EC115 Methods of Economic Analysis

Lecture 2: Linear equations 2 Economic

Applications
Week 3, Autumn 2008
A Model of Demand and Supply
Demand and Supply are the basic building blocks for economic
analysis
A model of demand and supply describes how prices affect the
behaviour of both consumers and producers
In general, the quantity demanded of a good sold in a market
depends not only on its own price but also on other factors, such as
the prices of other goods and consumers income.
For example, if the price of the Pepsi increases while the one of the
Coca-Cola remains constant, some consumers may switch and
consume more Coca-Cola if they feel that the two products are close
substitutes (they are very similar products).
Demand
The concept of a demand function is based on consumer theory: the
lower is the price of the good, the more the consumer wants to buy it
(taking as given the other factors)
Adding up all the individual demands gives us the market demand:
q
D
= -ap + b,
where p is the market price and a and b are positive parameters.
The demand curve is negatively sloped: The higher the price of the
good, the lower is the quantity demanded of that good Law of
Demand
The quantity demanded (q
D
) is the dependent variable, and we
assume that, for each individual, the market price (p) is given so that
she/he chooses how much to buy at that price.
Demand curve
q
p
q
D
= -ap + b
Supply
The concept of the supply function is based on the theory of firm:
The higher is the market price of the good, the more firms will
choose to supply that good
Combining all firms supply gives us the market supply: q
S
= cp + d,
where c>0 and d is zero or negative (with zero price firms wish to
supply nothing).
The supply curve is positively sloped: The higher is the price of the
good the higher is the quantity supplied of that good Law of
Supply
Quantity supplied (q
S
) is the dependent variable and price (p) is
assumed to be given.
Supply curve
p
q
q
S
= cp + d
Market Equilibrium
An equilibrium is a situation where none of the agents have an
incentive to change anything.
The market is in the equilibrium when the quantity that the
consumers are willing to buy equals the quantity the producers are
willing to supply:
q
D
= q
S
(equilibrium condition)
If q
D
> q
S
, then some consumers would like to buy more than is
supplied in the market by firms
If q
D
< q
S
, then some producers would like to supply more than is
demanded in the market by consumers
There is disequilibrium in the market.
Example (1)
Suppose the demand for books is specified as the following relationship
between quantity (Q) and price (P) : q
D
= 40 2p.
The supply of books is specified as another relationship: q
S
= 3p 10.
The equilibrium condition is: q
D =
q
S
.
This is a system of three linear equations and three unknowns (q
D
, q
S
,
p). To solve for the equilibrium, we set
40 2p = 3p 10,
and solve for p: p* = 10.
Plug this into one of the equations above to get q* = 3(10) 10 = 20.
Market Equilibrium
20
40
q
p
q
D
= 40 2p
-10
p* = 10
q* = 20
E
q
S
= 3p 10
10/3
Disequilibrium (q
D
> q
S
)
q
20
40
p
q
D
= 40 2p
-10
E
q
S
= 3p 10
5
y
D
= 30
y
D
= 5
Excess demand
Comparative statics
In addition to computing the equilibrium quantity and price of books,
we can use the model to analyse the impact of changes in the
circumstances under which the decisions are made.
For instance, buyers income or production technology may change,
or the government may intervene in the market (taxes etc.)
Comparing the initial equilibrium with the new equilibrium that is
