Topic 2: Linear Economic

Models
Jacques Text Book (edition 3):
section 1.2 – Algebraic Solution
of Simultaneous Linear Equations
section 1.3 – Demand and
Supply Analysis
 Content

• Simultaneous Equations
• Market Equilibrium
• Market Equilibrium + Excise Tax
• Market Equilibrium + Income
 Solving Simultaneous Equations
Example

• 4x + 3y = 11 (eq.1)
• 2x + y = 5 (eq.2)

Express both equations in terms of the same value of x (or y)

• 4x = 11 - 3y (eq.1’)
• 4x = 10 - 2y (eq.2’)

Hence
• 11 - 3y = 10 - 2y

Collect terms
• 11 – 10 = -2y + 3y
• y=1

Compute x
• 4x = 10 - 2y
• 4x = 10 – 2 = 8
• x=2
 15 4x+3y-11
2x+y=5

10

5
Y

0
-3 -2 -1 0 1 2 3 4 5 6 7

-5

-10
X
 Note that if the two functions do not
intersect, then cannot solve equations
simultaneously…..
• x – 2y = 1 (eq.1)
• 2x – 4y = -3 (eq.2)
Step 1
• 2x = 2 + 4y (eq.1*)
• 2x = -3 + 4y (eq.2*)
Step 2
• 2 + 4y = -3 + 4y BUT =>
2+3 = 0…………
• No Solution to the System of Equations
 Solving Linear Economic Models
• Quantity Supplied: amount of a good that sellers
are willing and able to sell
• Supply curve: upward sloping line relating price to
quantity supplied
• Quantity Demanded: amount of a good that buyers
are willing and able to buy
• Demand curve: downward sloping line relating
price to quantity demanded
• Market Equilibrium: quantity demand =
quantity supply
 Price of
Ice-Cream
Cone

Supply

2.00
equilibrium

Demand

0 7 Quantity of
Ice-Cream Cones
 Finding the equilibrium price and
quantity levels…..
• In general,

Demand: QD = a + bP (with b<0)

Supply: QS = c + dP (with d>0)
• Set QD = QS and solve simultaneously for
Pe = (a - c)/(d - b)
• Knowing Pe, find Qe given the demand/supply
functions
Qe = (ad - bc)/(d - b)
 Example 1
Demand QD = 50 – P (i)
Supply QS = – 10 + 2P (ii)

Set QD = QS find market equilibrium P P

and Q 50
• 50 – P = – 10 + 2P
• 3P = 60 S
• P = 20

Knowing P, find Q 20

• Q = 50 – P
• = 50 – 20 = 30 5
D
Check the solution
-10 0 30 50 Q
• i) 30 = 50 – 20 and (ii) 30 = – 10 + 40

In both equations if P=20 then Q=30

 Example 2
Demand QD = 84 – 3P (i)
Supply QS = – 60 + 6P (ii)

Set QD = QS to find market

equilibrium P
• 84 – 3P = – 60 + 6P S
• 144 = 9P 28
• P = 16
Knowing P, find Q 16
• Q = –60 + 6P
• = – 60 + 96 = 36 10
Check the solution D
• 36 = 84 – (3*16) and
• 36= –60 + (6*16)
-60 0 36 84 Q
In both equations if P=16 then
Q=36
Market Equilibrium + Excise Tax
• Impose a tax t on suppliers per unit sold……
• Shifts the supply curve to the left
• QD = a – bP
• QS = d + eP with no tax
• QS = d + e(P – t) with tax t on suppliers
So from example 1….
• QD = 50 – P,
• QS = – 10 + 2P becomes
• QS = – 10 + 2(P-t) = – 10 + 2P – 2t
cont…..
 Continued…..
Write Equilibrium P and Q as functions of t
• Set QD = QS
• 50 – P = – 10 + 2P – 2t
• 60 = 3P - 2t
• 3P = 60 + 2t
• P = 20 + 2/3t
Knowing P, find Q
• Q = 50 – P
• Q = 50 – (20+2/3t)
• Q = 30 – 2/3t
 Comparative Statics: effect on P
and Q of t
(i) As  t, then  P paid by consumers by 2/3t
 remaining tax (1/3) is paid by suppliers
total tax t = 2/3t + 1/3t

