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Chapter 1 Supply, Demand and Equilibrium

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A basic diagramPrice perunit or $/unit orjust P

Quantity perunit of time orQ

A

B

C

origin

PA

QA

In this chapter we want to ultimately work with a diagram like the one here. The diagram will be our representation of a market for a product during a period of

time -like the market for cups of coffee per day.

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observation, theory

In the real world we could observe on a given day the price of a cup of coffee and see how many cups are sold. Point A in the diagram on the previous screen, for example, has QA being observed in combination with price PA.We have a theory that the observed combination represented by the point is a point where the supply and the demand for the product are equal - a notion that economists call an equilibrium point.

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changeWe know prices and quantities change over time - like from point A to point B - and we have a theory about this as well. We will see changes in P and /or Q result from changes in economic variables that cause supply and/or demand to shift.But the points we see in the diagram are points where supply and demand are equal - perhaps after shifts.

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exploreIn this chapter we want to explore1) concepts of demand,2) concepts of supply,3) the interaction of supply and demand - equilibrium, and4) the application of taxation in a market for a product.

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DemandDemand, in general, refers to how much of a product consumers want during a particular time period. The amount consumers want is influenced by1) the price of the product,2) the consumer desire or taste and preference for the product,3) the level of prices of other goods,4) the level of consumer income, and5) the level of sales taxes or subsidies.

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The law of demandThe law of demand is our summary statement about how the price of a product influences how much we want. The law is a statement that the price and quantity demanded are inversely related.In a later chapter we will see why economists think the law of demand holds true, but for now we will accept this notion.

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Change in demandIf any of the items from our list from 2 to 5 should change, then we say there is a change in demand. Economists treat items 2 through 5 differently than the price item. If the price should change we say there is a change in the quantity demanded.

The logic behind this difference is the desire to use graphs as an aid to economic understanding. The graphs used most often are of only two dimensions. Q and P are the two primary variables of interest. Other variables may be of interest and so a different term is used to indicate those situations.

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change in demand in a graphP

Q

P1

P2Q1 Q2

D1 D2

As a consumer if you think about items 2 through 5 in our earlier list, when you see those items as being stable you then have a certain demand for the product. In a graph this means you demand curve is located at a certain place. Let’s say yours is at D1.

If the price should fall from P1 to P2 the movement from Q1 to Q2 is called a change in the quantity demanded - we move along the curve. If an item from our list 2 to 5 should change(and we started at P1) the movement from Q1 to Q2 is called a change in demand - the curve shifts.

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A sales tax on consumersExcept for the sales tax, we will wait until chapter 4 to really work through our list of concepts that influence how much of a product you and I want to buy.P

QD1

P1

Q1

Say that at a certain time there is no sales tax on an item. Then if the price is P1, Q1 is the quantity demanded. We will consider a sales tax one where the consumer pays a tax directly to the government.

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A sales tax on consumersWith a sales tax not only does the consumer have to pay the merchant, but money must be sent to the government as well. The amount paid to the merchant is called the price of the product. The amount the customer ultimately takes out of their pocket for the product is the price plus the tax.Your first inclination, when I say the product now has a lump sum tax of 10 cents per unit on it, would be to say the demand curve should shift up by 10 cents - P is paid to the merchant and the tax is added on and paid to the government. Let’s look at how we really want to handle this situation.

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A sales tax on consumersWithout a sales tax the amount the consumer pays the merchant and the amount taken out of pocket are the same. What really matters to the consumer is how much is taken out of the pocket.Say P1=50 cents and Q1=2 cups of coffee per day. Then before a tax the consumer is willing to pay $1 per day for coffee.Now say a tax of 10 cents per cup is imposed on the consumer. But the consumer wants 2 cups of coffee when $1 comes out of the pocket. With this tax the only way this is going to happen is if the price per cup is now 40 cents.

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A sales tax on consumersThis doesn’t mean the seller will lower the price to 40 cents!!! It just means the consumer will not demand 2 cups unless the price is 40 cents per cup.Thus the demand curve shifts DOWN by the amount of the tax. In our analysis we like to draw the demand curve both before and after the tax.

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effect of sales tax on the demand curve

P

QD1D2

D1 = demand curve before taxD2 = demand curve after tax

Note1) If Pbt is the price before the tax the quantity demanded would be Q1.2) With the tax Q1 will only still be demanded if the price is Pat. Then the

Q1

Pbt = Pat +tax

Pat

consumer will still only have to take out of their pocket Pbt for Q1.