induced by a disturbance or shock to the system is the basic idea of
comparative statics.
Comparative statics Example (1)
Suppose the demand for books is now a function of price (P) and
income (I): q
D
= 2P + 40 + I
Supply of books is as before: q
S
= 3P 10.
In the equilibrium: q
D =
q
S
, i.e.,
40 2P + I = 3P 10, and solving for P gives: P = 10 + I/5.
If I = 50, then P* = 20, and q* = 50.
Now suppose income increases to 100. The model tells us that the
quantity sold in the market increases by 30 and the price increases
by 10.
From the graph, the two demand curves are parallel but the new
curve has shifted upwards from the original one.
Comparative statics Example (1)
45
90
q
p
q
D
= 2P + 90
20
50
E
0
q
S
= 3P 10
q
D
= 2P + 140
E
1
80
70 30
140
Comparative statics Example (2)
A demand for beef is given by q
D
= -7p + 1000, while the supply for
beef is q
S
= 5p 200.
In the equilibrium: q
D
= q
S
, hence p* = 100 and q* = 300.
Now suppose government introduces a specific tax of t pence per
kilo sold. Suppose t = 25.The tax bill now depends on the quantity of
beef sold, not the price.
To analyse the effects of the tax, we must first make a distinction
between the market price, p, and the price actually received by the
sellers, p.
A seller who sells his product at the market price, p, has to pay a tax
of t pence and, therefore, for every unit he sells, he receives p = p
t.
Comparative statics Example (2)
Given the tax, the willingness of the sellers to supply beef now
depends on p rather than p.
We rewrite the supply function as: q
S
= 5p 200.
Collecting all the equations of the modified model, we have:
q
D
= -7p + 1000 (1)
q
S
= 5p 200 (2)
q
D
= q
S
(3)
p = p t (4)
t = 25 (5),
where t = 25 is the assumed tax rate per kilo of beef sold. We have
a linear system of 5 equations and 5 unknowns (q
D
, q
S
, p, p, t).
Comparative statics Example (2)
To solve this system, first replace (5) into (4):
p = p t = p 25 (4)
We can then substitute (4) into (2):
q
S
= 5(p 25) 200 = 5p 125 200 (2)
Note that (2) has the same slope as the original supply
function q
S
= 5p 200. However, we can see that the supply,
given any price, is lower in (2) than in the original equation.
The graphs are parallel but (2) has a smaller y-intercept, and
has shifted down.
Comparative statics Example (2)
It remains to set q
D
= q
S
and solve for p: p = 110,4 (price
paid by consumers).
p = 110,4 25 = 85,4 (price received by suppliers)
The corresponding equilibrium quantity: q* = 227,1.
Comparative statics Example (2)
1000
227,1
-200
q
S
= 5p 200
q
S
= 5p 125 200
q
D
= -7p + 1000
p
q
142, 9
300
110,4
E
0
E
1
Tax revenue
85,4
100
Comparative statics Example (2)
The tax shifts the supply function down by 125 units
Quantity has fallen from 300 to 227,1 and market price
has increased from 100 to 110,4.
The tax burden is shared by the consumers, who pay
more and producers, who receive less than before the
tax was introduced.
The shaded area indicates the tax revenue accruing to
the government.
Solving for the Market Equilibrium: A
general case
Consider the three equations in a demand and supply
model:
q
D
= -ap + b (1)
q
S
= cp + d (2)
q
D
= q
S
(3)
From the mathematical point of view, we have a system
of three linear equations and three unknowns (q
D
, q
S
, p).
To solve this is simple. When (3) holds, then we can set
the right-hand sides of (1) and (2) equal to each other
and solve for p.
Solving for the Market Equilibrium
Set
-ap + b = cp + d (4)
Equation (4) is a simple linear equation with only one variable, p,
and we can easily solve it:
c a
d b
p
d b a c p
b d ap cp
+

