Linear Equations

Reading List
• Basic Mathematics for Economists by Mike
Rosser, 2003, Routledge, Chapter 5
Demand OPTIONAL
1. Demand is the relationship between various prices and the quantities
consumers are willing and able to buy during some time period. The
demand curve is a picture of demand.
2. In general, people get less satisfaction (what economists call “utility”)
from additional units of a good or service. This is due to the “law of
diminishing marginal utility.” As people get more of something, they
value an additional unit less and less. (This does not violate the Pig
Principle because total satisfaction rises as society gets more.)
3. Price is the amount of money buyers actually must pay for a good or
service.
4. Buyers will buy units of a good or service as long as the amount of
satisfaction the buyer gains from the purchase is greater than the
price they must pay for the good. They will not buy when the
opposite is true.
5. The demand curve reflects the law of demand: As the price of a good
or service decreases, buyers buy more of it; as the price of a good or
service increases, buyers buy less of it.
Supply OPTIONAL

1. Cost is defined as what is given up (i.e., opportunity cost).

2. Cost is not a single-number concept (units of a good or service will have different
costs).
3. In general, the cost society incurs from additional units of a good rises because
more of other goods or services must be given up (rising opportunity cost).
4. The cost curve shows the additional cost society incurs from each individual unit of
the good or service (reading vertically up and then over).
5. Supply shows how sellers react to various prices of a good or service.
6. Sellers will produce units of a good or service when the cost of production for one
more unit is less than the price they are able to charge for that unit. They will not
produce when the opposite is true. The cost curve reads horizontally over and
then down. It shows the amount sellers would produce and offer for sale at
various prices and, thus, is also the supply curve for the good.
7. The supply curve reflects the law of supply: As the price of a good or service
decreases, sellers produce less of it; as the price of a good or service increases,
sellers produce more of it.
 OPTIONAL

Market Equilibrium

1. Price is determined in a market by the interaction of buyers and sellers

(buyers trying to pay the lowest possible price and sellers trying to sell
at the highest possible price).
2. When there are surpluses in a market, sellers and/or buyers will have an
incentive to push the price down, moving the price to where the
quantity demanded equals the quantity supplied.
3. When there are shortages in a market, sellers and/or buyers will have an
incentive to push the price up, moving the price to where the quantity
demanded equals the quantity supplied.
4. Price is a single-number concept—all units are sold at the equilibrium
price.
 OPTIONAL

Market Equilibrium
5. Market equilibrium answers two of the fundamental questions raised
earlier:
a. The allocation question: How much of each good should be produced?
The market answers with the equilibrium quantity.
b. The distribution question: Who receives the produced goods and
services? The market answers by allowing everyone who is willing and
able to pay the equilibrium price or more to purchase goods and
services.
6. The market equilibrium quantity is the quantity of a good found to be
allocatively efficient. The market demand curve accurately depicts society’s
willingness to pay, and the market supply curve accurately depicts society’s
costs. If markets determine price, as shown earlier, markets can produce
the allocatively efficient amounts of all goods and services, thus using
society’s scarce resources efficiently. Those are big “ifs,” however (which
are explored further in Session 6, which address market failures).
 OPTIONAL

Market Equilibrium, con’t

7. Price is not a measure of demand or a measure of supply; it is a
measure of the relative scarcity of the good (its desirability relative to
its availability). It takes both demand and supply to determine price.
(For example, although the demand for air is great, the price of air is
zero because of its abundance—that is, at a price of zero, the quantity
of air supplied is greater than the quantity demanded.)
8. Several factors can cause an increase or decrease in demand—that is, a
shift of the demand curve to the right or left:
a. changes in consumer tastes/preferences,
b. changes in consumer income/wealth,
c. changes in the prices of related goods,
d. changes in consumer expectations, and
e. changes in the number of buyers.
 OPTIONAL
Market Equilibrium, con’t
9. Several factors can cause an increase or decrease in supply—that is, a
shift of the supply curve to the right or left:
1. changes in productivity/technology,
2. changes in resource prices,
3. changes in government policies,
4. changes in expectations, and
5. changes in the number of sellers.
10. A change in demand or supply leads to a surplus or shortage at the
initial price, which causes the price to change and the market to move
to the new equilibrium price and quantity.
11. Price changes in one market often lead to price changes in other
related markets because of goods that are substitutes or complements
for one another or because one good is an input in the production of
another.
 OPTIONAL
Steps in Market Equilibrium Change

