The financial account

  The financial account

The financial account is one of the two major components under the financial and capital account. The major components of the financial account are:
- direct investment
- portfolio investment
- other investment
- reserve assets

The financial account records an economy’s transaction in external financial assets and liabilities. The major classifications in the financial account are:

- Functional type of investment (direct investment, portfolio investment, other investment, and reserve assets);
- Assets (residents’ financial claims on non resident) and liabilities non resident financial claims on resident);
- Instrument of investment (e.g. equity, debt);
- Sector of the domestic transactor (general government, monetary authorities, banks and other sectors).

National Income Accounts

National Income Accounts

National income accounts (NIAs) are fundamental aggregate statistics in macroeconomic analysis. The ground-breaking development of national income and systems of NIAs was one of the most far-reaching innovations in applied economics in the early twentieth century. NIAs provide a quantitative basis for choosing and assessing economic policies as well as making possible quantitative macroeconomic modeling and analysis. NIAs cannot substitute for policymakers’ judgment or allow them to evade policy decisions, but they do provide a basis for the objective statement and assessment of economic policies.

Combined with population data, national income accounts can provide a measure of well-being through per capita income and its growth over time. Also, NIAs, combined with labor force data, can be used to assess the level and growth rate of productivity, although the utility of such calculations is limited by NIAs’ omission of home production, underground activity, and illegal production. Combined with financial and monetary data, NIAs provide a guide to inflation policy. NIAs provide the basis for evaluating government policy and can rationalize political challenges to incumbents by people who are dissatisfied with measurable aspects of the government’s policies. In emerging and transition economies, implementing a dependable and accurate system of NIAs is a crucial step in developing economic policy.
NIAs, to be most useful, require honest and timely publication. Long-delayed information is of no use either in making policy or in monitoring the efficacy of policies already implemented. Delay frequently implies that the government has something to hide. Indeed, once released, NIAs can enforce their own discipline. That is, obfuscation cannot be maintained by altering or exaggerating one aspect of NIAs, say investment or growth of total income, since each such number is related to others, and consistency is a check on the accuracy of the components. Because the data cannot easily be faked, autocrats are loathe to publish their countries’ NIAs and either proscribe or delay their release. Turkmenistan’s dictator, for example, does not report to the IMF, and the governments of Myanmar (1999) and Zimbabwe (2000) ceased reporting NIAs. Conversely, nation-states that are committed to democracy report their NIAs, warts and all—for example, Croatia or Nigeria and proto-states such as Montenegro or Kosovo—laying bare the economic policy issues that confront them.

Measuring National Income

National income is the total market value of production in a country’s economy during a year. It can be measured alternatively and equivalently in three ways:

•

The value of expenditures

•

The value of inputs used in production

•

The sum of value added at each level of production

That the first two measures are identical can be seen by considering that any good—say, a loaf of bread—can be equivalently valued as either the price that is paid for it in the market by the final consumer or as the distributed factor payments—to labor (wages) and to capital (rent, interest, and profit)—used in its production. Since national output is the sum of all production, the total value will be the same whether added up by final expenditure or by the value of inputs (including profit) used in their production. The equivalence of the last measure can be seen by noting that the value of every final good is simply the sum of the value added at each stage of production. Again, consider a loaf of bread: Its value is the sum of the value of labor at each successive stage of production and other ingredients added by the farmer (wheat production), the miller (grinding to flour), the baker (flour plus other ingredients), and the grocer (distribution services).1
The broadest and most widely used measure of national income is gross domestic product (GDP), the value of expenditures on final goods and services at market prices produced by domestic factors of production (labor, capital, materials) during the year. It is also the market value of these domestic-based factors (adjusted for indirect business taxes and subsidies) entering into production of final goods and services. “Gross” implies that no deduction for the reduction in the stock of plant and equipment due to wear and tear has been applied to the measurements and survey-based estimates. “Domestic” means that the GDP includes only production by factors located in the country—whether home or foreign owned. GDP includes the production and income of foreigners and foreign-owned property in the home country and excludes the production and incomes of the country’s own citizens or their property located abroad. “Product” refers to the measurement of output at final prices as observed in market transactions or of the market value of factors (inclusive of taxes less subsidies) used in their creation. Only newly produced goods—including those that increase inventories—are counted in GDP. Sales of used goods and sales from inventories of goods produced in prior years are excluded, but the services of dealers, agents, and brokers in implementing these transactions are included.
Measured by expenditures, GDP is the sum of goods and services produced during the period. Total output comprises four groups’ purchases of final goods and services: households purchase consumption goods; businesses purchase investment goods (and retain unsold production as inventory increases); governments purchase goods and services used in public administration and welfare transfers; and foreigners purchase (net) exports. There is substantial uniformity in the shares of consumption and investment (the sum of capital expenditures and inventories) across nations with quite disparate income levels. As Table 1 shows, household consumption accounts for the largest share of GDP, an average of 65 percent for the nine countries considered; when added to government consumption, the share approximates 80 percent. Investment (gross capital formation plus increases in inventories) typically accounts for around 20 percent, although rapidly developing countries such as Thailand have higher investment and lower consumption shares. With few exceptions—for example, oil-exporting countries such as Nigeria—net exports are typically within plus or minus 5 percent of GDP. Five of the countries shown had average trade deficits during the fourteen-year period.

