply, market pressure will thus work to lower price until the demand meets the supply again, similarly if there is too low of a price, excess demand will work to increase the price until it is at equilibrium again.

These are just the basics of market supply and demand.

Law of Demand and Elasticity

June 11, 2013

This blog will focus on chapters 4 and 5 of the textbook. Chapter 4 is on the law of demand and chapter 5 focuses on changes in demand. These are some of the most fundamental ideas of basic economics and a good understanding of them is crucial for understanding more complicated economics.

The law of demand states that there is an inverse relationship between a good’s price and the quantity demanded of the good, all other things being constant. This is basically saying that as stuff gets cheaper people want more of it. While this seems to be a pretty straightforward there are some economics that this is based off of and there are a lot of factors that can affect demand. One of the key concepts that the law of demand relies upon is the idea of diminishing marginal value.

Diminishing marginal value is the idea that the marginal value, what people are willing to give up for each additional unit of a good, declines the more one has of that good, all other things held constant. There is also a time aspect to diminishing marginal value that is that this is per unit of time, over a lifetime your desire for water may not go down but in an hour there will be a limit to how much you actually want.

The law of demand is shown graphically by a downward sloping line with relative price on the y axis and quantity demanded on the x axis. The concept of relative price is how people make economic decisions and along with that is the idea of real income. In order to talk about the relative price and real income, for now, we make 3 assumptions. The first is that people have fixed incomes and cannot borrow from the bank, the second is that there are only two goods with price p1 and p2, and the third is that the prices constitute the entire cost of good 1 and good 2.

In order to get the real income of a person you look at what they can actually buy with their income. We do this by dividing their nominal income (m), what they make in dollars, divided by some sort of price index.  In this case we will use nominal income divided by p2, this would give a consumers real income in terms of good 2.

Relative prices are the price of one good in terms of another good. For example the price of good 1 in terms of how much good 2 must be given up. It can be found quite simply by dividing the price of 1 good by another good. There are a couple of things that can affect the relative price of a good. The most obvious is probably the change in price of a different get, however that is not the only thing that affects relative price. Relative price is also affected by fixed charges that are applied to goods. If we have two goods, one high quality and expensive, and one low quality and cheap, the more expensive good will actually have a lower relative price than before when a fixed charge is applied to both goods.

Going back to the law of demand for a little bit I stated that it is downward sloping. To understand why it is downward sloping we have to understand that all the demand curve is telling us is how much someone will pay for each unit of a good. In other words it is telling us the maximum that someone is willing to spend for incremental units of good 1, all other things being constant. This is, by definition, the marginal value of the good and as stated above the marginal value diminishes as the quantity we have increases.

Generally as economists we are concerned with finding the equilibrium for a consumer. In this case that is quite easy to do as a consumer is at equilibrium when the relative price equals the marginal value. If the relative price was above the consumer’s marginal value then the consumer would want less of the good and if the relative price is below the consumer’s marginal value then the consumer will want more.

At equilibrium we are often also interested in finding out what the consumer’s surplus is. The consumer surplus is basically how much the consumer benefited from engaging in trade. In order to find the consumer surplus we need to look at a consumer’s total value compared to their total expenditure. The total value is just the maximum amount that one would be willing to pay for a given quantity of a good, rather than have none at all. In order to get the total value we just add up all of the consumer’s marginal values up to the quantity of the good purchases. As more of the good is purchased the marginal value will fall for each extra unit but the total value will increase, just by a smaller and smaller amount. In this way there is a reverse relationship between the total value and the marginal value. In order to get the total expenditure we just multiply the price of the good by the quantity purchased. The consumer surplus then is the total value – the total expenditure.

In chapter 5 of the textbook we discuss changes in demand. There needs to be a very specific distinction made between a change in demand and the change in quantity demanded. Change in demand refers to a shift on the demand curve itself. When it shifts to the right we say that demand increases and when it shifts to the left we say that demand decreases. Changes in demand result from changes in exogenous variables such as income, the prices of other goods and preferences.

