4

Equilibrium and
Applications of the
Market Model
Equilibrium Prices and Market Transitions:

P
Surplus S Pe is the equilibrium price since it is
the price where every buyer can find
P1
a seller (or, at Pe the quantity
Pe supplied and the quantity demanded
in the market are equal).
Shortage
P2 D
Q
Q2 Q 1 Qe

At P1, the quantity demanded is less At P2, the quantity demanded

than the quantity supplied. Only the is more than the amount that
amount demanded will be sold and, producers are willing to supply
as a result, a surplus is created. at that price and, as a result, a
shortage arises.
Equilibrium Prices and Market Transitions:

Any shifts in the supply or demand curves (or both) create incentives for the market
equilibrium to adjust.

P
S For example, when demand shifts to the
B right, price and quantity demanded
transition along the supply curve from the
A
original equilibrium at point A to a new
D equilibrium at point B.
D This results in a higher equilibrium price
Q and quantity than before.
Equilibrium Prices and Market Transitions:

Markets take time to respond to price changes or to shifts in demand or supply curves. Lets
model how this transition works using an example
P S
Suppose a shift to the right of the
A
surplus S
supply curve.
B In the short run, this creates a
surplus
D In the longer term, price begins
Q
falling (and quantity rising according
to demand) creating movement
along the demand curve to point B.
Equilibrium Prices and Market Transitions:

The previous example is an illustration of transitional dynamics. In economics

we have two broad methods of analysis, dynamic and static.

Dynamic Analysis considers the transitional behavior of price and quantity as

the equilibrium point moves from point A to point B.

Comparative Static Analysis compares the equilibrium situations at point A

and point B under the assumption that the market transitions occur instantly.
Applications of the Market Model:

Unit Taxes:

Lets consider the tax incidence of a per unit sales tax

Suppose the government imposes a $3 sales tax per bottle of wine on
producers.
This tax will increase the cost of production for a bottle of wine by $3 per unit.
As a result, producers must add $3 to the price at each quantity supplied level
(see graph on next slide)
Applications of the Market Model:
P S
We can see that the $3 unit tax shifts the supply curve
S
$3 to the left. But how does this affect what consumers
P2 will pay for wine?
$3
The tax incidence refers to the manner in which the
P1
unit tax is borne (who pays what part of the burden)
Q between consumers and producers. To figure this out,
we need to consider consumer demand for wine.

P S
With this demand curve, the producers pay the
government $3 per bottle, yet the price that they are
11 S
able to extract from consumers in the new equilibrium
B
9.5 $3 at point B goes up by $1.50.
8 Thus, for this particular case, the tax burden is shared
A equally by consumers and producers (each incurs
$1.50 per bottle). We should notice that as the price
D increases, the equilibrium quantity falls.
Q
Applications of the Market Model:
How the tax burden is distributed will depend crucially on the elasticity of
demand and supply.
First, lets think about the consumers situation. Assume two cases where the
supply curves are identical but there are different demand curves (obviously,
with different demand elasticities).

P S P S
11 11
B S B S
10.90 $3 $3
8.25
8 8
A A D
D
Q Q
Demand Inelastic Demand Elastic

Not great for consumers! Pretty good for consumers!

Applications of the Market Model:

P S P S
11 11
B S B S
10.90 $3 $3
8.25
8 8
A A D
D
Q Q
Demand Inelastic Demand Elastic

Price goes up by nearly $3 Price goes up by less than half of

meaning that producers are
able to pass most of the tax
burden on to consumers in the
form of a price increase. We
will soon see that it pays for
consumers to have elastic
demand.
the tax meaning that producers
are able to pass on some small
portion of the tax through a price
increase but still must bear most
of the tax burden themselves.
Applications of the Market Model:
Next, lets think about the producers situation. Assume two cases where the demand curve
is identical but there are different supply curves (obviously, with different elasticities of
supply).
S
P S P
S
11 11
$3 10.21
B $3 S
B
8.35
8 A 8
A
D D
Q Q

Supply Inelastic Supply Elastic

Price goes up by less than half of the
tax meaning that producers cannot
pass much of the tax on to consumers
through a price increase. Producers
take most of the tax burden.
Price goes up by nearly the full amount of
the tax. By the same reasoning as in the
last slide, it pays for producers to have an
elastic supply curve since it allows them to
pass more of the burden to the consumer.
Applications of the Market Model:

By our reasoning so far, what is the worst case scenario for consumers? Can
the producer pass all of the tax burden on to the consumer through a price
increase?
P S
For the consumer, the worst demand
B
11 scenario is when the demand curve is
S perfectly inelastic. In the case where
$3
demand is perfectly inelastic, it does not
8 A matter what the supply elasticity isthe
producer can still pass on the entire burden
D
of the tax to the consumer through a price
Q
increase!