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Table 1 Percentage Shares of Components of GDP for Selected Countries, 1990–2003

1.. Income classes by per capita income level from World Bank indicators. The income classes are: low income (l), $765 or less; lower middle income (lm), $766–$3,035; upper middle income (um), $3,036–$9,385; and high income (h), $9,386 or more.
Country and World Bank Income Class1	Household Consumption	Government Consumption	Capital Formation	Change in Inventories	Net Exports
Chile (um)	63.2	11.2	23.4	1.1	1.1
Egypt (lm)	74.6	11.1	18.9	1.8	−6.4
France (h)	54.6	23.6	19.7	0.8	1.4
Morocco (lm)	68.4	18.0	22.3	−4.2	−4.6
Nigeria (l)	73.1	5.6	7.9	1.4	12.1
Poland (um)	62.2	18.0	20.6	0.7	−1.4
Thailand (lm)	55.2	10.4	32.3	0.8	1.3
Turkey (um)	69.1	12.8	22.6	−1.0	−3.5
United States (h)	67.8	15.4	18.5	0.4	−2.1
Average	65.3	14.0	20.7	0.2	−0.2
Source: IMF International Financial Statistics, October 2004.

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Measured by inputs, GDP is the sum of payments to domestic factors of production—wages, salaries, rent, interest, and profit, where profit is gross of the depreciation of domestic fixed capital—plus indirect business taxes less net subsidies to business. Because the value of any good or service is the sum of its inputs plus profit, the sum of the labor services, capital services (gross profit including depreciation), and indirect taxes less net business subsidies must equal the value of output, GDP. The third method of measurement is the sum of value added at each stage of production of each of these final goods and services.

The Importance of NIA Data in Policy and Development Analysis

The development of NIA statistics provided the potential for converting economic policymaking from a rule-of-thumb-based guessing game to a quantitatively based science. Yet, policy remains, in part, a normative decision process, and rival politicians, as advocates of conflicting policy agendas, frequently assess the economy’s performance differently and argue for divergent policies, even when citing the same NIA data. People’s disagreements often are based on the distribution of income as opposed to its average level. Nevertheless, quantitative assessments of the economy and its growth bring discipline to the discussion.
The importance of accurate and accessible NIA is implicit in an observation made by a West African policymaker: “What cannot be measured cannot be managed.” Of course, implementing measurability does not imply that all economic processes are manageable; and, in the case of government expenditures, unlike the other components of GDP, there is no way to assess value from observing voluntary market transactions. Because government expenditures are neither voluntarily elicited nor priced in the market, they are valued at cost, which is primarily the cost of labor. The capital cost of the buildings and land used is not included.

Limitation of NIA as a Gauge of Welfare

Per capita GDP is frequently used as a measure of welfare, both for indicating the rate of improvement over time and for comparisons across nations. Yet per capita GDP is an imperfect indicator of welfare of the representative individual. GDP does not account for nonmarket production in the household—for example, meal preparation, cleaning, laundry, and child care. Therefore, when these activities are, because of greater labor force participation, shifted to the market—as restaurant meals and semiprepared foods in grocery stores, cleaning and laundry services, and day care—the change in the value of production is overstated due to the decline in nonmarket (household) production. Second, gray market and illegal activities—such as production and distribution of marijuana or gambling—can be significant sources of sustenance in economies but are not included. Third, in benign climates, clothing and heating are less costly, so comparing across countries (or across regions within large states) will distort the relative level of well-being. Fourth, government services, because not subject to a market test, will typically be worth less than they cost, even though cost is used as a measure of value. Fifth, per capita income—an average measure—can be a misleading image of the representative resident’s well-being if the distribution of income is very unequal. A better measure is the median income level and, for many analytic purposes, the income level by quintiles of the income distribution; however, such distributional measures cannot be directly obtained from GDP data and population and require separate surveys. Another limit on per capita income as a measure of well-being is that it flies in the face of the way people think about having children. Most young couples see themselves as being better off when they have their first baby, even though the immediate impact is a 33 percent drop in the family’s per capita income.

