Microeconomics in the

Digital Age
Week 5: Introduction, Supply and Demand
Introduction

Instructor: Moira Daly

• Associate Professor, CBS Department of Economics
• Office: 2.67a, PH16A
• Email: [email protected]
• PhD, MA, BA in Economics, MS in Statistics
• Research in labor economics, applied microeconometrics
The details
Homework:
• Two kinds of homework as more practice is better!
1. MyLab, posted after each lecture. You can get guided help in doing these by selecting “get more help” below the
questions.
2. PDF Assignments to be reviewed in Exercise courses.
• Homework is generally posted after the lecture
• Answers (non necessarily full solutions) to the pdf assignments will be posted on Fridays.
Exercise classes:
• Start next week, week 6
• Instructors: Karin Hansson and Miguel Sousa Duarte
• Selected problems will be reviewed.
Math:
• We will be using basic calculus as needed: taking a derivative / partial derivative. I
will review this very briefly (5 minutes) before assuming you are comfortable and
moving forward.

Final Exam:
• Four hour, open book
• The exam will cover the material disucssed in class along with the material in the
reading list.
• Practice makes perfect:
• Do as many exercises as possible.
• Keep up with the material.
What is economics?
• The word economics comes from the ancient Greek word oikonomikos
which approximately means ``one who manages a household.”

• Like the manager of a household, economic agents (students,

consumers, CEOs, employees,…) have to manage their scarce or limited
resources to secure their goals as best as they can.

• Microeconomics deals with the behavior of individual economic agents

and the markets these comprise.

• Macroeconomics deals with the entire economy, focusing on

phenomena such as inflation, unemployment, and economic growth.
Scarcity
• Time!
• You have 24 hour in a day, no more.
• You cannot do everything.
• One extra hour running, one less hour with the kids!
• Going out for coffee? Give up two study hours (the opportunity cost
is the cost of coffe plus the two hours of study time)
• How do we respond? What happens if coffee becomes much more
expensive?
• Many things are scarce…
What is microeconomomics?
The study of the allocation of scarce resources

To allocate scarce resources, answer 3 questions:

1. What to produce?
2. How to produce?
3. How to distribute?

The answer to these questions affects

• How big the pie is
• How the pie is divided
What mechanisms can generate answers to
these 3 questions?
• Markets
• Government
• Mix between the two
We will seek to understand which
mechanisms work best to make the pie as
big as possible.
So what is a Market?
• Where consumers and producers interact
• Where prices link the decisions about which goods and services to produce,
how to produce them, and who gets them.
• Prices distill a TREMENDOUS amount of information into just one number

• they cooridinate the behavior of a large number of actors in a very simple

way
• A key part of this course is to understand how prices are determined.
• Markets are characherized or defined by
• Time
• Place
• Good or service
Models
Microeconomics uses models to understand causal relationships.
• Causal: If A happens then B will happen
• If the glass falls on the concrete pavement it will break
• If prices go up, how will consumers react?
• An economic model describes an economic sitaution in a simplified way, to
focus on the main forces at play.
• ``Everything should be made as simple as possible, but not simpler.” Einstein

Good models lead to testable predictions that are usable.

• Testable and useful: If the price of a product rises, the quantity demanded of
that product will fall
• Testable but not useful: the quantity demanded of a product depends on
random changes in taste that occur randomly in time

A hypothesis is a prediction about cause and effect.

• Collect data and see if data support or refutes the model: for
example if the price of movie tickets increases, check if less people
go to the cinema.
• Recall your basic statistics:
• Can find evidence to refute the model: reject the null hypothesis
• Never prove that the model is correct: never accept the null, just fail to reject it
Maximizing subject to some
constraint
• If goods and time were not scarce we could trade-offs would not exist

• Given that scarcity does exist, we must make trade-offs

• We as consumers must choose what we want most given that we

have a fixed amount of wealth

• Producers must choose how much of a good to produce given the

desire of customers to pay for it and how much it cost to produce it

• The interplay of these agents maximizing their objectives results in

1. What is produced
2. How it is produced
3. How it is distributed
Models
• The world is a complex place!
• Models help make sense of it and provide guidance in answering
difficult questions:

• I’m launching a new product, a model can help you predict how consumers
will react to various price points
• In order to design a compensation package that will elicit top performance, a
model of incentive pay can help you design an optimal compensation
package
• As a government policy maker, I would like to understand the consequences
of imposing a minimum wage, or imposing import tariffs
• The world is facing unprecedented threats to the climate, how will firms
respond if pollution limits are lowered?
• In November of 2022, the newest version of ChatGPT was introduced. Many
argue that this technology replaces the skills of many knowledge works.
What will be the effect on wages? Firm profits?
Posititive : IS Normative: OUGHT
A positive statement is a testable hypothesis A normative statement specifies what should be

Minimum wages cause an increase in unemployment. All individuals deserve to make a living wage.

