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Chapter 2

Supply and Demand
Talk is cheap because supply exceeds demand.
Chapter 2 Outline
2.1 Demand
2.2 Supply
2.3 Market Equilibrium
2.4 Shocking the Equilibrium: Comparative Statistics
2.5 Elasticities
2.6 Effects of a Sales Tax
2.7 Quantity Supplied Need Not Equal Quantity Demanded
2.8 When to Use the Supply-and-Demand Model
8 Main Topics
Demand
The quantity of a good or service that consumers
demand depends on price and other factors (eg.
income, prices of related goods)

Supply
The quantity of a good or service that firms supply
depends on price and other factors (eg. cost of
inputs that firms use to produce the good or
service)
8 Main Topics
Market Equilibrium
Interaction between consumers demand curve
and firms supply curve determines the market
price and quantity of a good or service that is
bought/sold

Shocking the Equilibrium: Comparative
Statics
Changes in a factor that affect demand (eg. a
persons income), supply (eg. rise in the price of
inputs), or a new government policy (eg. tax),
alter the market price and quantity of a good
8 Main Topics
Elasticities
Given estimates of summary statistics
(elasticities), economists can forecast the effects
of changes in taxes and other factors on market
price and quantity

Effects of a Sales Tax
How a sales tax increase affects the equilibrium
price and quantity of a good, and whether the tax
falls more heavily on consumers or on suppliers,
depend on the supply and demand curves
8 Main Topics
Quantity Supplied May Not Equal Quantity
Demanded
If the government regulates the prices in a market,
the quantity supplied might not equal the quantity
demanded (eg. rent control, minimum wage)

When to Use the Supply-and-Demand Model
The supply-and-demand model applies only to
competitive markets (eg. sales of pens)
2.1 Demand
2.1 Demand
What affects a persons demand for a good?
Price
Tastes
Information (or misinformation)
Prices of other goods
Substitutes
Complements
Income
Government rules/regulations
Other factors
2.1 Demand: Substitute Goods
If goods A and B are substitutes,
A can replace B
An increase (decrease) in the price of A
leftward (rightward) movement along the demand
curve of A demand curve for B to shift right
(left).
Positive cross elasticity of demand
Demand increases (decreases) when price of
other good is increased (decreased)
Perfect substitutes are identical products
2.1 Demand: Substitute Goods
Examples:
Margarine and butter
Tea and coffee
Milk and cream
AT&T and Verizon
Allstate and Geico
Car versus public transportation
Name brand versus store brand
2.1 Demand: Complement Goods
If goods A and B are complements,
They are demanded together.
An increase (decrease) in the price of A
leftward (rightward) movement along the demand
curve of A the demand curve for B to shift left
(right)
Less (more) of each good will be demanded
They have a negative cross elasticity of demand
Demand increases (decreases) when the price of
another good is decreased (increased).
Perfect complements good A must be consumed
with good B
2.1 Demand: Complement Goods
Examples:

Hot dogs and buns
Peanut butter and jelly
Printers and ink cartridges
DVD players and DVDs
Left footed and right footed shoes
The Law of Demand
Consumers demand more of a good the
lower its price, holding constant tastes, prices
of other goods, and other factors that might
influence how much they consume

The derivative of the demand function is
negative.
Example: Qd = 40 2p; Qd = -2
Inverse Demand
Given Q = 30 10p, determine the inverse demand
function.

Take the demand function and solve for price:

Inverse Demand
Given the following demand functions, find
their corresponding inverse demand
functions:
Q = 4 3p

Q = 10 2p

Q = 80 20p
Movement along the curve vs. shifting a
curve
A change in the price of a good causes a
movement along its demand (supply) curve.

A change in any other factor besides the
price of the good causes a shift of the
demand (supply) curve.

Shifting Curves
An upward demand shift occurs when
individuals are willing to purchase more
output at each price level (downward demand
shift is just the reverse)

An upward supply shift occurs when firms
are willing to produce less output at each
given price (downward supply shift is just the
reverse)
Upward Demand Shift
A new study shows that salmon has a very high
content of vitamin D and consumption of salmon is
essential to physical well being.
Upward Supply Shift
A wildfire burns throughout the rice farms in
India, which causes the world supply of rice
to drop.
Examples:
The demand curve for soda is given by QD = 6000 - 2y -
200p + 30pG, where QD is the quantity of soda
demanded, y is the per capita income and pG is the
price of Gatorade. An increase in per capita income will
cause what effect in demand?

