c 2009 Jerey A.

Miron

Lecture 13: Equilibrium

Outline
1. Introduction
2. Supply
3. Market Equilibrium
4. Special Cases
5. Inverse Demand and Supply Curves
6. Comparative Statics
7. Taxes
8. The Incidence of a Tax
9. The Deadweight Loss from Taxation
10. Pareto E ciency

Introduction

So far, we have constructed individual demand curves by using information

about preferences, prices, and income. We have also seen that we can add
up these individual demand curves to get market demand curves
In this lecture, we use the market demand curves to determine the equilibrium market price. This will involve two core principles of economics:
optimization and equilibrium. Until now, we have only focused on optimization; we will apply this principle again when we examine rms. Before
moving on to that, however, it is useful to consider some aspects of equilibrium analysis.
To do so, we need to look briey at supply.

Supply

We have already seen examples of supply, such as consumers being net suppliers of the goods they own. We have also seen labor supply decisions. In
these examples, the supply curve measures how much the consumer is willing
to supply of a certain good at each possible market price.
This is in fact the denition of supply: for each p, we determine how
much of the good will be supplied, S(p). We derive this formally later. For
now we accept this intuitive denition to develop other insights.

Market Equilibrium

Suppose we have a number of consumers of a good. We can obtain a market

demand curve by adding up their individual demand curves.
Likewise, if we have a number of suppliers, we can obtain the market
supply curve by adding up their individual supply curves.
For now we assume all individual suppliers and demanders take prices as
given and determine their best response given those market prices. This is
known as a competitive market.
No individual agent can determine the
market price; rather, the actions of all agents together determine the market
price.
The equilibrium price is the price such that the supply of goods equals
the demand. Geometrically this is where the demand and supply curves
cross.
To state this more explicitly, let D(p) be the market demand curve and
S(p) be the market supply curve. Then the equilibrium price solves
D(p ) = S(p )
Why is this an equilibrium? An equilibrium is a situation where all agents
are doing the best they can and every agents actions are consistent with
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everyone elses actions. The price that solves the equation above satises
these conditions.
At any other price, by contrast, someone would have an
incentive to change behavior. If, for example, the price were greater than the
equilibrium price, the quantity demanded would be less than the quantity
supplied. The sellers would therefore have unsold inventories and want to
cut back on production.

Special Cases

Two special cases of market demand and supply curves deserve mention
because they arise frequently and are also useful for understanding more
general cases.
The rst special case is where supply is perfectly inelastic (totally unresponsive to price). In that case the supply curve is vertical, as in the graph
below, and changes in demand only aect price, not quantity:

Graph: Perfectly Inelastic Supply

10
9
8

6
5

p*

4
3
2
1
0
0

q*

10

The second special case is where supply is perfectly elastic (innitely

responsive to price). In that case the supply curve is horizontal, as in the
graph below, and changes in demand only aect quantity, not price:

Graph: Perfectly Elastic Supply

10
9
8

7
6
5

p*

4
3
2
1
0
0

q*

10

Note that we could also consider perfectly inelastic or perfectly elastic

demand curves.

Inverse Demand and Supply Curves

As discussed earlier in the context of an individual demand curve, we normally think of these as telling us the quantity demanded at a given price.
In many instances, however, it is more convenient to consider the inverse
individual demand curve as telling us the price at which the consumer will
demand a given quantity.
We can readily extend the concept of an inverse demand curve to a market
demand curve: it tells us the price at which the overall market will demand
a given quantity of a good.
These same concepts can be applied to supply curves. An individual
inverse supply curve tells us the price at which an individual supplier will
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supply a given number of units of a good. A market inverse supply curve

tells us the price at which the overall market will supply a given number of
units of a good.
Consider the following linear example, which appears frequently throughout the rest of the course. Assume
D(p) = a

bp

S(p) = c + dp
where D(p) tells us the number of units demanded by the market at price
p and S(p) tells us the number of units supplied by the market at price p.
The coe cients a, b, c, and d are parameters.
The equilibrium price is the one that equates the quantity demanded and
the quantity supplied:
D(p) = a

bp = c + dp = S(p)

and the solution is

a c
d+b

p =

Substituting this back into the demand or supply curve then yields the equilibrium quantity:
q =

ad + bc
b+d

We could instead have solved this using the inverse demand and supply
curves. To get these, write
q=a

bp

q = c + dp
and solve these for p to get
PD (p) = (a=b)