1. An event occurs that changes the demand for or supply of

a given good or service.
2. Demand and/or supply shift(s) in response to the above
change.
3. A surplus or shortage occurs at the old equilibrium price.
4. The price moves: It increases if there is a shortage; it
decreases if there is a surplus.
5. The new equilibrium price and quantity are established at
the intersection of the new demand or supply curve and
the original demand or supply curve.
 OPTIONAL

Shifts in Supply and Demand

Causes of Shifts (Changes) in Demand
1. Consumer tastes/preferences (changes in a person’s willingness to
pay)
2. Consumer income/wealth (changes in a person’s ability to pay)
3. Prices of related goods (changes in the prices of substitute goods
or complementary goods)
4. Consumer expectations about the future
5. The number of buyers
Causes of Shifts (Changes) in Supply
1. Productivity/technology (resource savings in how the good is
produced)
2. Prices of resources used (resource prices are directly related to
costs)
3. Government policies (changes in taxes or subsidies)
4. Producer expectations about the future
5. The number of sellers
Excess Demand
• Excess demand, or
shortage, is the condition
that exists when quantity
demanded exceeds
quantity supplied at the
current price.

• When quantity demanded

exceeds quantity supplied,
price tends to rise until
equilibrium is restored.
Excess Supply

• Excess supply, or surplus, is

the condition that exists
when quantity supplied
exceeds quantity demanded
at the current price.

• When quantity supplied

exceeds quantity demanded,
price tends to fall until
equilibrium is restored.
 Changes in Equilibrium (IRDL)

• Increase in demand leads to • Increase in supply leads to

higher equilibrium price and lower equilibrium price and
higher equilibrium quantity. higher equilibrium quantity.
 Changes in Equilibrium (IRDL)

• Decrease in demand demand • Decrease in supply leads to

leads to lower price and lower higher price and lower
quantity exchanged. quantity exchanged.
 The Link Between Resource
and Product Markets
• Markets for resources and products are closely
linked.
– In the resource market, businesses demand resources,
while households supply them.
• Firms demand resources in order to produce
goods and services.
• Households supply them to earn income.
–The labour market is an important resource
market.
 The Link Between Resource
and Product Markets
• An increase in the demand for a product will lead to
an increase in demand for the resources used to
produce it.
– In contrast, a reduction in the demand for a product will
lead to a reduction in the demand for resources
used to produce it.
• An increase in the price of a resource will increase the
cost of producing products that use it, shifting their
supply curve to the left.
– A reduction in resource prices will have the opposite affect.
 Resource Prices Price
(wage)
S2
Resources
Market

and Product Markets S1

$10

• Suppose there is a reduction in the

$8
supply of young workers that pushes
restaurant waiters/waitress wages up.
• Higher wages increase the restaurant’s DR
cost, causing a reduction in supply in the Employment
E2 E1 (wait staff)
product market leading to higher meal
prices. Price
Product
S2 Market