History of NIA

An indication of NIAs’ impacts on economics is that the third and fifteenth Nobel Prizes in economic science were awarded largely for contributions to the development of national income statistics—to simon kuznets in 1969 and to richard stone in 1984. Their citations also noted the men’s advocacy roles in persuading the United States and United Kingdom to devote adequate resources to produce and maintain timely and accurate NIA data.
Working for the U.S. Commerce Department in the 1930s, Kuznets had developed time series of national income in order to develop a quantitative basis for studying and measuring economic growth and the shifts in production from agriculture to industry to services. Interestingly, Kuznets parted with the department because it refused to include estimates of household production. paul samuelson once quipped that the size of the U.S. GDP could be dramatically increased if housewives would simply contract out with their neighbors (reciprocally) to provide cleaning and cooking services. In fact, this very omission of household production has overstated the rise in national output of the economy due to the increase in women’s labor force participation from around 25 percent in the late 1930s to about 60 percent in 2003. Kuznets also strenuously objected to counting all government spending on goods and services as part of GDP because he regarded most such expenditures to be intermediate, not final, products.
In contrast to Kuznets, Stone developed a double-entry accounting system, also in the 1930s and 1940s, partly driven by the British government’s war effort. His social accounting matrix implemented many cross-checks on the validity of components of national income and, in so doing, derived means of measuring them. He demonstrated, empirically as well as theoretically, that national income could be measured as either the market value of final product or the total of the gross factor incomes used in producing it. Stone’s structure became the foundation for the United Nations System of National Accounts (SNA), first published in 1953, providing a uniform basis for all countries to report national output. Virtually all nations now use his system of national accounts.

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About the Author

Mack Ott is an international economic consultant whose major assignments have been in the former Soviet Union countries, the Balkans, and Egypt. During 2003 and 2004 he was macroeconomic adviser to the chief economist of Nigeria and to the West African Monetary Institute. He has also been a U.S. Treasury adviser to the Ministry of Finance of Saudi Arabia.

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Further Reading

Kendrick, John W. “National Income and Product Accounts.” In International Encyclopedia of the Social Sciences. New York: Macmillan and Free Press, 1968. Vol. 6, pp. 19–34.

Mankiw, N. Gregory. Macroeconomics. New York: Worth Publishing, 2000.

Ott, Mack. “National Income Accounts, Economic Policy Analysis and the Initial Estimates of Kosovo’s GDP.” Contemporary Economic Policy (April 2003).

Rothbard, Murray. “The Falacy of the ‘Public Sector.’” New Individualist Review (Summer 1961): 3–7. Available online at: http://www.mises.org/rothbard/public.asp.

United Nations. System of National Accounts 1993. New York: United Nations, 1993.

United Nations. Use of the System of National Accounts in Economies in Transition. New York: United Nations, 1996.

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Footnotes

1.

National output includes only the value of net exports. In each of these three equivalent measures, the value of imports is deducted from the value of exports.

Macroeconomics

Macroeconomics

Definition of 'Macroeconomics'

The field of economics that studies the behavior of the aggregate economy. Macroeconomics examines economy-wide phenomena such as changes in unemployment, national income, rate of growth, gross domestic product, inflation and price levels. 

Investopedia explains 'Macroeconomics'

Macroeconomics is focused on the movement and trends in the economy as a whole, while in microeconomics the focus is placed on factors that affect the decisions made by firms and individuals. The factors that are studied by macro and micro will often influence each other, such as the current level of unemployment in the economy as a whole will affect the supply of workers which an oil company can hire from, for example.

Introduction to Macroeconomics

1. An Overview of Macroeconomics

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1. What Is Macroeconomics
2. Macroeconomic Goals

A. Low Unemployment Rate
B. Price Stability

1. Inflation and Deflation
2. Changes in Purchasing Power and Uncertainty
3. Interest Rate

C. Economic Growth

1. Measuring Total Output
2. Correcting for Price Inflation
3. Cycles in Economic Growth

D. Complementary and Conflicting Goals

3. Key Principles of Economics

A. Limited Resources, Unlimited Wants, Scarcity, and Opportunity Cost

1. Resources and the Production Process
2. Scarcity, Choice, and Opportunity Cost
3. Economic Goods Versus Free Goods
4. Examples of Opportunity Costs
5. Allocation of Scarce Resources - the Role of Prices