The (equilibrium) outcome of our emission reduction The outcome of our emission reduction scenario should
scenario will involve a high risk of catastrophic climate avoid catastrophic climate change. Indeed both the US
change. and China are better off this way than under the
equilibrium.

Positive economic models can be used to predict whether particular government

programs will benefit poor people but NOT whether the programs are good or bad.
The rest of today – birds eye view
• Supply and Demand (Chapters 2 & 3)
• Demand (2.1)
• Supply (2.2)
• Equilibrium (2.3)
• Shocking the equilibrium (2.4)
• Equilibrium effects of government interventions (2.5)
• When to use the Supply and Demand model (2.6)
• Shapes of the Supply and Demand curves (3.1)
• Elasticities (3.2 & 3.3)
• Effects of a sales tax (3.4)

The rest of course – zooming in

• Consumer Choice, 4 & 5 (Demand)
• Firms and Production, 6 & 7 (Supply)
• Competitive Firms and Markets, 8 & 9 (EQBM)
• Rest of course, relaxing some of the competitive market
assumptions
Demand: Determinants
• Potential consumers decide how much of a good or
service to buy given its price and many other factors

• You are having some friends over tonight. You go to the

super market to buy some wine. What will affect the price
you are willing to pay for a German Riesling (a type of
white wine)?

• Aside from price, factors that affect the demand for a

good include:
1. Tastes
2. Information
3. Prices of other goods: substitutes vs complements
4. Income: Normal vs inferior goods
5. Government actions
The Demand Curve

Quantity demanded
The amount of a good that consumers are willing to
buy at a given price, holding constant other factors
that influence purchases.

Willing to buy not necessarily the same as Does buy

Demand curve
Shows the quantity demanded at each possible
price, holding constant other factors that influence
purchases.
Figure 2.1 A Demand Curve
“Law” of Demand:
12 • consumers demand more of
a good the lower its price,
Coffee demand curve, D1
p, $ per lb

holding constant all other

factors that influence
6 consumption.
• In theory this need not be
the case, but large amount
4 of empirical evidence
support it
2 • As prices change, we move
ALONG the curve.

0 6 8 10 12
Q, Million tons of coffee per year
 Warning
• A confusing convention in economics is to plot prices on the y-axis
and quantities on the x-axis as the causal relationship runs from p to
q: p changing will lead to a change in q
• The Demand function by definition is written as Q=D(p)
• The Inverse Demand function is written as P=D-1(Q)
• Why is this confusing? If you want to calculate the slope of the blue
line below, you would calculate the slope of the inverse demand
function

12
p, $ per lb

6
4
2
0 6 8 10 12
Q, Million tons of coffee per year
Moving along vs. shifting the
demand curve
• Changes in prices cause movements along a given
Demand curve
• When we look graphically at the (inverse) demand curve,
we show the relationship between price and quantity
demand that is calculated assuming particular values for
all other determinants of demand (tastes, income, etc.)
• In the case of linear demand, the total value of all of the
these other determinants are captured in the intercept
value
• Anytime one of these variables or shifters (tastes,
income, etc) changes, the demand curve will shift
Figure 2.2 A Shift of the Demand
Curve
D2, average
income is $50,000
p, $ per pound

Effect of a $15,000
increase in average income

D1, average
income is $35,000
2

0 10 11.5
Q, Million tons of coffee per year
 The Demand Function (1 of 3)

• The coffee demand function is:

Q D  p, ps, Y 
• where Q is the quantity of coffee demanded (millions of tons
per year)
• p is the price of coffee (dollars per lb)
• ps is the price of sugar (dollars per lb)
• Y is the average annual household income in high-income
countries (thousands of dollars)
• There could be many other variables…
The Demand Function (2 of 3)
• The estimated world (linear) demand function
for green coffee beans:
Q = 8.56 - p - 0.3 ps + 0.1Y
• Use the values of ps = $0.20 per lb and Y = $35 thousands
per year, we have
Q 12  p

