University of Essex Session 2011/12

Department of Economics Autumn Term

EC111: INTRODUCTION TO ECONOMICS

Shifts in demand and supply

A shift in demand (due to something other than own price)

The demand curve shifts from D1 to D2. The equilibrium quantity increases (by

less then the demand shift) and the equilibrium price increases. It is a shift of the

demand curve and a movement along the supply curve.

What could cause the demand shift?

More buyers enter the market

An increase in income (perhaps a change in income distribution).

A change in consumer tastes.

An increase in the price of goods that are substitutes in consumption.

A fall in the price of goods that are complements in consumption.

P

P2

P1

Q1 Q2 Q

D1

D2

S

A shift in the supply curve (due to something other than own price)

The supply curve shifts out from S1 to S2. Equilibrium quantity increases and

equilibrium price falls. A shift of the supply curve and a shift along the demand

curve.

Note: these shifts do not have to be parallel

What could cause an outward supply shift?

More suppliers enter the market

A change (improvement in) production technology.

A fall in the price of factors of production.

P

P1

P2

Q1 Q2 Q

D

S2

S1

The identification problem

Often we just observe equilibrium combinations of price and quantity, not the

supply and demand schedules themselves.

Can we conclude from the diagram that the demand curve has shifted but not

the supply curve?

Only that demand has shifted to the left more than supply.

Example: the beef crisis led to leftward shifts in both supply and demand

In the real word ceteris paribus does not hold. If we want to identify the demand

curve we must allow for other things that shift both demand and supply.

P

P1

P2

Q2 Q1 Q

Time to adjust

Example: The pork market following the beef crisis.

Q: If pork and beef are substitutes why has the demand for pork shifted to the

right, given that the price of beef has fallen?

In the short run there is a big rise in prices but that induces more farmers to

switch to pork. The long run supply curve is flatter and so quantity rises by more

and price rises by less in the long run.

Demand curves may also be flatter in the long run. E.g an unexpected rise in the

price of oil may induce people to change heating systems and buy smaller cars.

Q: Is it important that the price change is unexpected?

P

P2

P3

P1

Q1 Q2 Q3 Q

D1

SLR

SSR

D2

Elasticity

Measuring the responsiveness of quantity to price.

The following equation relates the quantity of pork consumed in kilos to the

price in per kilo.

QD

= 12000 800P

The slope of the demand function is the change in demand for a one unit change

in price, which is 80. More generally the slope is the ratio of the change in quantity QD to the change in price, P. So for discrete changes the slope is QD/ P

Note 1: we can evaluate the slope at a point rather than over an interval by

taking the derivative of the function QD/P.

Note 2: The slope of the demand curve as drawn in the diagrams is 1/80 because we have the price on the vertical axis and the quantity on the horizontal

axis.

Suppose we write the demand curve in terms of tonnes but still measure the price

in per kilo. The demand curve is now.

QD

= 12 0.8P

This is the same demand function (check this), but the slope is different because

it depends on the units of measurement. This is especially a problem if we are

comparing different types of goods (cartons verses kilos, bales versus barrels)

To escape this problem we measure responsiveness by taking the proportionate

change in quantity divided by the proportionate change in price.

Q

P

P

Q

PP

QQ

E

Note that the elasticity is negative for a demand curve but we shall often talk

about the absolute value (i.e. irrespective of sign).

Own price elasticity of demand and total expenditure

The demand curve becomes less elastic as we move from left to right, passing

through the point of unit elasticity (E = 1), which is halfway along a linear

demand curve. Note that the slope is constant but the ratio P/Q is changing along

the demand curve.

Total expenditure of buyers in this market is P Q. At price P1 it is the area of

the box formed by P1 and Q1. As we move along the demand curve total

expenditure first rises, reaching a maximum at E =1, then falls.

P

P1

P2

Q1 Q2 Q

E =

E < 1 (inelastic)

E > 1 (elastic)

E = 1

E = 0

Total

Exp

Q

E = 1

Other elasticities.

Cross-price elasticity: the proportionate change in quantity of x in response to a

proportionate change in the price of y: x

y

y

x

y

y

x

x

xyQ

P

P

Q

P

P

QQ

E

Note that: If Exy > 0 then y is a (gross) substitute for x

If Exy < 0 then y and x are (gross) complements

Income elasticity of demand

The responsiveness of quantity demanded to changes in income, where m is

income:

x

xx

x

xmQ

m

m

Q

mm

QQ

E

If Exm > 0 then x is a normal good

If Exm < 0 then x is an inferior good

Note:

The relationship between income and demand for a good does not have to be monotonic.

