ITE lecture no.3, October 4th 2004 Nancy Devlin
Introduction to Economics
Microeconomics
Topic 2 (continued) Analysing markets: supply and demand
lecture slides are available from:
The aim of this lecture is:
- To demonstrate the way in which ‘market forces’ operate to establish equilibrium.
- To show how linear Qs and Qd equations can be used to show equilibrium price and quantity.
Required reading for this topic:
Sloman Chapter 2, Sections 2.1-2.3
Key points from the last lecture…
- Qd = f(price, income, tastes, prices of other goods and services…)
- A change in price will move a consumer along their demand curve
- A change in any other variable will cause the demand curve to shift.
- Qs = f(price, costs of production, industry conditions…)
- A change in price will move the industry along their supply curve
- A change in any other variable will cause the supply curve to shift.
- In a private market, supply and demand interact to establish an equilibrium price i.e. where Qs = Qd
1a. Re-establishing equilibrium after a shift in the demand curve
1b. Re-establishing equilibrium after a shift in the supply curve
2. Linear demand and supply analysis
Linear demand and supply curves can be expressed as equations with an intercept and a slope.
Supply curve
QS = IS + SS*P
- QS is the amount of X supplied at price P
- IS is the intercept for the supply curve
- SS is the slope of the supply curve
- P is the price of X
ITE lecture no.3, October 4th 2004 Nancy Devlin
Linear demand and supply analysis
Example of linear supply curve:
QS = -20 + 2P
ITE lecture no.3, October 4th 2004 Nancy Devlin
Demand curve
QD = ID + SD*P
- QD is the amount of X demanded at price P
- ID is the intercept for the demand curve
- SD is the slope of the demand curve
- P is the price of X
ITE lecture no.3, October 4th 2004 Nancy Devlin
Linear demand and supply analysis
Example of linear demand curve:
QD = 220 - 4P
ITE Lecture 3, Monday October 4th 2004, Nancy Devlin.
3. Linear demand and supply analysis: equilibrium
Calculating the equilibrium point
QS = -20 + 2P
QD = 220 - 4P
In equilibrium, XS=XD, therefore
-20 +2 P=220 – 4P
6P=240
P=40
Substituting for P in the supply equation,
QS = -20 + (2*40) = 60
Substituting for P in the demand equation,
QD = 220 – (4*40) = 60
Giving the equilibrium position,
P = 40, and QS = QD = 60.
Linear demand and supply analysis: plotting demand and supply curves
The points marked are:
If QS = 0, P = 10
If QD=0, P = 55
If P = 0, QD = 220
If P = 40, Q = 60 (equilibrium)
Test your understanding:
For the following supply and demand equations, what is the equilibrium price?
Qs = -7 + 3P
Qd = 14 – 4P
(a)0.33
(b)1
(c)2
(d)2.5
(e)3
Answer: (e)
4. Putting theory into practice:
- Economists use data
(e.g time series, cross-sectional) to estimate demand and supply schedules (econometrics)
- these may be represented as linear or non-linear relationships, depending on the data.
What is the relevance of demand and supply analysis?
- Firms: interested in the factors determining demand as this affects their revenue
- Governments: essential to predict the effects of policies aimed at increasing or decreasing demand (e.g. subsidies, taxes)
5. Predicting the effect of a price ceiling
6. Predicting the effect of a sales tax
Note: if we do not get time to cover this in today’s lecture, we will do so in forthcoming lectures.
e.g. a tax on cigarettes
Incidence = who ‘bears’ the tax?
Total tax revenue = 80 x £1 = £80
- Tax paid by consumers = 80 x (£6 - £5.20) = £64
- Tax paid by suppliers = 80 x (£5 - £5.20) = £16
Note: the incidence of a tax depends on how ‘responsive’ demand and supply are to price.
In the diagram above, demand is ‘unresponsive’ to price [the demand curve is quite ‘steep’] so:
- Quantity demanded doesn’t change much
- The govt. earns a lot of revenue
- Consumers bear most of the tax burden
Test your understanding…
On a diagram, show the effects of a sales tax where the demand curve is flat and the supply curve is steep. Who bears the tax? Why?