S1
$12

$11

DP
Quantity
Q2 Q1 (of meals)
 Price Ceilings
• A price ceiling establishes a maximum price that sellers are legally
permitted to charge.
– Example: rent control
• When a price ceiling keeps the price of a good below market
equilibrium, there will be both direct and indirect effects.
– (Direct effect) Shortage: the quantity demanded will
exceed the quantity supplied. Waiting lines may develop.
– (Indirect effects) Quality deterioration and changes in other
non-price factors favorable to sellers and unfavorable to
buyers are likely to occur.
• The quantity exchanged will fall and the gains from trade will be
less than if the good were allocated by markets.
 Impact of a Price Ceiling
•Consider the rental housing market Price Rental housing
(rent) market
where the price (rent) P0 would S
bring the quantity of rental units
demanded into balance with the
quantity supplied.
•A price ceiling like P1 imposes a price
below market equilibrium causing P0
quantity demanded QD to exceed
quantity supplied QS resulting in a
shortage.
•Because prices are not allowed to Price
P1 ceiling
direct the market to equilibrium, non-
price factors will become more Shortage
important in determining where the D
scarce goods go. Quantity of
QS QD housing units
 Effects of Rent Control
• Shortages and black markets will develop.
• The future supply of housing will decline.
• The quality of housing will deteriorate.
• Non-price methods of rationing will increase in
importance (discrimination)
• Inefficient use of housing will result.
• Long-term renters will benefit at the expense of
newcomers.
 Price Floor
• A price floor establishes a minimum legal price for the
good or service.
– Example: minimum wage
• When a price floor keeps the price of a good above market
equilibrium, it will lead to both direct and indirect effects.
– (Direct effect) Surplus: sellers will want to supply a larger
quantity than buyers are willing to purchase.
– (Indirect effects) Changes in non-price factors favorable
to buyers and unfavorable to sellers.
– The quantity exchanged will fall and the gains from trade
will be less than if the good were allocated by markets.
 Impact of a Price Floor
Price
•A price floor like P1 imposes a S
Surplus
price above market equilibrium
causing quantity supplied Qs to P1 Price
floor
exceed quantity demanded QD
resulting in a surplus.
P0
•Because prices are not allowed to
direct the market to equilibrium,
non-price factors will become
more important in the allocation
of the good.
D
Quantity
QD QS
 Minimum Wage:
An Example of a Price Floor
• When the minimum wage is set above the market
equilibrium for low-skill labour, the following will
occur:
– Direct effect:
• Reduces employment of low-skilled labour.
– Indirect effects:
• Reduction in the non-wage components of
compensation (pension contribution)
• Less on-the-job training
• May encourage students to drop out of school
 Employment and the Minimum Wage
Price Low-skill
•Consider the market for (wage) labor market
low-skill labor where a price
(wage) of $7 could bring the S
Excess Supply
quantity of labor demanded Minimum
into balance with the quantity $10.00 wage level
supplied.
•A minimum wage (price floor) $7.00
of $10 would increase the
wages of low-skill labor, but
employment will decline from
E0 to E1.
•Those who lose their jobs
D
will be pushed into either Quantity
unemployment or less E1 E0 (low-skill
employment)
preferred employment.
 Economics of the Minimum Wage
• The basic postulate of economics indicates that a
higher minimum wage will reduce the employment
of low-skill workers.
– Research indicates that each 10 percent increase in the
minimum wage will reduce employment by between 1 and
2 percent.
– Because the wage increases are substantially larger than
the reductions in employment, a higher minimum wage
will nearly always increase the total earnings of low-skill
workers.
– Proponents of minimum wages believe that the higher
total earnings are worth the reductions in employment.
 Tax Incidence
• The legal assignment of who pays a tax is called
the statutory incidence.
– The actual burden of a tax (actual incidence) may
differ substantially.
• The actual burden does not depend on who legally
pays the tax (statutory incidence).
 Impact of a Tax Imposed on Sellers
• Consider the used car market where Price
a price of $7,000 would bring the S plus tax
quantity of used cars demanded into
balance with the quantity supplied. S
• When a $1,000 tax is imposed on
the sellers of used cars, the supply
curve shifts vertically upward by the $7,400
amount of the tax.
• The new price for used cars is $7,000 $1,000 tax
$7,400, sellers netting $6,400
($7,400 - $1000 tax).
$6,400
• Consumers end up paying $7,400
instead of $7,000 and bear $400 D
of the tax burden.
• Sellers end up receiving $6,400 # of used cars
500 750 per month
(after taxes) instead of $7000 (in thousands)
and bear $600 of the tax burden.
 Impact of a Tax Imposed on Sellers
•The new quantity of used cars that
clear the market is 500,000. Price
•Consumers bear $400 of the tax S plus tax
burden and, as there are 500,000 Tax revenue
from consumers S
units sold per month, tax revenues
derived from consumers (cross-
hatched red area) = $200,000,000.
•Sellers bear $600 of the tax burden $7,400
and so, as there are 500,000 units
sold per month, tax revenues derived Deadweight
$7,000 Loss due to
from the sellers (cross-hatched blue reduced trades
area) = $300,000,000.
•As only 500,000 cars are sold after the $6,400
tax (instead of 750,000), the yellow
area above the old supply curve and Tax revenue
below the demand curve represents from sellers D
the consumer and producer surplus
lost from the levying of the tax, called # of used cars
500 750 per month
the deadweight loss to society. (in thousands)
 Impact of a Tax Imposed on Buyers
•Suppose the $1,000 tax was levied
on buyers rather than the sellers. Price
•When a $1,000 tax is imposed on
buyers of used cars, the demand S
curve shifts vertically downward
by the amount of the tax.
•The new price for used cars is $7,400
$6,400.
•Buyers then pay taxes of $1,000 $7,000 $1,000 tax
making the after tax price $7,400.
•Consumers end up paying $7,400 $6,400
(after taxes) instead of $7,000 and
bear $400 of the tax burden. D
D minus tax
•Sellers end up receiving $6,400
instead of $7,000 and bear $600 # of used cars
500 750 per month
of the tax burden. (in thousands)
 Impact of a Tax Imposed on Buyers
•The new quantity of used cars
that clears the market is 500,000.
Price
•Consumers bear $400 of the tax
burden and, as there are 500,000 Tax revenue
units sold per month, tax revenues from consumers S
derived from consumers (cross-
hatched red area) = $200,000,000.
•Sellers bear $600 of the tax burden
and, as there are 500,000 units sold $7,400
per month, tax revenues derived Deadweight
from the sellers (cross-hatched blue $7,000 Loss due to
reduced trades
area) = $300,000,000.
•The yellow area above the supply Tax revenue
curve and below the old demand $6,400 from sellers
curve represents consumer &
producer surplus lost due to the tax D
– the deadweight loss to society.
D minus tax
•The incidence of the tax is the same
# of used cars
500 750 per month
regardless of whether it is imposed (in thousands)
on buyers or sellers.
 Impact of a
•For the consumers the area of the
Tax Imposed on Buyers
triangle is
•(Base*height)/2
Price
•Base=7400-7000=400
Tax revenue
•Height 750-500-250 from consumers S
•So for consumers is:
•(Base*height)/2=(400*250)/2=50000
•For the producers will be: $7,400
•Base=7000-6400=600 Deadweight
$7,000 Loss due to
•Height 750-500-250 reduced trades
•So for consumers is:
Tax revenue
•(Base*height)/2=(600*250)/2=75000 $6,400 from sellers
•So the deadweight cost= D
•Consumer burden+ producer
D minus tax
burden=50000+75000=125000 # of used cars
500 750 per month
•Alternatively (in thousands)

