Recap

Lecture 27 – academic year 2013/14Introduction to Economics

Fabio Landini

Micro

Market of cheese

The market for cheese is characterized by the following demand and supply curve:

Demand: QD= 9 – P

Supply: QS= 3P – 3

where P represent the price (in Euro per Kg.) and Q represent the quantity (in Kg.).

Market of cheese

1) Compute the elasticity of demand with respect to price, for Δp=2 and assuming that p0 = 3.

Formula for the elasticity of demand:

ED(p) = – [Δ q / q0] / [Δ p / p0] =

= – [(q1 – q0) / q0] / [(p1 – p0) / p0]

Market of cheese

p0 = 3 ; p1 = p0+ Δp = 5

Given our demand function QD= 9 – P we can compute q0 and q1.

In particular:p0 = 3 -> q0 = 6

p1 = 5 -> q1 = 4

Market of cheese

Now we can apply the formula:

ED(p) = – [Δ q / q0] / [Δ p / p0] =

= – [(q1 – q0) / q0] / [(p1 – p0) / p0]= – [(4 – 6) / 6] / [(5 – 3) /3]

= – [– 1 / 3] / [2 /3]=1/2

Final result: ED(p) = 1/2

High or low? Low…

Market of cheese

2) Draw the demand & supply graph and find the equilibrium price and quantity

Price of cheese

Quantity of cheese

9

9

D1

12

5

S

88

To find the equilibrium price and quantity we impose the equilibrium condition:

QD = QS

QD = 9 – P and QS= 3P – 3

Therefore, 9 – P = 3P – 3, from which we get:

P= 3 and Q = 6

Market of cheese

Market of cheese

Graphically,

Price of cheese

Quantity of cheese

9

9

D1

S

3

6

Market of cheese

2) Suppose the EU imposes a minimum price equal to 5.

i) What is the effect on the market? Show graphically and analytically.

ii) Will the farmers agree with this intervention?

Market of cheese

i) Graphically,

Price of cheese

Quantity of cheese

9

9

D1

S

3

6 QS

5

QD

Excess supply

Market of cheese

We can use the supply and demand function to compute the size of excess supply

QD = 9 – P -> P=5 -> QD = 4QS= 3P – 3 -> P=5 -> QS = 12

The size of excess supply is

12 – 4 = 8.

Market of cheese

ii) To verify whether farmers agree with this intervention we compute the TR before and after the intervention

Before: TR = P x Q = 3 x 6 = 18

After: TR = P x Q = 5 x 4 = 20

Yes, farmers will support the intervention.

Market of cheese

3) In order to avoid excess supply the EU decides to introduce a tax T on producers. Which is the value of T such that excess supply is avoided?

i)Show the effect of the tax graphicallyii)Find the correct value of T

Market of cheese

i) Graphically,

Price of cheese

Quantity of cheese

9

9

D1

S

3

6 12

5

4

S’

Market of cheese

ii) To find the correct value of T we write our new supply function

QD = 9 – P

QS= 3(P-T) – 3

To eliminate excess supply we have to satisfy the equilibrium condition QD = QS when P=5.

Market of cheeseTwo steps:First, we impose the equilibrium condition

QD = QS -> 9 – P = 3(P-T) – 3

Second, we replace P=5 and solve for T:9 – 5 = 3(5-T) – 3

7 = 15 - 3TT = 8/3

Market of cheese4) How is the tax burden shared ?

Show it graphically and analytically

Market of cheese

i) Graphically,

Price of cheese

Quantity of cheese

9

9

D1

S

3

6 12

5

4

S’

Portion paid by consumers..

Portion paid by producers..

Market of cheeseThe portion paid by consumers is simply the difference between the new equilibrium price and the equilibrium price before the intervention, i.e. 5 – 3 = 2

For producer is the difference between the old equilibrium price and the new price that they receive, i.e.: 3 – (5 – 8/3) = 3 – 7/3 = 2/3

Obviously, the sum of the two portion gives us the tax burden, i.e. 2 + 2/3 = 8/3

Market of cheese5) Finally, evaluate the effect of the intervention in terms of allocative efficiency.