So far weve analyzed the imposition of a tax without considering how the third party in the
market is affected. Does anyone know the third party that Im talking about?

THE GOVERNMENT !!!!

Applications of the Market Model:
Government revenue (GR) is determined by the tax per unit () and the quantity at the new
equilibrium at point B.

P S
11
B $3 S
8.40
8
A D (Demand Elastic)
5.40
Q
Qafter tax Qbefore tax

is government revenue, where GR = Qafter tax

One of the reasons that governments prefer to levy this type of tax on commodities for which
demand is inelastic is easy to understand. If this demand curve became steeper then Q
would decrease by much less and the government revenue (the checkered area) would
become much larger.
To convince yourselves of this, draw the above diagram for an inelastic demand curve.
Applications of the Market Model:

To clarify, $8.40 is the price that consumers pay at the new equilibrium B. Since this is the
price that consumers pay, it follows that this is the price that producers receive in the market
(i.e. at the cash register).
P S
11
B $3 S
8.40
8
A D (Demand Elastic)
5.40
Q
Qafter tax Qbefore tax

is government revenue, where GR = Qafter tax

However, the producer must pay the per unit tax of $3 to the government for every unit sold
at the equilibrium B. So the producer effectively only keeps $5.40.

The government revenue is the $3 per unit tax for every unit up to Qafter tax. This is the area
between the S and S curves at the new equilibrium quantity.
Applications of the Market Model:

Unit Subsidies:

P Stax

S A per unit subsidy is simply the opposite of a

$3 Ssubsidy per unit tax. The subsidy shifts the supply
curve to the right since the producers costs
have fallen and they are now willing to supply
$3
more at any given price level.

As a good learning exercise, you might re-write the tax analysis (on the last few slides) within
the context of a subsidy instead of a tax. We will return to an application of this concept
later in the course
Now that we have the theoretical knowledge, lets put it to practical use by solving an
example of a unit tax on producers
Applications of the Market Model:

Solved Problem: Unit Tax on Suppliers:

The supply and demand of concert tickets are given by the following
equations:
QS = 3P
QD = 150 2P
a) Solve for the equilibrium price and quantity.

At equilibrium, we know that QS = QD. Since both of these equations are

functions of P, we can solve for the equilibrium price (P*) and substitute this
magical P* back into the supply and demand equations to find the equilibrium
quantity.
Applications of the Market Model:

3P = 150 2P
5P = 150
P* = 30

Sub P* = 30 into QS = 3P and into QD = 150 2P to obtain the Q*

QS = 3P QD = 150 2P
QS = 3(30) QD = 150 2(30)
Q* = 90 Q* = 90

b) Calculate the price elasticity of demand and supply at the equilibrium. Denote the price
elasticity of demand ed and the elasticity of supply as es.

Lets begin with the demand equation, QD = 150 2P and use the elasticity formula we
learned earlier.
Applications of the Market Model:

ed = QD P* Notice that the ( QD / P) term is simply the slope of the linear

P Q* demand curve (i.e. the coefficient on P in the equation) and weve
already solved P* and Q* above.

ed = - 2 30 ed = - 60 ed = - 2/3
90 90

Next, we deal with the supply equation, QS = 3P and use the elasticity formula we learned
earlier.

es = QS P* Notice that QS is simply the slope of the supply curve (i.e. the
P Q* coefficient on P in the equation) and weve already solved P* and Q*.

es = 3 30 es = 90 es = 1
90 90
Applications of the Market Model:

c) Use the elasticity figures from part b) and the following formula to calculate the increase in
price for consumers that results from a $5 per ticket tax on the producers of concert tickets.
Assume that there was no prior tax in place before this tax was levied (i.e. t = 5).