• The slope of any function =

• The slope of the demand function is =
• In the case of linear demand, shown in slope intercept
form this is direct (recall slope intercept form from high
school: y=mx+b)
• Here =
The Demand Function (3 of 3)
∆𝑝
𝑆𝑙𝑜𝑝𝑒 𝑜𝑓 𝑡h𝑒 𝑖𝑛𝑣𝑒𝑟𝑠𝑒 𝑑𝑒𝑚𝑎𝑛𝑑=
∆𝑄
12 In this case, ∆Q= −∆p”
Coffee demand curve, D1
p, $ per lb

0 6 8 10 12
Q, Million tons of coffee per year
Solved Problem 2.1

• How much would the price have to fall for consumers to be

willing to buy 1 million more tons of coffee per year?

• We just saw that =

• The problem tells us that =1

• Just plug it in:

•

• Prices must decrease by $1 per unit

 Summing Demand Curves
• In the prior example we look at a form a total demand. But where does that come
from?
• It comes from aggregating over many individual demands
• The total quantity demanded at a given price is the sum of the quantity each
consumer demands at that price.
• In the next example, we are calculating the aggregate demand from 2 agents, those
who want corn to feed their animals and those who want corn for human
consumption
Q Q1  Q2
D1  p   D 2  p 
• Pay attention to the details: where are the superscripts
and what do they mean?
Application: Aggregating
Corn Demand Curves

Notice that at prices above $27.56, there is no feed demand

Supply

Firms determine how much of a good to supply on the

basis of the price of that good and other factors. What
are a few such factors?

1. The costs of production

• Input costs
• Available technology
2. Government rules and regulations
The Supply Curve

• Quantity supplied – the amount of a good that firms

want to sell at a given price, holding constant other
factors that influence firms’ supply decisions, such as
costs and government actions.

Want to sell does not necessarily mean Does sell

• Supply curve – shows the quantity supplied at each

possible price, holding constant the other factors that
influence firms’ supply decisions.
Figure 2.3 A Supply Curve
p, $ per lb

Coffee supply curve, S1

0 10 11
Q, Million tons of coffee per year
Figure 2.4 A Shift of a Supply
Curve
p, $ per pound

S2, Cocoa S1, Cocoa

$6 per lb $3 per lb

Effect of a $3 increase
in the price of cocoa

0 9.4 10
Q, Million tons of coffee per year
 The Supply Function (1 of 2)

• The coffee supply function is:

Q S  p, pc 
• where Q is the quantity of coffee supplied (millions of tons
per year)
• p is the price of coffee (dollars per lb)
• pc is the price of cocoa (dollars per lb)
The Supply Function (2 of 2)

• The estimated coffee supply function is (Q measured in

millions of tons per year):
Q 9.6  0.5 p  0.2 pc
• Using the values pc = $3 per lb:

Q 9  0.5 p
• What happens to the quantity supplied if the price of
coffee increases by
p  p2  p1 ?
• Quanitity changes by . For a one dollar increase, quantity
demanded changes by half a million tons per year
Summing Supply Curves

• The total supply curve shows the total quantity

produced by all suppliers at each possible price.
• Horizontal sum of each producer’s supply curve.
• Sum of all quantities supplied at a given price.
Figure 2.5 Total Supply: The Sum
of Domestic and Foreign Supply
 Solved Problem 2.2:
How does a quota set by the United States on foreign sugar imports affect the total
American supply curve for sugar given the domestic supply curve (S d) in panel a of the
graph, and foreign supply curve (Sf), in panel B ?