It is drawn ceteris paribus: all other relevant influences are held constant.

Q: is the relationship as drawn always elastic, always inelastic or elastic over

some range and inelastic elsewhere?

Income, m

Qx

Application 1: The effect of a per unit tax

Suppose the government imposes a tax of T per unit of a good (it is per unit, not

ad valorem).

We must distinguish between the price paid by consumers PC and the price

received by producers, PS = PC T. If the vertical axis measures the consumer price then then imposing the tax shifts the supply curve upwards by the amount

of the tax T.

Note that:

Producers originally required a price of PC0 in order to induce them to supply Q0. After the tax they require a price of PC1 in order to receive the

same price net of tax.

If we had the producer price on the vertical axis then the imposition of the tax would have appeared as a downward shift in the demand curve.

This is exactly equivalent.

Notice that tax revenue is tax per unit times the number of units, in this case Q0 * T; or the area of the box formed by PC0, PC1 and Q0.

Q0 Q

PC

PC1

PC0

S

S

T

The incidence of the tax

In the new equilibrium the price to consumers rises and the quantity falls.

The burden of the tax is shared between producers and consumers.

The price facing producers rises but by less than the amount of the tax: PC1 PC0 < T

The price facing producers falls but by less than the amount of the tax: (PP1 PP0) = (PC1 T PC0) < T.

This does not depend on who actually remits the tax to the government.

The burden of the tax depends on the elasticities of demand and supply. The more elastic (the flatter) is the supply curve and the less elastic (the

steeper) is the demand curve, the more the burden of the tax falls on

consumers.

Note:

A subsidy is a negative tax. If the government placed a subsidy on a good,

then this would be equivalent to shifting the supply curve in the diagram

down by the amount of the subsidy.

Q1 Q0 Q

PC

PC1

PC0

PC1-T

S

S

T

Elastic supply; inelastic demand

Inelastic supply; elastic demand

T

Q1 Q0 Q

PC

PC1

PC0

PC1-T

S

S

T

Q1 Q0 Q

PC

PC1

PC0

PC1-T

S

S

Application 2: International Competition

Domestic demand for wheat: QD

= 200 P

Domestic supply of wheat: P = 20 + 2QS (or Q

S = 10 + P/2).

Initially imports are banned, so the equilibrium is where QD = Q

S

200 P = 10 + P/2; 210 = 1.5P ; P* = 140, Q* = 60

Now suppose the country opens to trade and the rest of the worlds supply curve of what is perfectly elastic. The country can import as much as it wishes to at the

world price PW = 100. [Q: why should that be? Is it a reasonable assumption?]

The world supply is the horizontal line SW

. This is now the ruling price.

In the new equilibrium consumers now demand QD = 200 100 = 100

Producers supply QS = 10 + 100/2 = 40.

Excess domestic demand QD QS = 60 is met by imports from abroad.

Note that if PW

was higher than the domestic equilibrium price then this country

would become an exporter.

SH

DH

SW

P

140

100

40 60 100 Q

Suppose the Government wishes to protect domestic agriculture

Policy 1: A Tariff

Imports are taxed an amount T per unit

Here producers are protected by the tariff on imports; the price to them rises by

the full amount of the tariff; their income increases

The incidence of the tariff falls entirely on consumers. Q: why is this?

Domestic production increases and imports decrease to the new level of QD QS

Tariff revenue is T (QD QS).

So the government gains revenue, producers gain from protection but consumers

lose.

SH

DH

SW

P

PW

+T

PW

QS Q

D Q

Tariff Revenue

Policy 2: A subsidy to producers

Producers are given a subsidy of V per unit, which raises the effective price they

receive to PW

+ V. They increase output from QS

1 to QS

2.

Imports fall by the amount of the increase in domestic output.

Consumers can still buy at the world price PW

.

But the cost of the subsidy is QS

2 V. If this has to be finance from other taxes

then it ultimately falls on the consumer.

Example

The EUs Common Agricultural Policy (CAP) has involved both tariffs and subsidies on specific agricultural products.

The CAP absorbs 40 percent of the EU budget, which must be financed by taxes.

Producers gain and consumers lose so it has distributional consequences.

Economists argue against it because it is distortionary; the loss to consumers

outweighs the gain to producers.

Q: How do we know this?

SH

1

DH

SW

P

PW

+V

PW

QS

1 QS

2 QD Q

Subsidy cost

SH

2