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 D
1
to D
2
. 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




P
2



P
1
Q
1
Q
2
Q
D
1
D
2
S
A shift in the supply curve (due to something other than own price)






The supply curve shifts out from S
1
to S
2
. 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






P
1

P
2
Q
1
Q
2
Q
D

S
2
S
1
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


P
1


P
2
Q
2
Q
1
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



P
2
P
3
P
1

Q
1
Q
2
Q
3
Q
D
1
S
LR
S
SR
D
2
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.

Q
D
= 12000 800P

The slopeof 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 Q
D
to the change in price, P. So for discrete changes the slope is Q
D
/
P

Note 1: we can evaluate the slope at a point rather than over an interval by
taking the derivative of the function Q
D
/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.

Q
D
= 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
P
P
Q
Q
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 P
1
it is the area of
the box formed by P
1
and Q
1
. As we move along the demand curve total
expenditure first rises, reaching a maximum at E =1, then falls.





P


P
1


P
2

Q
1
Q
2
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
xy
Q
P
P
Q
P
P
Q
Q
E
Note that: If E
xy
> 0 then y is a (gross) substitute for x
If E
xy
< 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
x x
x
xm
Q
m
m
Q
m
m
Q
Q
E

If E
xm
> 0 then x is a normal good

If E
xm
< 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

Q
x
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 P
C
and the price
received by producers, P
S
= P
C
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 P
C0
in order to induce them to
supply Q
0
. After the tax they require a price of P
C1
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 Q
0
* T; or the area of the box formed by P
C0
, P
C1
and Q
0
.








Q
0
Q

P
C





P
C1



P
C0
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:
P
C1
P
C0
< T

The price facing producers falls but by less than the amount of the tax:
(P
P1
P
P0
) = (P
C1
T P
C0
) < 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.








Q
1
Q
0
Q

P
C





P
C1



P
C0

P
C1
-T
S
S
T




Elastic supply; inelastic demand






















Inelastic supply; elastic demand






















T
Q
1
Q
0
Q

P
C





P
C1



P
C0

P
C1
-T
S
S
T
Q
1
Q
0
Q

P
C





P
C1

P
C0



P
C1
-T
S
S
Application 2: International Competition


Domestic demand for wheat: Q
D

= 200 P

Domestic supply of wheat: P = 20 + 2Q
S
(or Q
S
= 10 + P/2).

Initially imports are banned, so the equilibrium is where Q
D
= 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 P
W

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
























The world supply is the horizontal line S
W
. This is now the ruling price.

In the new equilibrium consumers now demand

Q
D
= 200 100 = 100

Producers supply Q
S
= 10 + 100/2 = 40.

Excess domestic demand Q
D
Q
S
= 60 is met by imports from abroad.

Note that if P
W
was higher than the domestic equilibrium price then this country
would become an exporter.

S
H
D
H
S
W
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 Q
D
Q
S


Tariff revenue is T (Q
D
Q
S
).

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









S
H
D
H
S
W
P





P
W
+T

P
W
Q
S
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 P
W
+ V. They increase output from Q
S
1
to Q
S
2
.

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

Consumers can still buy at the world price P
W
.

But the cost of the subsidy is Q
S
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?
S
H
1
D
H
S
W
P






P
W
+V

P
W
Q
S
1
Q
S
2
Q
D
Q
Subsidy cost

S
H
2