Different preferences simply means that we have differing marginal values and differing rates at which those marginal values might diminish. Everyone’s demand curves have different heights and slopes. Preference and demand have a positive relationship. In other words as a person’s preference for a good increases so does their demand for the good.

Income has a slightly more complicated relationship with demand. For most goods when income increases demand increases as well. These goods are called normal goods. However there are some goods that as income increases demand decreases, these are called inferior goods. An example of this could be spam and steak. If you have very little money you might eat more spam and less steak, however as your income increases you will probably eat more steak and less spam. In this example steak is a normal good and spam is an inferior good.

Changes in the prices of other goods also have an impact on the demand for a good. As with income this is a bit more complicated than with preferences. For example if the price of good 2 increases, this changes the relative price and makes good 1 relatively cheaper. However a change in price also changes the real income which has an impact on how much of a good is demanded depending on whether a good is a normal good or an inferior good. Another aspect that complicates how the change in price of one good can affect another good is if goods are complimentary or substitutes for each other.

For substitute goods, when the price of good 2 increases, the demand for good 1 increases. For complementary goods, when the price of good 2 increases, the demand for good 1 decreases. An example of substitute goods would be tea and coffee, if you drink both and the price of coffee rises you will probably switch over to drinking more tea. Complimentary goods would be like bread and jam. If you often eat toast with jam in the morning and the price of bread drastically increases you are probably going to buy less of it and less jam as well.

While the three things listed above cause a change in demand, that is different from a change in the quantity demanded. A change in the quantity demanded is a movement along the demand curve instead of a shift left or right of the demand curve. A change in the quantity demanded is caused by a change in the price of the good itself.

In order to tell how much a change in price will affect the change in quantity demanded we use a concept called elasticity. The own price elasticity of a good is how much impact the change in price has on the quantity demanded of the good. It is equal to the inverse slope of the demand curve multiplied by the relative sizes of price and quantity. This may result in a negative number but it is economic convention to drop the negative number to own price elasticity.

There are three possible results that we can get for own price elasticity. If the number is greater than 1 it is considered elastic, this means that a small change in price leads to a relatively large change in quantity. If the number is equal to 1 than it is considered unitary elastic, this means that the percentage change in quantity demanded equals the percentage change in price. So a change in price leads to the same change in the quantity demanded. If the number is less than 1 but greater than 0 than demand is considered inelastic, this means that the percentage change in quantity demanded is smaller than the percentage change in price. So a change in price will lead to a smaller change in quantity demanded.

Own price elasticity is not the only type of elasticity though, there is also arc elasticity, income elasticity and cross price elasticity. Arc elasticity is calculated by the average elasticity between two points on the demand curve. Firms use elasticity to better understand how changes in price will affect their total revenue. When the demand for a good is elastic then the total revenue and price move in the opposite direction. When demand is inelastic total revenue and price move in the same direction.

After own price elasticity and arc elasticity there is income elasticity. Which is how demand changes with income. For income elasticity it is important whether the number is negative or positive. A normal good has a positive income elasticity while an inferior good has a negative income elasticity.

Finally there is cross price elasticity. Cross price elasticity is how the change is a different products price will affect demand. It is also important for cross price elasticity whether the number is positive or negative. A complementary good has a negative cross price elasticity whereas a substitute good has a positive cross price elasticity.

Elasticity has some basic rules for demand. When a good is considered to have elastic demand it tends to have a large number of substitutes like a breakfast cereal or take up a large portion of an individual’s budget share like a particular car. For inelastic demand there tends to be a small number of substitutes or take up a small portion of an individual’s budget share. Finally we get to what is call the second law of demand, which is that the long run demand curve is more elastic than the short run demand curve.

This has been a summary of the law of demand and elasticity. For any mistakes please leave a comment or feedback.