As the price of a good increases, the change in the
quantity demanded can be shown by
A) shifting the demand curve leftward.
B) shifting the demand curve rightward.
C) moving down along the same demand curve.
D) moving up along the same demand curve.
Examples:
An increase in the demand curve for orange juice
would be illustrated as a
A) leftward shift of the demand curve.
B) rightward shift of the demand curve.
C) movement up along the demand curve.
D) movement down along the demand curve.

Examples:
If the price of cars were to decrease substantially, the
demand curve for gas would most likely
A) shift leftward.
B) shift rightward.
C) become flatter.
D) become steeper.

If the price of cars were to decrease substantially, the
demand curve for public transportation would most likely
A) shift leftward.
B) shift rightward.
C) remain unchanged.
D) remain unchanged while quantity demanded would
change.
2.1 Demand
The quantity of a good or service that consumers demand
depends on price and other factors such as consumers
incomes and the prices of related goods.
The demand function describes the mathematical
relationship between quantity demanded (Q
d
), price (p) and
other factors that influence purchases:

p = per unit price of the good or service
p
s
= per unit price of a substitute good
p
c
= per unit price of a complementary good
Y = consumers income

2.1 Demand
We often work with a linear demand function.
Example: estimated demand function for pork in Canada.

Q
d
= quantity of pork demanded (million kg per year)
p = price of pork (in Canadian dollars per kg)
p
b
= price of beef, a substitute good (in Canadian dollars
per kg)
p
c
= price of chicken, another substitute (in Canadian
dollars per kg)
Y = consumers income (in Canadian dollars per year)
Graphically, we can only depict the relationship between Q
d

and p, so we hold the other factors constant.
p
b
, p
c
, and Y to
simplify equation
p
b
= \$4/kg
p
c
= \$3.33/kg
Y = \$12.5 thousand

Changing the price of
pork simply moves us
along an existing
demand curve.

Changing one of the
things held constant
(e.g. p
b
, p
c
, and Y)
shifts the entire
demand curve.
p
b
to \$4.60 /kg

2.1 Demand Example
Suppose an individual inverse demand curve is
given as p = 3 qi, where qi is the quantity
demanded by individual i. There are 20 individual
consumers with this identical, individual inverse
demand curve. Solve for the market demand curve.

Solve for the individual, regular demand curve:

Multiply the individual demand curve by 20:

2.2 Supply
The quantity of a good or service that firms supply
depends on price and other factors such as the
cost of inputs that firms use to produce the good
or service.
The supply function describes the mathematical
relationship between quantity supplied (Q
s
), price
(p) and other factors that influence the number of
units offered for sale:

p = per unit price of the good or service
p
h
= per unit price of other production factors
2.2 Supply
We often work with a linear supply function.
Example: estimated supply function for pork in Canada.

Q
s
= quantity of pork supplied (million kg per year)
p = price of pork (in Canadian dollars per kg)
p
h
= price of hogs, an input (in Canadian dollars per kg)

Graphically, we can only depict the relationship between Q
s

and p, so we hold the other factors constant.
h
to simplify equation
p
h
= \$1.50/kg

40 =
dp
dQ
s
slope
dQ
dp
s
= =
40
1
Changing the price of
pork simply moves us
along an existing supply
curve.

Changing one of the
things held constant (e.g.
p
h
) shifts the entire supply
curve.
p
h
to \$1.75 /kg

2.2 Supply Example
Suppose the demand curve for a good shifts rightward,
causing the equilibrium price to increase. This increase in
the price of the good results in
A) a rightward shift of the supply curve.
B) an increase in quantity supplied.
C) a leftward shift of the supply curve.
D) a downward movement along the supply curve.

