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Price elasticity of demand and supply

Price elasticity of demand and supply

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Introduction

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Market forces of demand and supply determines any business operations as well as consumption of goods and services. Consumers behave in a given way after realizing that the price of a commodity has been changed. Some will reduce the number of units of a product they consume; some will increase their consumption depending on the direction of price or supply changes. Similarly, the operating and production conditions will determine whether the producers will supply goods and services or not. The effects of taxes, improved technology and natural catastrophes usually affect the supply of a product. These behaviors from the two parties are studied in the price elasticity of demand and supply. This paper is going to shed light on the different types of price elasticity of demand and supply, the various factors that determine the elasticity’s and their importance. In the research, the paper will first consider price elasticity of demand and then price elasticity of supply.

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PRICE ELASTICITY OF DEMAND

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Definition

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Marshall states that Price elasticity of demand is the responsiveness of the quantity demanded of a product to changes in its own price. It gives the percentage change in quantity demanded with responses to one percentage change in its own price. In this case, other factors like income of the consumers are held constant. Price elasticity of demand is always negative for a normal good unless in cases involving Veblen and Giffen goods where the price elasticity is positive. The rationale behind this is the inverse relationship between price of a commodity and the quantity demanded, (Marshall, 2010). The formula for calculating the price elasticity of demand is given by

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Ed= % change in quantity demanded

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% change in price

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= ∆ Qd/ Qd

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∆P/P

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Where

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Qd= quantity demanded

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P= price of a commodity

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There are short comings involved when one uses the above formula to calculate the price elasticity of demand. The percentage change is not sometimes the same in different directions although the magnitude of change may be the same. For instance a change quantity demanded from 20 to 15 and the change from 15 to 20 units. The percentage changes are different. That is (20-15)/20 and (15-20)/15. A solution to such scenarios involves the use of arc elasticity of demand and point elasticity of demand.

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Arc price elasticity

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In this case two points on the demand curve are selected (an initial point and a new point) in order to calculate the percentage change in price and quantity demanded. The “average” elasticity between the two points gives the elasticity. In other words the arc made between the two points. Mathematically,

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Ed = p1+p2 ÷ q1+q2 × ∆ Qd

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2 2 ∆P

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= p1+p2 × ∆ Qd

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q1+q2 ∆P

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Where

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        q1 = Initial quantity        q2 = Final quantity        p1 = Initial price        q2 = Final price

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This formula assumes that the demand curve is a straight line. The greater the curvature of the demand curve the greater the range.

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“Point” price elasticity of demand.

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Point price elasticity of demand considers the infinite changes in price and quantity demanded. Integral calculus is used in calculating the elasticity. It is given as

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Ed= ∂Qd × P

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∂P Q

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Where ∂Qd= change in the quantity demanded

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∂P= change in the price of a commodity

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P= price of a commodity

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Q= quantity demanded

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In using this formula, quantity demanded is assumed to be a function of price (the demand function).

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Graphically;

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Perfect inelastic demand

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Price

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Perfect elastic demand

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Quantity demanded

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Perfect elasticity of demand An in increase in the price of a commodity will cause a more than proportionate increase in the quantity demanded. From the graph above it is shown by a horizontal straight line. This is from the theoretical perspective. In the real sense, any increase in the price will lead to a fall in the revenue collected by the producer or the price setter. Consumer will immediately lower their demand of the product whose price has been increased. They will switch their consumption to other related products will can satisfy their utility. An example of such products includes bread. In such cases the quantity demanded of bread is relatively elastic. Price elasticity of demand is usually infinity, (Marshall, 2010).

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Perfect price inelasticity of demandAny increase in the price of a commodity will cause a less than proportionate increase in the quantity demanded of a product. Under such circumstances, consumers have no option of consuming a given product and therefore will not consider it prices. From the graph above, perfect inelastic demand is illustrated by a vertical line. Monopoly’s usually face such conditions since they produce unique commodities.

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An increase in price of a commodity will lead to an increase in revenue. This is because the revenue lost by a marginal decrease in quantity demanded is less than the revenue gained after the price increase. Perfect inelastic demand usually have an Ed = 0. An example of products or services which has perfect inelastic demand is in a scenario when the consumer is supplied with electricity as the only source of energy from one company. Another product is sugar produced from only one company. The only assumption under such conditions is there is no importation of such products.

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Unitary elasticity of demand In this case, a product is said to have unitary elasticity of demand when an increase in price does not cause any change in the quantity demanded or the change is very minimal.

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Unitary elasticity of demand

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Price rectangular hyperbola

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Quantity demanded

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Unitary elasticity of demand happens when an increase in price causes the same effect to the quantity demanded. The change (as shown from the figure above) is the same at high and low prices.