There is a useful formula to calculate the change in price due to a tax increase (or decrease)
that can be derived as:

Elasticity Formula Method

P = __es__ t
(es ed)
Applications of the Market Model:
P = __es__ t
(es ed) The increase in the price (burden to consumers) is $3 of
the $5 tax.
P = ____1____ 5 This means that the producer can pass $3 out of the $5 on
(1 (-2/3)) to consumers through a price increase. So the consumer
P = ___1___ 5 pays 60% of the tax burden as opposed to the producer
5/3 who only pays 40%.

P = (0.6) 5 This result stems from the fact that supply is more elastic
than demand and so producers will pay less than of the
P=3 tax.
Applications of the Market Model:
d) There is another way to find the price increase in part c) without the
formula. To use this method, we write the QD and QS equations in terms of P
and equate them. This Demand and Supply Method particularly useful
when you dont want to bother calculating the elasticities of supply and
demand.
Once we have done that, we will levy the tax on the producers additively in
the expression that includes QS. Then we will solve for the new Q* and P*
recognizing that the price difference between P*OLD and P*NEW is P.

Step 1: Get the supply and demand equations in terms of P

QD = 150 2P QS = 3P
2P = 150 QD P = 1/3 QS
P = 75 QD
Applications of the Market Model:

So, in the original equilibrium we have 75 QD = 1/3 QS

Step 2: Now, we levy the tax on producers by adding it to the RHS
75 QD = 1/3 QS + 5
70 = (1/2 + 1/3) QNEW
70 = 5/6 QNEW
QNEW = 84

Step 3: Now we can find the new equilibrium price (i.e. the after tax price) by subbing QNEW
into either 75 QD = P or P = 1/3 QS + 5.

P = 75 (84) OR P = 1/3 (84) + 5

P = 75 42 P = 28 + 5

PNEW = 33 PNEW = 33
Applications of the Market Model:
Recall from part a) that P* = 30 when no tax was levied, so
P = PNEW P*
P = 33 30
P=3
Which is exactly the same P as in part c) !!!!!!

So, of course, our analysis in part d) is exactly the same as it was in part c) only the
methodology has changed.

Exam Tip: You should be familiar with both methods of calculating tax incidence, since they
have different informational requirements (i.e. one uses elasticities and the other does not).
On a test, I could specify which method that I want you to present as an answerso you
should know and understand both the Elasticity Formula Method and the Demand and
Supply Method.
Lecture #4: Homework Questions

1. Draw (side-by-side) two graphs. In the left hand graph, represent the case of a very inelastic demand
curve. In the right hand graph, represent the case of a very elastic demand curve. Now draw identical
unit elastic supply curves in both graphs.

a) Show the effect of an identical unit tax on suppliers in each case.

b) Which case (inelastic or elastic) looks like it produces more government revenues? Can we tell
just by looking?

2. The supply and demand of concert tickets are given by the following equations:
QS = - 120 + 12P
QD = 2000 10P

a) Solve for the equilibrium price and quantity.

b) Calculate the price elasticity of demand and supply at the equilibrium.
c) Use the elasticity figures from part b) and the following formula to calculate the increase in price
for consumers that results from a $5 per ticket tax on the producers of concert tickets. Assume that
there was no prior tax in place before this tax was levied (i.e. t = 5).
P = __es__ t
(es ed)
Lecture #4: Homework Questions

d) There is another way to find the price increase in part c) without the formula. This method is
particularly useful when you dont want to bother calculating the elasticities of supply and
demand. To use this method, we write the QD and QS equations in terms of P and equate them.

Once we have done that, we will levy the tax on the producers additively in the expression that
includes QS. Then we will solve for the new Q* and P* recognizing that the price difference
between P*OLD and P*NEW is P.

3. The supply and demand of concert tickets are given by the following equations:
QS = 12P
QD = 1800 8P

a) Solve for the equilibrium price and quantity.

b) Calculate the price elasticity of demand and supply at the equilibrium.
c) Use the elasticity figures from part b) and the following formula to calculate the increase in price for
consumers that results from a $7 per ticket tax on the consumers of concert tickets. Assume that there
was no prior tax in place before this tax was levied (i.e. t = 7).
P = __es__ t
(es ed)
Lecture #4: Homework Questions

d) There is another way to find the price increase in part c) without the formula. This method is
particularly useful when you dont want to bother calculating the elasticities of supply and demand. To
use this method, we write the QD and QS equations in terms of P and equate them.

Once we have done that, we will levy the tax on the consumers (subtracting the tax in the expression
that includes QD. Then we will solve for the new Q* and P* and find P.