If the supply curve of a product changes so that sellers are
now willing to sell two additional units at any given price,
the supply curve will
A) shift leftward by two units.
B) shift rightward by two units.
C) shift vertically up by two units.
D) shift vertically down by two units.
2.2 Supply Example: Quotas
The U.S. government imposes a number of import quotas on dairy
products, including Swiss cheese. The domestic supply of Swiss
cheese is given by:
QDom = 60p - 240
The supply of Swiss cheese from foreign producers to the U.S.
(mostly from Switzerland, of course), is given by:
QFor = 100p - 400
In both equations above, Q is the quantity of cheese (100s of
lbs/month), and p is the price per pound.

a. Using the equations above, derive the total supply of cheese
equation to the U.S. in the absence of any quota.

b. Suppose that fears of neutral countries (like Switzerland)
spark the U.S. to restrict imports of Swiss cheese to Q = 200.
On a graph, draw (i) the domestic, (ii) foreign and (iii) total supply
with the quota.
2.2 Supply Example: Quotas
a. Determine total supply by adding domestic and
foreign supply (add quantities at any price):

b. To find the kink point, first find the price at which
the quota restricts the foreign supply:

2.2 Supply Example: Quotas
Equations:
Domestic
Solve for p
Foreign
No quota: solve for p
Quota: Q = _____
Total
No quota: solve for p
Quota: Determine kink point
Before kink: solve for p
After kink: Add domestic supply + quota amount; solve for p
2.2 Supply Example: Quotas
50 100 150 200 250 300 350 400
1
1
2
3
4
5
6
7
8
9
x
y
2.3 Market Equilibrium
The interaction between consumers demand curve
and firms supply curve determines the market price
and quantity of a good or service that is bought and
sold.
Mathematically, we find the price that equates the
quantity demanded, Q
d
, and the quantity supplied, Q
s
:
Given:
and , find p such that Q
d
= Q
s
:
p Q
d
20 286 = p Q
s
40 88 + =
p p 40 88 20 286 + =
p = \$3.30
2.3 Market Equilibrium
Graphically, market equilibrium occurs where the
demand and supply curves intersect.
- At any other
price, excess
supply or excess
demand results.

- Natural market
forces push
toward equilibrium
Q and p.
2.3 Market Equilibrium Example:
This figure shows a graph of the market for pizzas in
a large town.
At a price of \$12, there will be
At a price of \$6, there will be
A) no pizzas supplied.
B) equilibrium.
C) excess supply.
D) excess demand.

2.3 Market Equilibrium Example:
The figure shows a graph of the market for pizzas in a large
town. What are the equilibrium price and quantity?

At a price of \$7,
what is the amount
of excess demand?
A) 0; there is excess
supply at \$7.
B) 20 units
C) 30 units
D) 10 units
2.3 Market Equilibrium Example
Given the following demand and supply functions,
calculate the market equilibrium price and quantity:
p = 20 - .1Qd
p= 5 + .05Qs
2.4 Shocking the Equilibrium: Comparative
Statics
A method used to analyze how variables controlled by
consumers and firms (here: price/quantity) react to a
change in exogenous variables (eg. Prices of
substitutes, complements, income levels, prices of
inputs)
Changes in demand and supply factors can be analyzed
graphically and/or mathematically.
Graphical analysis should be familiar from intro micro
Mathematical analysis uses the demand and supply
functions to solve for a new market equilibrium.
Changes in demand and supply factors can be large or
small.
Small changes are analyzed with Calculus.
2.4 Shocking the Equilibrium: Comparative
Statics with Discrete (large) Changes
Graphically analyzing the effect of an increase in
the price of hogs

When an input gets
more expensive,
producers supply less
pork at every price.
2.4 Shocking the Equilibrium: Comparative
Statics with Discrete (large) Changes
Mathematically analyzing the effect of an increase
in the price of hogs
If p
h
increases by \$0.25, new p
h
= \$1.75 and
p Q
s
40 73 + =
55 . 3 \$
40 73 20 286
=
+ =
=
p
p p
Q Q
s d
( ) 215 55 . 3 20 286 = =
d
Q
( ) 215 55 . 3 40 73 = + =
s
Q
Why Shape of Demand Curve Matters
The shape of demand and supply curves influence
how much shifts in demand or supply affect
market equilibrium.
In the images below, we see how a \$0.25
increase in the price of hogs affects the
equilibrium in each case.
2.4 Comparative Statics Example:
This figure shows four different markets
with changes in either the supply curve or
the demand curve.