Consumers pay Suppliers pay

Price consumers pay – price suppliers
receive = total tax t

(ii) and  Q by 2/3t , reflecting a shift to the

left of the supply curve
For Example let t = 3 P
50

• QD = 50 – P S with tax
• QS = – 10 + 2(P-t) S no tax
= – 16 + 2P 22
Tax = 3

19
• New equilibrium Q = 28
(Q = 30 - 2/3t) 8
• New equilibrium P = 22 5 D
( P = 20 + 2/3t )
-16 -10 0 28 30 50 Q
Supplier Price = 19
Tax Revenue = P*Q = 3*28 = 84
 Another Tax Problem….
QD = 132 – 8P
QS = – 6 + 4P
• Find the equilibrium P and Q.
• How does a per unit tax t affect
outcomes?
• What is the equilibrium P and Q if unit
tax t = 4.5?
 Solution…..
(i) Market Equilibrium S
values of P and Q P
• Set QD = QS
16.5
132 – 8P = – 6 +4P
12P = 138
11.5
P = 11.5
• Knowing P, find Q
Q = – 6 +4P
•
1.5 D
= – 6 + 4(11.5) = 40
-6
0 40 132 Q
• Equilibrium values: P =
11.5 and Q= 40
(ii) The Comparative Statics of
adding a tax……
QD = 132 – 8P
QS = – 6 + 4(P – t) = – 6 + 4P – 4t
Set QD = QS
132 – 8P = – 6 +4P – 4t
12P = 138 + 4t

P = 11.5 +1/3 t = 13 if t = 4.5

Imposing t =>  consumer P by 1/3t, supplier pays

2
/3t

Knowing P, find Q
Q = 132 –8(13) = 28
 (iii) If per unit t = 4.5
S with tax
S no tax
Tax = 0 P
Consumer Price = 11.5 16.5

13
Supplier Price = 11.5
Tax = 4.5
8.5
Tax = 4.5 6

Consumer Price = 13 1.5 D

Supplier Price = 8.5 -24 -6

0 28 40 132
Q

Tax Revenue = P*Q = 4.5*28 =126

 Market Equilibrium and Income
• Let QD = a + bP + cY

Example: the following facts were observed

for a good,
• Demand = 110 when P = 50 and Y = 20
• When Y increased to 30, at P = 50 the
demand = 115
• When P increased to 60, at Y = 30 the
demand = 95
 (i) Find the Linear Demand
Function QD?
Rewriting the facts into equations:
• 110 = a + 50b + 20c eq.1
• 115 = a + 50b + 30c eq.2
• 95 = a + 60b + 30c eq.3

To find the demand function

QD = a + bP + cY
we need to solve these three equations
simultaneously for a, b, and c
Rewriting 1 and 2
• a = 110 - 50b - 20c (eq.1*)
• a = 115 - 50b - 30c (eq.2*)
• =>
• 110 – 50b – 20c = 115 – 50b – 30c
• 10c = 5
• c=½

Rewriting 1 & 3 given c = ½

• 110 = a + 50b + 10 (eq.1*)
• 95 = a + 60b + 15 (eq.3*)
• a = 100 – 50b (eq.1*)
• a = 80 – 60b (eq.3*)
• 100 – 50b = 80 – 60b
• 10b = -20
• b = -2
Given b= -2 and c = ½ , solve for a
• a = 110 – 50b – 20c
eq.1’
• a = 110 + 100 – 10 = 200

  QD = 200 -2P + ½Y
Now, let QS = 3P – 100

Describe fully the comparative static’s of the

model using QD and QS equations?

Set QD = QS for equilibrium values of P and Q

• 200 -2P + ½Y = 3P – 100
• 5P = 300 + ½Y
• P = 60 + 1/10Y

Knowing P, find Q
• Q = 3(60 + 1/10Y) -100
• = 80 + 3/10Y
 What is equilibrium P and Q
when Y = 20
• P = 60 + 1/10Y
• P = 60 + 1/10 (20) = 62

i.e  P by 1/10 of 20 = 2

• Q = 80 + 3/10Y
• Q = 80 + 3/10 (20) = 86

i.e  Q by 3/10 of 20 = 6
 Qd = 200 – 2P + ½ Y
Qs = 3P – 100

• Finding Intercepts:
S(Q,P): (-100, 0)
and (0, 331/3 )
Y=0:
D1(Q,P): (200, 0)
and (0, 100)
Y=20:
D2(Q,P): (210, 0)
and (0, 105)
 Questions Covered
Topic 2: Linear Economic Models
• Algebraic Solution of Simultaneous Linear
Equations
• Solving for equilibrium values of P and Q
• Impact of tax on equilibrium values of P and
Q
• Impact of Income on Demand Functions
and on equilibrium values of P and Q