B. Individual Behavior and Rational Self-Interest
C. Relationship Between Opportunity Cost and Rational Self-Interested Behavior
D. Decisions Are Made at the Margin

3. Economic Theory in Practice

A. Economic Theory and Models
B. Empirical Applications
C. Normative Versus Positive Economics

Theory of Costs - Introduction to Costs

Theory of Costs - Introduction to Costs

Theory of Costs - Introduction to Costs Nitish Kumar Arya M.A. Economics Banaras Hindu University Varanasi 221005

Why Study Costs?: 

Why Study Costs? Whatever may be the type of firm, it is important to ascertain that it is not incurring losses Decisions relating to expansion (or otherwise), new product development, forecasting and policy making, etc can be taken only after considering costs Concept of cost is closely related to production theory Cost function is the relationship between a firm’s costs and the firm’s output The production function combined with input prices yields the firm’s cost function

Cost Concepts: 

Cost Concepts Money costs (Actual Costs) are the total money incurred by a firm in producing a commodity or service wages and salaries, cost of raw materials, expenses on machines/buildings/capital goods, power charges, transportation, advertisement, interest expenses, taxes, depreciation etc Implicit costs are the imputed value of the entrepreneurs own resources and services Variable costs are costs that vary with the volume of output Fixed costs do not vary with output in the short-run

Cost Concepts: 

Cost Concepts Opportunity cost is the cost of missed opportunity or alternative forgone in having one thing rather than the other (since resources are limited they cannot be used to produce all things simultaneously) Actual Cost Vs Opportunity Cost Measurement of opportunity cost is difficult Marginal Cost is the addition to the total cost by producing an additional unit of out put MC = change in TC/change in TO

Costs: 

Costs

Cost Curves: 

Cost Curves

Cost Concepts: 

Cost Concepts TC=TFC+TVC AFC=TFC/Total Output AVC=TVC/Total Output AC=TC/Q = (TVC+TFC)/Q = AVC+AFC MC = change in TC/change in TO

Short-run and Long-run: 

Short-run and Long-run Meaning of Short-run and Long-run in Economics Short-run is defined as a time period during which some factors of production are fixed and others are variable In the Long-run all factors of production are variable It is important to note that these periods are not defined by any specified length of time but instead are determined by the variability of factors of production

PowerPoint Presentation: 

MC ATC AVC AFC cost output

Short-run Cost Curves: 

Short-run Cost Curves AFC+AVC= ATC and therefore, ATC curve lies above both AFC and AVC AFC curve does not touch Y and X axes. Because the total FC is constant and increased output is accomplished by falling AC MC curve cuts AVC and ATC curves from below at the lowest points of both the curves

Why Short-run Avg Cost curve U shaped?: 

Why Short-run Avg Cost curve U shaped? Average Cost curve is made of of AFC and AVC AFC and AVC both slopes downwards in the initial stages (therefore, AC) After a particular point, AVC starts raising (rate which more than offsets the rate of fall in AFC) This results in U shaped Average Cost curve fixed factor better utilized as output increases marginal cost increases - therefore average cost

Long-run Average Cost: 

Long-run Average Cost SAC1 SAC2 SAC3 SAC4 SAC5 LAC

Long-run Average Cost: 

Long-run Average Cost In the long-run all factors of production are variable LAC can only be tangential to an SAC, because long-run cost can not be higher than short-run LAC is also known as planning curve Shape of LAC depends on the returns to scale (if returns are constant LAC will be parallel to X axis. If increasing returns then, LAC will be falling downward and if diminishing returns LAC will move upwards)

PowerPoint Presentation: 

MC ATC AVC AFC cost output

Law of Variable Proportions: 

Law of Variable Proportions “as the quantity of a variable input is increased by equal doses, keeping the quantities of other inputs constant, the total product will increase, but after a point, at a diminishing rate” In other words, when more and more units of the variable factor is used (holding the quantities of other factors constant), a point is reached beyond which the marginal product, then the average product and finally the total product will diminish This law is also known as law of diminishing returns

Law of Diminishing Returns: 

Law of Diminishing Returns

PowerPoint Presentation: 

Law of Diminishing Returns

Importance of Law: 

Importance of Law It applies to not only agriculture but also industry - universal applicability By substituting one factor in place of other, efficiency (or higher levels of production and productivity) can be achieved Remember the importance of capital and labour as factors of production in developing nations

Law of Returns to Scale: 

Law of Returns to Scale What happens when all the inputs are increased in the same proportion? The scale of production will increase - but effect on production shows three stages Increasing Returns to Scale Constant Returns to Scale Diminishing Returns to Scale

Law of Returns to Scale: 

Law of Returns to Scale

Production Function Isoquant and Isocost Approach: 

Production Function Isoquant and Isocost Approach An isoquant is a curve on which the various combinations of labor and capital show the same output. This curve is also known as production indifference curve

Production Function Isocost Approach: 

Production Function Isocost Approach Isocost curves are also known as outlay lines, price lines, input-price lines, factor-cost lines, constant-outlay lines etc. Each isocost line represents the different combinations of two inputs that a firm can buy for a given sum of money at the given price of each point.