Which graph best illustrates the market for
in making computers occur?

Which graph best illustrates the market for
computer accessories after technological

Which graph best illustrates the market for
in making computers occur?
2.4 Comparative Statics Example:
Suppose a market were currently at equilibrium. A
rightward shift of the demand curve would cause
A) an increase in price but a decrease in quantity.
B) a decrease in price but an increase in quantity.
C) an increase in both price and quantity.
D) a decrease in both price and quantity.

Suppose a market were currently at equilibrium. A
rightward shift of the supply curve would cause a(n)
A) increase in price but a decrease in quantity.
B) decrease in price but an increase in quantity.
C) increase in both price and quantity.
D) decrease in both price and quantity.
2.4 Comparative Statics Example:
Suppose the demand for widgets is given by: Qd=100-
5p+pc+2Y, where Y is average consumer income, p is the price of a
widget, and pc is the price of a doodad. According to this equation, a
doodad is a _____________ for a widget.

2.4 Comparative Statics: Example
When two goods are substitutes, a shock that lowers the
price of one good causes the price of the other good to
A) remain unchanged.
B) decrease.
C) increase.
D) change in an unpredictable manner.

A drought in the Midwest will raise the price of wheat
because of a
A) leftward shift in the supply curve.
B) rightward shift in the supply curve.
C) leftward shift in the demand curve.
D) rightward shift in the demand curve.
2.4 Comparative Statics: Example
If chicken and turkey are substitutes, a decrease in the price of
A) decrease in the demand curve for chicken.
B) decrease in the quantity demanded of chicken.
C) decrease in the price of chicken.
D) All of the above.

The supply and demand for corn is given by QS=200+.6A+p
and QD=800-2p, where p is the price of wheat and A is the
amount of rainfall (inches per year). The effect of an
incremental increase in rainfall on equilibrium will be a(n)
Determine market equilibrium and solve for p:
2.4 Comparative Statics: Example
If the demand curve for a good is horizontal and the
price is positive, then a leftward shift of the supply
curve results in:

A vertical demand curve for a particular good implies
that consumers are
A) sensitive to changes in the price of that good.
B) not sensitive to changes in the price of that
good.
C) irrational.
D) not interested in that good.
2.4 Comparative Statics: Example
The supply and demand for wheat are given by
QS = 20 + 100p
QD = 4000 - 100p +10Y
where Y is the average consumer income.
Compute the partial derivative of quantity demand with respect to
changes in average consumer income.

Find the equilibrium price & quantity as functions of the consumer
income.

Compute the derivatives of the equilibrium price & quantity wrt income.

2.4 Comparative Statics Review
Demand shifts left:
Price of a substitute good drops
Price of a complement good increases
Income decreases

Demand shifts right:
Price of a substitute good increases
Price of a complement good drops
Income increases

2.4 Comparative Statics Review
Supply shifts left:
Price of a factor of production rises.
Price of alternative good rises (that can be
supplied with same resources)

Supply shifts right:
Price of a factor of production drops
Improvements in technology
2.5 Elasticities
Definition: The price elasticity of demand
( ) is the percentage change in quantity
demanded brought about by a percent
change in price:
P Q,
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2.5 Elasticities
The elasticity will be negative because the demand
curve has a negative slope.

What does this value mean?

: perfectly inelastic demand
: inelastic demand
: unitary elastic demand
: elastic demand
: perfectly elastic demand
=
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2.5 Elasticities
Elasticity indicates how responsive one variable is
to a change in another variable.
The price elasticity of demand measures how
sensitive the quantity demanded of a good, Q
d
, is
to changes in the price of that good, p.

If , then and elasticity can be
evaluated at any point on the demand curve.
bp a Q
d
=
2.5 Example: Elasticity of Demand
Previous pork demand was
Calculating price elasticity of demand at
equilibrium (p=\$3.30 and Q=220):

Interpretation:
Negative sign consistent with downward-
sloping demand
A 1% increase in the price of pork leads to a
0.3% decrease in quantity of pork demanded
p Q
d
20 286 =
2.5 Elasticity of Demand
Elasticity of demand varies along a linear demand
curve

Can price elasticity be constant?
Consider:

What is the price elasticity?