(1=b)q
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PS (p) = (c=d) + (1=d)q

We then set the two equations for price equal and solve for q. This expression
for q can then be inserted in either the inverse demand curve or the inverse
supply curve to get a solution for p.
The two solutions are the same as
those derived above using demand and supply curves themselves.

Comparative Statics

The key thing we want to do with the supply-demand framework is derive

comparative static results. This means we consider the eect of a change
in something other than price or quantity (e.g., consumer income or input
prices or taxes or other policies) and then determine how equilibrium price
and quantity change as the result of a change in the exogenous factor.
For example, consider the eect of drug prohibition on the equilibrium
price and quantity of drugs. Prohibition imposes penalties on consumers
for purchasing drugs (arrest, incarceration, nes), so this should shift the
demand curve inward. Prohibition also imposes costs on suppliers (paying
bribes, transporting goods in secret), and this shifts the supply curve up.
This means that drug prohibition should reduce the equilibrium quantity
consumed relative to a legal market and have an ambiguous eect on price,
as illustrated below:

Graph: Shifting Supply and Demand Curves

10
9

S'

8
7

D'

p*

5
4
3
2
1
0
0

q'

q*

10

Taxes

A key comparative static of interest is the eect of a tax on the equilibrium

price and quantity of the taxed good. We can think about imposing and
collecting this tax in two ways.
The rst imposes this tax on consumers, which means that everyone
who buys the good pays t dollars in addition to the price (the seller collects
this tax and passes it along to the government). The eect of imposing
the tax in this way is to shift the demand curve down by exactly t. The
explanation is that if consumers demand q units of the good at a price of p,
they should demand exactly the same number of units at a price of p t,
since once the tax is added in the eective price is till p. We can illustrate
this as follows:

Graph: Imposition of a Tax on Purchases of a Good

p(S)

10
9

p-d 7
p* 6
p-s 5
4

3
2

D'

1
0
0

q*

10

An alternative approach is to impose the tax on sellers of the good. This

means that every time a seller sells a unit at price p, the seller must send t
dollars to the government. This means the supply curve must shift up by
exactly p, since if sellers were originally willing to sell q units at price p, they
should now be willing to sell q units at a price of p + t (they net exactly p
after sending t to the government). We can illustrate this as follows:

Graph: Imposition of a Tax on the Sellers of a Good

p(D)

10
9

S'

p-d 7
p* 6
p-s 5
4

3
2
1
0
0

q*

10

Geometry tells us that these two approaches must yield the same result
for the equilibrium price and quantity under the tax. We can also see this
another way. We know that in equilibrium the price paid by the demander
and the price received by the seller must dier by exactly t, and the quantity
demanded must equal the quantity supplied.
We can nd this point by
inserting a line segment of length t in the diagram as shown below:

10

Graph: The Impact of a Tax

10
9

p-d 7
p-d - p-s = amount of tax

p-s 5
4

3
2
1
0
0

q*

10

Thus, we do not need to say anything about whether buyers or sellers

pay the tax. Indeed, a crucial point is that the side of the market that
pays the taxneed bear no relation to the side of the market that bears the
true economic burden of the tax.

The Incidence of a Tax

A crucial question for economic policy is determining who bears the burden
of a particular tax. The naive, non-economist view is that the person who
pays out the cash for the tax bears the burden of the tax, but this is incorrect.
As we have already seen, we get the same prices for demanders and suppliers
net of tax whether we impose the tax on the purchasers or sellers. Thus,
the true burden, or incidence, must depend on something else.
This something else is the elasticity of supply and demand. The side
of the market whose behavior is least responsive to price bears the greater

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burden of the tax.

cases.