Equilibrium of Firm -What is equilibrium?: 

Equilibrium of Firm -What is equilibrium? Firms will produce in such a way that the profit is maximized Firms will not change the production function at equilibrium output Profit = TR-TC TR = P x Q (price x quantity) AR = TR/Q = (P x Q)/Q = P therefore, AR curve showing different values of AR at various levels of output is same as the demand curve faced by an individual firm (latter shows quantities)

Shape of Demand Curve: 

Shape of Demand Curve Relationship between AR and Q is shown by the shape of the demand or AR curve AR upward sloping or rising left to right AR downward sloping AR horizontal to X axis First possibility is unlikely - a firm may not be able to sell larger and larger output by charging higher and higher price The second and third depends on the type of market

Marginal Revenue: 

Marginal Revenue MR= TR (N+1) - TR (N) or change in total revenue upon change in quantity Therefore, MR is equal to the slope of TR curve Relation between AR and MR MR = change TR/change Q MR = change (PxQ)/change Q = change (ARxQ)change Q =AR(change Q/change Q) + Q (change AR/change Q) MR=AR+Q(change AR/change Q) therefore (MR-AR) = Qx(slope of AR curve) MR = AR when AR is horizontal and MR is <AR when AR is downward sloping

Thank You: 

Thank You Nitish Kumar Arya M.A. Economics Banaras Hindu University Varanasi 221005

Market Theory and the Price System

 Market Theory and the Price System

 

About this Title:

The second volume in Liberty Fund’s The Collected Works of Israel M. Kirzner series, Market Theory and the Price System was published in 1963 as Kirzner’s first (and only) textbook. This volume presents an integrated view of Austrian price theory. The basic aim of Market Theory is to utilize the tools of economic reasoning to explain the market process. The unique framework Kirzner develops for microeconomic analysis, following Mises and Hayek, examines errors in decision-making, entrepreneurial profit, and competition as a process of discovery and learning.

Copyright information:

The copyright to this edition, in both print and electronic forms, is held by Liberty Fund, Inc.

Fair use statement:

This material is put online to further the educational goals of Liberty Fund, Inc. Unless otherwise stated in the Copyright Information section above, this material may be used freely for educational and academic purposes. It may not be used in any way for profit.

Table of Contents:

• THE COLLECTED WORKS OF ISRAEL M. KIRZNER
• CONTENTS
• INTRODUCTION TO THE LIBERTY FUND EDITION
• ACKNOWLEDGMENTS
• BIBLIOGRAPHY OF WORKS CITED IN THE INTRODUCTION
• PREFACE
• MARKET THEORY AND THE PRICE SYSTEM
• 1: THE NATURE AND TASKS OF MARKET THEORY
• THE INDIVIDUAL AND THE MARKET
• THE MARKET SYSTEM
• THE FOUNDATIONS OF MARKET THEORY
• THE INDIVIDUAL AND ECONOMIC BEHAVIOR
• ECONOMIC THEORY AND ECONOMIC REALITY
• MARKET THEORY, ECONOMIC THEORY, AND ECONOMICS
• SUMMARY
• SUGGESTED READINGS
• 2: THE MARKET: ITS STRUCTURE AND OPERATION
• THE CONDITIONS UNDER WHICH THE MARKET OPERATES
• MARKET ROLES
• THE STRUCTURE OF THE MARKET SYSTEM: VERTICAL RELATIONSHIPS
• THE STRUCTURE OF THE MARKET SYSTEM: HORIZONTAL RELATIONSHIPS
• THE ANALYSIS OF HUMAN ACTION IN THE MARKET: THE CONCEPT OF EQUILIBRIUM
• COMPLETE AND INCOMPLETE EQUILIBRIUM
• THE PATTERN OF MARKET ADJUSTMENT
• THE CHANGING MARKET
• THE MARKET SYSTEM AS A WHOLE
• SUMMARY
• SUGGESTED READINGS
• 3: EFFICIENCY, COORDINATION, AND THE MARKET ECONOMY
• THE ECONOMIC PROBLEM
• SOCIETY AND THE ECONOMIC PROBLEM
• THE PROBLEM OF COORDINATION
• HOW THE MARKET SOLVES THE PROBLEMS OF COORDINATION
• THE COORDINATING FUNCTION OF PROFITS IN A MARKET ECONOMY
• SUMMARY
• SUGGESTED READINGS
• 4: UTILITY THEORY
• THE SCALE OF VALUES
• MARGINAL UTILITY
• DIMINISHING MARGINAL UTILITY
• THE MARGINAL UTILITIES OF RELATED GOODS
• MARGINAL UTILITY—SOME FURTHER REMARKS
• The Paradox of Value
• The Subjective Character of Utility
• Utility as a Relative Concept
• The Ordinal Character of Utility
• Total Utility and Marginal Utility
• MARGINAL UTILITY AND THE CONDITIONS FOR EXCHANGE
• SUMMARY
• SUGGESTED READINGS
• 5: CONSUMER INCOME ALLOCATION
• MARGINAL UTILITY AND THE ALLOCATION OF INCOME
• THE POSITION OF CONSUMER’S EQUILIBRIUM
• A GEOMETRICAL ILLUSTRATION
• THE EFFECTS OF CHANGES
• 1.: Change of Tastes
• 2.: Change of Income
• 3.: Change of Prices
• Price Change for a Single Good
• THE INDIVIDUAL DEMAND CURVE
• SOME REMARKS ON EXPECTATIONS
• SUMMARY
• SUGGESTED READINGS
• 6: MARKET DEMAND
• MARKET DEMAND
• THE MARKET DEMAND CURVE
• DEMAND ELASTICITY
• MEASURES OF ELASTICITY
• MARKET DEMAND AS SEEN BY THE INDIVIDUAL ENTREPRENEUR
• DEMAND AND REVENUE
• DEMAND AND THE PRICES OF OTHER GOODS
• DEMAND AS A MARKET FORCE
• SUMMARY
• SUGGESTED READINGS
• 7: MARKET PROCESS IN A PURE EXCHANGE ECONOMY
• THE NATURE OF COMPETITION
• A SIMPLE CASE OF PRICE COMPETITION
• SIMPLE PRICE COMPETITION WITHOUT PERFECT KNOWLEDGE
• THE MARKET FOR SEVERAL NON-PRODUCIBLE GOODS: THE PROBLEM
• THE EQUILIBRIUM SITUATION FOR THE MULTI-COMMODITY MARKET
• THE MULTI-COMMODITY MARKET WITHOUT PERFECT KNOWLEDGE
• MONOPOLY IN A PURE EXCHANGE MARKET
• THE AGITATION OF THE MARKET
• SUMMARY
• SUGGESTED READINGS
• APPENDIX
• 8: PRODUCTION THEORY
• THE ECONOMIC ASPECT OF PRODUCTION
• PRODUCTION BY THE ISOLATED INDIVIDUAL
• PRODUCTION IN SOCIETY
• PRODUCTION IN THE MARKET ECONOMY
• FACTORS OF PRODUCTION
• PRODUCTION FUNCTIONS AND ISOQUANTS
• THE SHAPE OF THE ISOQUANT AND THE SUBSTITUTABILITY OF FACTORS