•(t*250)/2=125000
 Deadweight Loss
• The deadweight loss of taxation is the loss of the
gains from trade as a result of the imposition of a
tax.
– It imposes a burden of taxation over and above the
burden of transferring revenues to the government.
– It is composed of losses to both buyers and sellers.
– The deadweight loss of taxation is sometimes referred
to as the “excess burden of the tax.”
 Elasticity and Incidence of a Tax
• The actual burden of a tax depends on the
elasticity
of supply relative to demand.
– As supply becomes more inelastic, more of the burden
will fall on sellers and resource suppliers.
– As demand becomes more inelastic, more of the
burden will fall on buyers.
Test Yourself, Exercise 5.2 Question 2
• A competitive market has the demand
schedule p = 610 − 3q and the supply schedule
p = 50 + 4q where p is measured in pounds.
• (a) Find the equilibrium values of p and q.
• (b) What will happen to these values if the
government imposes a tax of £14 per unit on
q?
• (c) What is the government revenue from the
taxation?
(a)
• 610 − 3q= 50 + 4q
• 7q=560
• q=80
• Substitute for the equilibrium quantity in demand
function
• p= 610 − 3q=610-3*80=610-240=370
• And then in the supply function
• p= 50 + 4q=50+4*80=50+320=370
• When the tax is imposed to producers-sellers the supply function
shifts by 14 and it will become:
• p = 50 + 4q+14
• p=64+4q
• The demand function remains the same. The new equilibrium point
will be:
• 610 − 3q =64+4q
• 7q=610-64
• 7q=546
• q=78
• Then we substitute in both demand and supply functions to find the
price in the new equilibrium point.
• p = 610 − 3q=610-3*78=610-234=376
• p = 64 + 4q=64+4*78=64+312=376

• So, the price increases from 370 to 376 and the quantity reduces
from 80 to 78
• p = 610 − 3q
• p = 50 + 4q
• Take the inverse functions
• Demand
• p = 610 − 3q
• 3q=610-p
• q=610/3-(1/3)p
• Supply
• p = 50 + 4q
• 4q=-50+p
• q=-50/4+(1/4)p
• The supply function after tax will become
• q=-50/4+(1/4)(p-14)
• q=-50/4+1/4p-14/4
• q=-64/4+1/4p
• The new supply function is:
• q=-64/4+1/4p
• And the demand function remains the same:
• q=610/3-(1/3)p
• 610/3-(1/3)p=-64/4+1/4p
• We multiply with 12 to eliminate the denominators
since 3 and 4 are common to 12
• (12*610)/3- (12/3)p= =-(64*12)/4+12/4p
• 2440-4p=-192+3p
• 7p=2632
• p=376 which is the same as before
• Substitute to the demand function
• Qd=610/3-(1/3)p =610/3-(1/3)*376
• Qd=(610-376)/3=234/3=78
• Qs=-64/4+1/4p= =-64/4+(1/4)*376=-16+94=78
• (c)
• The government revenue is
• Revenue=tax*Quantity in the new equilibrium
point
• Revenue=14*78=1092