=
= +
=
*
) (
Solving for the Market Equilibrium
p* now denotes the equilibrium value of the price in the
market, that is, the price at which quantity demanded is
equal to the quantity supplied.
To obtain the equilibrium quantity, substitute p* into the
demand (or supply) function:
( ) ( )
c a
bc ad
q
c a
bc ba ad ab
q
c a
c a b
c a
d b a
b
c a
d b
a q
b ap q
D
D
D
+
+
=
+
+ + +
=
+
+
+
+

= +

=
+ =
*
Solving for the Market Equilibrium
The solution to the system is:
c a
ad bc
q
c a
d b
p
+
+
=
+

= * , *
We started with three equations and three variables. But one of
the equations in our system simply says that q
D
=q
S
. Thus, at the
solution of our system q
D
= q
S
= q*.
Graphically, the solution p* and q* represents the coordinates of
the point where the demand and supply intersect.
Inverse Demand and Supply
So far we have treated the quantity as the dependent
variable and plotted it on the vertical axis of the graph.
The convention in economics is generally to place p, the
price, on the vertical axis when plotting demand and
supply functions.
Following the convention in economics, we need to
rearrange the demand and supply functions so as to
isolate p on the left-hand side of the equation.
Inverse Demand and Supply
Recall our example of the market for beef.
Rearranging the demand function q
D
= -7p + 1000 gives:
7
1000
7
+ =
D
q
p This function is called the inverse demand function.
40
5
+ =
S
q
p
Rearranging the supply function, q
S
= 5p 200, we obtain:
This function is called the inverse supply function.
Inverse Demand and Supply
We can use the inverse demand and supply functions to
solve for the market equilibrium
We have the two inverse functions,
40
5
,
7
1000
7
+ =
+ =
S
D
q
p
q
p
together with the familiar market equilibrium condition: q
D
= q
S.
Hence, we have a system of three linear equations with three
unknowns (q
D
, q
D
, p).
Inverse Demand and Supply
Since q
D
= q
S
in the equilibrium, we can replace one of the
variables with the other. For example, rewrite the inverse
supply function:
40
5
+ =
D
q
p
We can then set:
, 40
5 7
1000
7
+ = +
D D
q q
and solve this linear equation with only one unknown.
100 * 300 *
3600 12
1400 7 5000 5
= =
=
+ = +
p q
q
q q
D
D D
Inverse Demand and Supply
40
p
q
p = q
S
/5 + 40
p = -q
D
/7 + 1000/7
1000
142,9
300
100
E
Macroeconomic equilibrium
Macroeconomics studies the economy as a whole
In the following we will consider a linear macroeconomic model to
find how the equilibrium level of income for the whole economy is
determined
The key relationships of the model are:
1) Y Q and Q E.
This means that households earn their incomes (Y) by producing
output (Q), and so the aggregate household income, Y, must equal
the value of output, Q. In addition, The output (Q) must be bought by
somebody and this creates the expenditure (E).
Macroeconomic equilibrium
Combining Y Q and Q E gives our first equation
Y E (1)
Equation (1) is an identity. It means that the aggregate income
and aggregate expenditure are necessarily equal.
2) Aggregate expenditure that consists of households
consumption expenditure, C, and firms investment
expenditure, I.
E C + I (2)
Macroeconomic equilibrium
3) The planned or desired consumption expenditure of households.
This is represented by a consumption function, where consumption
is a function of income:
= aY + b, (3)
where is the planned consumption and a and b are positive
parameters. Parameter a is called the marginal propensity to
consume (MPC) and it is less than 1. The positive slope means that
the higher is income, Y, the higher is consumption, . As a specific
consumption function, consider
= 0.5Y + 200
The MPC is 0.5. This means that if the consumer earns an extra 1
he will spend half of it and save the rest.
Macroeconomic equilibrium
The planned savings can then be represented by
Y
This is an identity because what is not consumed will be necessarily
saved.
Substituting from above into the identity gives us the savings
function:
= Y (aY + b) = Y(1 a) b
In our specific example, the savings function takes the form:
= Y (0.5Y + 200) = 0.5Y 200
Macroeconomic equilibrium
C and are not necessarily equal. C is the actual output
and is what the consumers would like to consume.
Whenever C , there will be changes in spending,
which will, in turn, cause changes in income
Therefore, for an equilibrium, we need
C = (4)
Macroeconomic equilibrium
Equations (1) (4) constitute our macroeconomic model
with four equations and five unknowns (Y, E, I, C, ).
Because we have more unknowns than equations, the
solution to the system is not unique.
To solve this system, first replace (1) into (2):
Y C + I (5)
Macroeconomic equilibrium
Then plug (4) into (5) to get:
C = 0.5Y + 200 (6)
Then substitute (6) into (5) to obtain:
Y = 0.5Y + 200 + I, and rearrange:
5 . 0
200
200 ) 5 . 0 1 (
200 5 . 0
I
Y
I Y
I Y Y
+
=
+ =
+ =
(7)
Macroeconomic equilibrium
Equation (7) expresses Y as a function of I.
Because there are two unknowns, it doesnt give us a
unique solution.
Note that the denominator is equal to 1 MPC = 1 a.
If a = 1, the denominator is zero.
If a > 1, the denominator is negative.
Hence, we want a<1.
Macroeconomic equilibrium
To obtain a specific value for Y, we need to find additional
information about I.
For simplicity, suppose that I has a fixed value, say I = 500.
Then we have that:
1400
5 . 0
500 200
5 . 0
200
=
+
=
+
=
I
Y
This is the equilibrium level of income. The plans of households to
consume and firms to invest are consistent with the economys
actual production of these goods.
Macroeconomic equilibrium
Here I is considered as an exogenous variable, because
its value comes from outside the model.
Variables whose values are determined within the
model, such as Y and C, are called endogenous.
Macroeconomic equilibrium
Y
, E = + I
Y = E
= 0.5Y + 200
200
700
E = + I = 0.5Y + 700
1400
1400
Comparative Statics
Suppose that investment increases to I = 550. This
means that the income increases to
1500
5 . 0
550 200
5 . 0
200
=
+
=
+
=
I
Y
The increase of 50 in investment results in an increase of 100
for income. In fact, any given increase in investment will
increase income twice as much.
This effect is due to the investment multiplier.
Graphically, this corresponds to an upward shift of the
aggregate demand function, E = + I.
Y
, E = + I
Y = E
= 0.5Y + 200
200
700
E = + I = 0.5Y + 700
1400
1400
E = + I = 0.5Y + 750
750
1500
1500