This is true in general for functions of this type.
b
aP Q

=
b
aP
abP
aP
P
abP
Q
P
abP
b
b
b
b b
P Q
= = = =

1
1 1 1
,
1
c
Constant-Elasticity Demand Curves
c
= aP Q
2.5 Elasticities
There are other common elasticities that are used
to gauge responsiveness.
Income elasticity of demand (ratio of the
percentage change of the quantity demanded
and the percent change in income)

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Y
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lim
/
/
%
%

2.5 Elasticities
Cross-price elasticity of demand (ratio of the
percentage change of the quantity demanded
of one good with respect to the percent change
in the price of another good)

Note: this number may be positive or negative
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2.5 Complements and Substitutes
Good i is a substitute for good j if

Two goods are perfect substitutes if the consumer
substitutes one good for another at a constant rate (linear
indifference curve)
Example: Coke and Pepsi
If the price of Pepsi increases, people might be more inclined to buy Coke
as a substitute

Good i is a complement of good j if

Two goods are perfect complements if they are consumed
together in fixed portions
Example: hotdogs and buns
If the price of hotdogs increases, people may be less inclined to buy buns.
0 <
c
c
j
i
P
Q
0 >
c
c
j
i
P
Q
Complements and Substitutes
Goods i and j are substitutes if both:

and

Goods i and j are complements if both:

and
0 0 >
c
c
>
c
c
i
j
j
i
P
Q
P
Q
0 0 <
c
c
<
c
c
i
j
j
i
P
Q
P
Q
Example:
Given the demand curve for i and j as below, are
the goods substitutes, complements, or neither?
j i j
j i i
dP cP Q
bP aP Q
+ =
=
j i j
j i i
P P Q
P P Q
2 5
3 4
=
+ =
2.5 Elasticities
Elasticity of supply (ratio of the percent change
in quantity supplied and the percentage
change in price)

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P
P
Q
P P
Q Q
P
Q
P 0
lim
/
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%
%
q
Constant-Elasticity Supply Curves
q
bP Q =
2.5 Elasticities Example
Given Q = 120 2p, determine the value at
which the demand is unitary elastic. At a
price of \$50, is the demand curve elastic or
inelastic?
2.5 Elasticities: Example
This figure shows an
inverse demand curve. If
the market price is \$10,
what is the price elasticity
of demand?
A) -1/32
B) -1
C) -1/4
D) -1/2
The demand curve has
unitary price elasticity
when price equals
A) \$1.
B) \$10.
C) \$15.
D) \$20.
20 40 60 80 100 120 140
5
5
10
15
20
25
30
35
x
y
2.5 Elasticities Example:
If the price of cars increases by 15%, and the
quantity demanded falls by 10%, what is the price
elasticity of demand?

If a consumer increases a quantity consumed by
50% when her income rises by 25%, then her
income elasticity of demand is:
A) 8.0.
B) 4.0.
C) 2.0.
D) .50.
2.5 Elasticities Example:
If the supply curve for orange juice is estimated to be Q =
60 + 3p, then
A) supply is price elastic at all prices.
B) supply is price inelastic at all prices.
C) supply is elastic only at prices below 20.
D) no general statements about price elasticity of supply

A given supply curve has a zero intercept. At the current
equilibrium price the price elasticity of supply equals
A) 1.
B) 0.
C) 2.
D) Not enough information.
2.5 Elasticities Example:
The price elasticity of demand is estimated to
be -1/5. A quantity of 50 is sold at a price of \$2.
Use this information to calculate a demand
curve assuming it is linear.

2.6 Effects of a Sales Tax
Two types of sales taxes:
Ad valorem tax is in percentage terms
Californias state tax rate is 8.25%, so a \$100
purchase generates \$8.25 in tax revenue
Specific (or unit) tax is in dollar terms
U.S. gasoline tax is \$0.18 per gallon
Ad valorem taxes are much more common.

The effect of a sales tax on equilibrium price and
quantity depends on elasticities of demand and
supply.
2.6 Equilibrium Effects of a Sales Tax
Consider the effect of a \$1.05 per unit (specific)
sales tax on the pork market that is collected from
pork producers.