Using panel (c), what can you say about the relationship between prices and total
quantity supply with and without quotas?
Market Equilibrium
• Equilibrium - a situation in which no one wants to
change his or her behavior.
• equilibrium price is the price at which consumers can buy
as much as they want and sellers can sell as much as they
want. This price is also called the market clearing price
• equilibrium quantity is the quantity bought and sold at
the equilibrium price.
Use a Graph to Determine the
Equilibrium
p, $ per lb

Market equilibrium, e
e
2

0 10.0
Q, Million tons of coffee per year
 Use Math to Determine the
Equilibrium
• Demand: Qd 12  p
• Supply: Qs 9  0.5 p
• Equilibrium:
Qd Qs
12  p 9  0.5 p
1.5 p 3
p $2
Q 12  2 10 or
Q = 9 + 0.5 × 2 = 10
 Forces that Drive the Market to
Equilibrium
• Disequilibrium - the quantity demanded is not equal to the
quantity supplied.
• Excess demand - the amount by which the quantity
demanded exceeds the quantity supplied at a specified
price.
• Excess supply - the amount by which the quantity supplied
is greater than the quantity demanded at a specified price.
Figure 2.6 Market Equilibrium
p, $ per lb

S
Excess supply = 1.5

3 Market equilibrium, e
e
2

1
Excess demand = 1.5

0 9 9.5 10.0 10.5 11.0

Q, Million tons of coffee per year
Shocking the Equilibrium

• The equilibrium changes only if a shock occurs that

shifts the demand curve or the supply curve.
• These curves shift if one of the variables we are holding
constant changes.
• If tastes, income, government policies, or costs of
production change, the demand curve or the supply
curve or both shift, and the equilibrium changes.
Figure 2.7 (a) Equilibrium Effects of
a Shift of a Demand or Supply
Curve
Figure 2.7 (b) Equilibrium Effects of
a Shift of a Demand or Supply
Curve
 Solved Problem 2.3
• Using algebra, determine how the equilibrium price and
quantity of coffee change from the initial levels, p = $2
and Q = 10, if the price of cocoa increases from its
original price of pc = $3 by $3 to $6 per lb.
 Solved Problem 2.3: Answer
(1 of 4)

1. Show how the demand and supply functions change

due to the increase in the price of cocoa.
The demand function remains unchanged: S
Qd 12  p
The new supply function:
Qs 9.6  0.5 p  0.2 6 
8.4  0.5 p
 Solved Problem 2.3: Answer
(2 of 4)

2. Equate the supply and demand functions to

determine the new equilibrium.
12  p 8.4  0.5 p
Solve this equation for the equilibrium price is p = $2.40,
then calculate the equilibrium quantity for substituting this
price into the demand or supply functions:

Q 12  2.4 8.4  0.5 2.40 

9.6 million tons per year
 Solved Problem 2.3: Answer
(3 of 4)

3. Show how the equilibrium price and quantity of coffee

changes by subtracting the original price and quantity
from the new ones.
The change in the equilibrium price is
p $2.40  $2 $0.40
The change in the equilibrium quantity is
Q 9.6  10  0.40 million tons per year
Solved Problem 2.3: Answer
(4 of 4)
 Effects of Government
Interventions
• Government actions can cause
• a shift in the supply curve, the demand curve, or both curves.
• the quantity demanded to differ from the quantity supplied.
• Policies that shift supply curves
• Licensing laws (restrictions on number of firms)
• Quotas (restriction on quantity)
• Policies that cause demand to differ from supply
• Price ceilings
• price floors
• Note the price controls, licenses and quotas can be used
on either side of the market. Above examples are just
based on the most commonly occurring.
Figure 2.8 A Ban on Rice Imports
Raises the Price in Japan
Binding vs Not Binding
• If a price ceiling is below the equilibrium price,
market forces will attempt to push the price upward
but will be thwarted by the price ceiling. In this case,
the price ceiling is binding.

• If the price ceiling is above the equilibrium price, it

has no effect (even if the price ceiling is below the
equilibrium price…). In this case, the price ceiling is
non-binding.

• The concept of “binding” applies to any policy that

had an effect, or, restricts/binds/inhibits the market
from achieving market clearing. Example of binding
policies:
• A minimum wage above the equilibrium price
• An import quota=0 imposed when goods are
imported
Solved Problem 2.4

• What is the effect of a United States quota on sugar on

the equilibrium in the U.S. sugar market? Hint: The
answer depends on whether the quota binds (is low
enough to affect the equilibrium).
Solved Problem 2.4: Answer
Figure 2.9 Price Ceiling on
Gasoline
When OPEC reduced supplies of oil

• After OPEC reduces supplies of oil, what level of Gasoline is actually sold?
• What determines who gets the gas?
 Solved Problem 2.5
Suppose everyone is paid the same wage in a labor market.
what happens to the equilibrium in this market if the
government imposing a binding minimum wage, w?