To see this, it is useful to consider rst the extreme

Consider the case of perfectly elastic supply:

12

Graph: The Incidence of Taxation with Perfectly Elastic Supply

p(D)

10
9

t = vertical distance between S and S'

S'

p*+t 6
5

p* 4
3
2
1
0
0

10

If supply is perfectly elastic, the imposition of a tax raises the cost per
unit by t, and this shifts up the supply curve by exactly t. The price rises
by the full amount of the tax, so purchasers bear the entire burden.
Now, consider the extreme alternative, perfectly inelastic supply:

13

Graph: Incidence of Taxation with Inelastic Supply

p(D)

10
9
8

t = vertical distance
between p* and p*-t

6
5

p* 4
3

p*-t 2
1
0
0

10

If supply is perfectly inelastic, the imposition of tax has no eect on the

supply curve, so suppliers bear the entire burden of the tax.
If the supply curve is not perfectly elastic or perfectly inelastic, these
extreme results do not hold, but the general pattern is similar:

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Graph: Incidence of Taxation with Elastic Supply

p(D)

10
9

t = vertical distance between S and S'

p'

S'

6
5

p* 4

3
2
1
0
0

10

Graph: Incidence of Taxation with Elastic Supply

p(D)

10
9

t = vertical distance
between S and S'

S'

p'
p* 4
3
2
1
0
0

15

10

In the top graph, supply is almost perfectly elastic, and purchasers bear
most of the burden; in the bottom graph, supply is almost perfectly inelastic,
and sellers bear most of the burden.
We can conduct the analogous analysis for elastic versus inelastic demand
curves (do this for yourself as an exercise). If demand is inelastic, then
purchasers bear much of the burden of the tax. If demand is elastic, then
suppliers bear much of the burden of the tax.
Remember that none of these results about incidence depends on whether
we tax demanders or suppliers; the incidence depends only on which side
of the markets behavior is relatively elastic. In the general case, both
demanders and suppliers bear some burden; but the side whose behavior is
least responsive bears the greater share of the burden. This makes intuitive
sense; the side of the market that can most easily adjust its behavior in
response to a tax will bear the lowest costs of that tax.

The Deadweight Loss of a Tax

The last issue about taxation that we address is the welfare impact. The
diagram below shows the eect of a tax on consumer and producer surplus:

16

Graph: Deadweight Loss from Taxation

10
9

p-d 7

p-d - p-s = amount of tax

5
4

B+D = deadweight loss

p-s 3

2
1
0
0

q*

10

Before imposition of the tax, consumer surplus was the area below the
demand curve but above price, while producer surplus was the area above
the supply curve but below price.
After imposition of the tax, consumer surplus shrinks to the smaller triangle above pd and below the demand curve (remember that purchasers pay
the price inclusive of the tax, pd ).
Also, producer surplus shrinks to the area above the supply curve and
below ps (remember that suppliers collect pd from purchasers but only get to
keep this amount minus the tax, t; they send the amount t per unit to the
government).
The area A + C corresponds to the tax revenue collected and sent to the
government. This amount is not a loss; someone still gets to consume it.
The loss caused by the tax is the triangle corresponding to B + D. This
is lost consumer plus producer surplus. Over this range, consumers exist
who are willing to pay more for the good than it costs to produce it. If
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these consumers and suppliers could trade without having to pay the tax,
both groups would be better o.
This loss is known as the deadweight loss from taxation. It is also
known as a Harberger triangle, after a famous University of Chicago economist.

10

Pareto E ciency

An economic situation is Pareto e cient if there is no way to make any

person better o without hurting somebody else.
The competitive equilibria that we have been examining are Pareto e cient, as illustrated below:

18

Graph: The Pareto E ciency of Competition

p(D)

10
9

willing to buy at price p-d

willing to sell at price p-s

p-d 7
6

p-d=p-s
5
4

p-s 3

2
1
0
0

q*

10

At any output level below the equilibrium level, consumers exist whose
willingness to pay exceeds the costs of production, so this is not a pareto
e cient allocation. At the equilibrium, however, such a combination of
consumers and suppliers no longer exists.

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