• CHANGES IN FACTOR PROPORTIONS, AND CHANGES IN THE SCALE OF FACTOR EMPLOYMENT
• RETURNS TO SCALE
• THE LAWS OF VARIABLE PROPORTIONS: THE PROBLEM
• THE LAWS OF VARIABLE PROPORTIONS
• ECONOMIC IMPLICATIONS OF THE LAWS OF VARIABLE PROPORTIONS
• THE LEAST-COST COMBINATION
• GRAPHIC ILLUSTRATION OF THE LEAST-COST COMBINATION
• SUMMARY
• SUGGESTED READINGS
• 9: COSTS AND SUPPLY
• COSTS AND RENTS
• OPPORTUNITY COSTS AND SUPPLY THEORY
• PROSPECTIVE AND RETROSPECTIVE COSTS
• CAPITAL GOODS AND COST THEORY
• FACTOR DIVISIBILITY AND SHORT-RUN PER-UNIT COSTS
• SHORT-RUN COSTS AND THEIR EFFECT ON SUPPLY
• LONG-RUN COSTS AND SUPPLY
• FACTOR PRICES AND SUPPLY
• SUMMARY
• SUGGESTED READINGS
• 10: PARTIAL MARKET PROCESSES—THE DETERMINATION OF PRODUCT PRICES AND FACTOR PRICES
• THE MARKET FOR A SINGLE PRODUCT
• LONG-RUN EQUILIBRIUM
• SHORT-RUN EQUILIBRIUM IN THE SINGLE-PRODUCT MARKET
• EQUILIBRIUM IN THE SINGLE-PRODUCT MARKET IN THE VERY SHORT RUN
• ADJUSTMENT TO CHANGE IN A MARKET FOR A SINGLE PRODUCT
• THE MARKET PROCESS IN A MARKET FOR A SINGLE PRODUCT
• THE MARKET FOR A SINGLE FACTOR OF PRODUCTION
• EQUILIBRIUM IN A FACTOR MARKET
• THE MARKET PROCESS IN A MARKET FOR A SINGLE FACTOR OF PRODUCTION
• TOWARD THE GENERAL MARKET PROCESS
• SUMMARY
• SUGGESTED READINGS
• 11: THE GENERAL MARKET PROCESS
• A PRELIMINARY MODEL
• THE PRELIMINARY MODEL AND THE GENERAL MODEL
• GENERAL MARKET EQUILIBRIUM CONDITIONS
• A GENERAL MARKET IN DISEQUILIBRIUM
• DISEQUILIBRIUM IN THE GENERAL MARKET AND ENTREPRENEURIAL OPPORTUNITIES
• ENTREPRENEURIAL ACTIVITY AND THE GENERAL MARKET PROCESS
• PARTIAL ANALYSIS AND THE ANALYSIS OF A GENERAL MARKET
• TOWARD FURTHER EXTENSIONS OF THE GENERAL MARKET MODEL
• SUMMARY
• SUGGESTED READINGS
• 12: MONOPOLY AND COMPETITION IN THE GENERAL MARKET
• THE MONOPOLIZED RESOURCE
• THE RESOURCE CARTEL
• RESTRICTION OF SUPPLY: A SPECIAL CASE
• COMBINATIONS OF RESOURCE BUYERS
• MONOPOLY IN PRODUCTION
• THE CONSEQUENCES OF MONOPOLY OUTPUT RESTRICTION
• THE MONOPOLIST-PRODUCER AS A RESOURCE BUYER
• FURTHER REMARKS ON MONOPOLIZED PRODUCTS
• THE SINGLE PRODUCER WITHOUT MONOPOLY
• SOME REMARKS ON THE MODEL OF “PURE” OR “PERFECT” COMPETITION
• MONOPOLISTIC PRICE DISCRIMINATION
• SUMMARY
• SUGGESTED READINGS
• 13: THE PRICE SYSTEM AND THE ALLOCATION OF RESOURCES
• THE POSSIBLE LEVELS OF “WELFARE” APPRAISAL
• MISALLOCATION OF A RESOURCE IN A MARKET SYSTEM
• IMPERFECT KNOWLEDGE, THE SOURCE OF RESOURCE MISALLOCATION
• PRICES, PROFITS, AND THE REALLOCATION OF RESOURCES
• THE ENTREPRENEUR AND RESOURCE ALLOCATION
• RESOURCE MOBILITY AND THE ALLOCATION PATTERN
• MONOPOLY AS AN OBSTACLE TO CORRECT RESOURCE ALLOCATION
• ARTIFICIAL OBSTACLES TO CORRECT RESOURCE ALLOCATION
• SUMMARY
• SUGGESTED READINGS
• Appendix:: THE APPLICATION OF MARKET THEORY TO MULTI-PERIOD PLANNING
• MULTI-PERIOD DECISIONS IN THE PURE EXCHANGE ECONOMY
• THE INTERTEMPORAL MARKET
• SPECULATION AS AN ASPECT OF INTERTEMPORAL MARKETS
• MULTI-PERIOD DECISIONS OF PRODUCERS
• THE PLACE OF CAPITAL GOODS IN PRODUCTION
• SUGGESTED READINGS