• Answer:
• Show the initial equilibrium before the minimum wage is
imposed.
• Draw a horizontal line at the minimum wage, and show
how the market equilibrium changes.
Solved Problem 2.5: Answer (2 of 2)
Why the Quantity Supplied Need
Not Equal the Quantity Demanded
• Common Confusion: Demand must equal supply
• The quantity that firms want to sell and the quantity
that consumers want to buy at a given price need not
equal the actual quantity that is bought and sold.
• Example: binding minimum wage, the last example.
When to Use the Supply-and-
Demand Model
• Everyone is a price taker.
Consumers and producers are small and there are many
of them. Rules out strategic behaviour
• Firms sell identical products.
For instance, no brand loyalty
• Everyone has full information about the price and quality of goods.
• Costs of trading are low.

If these assumptions are met, we call the market a perfectly

competitive market, and the supply and demand model makes sense
to use

We maintain these assumption through Chapter 9.

When to Use the Supply-and-Demand
Model
• Electricity?
• Baking potatoes?
• Used cars?
• Grocery store clerks?
• Movies?
• Nuclear Reactors?
Quantities and Prices of
Genetically Modified Foods
Finishing the chapter with the
opening quote:

“Talk is cheap because

supply exceeds demand”
Perloff, page 33
Chapter 3: Applying the
Supply and Demand Model
3.1 How Shapes of Supply and Demand Curves
Matter.
3.2 Sensitivity of the Quantity Demanded to Price.
3.3 Sensitivity of the Quantity Supplied to Price.
3.4 Effects of a Sales Tax.
Quantifying equilibrium shocks
How Shapes of Supply and
Demand Curves Matter
• The shapes of the supply and demand curves determine
by how much a shock affects the equilibrium price and
quantity.

• Example: avocado
• The supply of avocados depends on the price of avocados
and the price of fertilizer, a major input in producing
avocados.
Figure 3.1 How the Effect of a Supply
Shock Depends on the Shape of the
Demand Curve
A 55¢ increase in the price of fertilizer
shifts the avocado supply curve to the
left from S1 to S2
Sensitivity of Quantity
Demanded to Price
• Elasticity – the percentage change in a variable in
response to a given percentage change in another
variable.
• Price elasticity of demand (e) – the percentage change
in the quantity demanded in response to a given
percentage change in the price, at a particular point on
the demand curve.
 Price Elasticity of Demand (1 of 2)

• Formally,
Q
%Q Q Q p
  
%p p p Q
p
• where D indicates a change.
• Example
• If a 1% increase in price results in a 3% decrease in the
quantity demanded, the elasticity of demand is
 3%
e  3.
1%
 Price Elasticity of Demand (2 of 2)

• Along a linear demand curve with a function of:

Q a  bp
• Where −b is the ratio of the fall in quantity to the rise in price:

Q
b
p
• the elasticity of demand is
Q p p
  b
p Q Q
 Solved Problem 3.1
• The estimated demand curve for the U.S. corn is:
Q 15.6  0.5 p
• where Q is the quantity demanded in billion bushels per
year and p is the price in dollars per bushel.
• What is the elasticity of demand at the point on the demand
curve where the price is p = $7.20 per bushel?
 Solved Problem 3.1: Answer
• Substitute the slope coefficient b, the price, and the
quantity values into elasticity equation
• First need to get Q by plugging $7.20 into Q 15.6  0.5 p
• The slope coefficient for this demand equation is b = -0.5
• Substituting b = -0.5, p = $7.20, and Q = 12 into Equation
3.4, we find that the elasticity of demand at this point on
the demand curve is:

p 7.20
  b  0.5   0.3
Q 12
• A 1% increase in price leads to a -0.3% change
in quantity demand
 Elasticity Along the Demand
Curve
• The elasticity of demand varies along most demand
curves.
• The elasticity of demand is different at every point along
a downward-sloping linear demand curve.
• The elasticities are constant along horizontal and vertical
linear demand curves.
• The Constant Elasticity Demand function has the same
elasticity all along the curve, the horizontal and vertical
linear demand curves are just special cases of this type
of function
Figure 3.2 Elasticity Along the
Corn Demand Curve
With a linear demand curve, the higher
The price, the more elastic the
demand curve
 Horizontal Demand Curve
• Along a horizontal demand curve, elasticity is
infinite – perfectly elastic demand.
• People are willing to buy as much as firms sell
at any price less than or equal to p * .

