Lecture4 - Fin501 FinancialEconomics...

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1 Fin 501 Financial Economics Lecture 4: Supply, Production and Costs Professor Nolan Miller
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2 Announcements Problem Set #1 is due TUESDAY (revised due date). For future reference: Hand written assignments are ok. Please turn in a hard copy (no emails). Problem Set #2 is due September 14 th .  Available on Compass. Office Hours Today: 4:00 – 4:45.
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3 The story so far … We’ve studied the demand side of the market. Preferences   utility. UMP: Max U(x,y) s.t. p x x+p y y≤m. Solution   x(p x ,p y ,m) and y(p x ,p y ,m).
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4 Plan for Today Finish up demand theory: Elasticities Market Demand Start Supply Theory Firms’ objectives. Firms’ technology/production processes. Firms’ production decisions.
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Measuring changes: elasticities Frequently we are interested in understanding how a change in some variable affects  behavior. How much will gasoline sales decline if price goes up? How much more will people spend if the government gives them $300? How many more cars will be sold if cash-for-clunkers is enacted? One approach: take the demand function, x i (p 1 ,…,p n ,m) and differentiate it: Problem: units. If an x = gasoline and y = cars, and ∂x/ ∂p x  = -4 and ∂x/ ∂p y  =-27, what does that  mean? Depends on whether gasoline is measured in gallons or barrels, eggs are per egg  or per dozen. A $1 change in the price of gasoline is not the same as a $1 change in the price of  a car. To get around this, we want a unit-free measure. i i x impact p = 5
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Answer: Elasticities An elasticity is a unit-free measure of the impact of a change. It answers the question: By what percent does x change if I change  some other variable by 1%? Common elasticities: Income elasticity of demand for x. Impact of a % change in m. Price elasticity of demand for x. Impact of a % change in p x . Cross-price elasticity of demand for x with respect to y. Impact of a % change in p y . 6
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Elasticities Formally, the elasticity of demand for x with respect to a change  in some factor, z, is: And, if you believe in calculus (like we do), then Δx/Δz   ∂x/∂z. Usually, use the initial values of x and z.  But, for large changes,  may want to use the average.  In this case, we call it an “arc  elasticity.” % / * % / x x x x z z z z z x = = % / * % / x x x x z x z z z z z x z x = = = 7
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Income Elasticity By what % does quantity of x change if income increases by 1%? Normal: 
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Lecture4 - Fin501 FinancialEconomics...

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