Cross-Price Elasticity of Demand

Cross-Price Elasticity of Demand

The Cross-Price Elasticity of Demand measures the rate of response of quantity demanded of one good, due to a price change of another good. If two goods are substitutes, we should expect to see consumers purchase more of one good when the price of its substitute increases. Similarly if the two goods are complements, we should see a price rise in one good cause the demand for both goods to fall. Your course may use the more complicated Arc Cross-Price Elasticity of Demand formula. If so you'll need to see the article on Arc Elasticity. The common formula for the Cross-Price Elasticity of Demand (CPEoD) is given by: CPEoD = (% Change in Quantity Demand for Good X)/(% Change in Price for Good Y)

Calculating the Cross-Price Elasticity of Demand

You're given the question: "With the following data, calculate the cross-price elasticity of demand for good X when the price of good Y changes from $9.00 to $10.00." Using the chart on the bottom of the page, we'll answer this question. We know that the original price of Y is $9 and the new price of Y is $10, so we have Price(OLD)=$9 and Price(NEW)=$10. From the chart we see that the quantity demanded of X when the price of Y is $9 is 150 and when the price is $10 is 190. Since we're going from $9 to $10, we have QDemand(OLD)=150 and QDemand(NEW)=190. You should have these four figures written down:
Price(OLD)=9
Price(NEW)=10
QDemand(OLD)=150
QDemand(NEW)=190
To calculate the cross-price elasticity, we need to calculate the percentage change in quantity demanded and the percentage change in price. We'll calculate these one at a time.

Calculating the Percentage Change in Quantity Demanded of Good X

The formula used to calculate the percentage change in quantity demanded is: [QDemand(NEW) - QDemand(OLD)] / QDemand(OLD)
By filling in the values we wrote down, we get:
[190 - 150] / 150 = (40/150) = 0.2667
So we note that % Change in Quantity Demanded = 0.2667 (This in decimal terms. In percentage terms this would be 26.67%).

Calculating the Percentage Change in Price of Good Y

The formula used to calculate the percentage change in price is: [Price(NEW) - Price(OLD)] / Price(OLD)
We fill in the values and get:
[10 - 9] / 9 = (1/9) = 0.1111
We have our percentage changes, so we can complete the final step of calculating the cross-price elasticity of demand.

Final Step of Calculating the Cross-Price Elasticity of Demand

We go back to our formula of: CPEoD = (% Change in Quantity Demanded of Good X)/(% Change in Price of Good Y)
We can now get this value by using the figures we calculated earlier.
CPEoD = (0.2667)/(0.1111) = 2.4005
We conclude that the cross-price elasticity of demand for X when the price of Y increases from $9 to $10 is 2.4005.

How Do We Interpret the Cross-Price Elasticity of Demand?

The cross-price elasticity of demand is used to see how sensitive the demand for a good is to a price change of another good. A high positive cross-price elasticity tells us that if the price of one good goes up, the demand for the other good goes up as well. A negative tells us just the opposite, that an increase in the price of one good causes a drop in the demand for the other good. A small value (either negative or positive) tells us that there is little relation between the two goods. Often an assignment or a test will ask you a follow up question such as "Are the two goods complements or substitutes?". To answer that question, you use the following rule of thumb:

• If CPEoD > 0 then the two goods are substitutes
• If CPEoD =0 then the two goods are independent (no relationship between the two goods
• If CPEoD < 0 then the two goods are complements

In the case of our good, we calculated the cross-price elasticity of demand to be 2.4005, so our two goods are substitutes when the price of good Y is between $9 and $10. If you'd like to ask a question about elasticity, microeconomics, macroeconomics or any other topic or comment on this story, please use the feedback form.

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Types of Elasticity

A Shift versus a Movement Along a Demand Curve

A Shift versus a Movement Along a Demand Curve

It is essential to distinguish between a movement along a demand curve and a shift in the demand curve. A change in price results in a movement along a fixed demand curve. This is also referred to as a change in quantity demanded. For example, an increase in video rental prices from $3 to $4 reduces quantity demanded from 30 units to 20 units. This price change results in a movement along a given demand curve. A change in any other variable that influences quantity demanded produces a shift in the demand curve or a change in demand. The terminology is subtle but extremely important. The majority of the confusion that students have with supply and demand concepts involves understanding the differences between shifts and movements along curves.

TABLE 4 Change in Demand for Videos after Incomes Rise
Price	Initial Quantity Demanded	New Quantity Demanded	Quantity Supplied
$5	10	30	50
$4	20	40	40
$3	30	50	30
$2	40	60	20
$1	50	70	10

Suppose that incomes in a community rise because a factory is able to give employees overtime pay. The higher incomes prompt people to rent more videos. For the same rental price, quantity demanded is now higher than before. Table 4 and the figure titled "Shift in the Demand Curve" represent that scenario. As incomes rise, the quantity demanded for videos priced at $4 goes from 20 (point A) to 40 (point A'). Similarly, the quantity demanded for videos priced at $3 rises from 30 to 50. The entire demand curve shifts to the right.

A shift in the demand curve changes the equilibrium position. As illustrated in the figure titled "Equilibrium After a Demand Curve Shift" the shift in the demand curve moves the market equilibrium from point A to point B, resulting in a higher price (from $3 to $4) and higher quantity (from 30 to 40 units). Note that if the demand curve shifted to the left, both the equilibrium price and quantity would decline.