• If the price increases even slightly above p*,

demand falls to zero.
• A small increase in price causes an infinite drop in
quantity demanded.
 Vertical Demand Curve
• Along a vertical demand curve, elasticity is zero – perfectly
inelastic demand.
• If the price goes up, the quantity demanded is unchanged.
• A demand curve is vertical for essential goods: goods that
people feel they must have and will pay anything to get.
Figure 3.3 Vertical and Horizontal
Demand Curves
 Estimated of the Elasticity of Demand assuming a
Constant Elasticity of Demand function

Constant
price
elasticity
of
demand:
examples

Look at the board to better understand Constant Elasticity of Demand

Demand Elasticity and Revenue

• Any shock that causes the equilibrium price to change

can affect the industry’s revenue.
• Whether the revenue rises or falls when the equilibrium
price increases depends on the elasticity of demand.
• With elastic demand, a higher price reduces revenue.
• With inelastic demand, a higher price increases revenue

Look at the board to better understand elasticity’s effect on total revenue

Figure 3.4(a) Effect of a Price
Change on Revenue
Figure 3.4(b) Effect of a Price
Change on Revenue
Solved Problem 3.2: Answer (2 of 2)
Application: Amazon Prime
What factors affect elasticity of
Demand?
1. Availability of substitutes
2. If the good is a luxury or a necessity
3. The proportion of income spent on the good
4. How much time has elapsed since the time the price
changed.
Demand Elasticities Over Time

• Demand elasticities may be different in the short-run

and the long-run.
• The difference depends on substitution and storage
opportunities.
• For most goods elasticities tend to be larger in the long-
run.
• For easily storable or durable goods, the reverse is true.
 Income Elasticity
• Formally,
Δ𝑄
% Δ𝑄 𝑄 Δ𝑄 𝑌
𝜉= = =
% Δ𝑌 Δ𝑌 Δ𝑌 𝑄
𝑌

• where Y stands for income.

• Example
• If a 1% increase in income results in a 3% increase in quantity
demanded, the income elasticity of demand is

3 %
𝜉= =3
1%
 Cross-Price Elasticity (1 of 2)

• Formally,
Q
%Q Q po
 Q 
%po po po Q
po
• where Po stands for price of another good.
• Example
• If a 1% increase in the price of a related good results in a 3%
decrease in quantity demanded, the cross-price elasticity of
demand is
 3%
  3.
1%
Cross-Price Elasticity (2 of 2)

Q
%Q Q po
 Q 
%po po po Q
po

Cross-price elasticity <0  complements

• Price of other good goes up
• Quantity demand of other good goes down
• If I like to consume these goods together, demand of primary good also goes down

Cross-price elasticity >0  substitutes

• Price of other good goes up
• Quantity demand of other good goes down
• To substitute for the reduced demand of the other good, my demand for the primary good
goes up
 Cross-Price Elasticity: Example
• Again, the estimated demand function for avocados is:

Q 104  40 p  20 pt  0.01Y

Question: what would be the cross-price elasticity between

the price of tomatoes and the quantity of avocados if Q =
80 and pt = $0.80?
 Elasticity of Supply (1 of 2)

• Formally,
Q
%Q Q Q p
  
%p p p Q
p
• where Q indicates quantity supplied.
• Example
• If a 1% increase in price results in a 2% increase in quantity
supplied, the elasticity of supply is
2%
 2.
1%
 Elasticity of Supply (2 of 2)

• Along a linear supply curve with a function of:

Q g  hp
• Where h is the slope or
Q
h
p
• the elasticity of supply is

Q p p
 h
p Q Q
 Elasticity of Supply: Example
• The estimated linear supply function for corn is:
Q 10.2  0.25 p
• where Q is the quantity of corn supplied in billion bushels
per year and p is the price of corn in dollars per bushel.
• If p = $7.20 and Q = 12, the elasticity of supply is:

Q P 7.20
 0.25  0.15
p Q 12
Figure 3.5 Elasticity Along the
Corn Supply Curve
Supply Elasticities Over Time