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Inelastic and elastic demand

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Elastic demand

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Relative inelastic demand

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Price

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Quantity demanded

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Elastic and inelastic demand occurs when a change in price leads to a more than proportionate change in quantity demanded. Inelastic demand occurs when a change in price of a commodity leads to a less than proportionate change in quantity demanded. The curves to this elasticity’s are shown in the graph above.

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Factors Affecting the Price Elasticity of Demand

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The availability of substitutes determines the elasticity of a product; if the consumer can get other products (availability of substitute) it means they can easily change their consumption from one product to the especially if there is an increase in price of one commodity. The more the substitutes the greater the price elasticity of supply,(Marshall, 2010).

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Nicholson and Snyder assert that the degree of necessity of a product also determines the price elasticity of demand. If the product is a necessity then its price elasticity will be greater than that of products which are not necessary. Basic needs have high elasticity of demand compared to luxuries. To some consumers automobiles are not necessary and therefore they are not affected by the changes in the prices, (Nicholson & Snyder, 2007).

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Proportion of the buyer’s budget consumed by an item; products which consume a large portion of the buyer’s budget tend to have greater price elasticity. This is because the consumer may want to satisfy his utility subject to the money income. Items which do not consume a large proportion of a consumer’s budget will not be affected.

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The time period considered; in a very long period of time, price elasticity of demand tends to be higher. This is because the consumer gets time to adjust after gathering full information about products in the market.

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The nature of a change; if there is a permanent change in prices consumers will look for ways of changing their consumption bundles. A temporary change will be assumed by many since some usually take a very long period of time to shift their consumption of one product to the other.

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The range of price changes; a slight increase or decrease in price will not cause more effects on the consumer’s consumption basket but a large price change will. If the price of sugar decreases from $2.00 to $1.99, the price elasticity of demand is lower compared to a change of the same product from $2.00 to $1.50. In cases where the consumer is not the one paying for the goods, the elasticity of such products is likely to be perfectly inelastic. These are scenarios when the company is responsible for funding for one’s consumption, (Nicholson & Snyder, 2007).

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Importance of price elasticity of demand

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Many producers use the concept of price elasticity of demand to make decision about price settings. Products that have high price elasticity of demand; their prices are not easily increased by the producer for reasons of loss in revenue. The producer can also use the concept of price elasticity to do price discrimination in the market in order to maximize revenue. The producer can only maximize profits when the marginal revenue is zero. At this point, the price elasticity of demand should be unitary, (Mankiw, 2008).

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The government usually uses the concept of price elasticity to determine which goods should be taxed more then others. It is very easy for the government to increase the price of cigarettes and beer without the consumer reducing the quantity demanded. It is hard for the government to increase prices of bread by taxing the product more. Consumers will consume substitutes which are cheap.

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PRICE ELASTICITY OF SUPPLY

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Price elasticity of supply is the measure of the degree of responsiveness of the quantity supplied of a good to changes in its own price. It is also defined as the measure of sensitivity of quantity supplied of the good with respect to changes in the market prices. In this case it is assumed that other factors like income of the consumer, government taxes are kept constant, (Tucker, 2008).

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Mathematically,

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Es= % change in quantity supplied

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% change in price

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= ∆ Qs/ Qs

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∆P/P

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Where

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Qs= quantity demanded

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P= price of a commodity

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For instance, in using the above formula, if a 10% change in price causes a 20% change in quantity supplied, then the price elasticity of supply is 2. In this case it is positive; the reason behind this is the positive relationship between price and quantity supplied. (the law of supply).

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Illustrating different price elasticity of supply

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Perfect inelastic supply

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Price perfect inelastic supply

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Demand 2

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Demand 1

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Quantity supplied

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From the above graph, it is observed that any changes in the price will not have an effect on the quantity supplied; this usually happens with the monopoly’s that prefer supplying a fixed quantity of goods to the market. What happens is that the monopoly alters the prices but not the quantities. The consumer has limited options as the power is with the supplier. In such cases the price inelasticity of supply is zero and it is shown on the graph by a vertical line.