Does the intervention improve social welfare?

Show it graphically and analytically

Market of cheese

i) Graphically,

Price of cheese

Quantity of cheese

9

9

D1

S

3

6 12

5

4

S’

Producer surplus

Consumer surplus

Market of cheese

i) Graphically,

Price of cheese

Quantity of cheese

9

9

D1

S

3

6 12

5

4

S’

Producer surplus

Consumer surplus

Market of cheeseValue of Consumer Surplus (CS) and Producer Surplus (PS)

Before the intervention:CS = (6 x 6) /2 = 18PS = (6 x 2) /2 = 6 -> Total = 18+6 = 24

After the intervention:CS = (4 x 4) /2 = 8PS = {4 x [5 – (1+8/3)]} /2 = {4 x [5 – 11/3]} /2 = ={4 x 4/3} /2 = 8/3 -> Total = 6 + 8/3 = 26/3

Macro

Macroeconomic EquilibriumConsider an economy characterized by the following equations:•C = 1000 + 0,4YD

•I = 1000 – 5.000i + 0,1Y•T = 1000•G = 1200•MS/P = 600•MD = 0,2Y – 3.000i

Find the equilibrium level of income and interest rate.

Macroeconomic Equilibrium

The equilibrium condition in the goods market requires Y=Z:

Y = C + I + GY = 1,000 + 0.4YD + 1,000 – 5,000i + 0.1Y + 1,200

Y = 3,200 + 0.4(Y-1,000) – 5,000i + 0.1Y Y = 2,800 + 0.5Y – 5,000i

0.5 Y = 2,800 – 5,000i Y = 1,400 – 2,500i

Macroeconomic Equilibrium

The equilibrium condition in the financial market requires MS/P = MD:

600 = 0.2Y – 3,000i 0.2Y = 600 + 3,000i Y = 120 + 600i

Macroeconomic Equilibrium

Two equations with two unknowns:

Y = 1,400 – 2,500i -> Goods Market Y = 120 + 600i -> Financial Market

We can solve the system of equation to find the value of Y and i that satisfy the equilibrium conditions in both markets.

Macroeconomic Equilibrium

First we solve for i:

120 + 600i = 1.400 – 2.500i 3.100i = 1.280

i = 0.4129 We substitute for i in one of the goods market equation:

Y = 1,400 – 2,500i Y = 1,400 – 2,500 x 0.4129

Y = 367.75

Increase in public expenditure2) Using the AS-AD investigate the consequences of a fiscal policy in which public expenditure are increased. Explain the effect in the short period, during the transition, and in the medium period.

Increase in public expenditure( G )

Initially, let’s assume Y = Yn

Then, government reduces G

What are the short-period effects on equilibrium prices (P) and quantities (Y)? An what about the medium-period effects?

Increase in public expenditure

AS -> P= PE (1+m) F( , z) +

AD ->

+ + -

T,G,

PM

YYS

Expansive monetary policy

AS

AD

P

Y

A

Yn

AD’

A’

YA’

PA’

PA

G -> AD shifts rightwardEquilibrium A->A’ -> Y (YA -> YA’) P (PA -> PA’)

In A’ Y>Yn -> P>PE -> PE -> the transition starts

Y

PE -> AS shifts upward

When Y=Yn the adjustment process stops

AS

AD

P

A

Yn

A’

YA’

PA’

PA

PA’’

A’’

Y

During the transition -> Y and PIn the medium period -> YA’’ =Yn=YA and PA’’ >PA

AS

AD

P

A

Yn

A’

YA’

PA’

PA

PA’’

A’’

Total effects of the intervention:•Short period -> Y P•Transition -> Y P•Medium period -> Y= P

This is usually meant when it is argued that expansionary fiscal policy are inflationary in the medium period.

This result however is obtained under fairly stringent assumptions. For instance, G does not affect Yn (think

of public investments in scientific research)

Reduction of public deficit

Interesting readings

Economic development in the long-run

- Acemoglu & Robinson, “Why nations fail?”