Business Economics MECO 6303

Fall 2014

Instructor: Alejandro Zentner

Business Economics

Lecture Notes

Demand, Supply, and Equilibrium. Engel Curves. Policy Applications:

Taxes, Subsidies.

Demand for Coffee

Law of demand: when the price goes up the quantity demanded

goes down

PriceQuantity

Demanded

20 cents a cup

5 cups/day

30 cents a cup

4 cups/day

40 cents a cup

2 cups/day

50 cents a cup

1 cups/day

The demand curve

0

10

20

30

40

50

60

0 1 2 3 4 5 6

Quantity

Pri

ce p

er c

up

Important to notice the difference between the demand function and the quantity demanded at each price.

PriceQuantity

DemandedQuantity

Demanded

20 cents a cup

5 cups/day 6 cups/day

30 cents a cup

4 cups/day 5 cups/day

40 cents a cup

2 cups/day 3 cups/day

50 cents a cup

1 cups/day 2 cups/day

Changes in DemandTwo consumers with different demand curves

Changes in the demand curve

D’D

D’’

Pric

e pe

r cu

p

Quantity

P

Q’’ Q Q’

Coffee and Tea: The price of tea increases

Coffee and Cream: The price of cream increases

Income changes: you win the lottery

Engel Curves

Qua

ntity

Income

Normal GoodInferior Good

Application: Demand for Crime

Number of Crimes Committed

Pro

babi

lity

of B

eing

Cau

ght

(per

crim

e co

mm

itted

)

DD’

D’’

P’

Q*

P*

Q**

Application: Job Market and Discrimination

Hours

Wag

e pe

r ho

ur

D

D’ (black)

(white)

Firms demand labor

Quiz

1- When the price goes up, do we expect to see a change in demand or a change in quantity demanded? Do we expect to see a movement along the demand curve or a shift of the demand curve itself?

2- How do you think the demand for fast food shift with an increase in income?

3- How does the demand for popcorn change with a decrease in the price of theater tickets?

4- How might an increase in the price of Big Macs affects the demand for Whoppers?

Market Demand

D1+D2D2

D1

Pric

e

Quantity

P

Q1 Q2 Q1+Q2

Q1

Elasticity of Demand

D2D1

Pric

e

Quantity

P

Q

P’

Q’1 Q’2

Why do we use the elasticity and not just the slope?

$

Cups per month

D

Cups per week

D’

Why do we use the elasticity and not just the slope?

$

Cups per month

D

D’

Euros

Elasticity

• To compare how responsive is the demand to a change in prices we use elasticities instead of slopes.

• Elasticity=Percentage change in quantity/Percentage change in price

• Elasticity= )/)(/()//()/( QPPQPPQQ

Elasticity of Demand

$

Cups per month

D

D’

Elasticity=0

Infinite Elasticity

Think about elasticities of parallel demands and linear demands

Supply of Coffee

Law of Supply: when the price goes up

the quantity supplied goes up

PriceQuantity Supplied

20 cents a cup

100 cups/day

30 cents a cup

300 cups/day

40 cents a cup

400 cups/day

50 cents a cup

500 cups/day

Supply curve

Pric

e

Quantity

P

Q

S

P’

Q’

S’’

S’

Q’’

Changes in costs or technology shift the supply curve

Reduction in price of an input

Elasticity

• Elasticity is a mathematical concept and can be applied to any function.

• Elasticity=

• Elasticity of supply=Percentage change in quantity divided by percentage change in price

• Elasticity of an Engel Curve=Percentage change in quantity divided by the percentage change in income (is a steep Engel curve elastic or inelastic?)

)/)(/()//()/( yxxyxxyy

Quiz

1- How do you think an innovation that reduces the cost of producing corn shift the supply of corn?

2- How might predicted bad weather affect the supply of corn?

Equilibrium

Pric

e

Quantity

P*

Q*

QD=QS

SD

P

QSQDQ’s Q’D

P’

Excess Supply

Excess Demand

Numerical problemThe demand curve for oranges is Q=500-50P and the supply curve for oranges is Q=800P+250. Compute the equilibrium price and quantities.