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Perfect elastic supply

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Price

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Perfect elastic supply

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Demand 2

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Demand 1

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Quantity supplied

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There are some situations when the government can regulate prices of given goods with the purpose of protecting its citizens from suppliers exploitation. In such cases the suppliers supply any quantity to the market at a fixed price. Agricultural products usually experience such cases. The government can put a price ceiling to sugar. The sugar factories may sell their sugar at that price or less. Perfect Price elasticity of supply is always infinity and it is shown by a horizontal line. This is shown clearly in figure above

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Elastic supply

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price

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Elastic supply

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Demand2

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Demand 1

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Quantity supplied

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In the case of elastic supply, any increase in the price leads to a less than proportionate change in quantity supplied of a given good to the market. For instance if the price of maize is increased by 2%, the quantity supplied may increase by 1.5%;

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Inelastic supply

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Price inelastic supply

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Demand 2

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Demand 1

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Quantity supplied

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It may happen that the supply of a given good cannot be altered with a large margin by a change in price. This involves cases when it takes very long to produce and supply extra goods to the market so as to take care of the price increase (The use of the law of demand and supply in ensuring that the equilibrium in the market is reached). Agricultural products can give best examples for price inelasticity of supply, (Nicholson & Snyder, 2007).

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Unitary elasticity of supply

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Unitary elasticity of supply occurs when the coefficient of elasticity is one. In such cases a change in price causes the same change in the quantity supplied of a product. For instance if the price of coffee increases by 20%, the quantity supplied increases by the same margin.

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FACTORS THAT DETERMINE ELASTICITY OF SUPPLY

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The price elasticity of supply is determined by the following factors

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The spare capacity

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According to McConnell the availability of spare capacity determines the elasticity; if there is an abundance supply of spare capacity then it becomes very easy for the supplier to increase output within the shortest time period making the price elasticity of supply to be elastic. It may happen that the supplier may run short of raw materials, ordering for such materials may take long therefore the supply to be inelastic, (McConnell, 2005).StocksA change in demand can only be responded to quickly if the suppliers have enough stock of inventory or raw materials within his reach. This makes the price elasticity of supply to be elastic. If at all the supply doesn’t keep stocks within his premises (stores). It may take some period of time to produce and ensure that there are enough stocks are kept for future demand. The quantity of stock to be kept can depend on factors like availability of space and he storage cost. These factors in turn affect the price elasticity of supply.

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Ease of Factor SubstitutionThe substitutability of factor of product for another will determine the price elasticity of supply. If labor can be substituted for capital the price elasticity of supply can be high. Such cases happen when there is perfect mobility of labor. If factors of production cannot be substituted for one another then the price elasticity of supply becomes inelastic

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Time PeriodSupply of a given product is likely to more elastic if the supplier takes a very long period of time to adjust to the changes in production. Agricultural goods give the best example of such goods; it takes a very long period of time to increase agricultural production due to increases in price. In this case, farmers face price inelasticity of supply. Manufactured goods on the contrary have price elasticity of supply; it takes a very short period of time to adjust the production rate in order to increase the output so as to take care of the increased prices, (Tucker, 2008).

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Availability of substitutes

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The ease with which a product can be substituted for another determines the price elasticity of supply. There are products which can be produced in various forms. This gives the suppliers the advantage of changing the products using the same inputs. In this case the price elasticity of supply is elastic. A milk processor factory can choose not to supply milk but process butter, cheese and milk powder. The decrease in the quantity demanded of milk may cause an increase in quantity demanded of milk powder. College students may opt to prefer milk powder than milk itself for making beverages. This gives the supplier a high price elasticity of supply for milk and its products.

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Importance of the price elasticity of supply

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Price elasticity of supply helps the supplier to know the periods when stocks should be kept and when not. There is some product whose price elasticity is inelastic; the government can decide to levy taxes on such product in knowing that the quantity supplied will not be interfered with. The government can also put either price ceilings or floors on some products depending on their price elasticity’s. Agricultural goods should have price floors otherwise the farmers will be exploited. Similarly, the manufactured goods should have price ceiling otherwise the manufacturer will impose their own prices. The concept of price elasticity can be used by the government to regulate the number of suppliers in the market, (Mankiw, 2008).

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Conclusion

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The knowledge of Price elasticity of demand and supply is needed by all participants in the market in order to help them know when to buy and sell products. The government also uses this concept when identifying the types of products to be taxed. Were it not for this concept the government could be collecting very low taxes. The consumer is usually carries the burden of exploitation; the government can use the concept of price elasticity of demand and supply to limit the power of suppliers to exploit the consumers.

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References

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Mankiw G. (2008). Principles of Microeconomics, Fifth Edition. Cengage Learning publishers, New York

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Tucker B. (2008). Microeconomics for Today, Sixth Edition; Revised. Cengage Learning publishers, London

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Nicholson W., Snyder C., (2007). Microeconomic theory: basic principles and extensions, Tenth edition. South Western Educational Publisher, Australia

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Marshall A. (2010). Principles of Economics: Abridged edition Cosimo publishers, Inc., New Jersey.

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McConnell C. (2005). Economics: principles, problems, and policies.Edition16, McGraw-Hill/Irwin, U. S. A

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