• Supply elasticities may differ in the short-run and the

long-run.
• The difference depends on the ability to convert fixed
inputs into variable inputs.
• Firms’ long-run supply elasticity is generally greater
than short-run elasticity.
Solved Problem 3.3
• What would be the effect of ANWR (Arctic National Wildlife
Refuge) production on the world price of oil given that
  0.25,  0.25,
• the pre-ANWR daily world production of oil is Q1 = 94
million barrels per day
• the pre-ANWR world price is p1 = $50 per barrel,
• and daily ANWR production would be 0.8 million barrels
per day?
• We assume that the supply and demand curves are
linear and that the introduction of ANWR oil would
cause a parallel shift in the world supply curve to the
right by 0.8 million barrels per day.
Solved Problem 3.3: Answer
Effects of a Sales Tax
1. What effect does a sales tax have on equilibrium prices and
quantity as well as on tax revenue?
2. Are the equilibrium price and quantity dependent on
whether the government collects a specific tax from the
suppliers or their customers?
3. Is it true, as many people claim, that producers pass along to
customers any taxes collected from producers? That is, do
consumers pay the entire tax?
4. Do comparable ad valorem and specific taxes have
equivalent effects on equilibrium prices and quantities and
on tax revenue?
 Two Types of Sales Taxes
• Ad valorem tax - for every dollar the consumer
spends, the government keeps a fraction,  ,
which is the ad valorem tax rate.
• Specific tax (or unit tax) - where a specified dollar
amount, t, is collected per unit of output.
Figure 3.6(a) Specific Tax
Collected from Producers
After tax price
paid by buyer

After tax price

received by seller
Figure 3.6(b) Specific Tax
Collected from Customers

After tax price paid

by consumers

After tax price

received by firms
Solved Problem 3.4
• Show mathematically the effects on the equilibrium
price and quantity of corn from a specific tax of t =
$2.40 collected from suppliers,

•
Solved Problem 3.4: Answer

1. Show how the tax shifts the supply curve.

2. Determine the after-tax equilibrium price by equating
the after-tax supply function and the original demand
function.
3. Determine the after-tax equilibrium quantity by
substituting the equilibrium price in either the
demand function or the after-tax supply function.
 Tax Incidences
• The government sets a new specific tax of t, it raises the
tax from 0 to t, so the change in the tax is
t t  0 t .
• The incidence of a tax on consumers is the share of
the tax that consumers pay.
p
• The incidence of the tax that falls on consumers is ,
t

the amount by which the price to consumers rises as a

fraction of the amount the tax increases.
Tax Effects Depend on Elasticities (1
of 2)

• The tax incidence on customers depends on the elasticities of

supply and demand.
• The price customers pay increases by (this is not obvious and I would
not ask you to prove it):
  
p   t
   
• If   0.3 and  0.15, a change of a tax of
t $2.40 causes the price buyers pay to rise by

   0.15
p   t  $2.40 80¢
    0.15  [  0.3]
Tax Effects Depend on Elasticities (2
of 2)

• The incidence of tax that consumers pay is

• Therefore, the incidence of the corn tax on consumers

is
0.15 1

0.15  [  0.3] 3

• The side of the market that is relatively most inelastic is

the side of the market that bears the larger share of the
tax
Solved Problem 3.5

• If the supply curve is perfectly elastic and demand curve

is downward sloping, what is the effect of a $1 specific
tax collected from producers on equilibrium price and
quantity, and what is the incidence on consumers?
Why?
Solved Problem 3.5: Answer

Infinitely elastic supply means the firm will not supply the good at any price
below p1  Entire tax passed on to the consumer. Some consumers drop
out given the higher price, hence the drop in EQBM quantity
Figure 3.7 Comparison of an Ad
Valorem and a Specific Tax
This should say D not
a

DV
Solved Problem 3.6

• If the short-run supply curve for fresh fruit is perfectly

inelastic and the demand curve is a downward-sloping
straight line, what is the effect of an ad valorem tax on
equilibrium price and quantity, and what is the
incidence on consumers? Why?
 Solved Problem 3.6: Answer

Perfectly inelastic supply means supply the same no matter the price (here because
fruit would spoil if not used) – hence firm absorb entire tax
Who Pays the Gasoline Tax?

In the Short Run, consumers pay the same amount before and after tax – firms
take the full brunt of the tax! Not so in the long run