2.6 Tax Incidence

Tax incidence on consumers, the amount by which
the price to consumers rises as a fraction of the
amount of the tax

Tax incidence on firms, the amount by which the
price paid to firms rises, is 1 dp/d
t
Example
If a products demand curve is perfectly
inelastic, and its supply curve is linear and
upward sloping, what effect does a \$1
specific tax collected from producers have on
the products equilibrium price and quantity?
What effect does the tax have on
consumers? Why?
Solution
1. Determine the equilibrium in the absence of
a tax.
2. Show how the tax shifts the supply curve and
determine the new equilibrium.
3. Compare the before and after tax equilibria.
Solution
1 2 3 4 5
1
2
3
x
y
Effects
Does it matter whether the tax is collected from producers or
consumers?
Tax incidence is not sensitive to who is actually taxed.
A tax collected from producers shifts the supply curve back.
A tax collected from consumers shifts the demand curve back.
Under either scenario, a tax-sized wedge opens up between
demand and supply and the incidence analysis is identical.

Does it matter whether the tax is a unit tax or an ad valorem tax?
If the ad valorem tax rate is chosen to match the per unit tax
divided by equilibrium price, the effects are the same.
2.6 Important Questions About Tax Effects
Does it matter whether the tax is a unit tax or an ad
valorem tax?
2.6 Effects of a Sales Tax Example:
Suppose the supply curve and the demand
curve both have unitary elasticity at all prices.
The price increase to consumers resulting from
a specific tax of \$3 imposed on sellers will be

Consumers will always pay the entire amount
of a specific tax whenever:
2.6 Effects of a Sales Tax Example:
For a given positively sloped supply curve,
the price increase to consumers resulting
from a specific tax imposed on sellers will be
A) greater the more price elastic demand is.
B) greater the less price elastic demand is.
C) equal to the entire tax when demand is
perfectly elastic.
D) equal to half of the tax whenever demand is
unit elastic.
2.6 Effects of a Sales Tax Example:
Suppose the demand curve for a good is downward
sloping and the supply curve is upward sloping. At the
market equilibrium, if demand is more elastic than supply
in absolute value, a \$1 specific tax will
A) raise the price to consumers by 50 cents.
B) raise the price to consumers by less than 50 cents.
C) raise the price to consumers by more than 50
cents.
D) raise the price to consumers by \$1.
2.6 Effects of a Sales Tax Example:
Suppose the market for grass seed can be expressed
as:
Demand: QD = 120 - 5p
Supply: QS = 3p
At the market equilibrium, calculate the price elasticities
of supply and demand. Use these numbers to predict the
change in price resulting from a specific tax.
If government imposes a \$8 specific tax to be collected
from sellers, what is the price consumers will pay?
How much tax revenue is collected?
What fraction is paid by sellers?

2.6 Effects of a Sales Tax Example:
Market Equilibrium:

The change in price resulting from a specific tax =

Tax of \$8

Thus, tax revenue =
2.7 Quantity Supplied Need Not Equal
Quantity Demanded
Price determines whether Q
s
= Q
d
A price ceiling legally limits the amount that can be charged
for a product.
Effective ceilings force the price below equilibrium price.
2.7 Quantity Supplied Need Not Equal
Quantity Demanded
Price determines whether Q
s
= Q
d
A price floor legally inflates the price of a product above
some level.
Effective floor forces the price above equilibrium price.
2.7 Quantity Supplied Need Not Equal
Quantity Demanded Example:
If a government-imposed price ceiling causes
the observed price in a market to be below
the equilibrium price,
A) there will be excess demand.
B) there will be excess supply.
C) the curves will shift to make a new equilibrium
at the regulated price.
D) None of the above.
2.7 Quantity Supplied Need Not Equal
Quantity Demanded Example:
Suppose the market for corn can be expressed as
follows:
Supply: QS = -60 + 20p
Demand: QD = 600 - 40p
If the government sets a maximum price of \$10 per
unit, what will be the quantity demanded and quantity
supplied?

2.8 When to Use the Supply-and-Demand Model
This model is appropriate in markets that are
perfectly competitive:
1. There are a large number of buyers and
sellers.
2. All firms produce identical products.
3. All market participants have full information