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Recap
Lecture 27 – academic year 2013/14
Introduction 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
9
S
5
D
1
9
12
Quantity of cheese
Market of cheese
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
8
Market of cheese
Graphically,
Price of
cheese
9
S
3
D
1
6
9
Quantity of cheese
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
9
Excess supply
S
5
3
D
1
QD
6
9
QS
Quantity of cheese
Market of cheese
We can use the supply and demand function to compute
the size of excess supply
QD = 9 – P -> P=5 -> QD = 4
QS= 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 graphically
ii) Find the correct value of T
Market of cheese
i) Graphically,
Price of
cheese
S’
9
S
5
3
D
1
4
6
9
12
Quantity of cheese
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 cheese
Two 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 - 3T
T = 8/3
Market of cheese
4) How is the tax burden shared ?
Show it graphically and analytically
Market of cheese
i) Graphically,
Price of
cheese
Portion paid by
consumers..
S’
9
S
5
3
Portion paid by
producers..
D
1
4
6
9
12
Quantity of cheese
Market of cheese
The 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 cheese
5) 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
S’
9
S
5
3
Consumer
surplus
Producer
surplus
D
1
4
6
9
12
Quantity of cheese
Market of cheese
i) Graphically,
Price of
cheese
S’
9
5
S
Consumer
surplus
Producer
surplus
3
D
1
4
6
9
12
Quantity of cheese
Market of cheese
Value of Consumer Surplus (CS) and Producer Surplus (PS)
Before the intervention:
CS = (6 x 6) /2 = 18
PS = (6 x 2) /2 = 6 -> Total = 18+6 = 24
After the intervention:
CS = (4 x 4) /2 = 8
PS = {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 Equilibrium
Consider 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+G
Y = 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 expenditure
2) 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
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?
Expansive monetary policy
AS -> P= PE (1+m) F( 1 - Y , z)
L
+
 MS

AD -> Y  Y
, G, T 
 P



+ + -
G -> AD shifts rightward
Equilibrium A->A’ -> Y (YA -> YA’) P (PA -> PA’)
In A’ Y>Yn -> P>PE -> PE -> the transition starts
P
AS
PA’
A’
A
PA
AD’
AD
Yn
YA’
Y
PE -> AS shifts upward
When Y=Yn the adjustment process stops
P
PA’’
PA’
A’’
AS
A’
A
PA
AD
Yn
YA’
Y
During the transition -> Y and P
In the medium period -> YA’’ =Yn=YA and PA’’ >PA
P
PA’’
PA’
A’’
AS
A’
A
PA
AD
Yn
YA’
Y
Reduction of public deficit
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)
Interesting readings
Economic development in the long-run
- Acemoglu & Robinson, “Why nations fail?”