Numerical Example of EquilibriumQd=100–20pQs=20+20p

Two equations in two unknownsQd=Qs

100-20p=20+20p

80=40pp=2

Q=100-20*2=60=20+20*2{p=2; Q=60}

Equilibrium

D

0

1

2

3

4

5

6

0 10 20 30 40 50 60 70 80 90 100 110 120 130

Quantity

Pri

ce

DS

Qs=20+20p thenP=-1+Q/20

Qd=100–20p then P=100/20-Qd/20

Changes in Equilibrium QuantitiesMusic Market and File Sharing

Quantity of CDs

Pric

e of

a C

D

D

D’

S

QQ’

P

P’

Tax on ConsumersTotal Amount Consumers Pay=Consumers Pay to the Government

(tax)+Consumers Pay to the Firm

Quantity Total Amount

Consumers Pay

Consumers Pay to the

Government (tax)

Consumers Pay to the

Firm

Q* P* 5 cents Pf

P*=Pf+5cents

Q** P** 5 cents Pff

P**=Pff+5 cents

Policy Application

Tax on Consumers

Pric

e

Quantity

P*

D

Q*

D’P**

5 cents

Q**

Pf5 cents

Pff

Tax on Firms

Quantity Total Amount Firms

Receive from

Consumers

Firms Pay to the

Government (tax)

Net Amount Firms Keep

Q** Pcc 5 cents P**

Policy Application

Tax on Firms

Pric

e

Quantity

P**

Q**

S

5 centsPcc

S’

Policy Application

Tax on Suppliers Vs Tax on Consumers

Pric

e

Quantity

P*

SD

Q*

D’

S’

Q’

Pc

Pf

5 cents

Incidence on Firms and on Consumers

Pric

e

Quantity

P*

S

D

Q*

D’

Q’

Pc

Pf

5 cents

Incidence on Firms and on Consumers

Pric

e

Quantity

P*

S

D

Q*

D’

Q’

Pc

Pf

5 cents

Policy Application: Labor Market

Tax on Firms Vs Tax on Workers

Wag

e pe

r ho

ur

Hours

w*

SD

Q*

D’

S’

Q’

w firms

w worker5 cents

What fraction of the tax is paid by workers and employers, respectively?

A tax on labor

hd=100–20w

hs=20+20w

{hs=hd=60, w=2}

$1 tax an hour is imposed on employers

Compute the new equilibrium quantity, the wage the employer pays after the tax is imposed,

and the wage that workers receive.

Tax Imposed on Employers

hd=100–20w20w=100-hd

w=100/20-hd/20A tax of $1 an hourw=(100/20-hd/20)-1

w=(5-hd/20)-1w=4-hd/20

From the supply functionhs=20+20w

w=-1+(1/20)hs

Tax Imposed on Employers

4-h/20=-1+(1/20)h

5=h/20+h/20=(2h)/20100=2h

h=50

w=4-hd/20w=1.5

Employers pay 1.5+1Employees receive 1.5

Policy Application: A Subsidy

Pric

e pe

r un

it

Quantity

P*

D’

Q*

D

S

Q**

Pf

Pc

S’

Policy problems

• Should taxes be imposed on producers or on consumers?

• How is the demand curve for cars affected by a $100 sales tax on cars? How is the supply curve affected by a $100 tax on suppliers of cars?

• Subsidies: Show in a graph the effect of giving a subsidy of 5 cents per pound to orange farmers.

• Labor Market: Use a graph to show that it is equivalent to impose a tax on workers and on firms. What is more fair: a tax on workers or on firms?

Questions from Previous Exams

True/False• The price of gas went up and the quantity sold

went down, therefore the law of supply has been violated.

Multiple Choice• If the supply of oil falls and all other relevant

factors remain unchanged, then

a) the demand for oil will fallb) the quantity demanded for oil will fallc) the demand for oil will rised) the quantity demanded of oil will rise

• ____ 3. An increase in the price of corn will cause a rise in the supply of corn.

• ____ 4. If the price and quantity exchanged of a good simultaneously rise, then the law of demand has been violated.

• ____ 6. Suppose the price of a commodity is $15 per unit. At that price, consumers wish to purchase 6,000 units weekly and producers wish to sell 4,000 units weekly. In this situation,

• a.unsatisfied consumers will bid up the market price.• b.the market price will fall because producers are

unsatisfied.• c.the price will rise and the demand will fall to bring the

market to equilibrium.• d.supply will increase by 2,000 units in order to satisfy

consumers.

• 10. To make child daycare more affordable, government advisors are debating two possible options. Plan A is to give daycare centers a $100 subsidy per month per child. Plan B is to give the parents $100 reduction in taxes per month per child in daycare. Which plan benefits parents more?

• a.Plan A because it will increase the supply of childcare and decrease the price.

• b.Plan B because the $100 goes directly to the parents.• c.The plans are equivalent in terms of their impact on the

price minus subsidy paid by parents.• d.Plan A because the price will fall, while under Plan B

the price will rise.

• ____ 14. Comparing the elasticity of demand when the price is 12 and when the price is 4, when is the elasticity bigger?

• a.They are equal.• b.The elasticity is bigger when the price is 12.• c.The elasticity is bigger when the price is 8.• d.More information is needed to answer this question.

0

2

4

6

8

10

12

14

16

18

0 2 4 6 8 10 12 14 16 18

Cups of coffee per week

Pri

ce (

US

$)