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SupplySupply, in general, refers to how much of a product sellers want to make available during a particular time period. This amount is influenced by1) the price of the product,2) the level of costs of inputs to production,3) the level of technology in production, and4) the level of an excise taxes.

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Law of supplyThe law of supply is the statement that the price and the quantity supplied are positively related.We will see about why this is the case later, but let’s just accept this statement for now.

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Change in supplyIf items 2 thru 4 in our list should change the supply curve will shift and we say there has been a change in supply. Note a decrease in supply is a leftward movement of the supply curve. The amount supplied is measured horizontally, i.e., rightward and leftward.P

Q

S2 S1

S2 represents a lower supply.

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excise taxAn excise tax is a tax on the seller of a product. We treat the tax as a cost of doing business. If there is no tax the seller will offer Q1 for sale when the price is P1. In other words the seller is indicating they need P1 to supply Q1.

Q

S1

P

P1

Q1

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excise taxIf a lump sum excise tax is imposed then the seller still needs to get P1 for their own efforts in order to supply Q1. This means the price in the market will have to be P1 plus the tax to supply Q1. Thus the supply curve shifts up by the amount of the tax.

Q

S1

P

P1

Q1

P2 = P1 + tax

S2

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Something seems weird about the sales tax and the excise tax when I compare the two. The sales tax is paid by the consumer. So prices on the demand curve WILL NOT include the sales tax because consumers know after they take the item they will also have to pay the tax to the government. But, consumers only want to pay a certain amount for a good or service, regardless of taxes or not.The excise tax is paid by the producer. So prices on the supply curve WILL include the excise tax because after the government gets the tax the suppliers still need to get the amount they want for the item sold.

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EquilibriumEquilibrium in a market is a situation where1) Buyers can buy all they want at the price considered and2) Sellers can sell all they want at the price considered.

If both situations do not occur there is a force for change in the market. Equilibrium is the absence of a force for change.

Equilibrium in a market occurs where supply and demand cross.

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EquilibriumP

D1 S1

P1

Q1

Any price above P1 is not equilibrium because sellers can only sell the amount buyers will buy and above P1 there is a surplus so sellers have a force for change - lower the price.

Qd QsAt the higher price the quantity supplied is greater than the quantity demanded and since you can only sell what buyers buy, Qs – Qd is a surplus.

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EquilibriumP

D1 S1

P1

Q1

Any price below P1 is not equilibrium because buyers can only buy the amount sellers will sell and below P1 there is a shortage. So, buyers have a force for change - raise or bid-up the price.

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Change in EquilibriumSteps to analysis1) start out at initial equilibrium,2) see a condition change - item 2 to 5 on demand and/or 2 to 4 on supply change,3) Shift the appropriate curve the appropriate direction,4) at initial price note if excess supply or demand results,5) move to the new equilibrium point, and6) compare the new equilibrium with the initial equilibrium.

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effect of sales tax on the market

P

Q

P2 + taxP1

P2

S1

D1D2

S1 = supply curveD1 = demand curve before taxD2 = demand curve after taxP1, Q1 = initial equil.P2, Q2 = new equil.

Note1) Q2 < Q1 - lower output2) P2 < P1 - lower market price3) Consumer pays P2 to the seller and pays a tax on each unit purchased to the government,the total paid per unit is P2 + tax.

Q2 Q1

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effect of sales tax on the market

4) Tax = P2 + tax - P1 + P1 - P2

Amount of increase in per unitpay out made by the consumer.

Amount of decrease in the per unit amountseller receives.

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effect of excise tax on the market

P

Q

P3P1

P3 - tax

S1

D1

S1 = supply curve before taxD1 = demand curve S2 = supply curve after taxP1, Q1 = initial equil.P3, Q2 = new equil.

Note1) Q2 < Q1 - lower output2) P3 > P1 - higher market price3) tax = P3 - P1 + P1 - P3 + tax = P3 – P1 + P1 – (P3 – tax)

Q2 Q1

S2

increase in amount paidby consumer on per unit basis

decrease in amount seller keeps after the tax, per unit

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Comparing excise and sales tax

P

Q

S1

D1

Q2 Q1

S2

D2

If the excise tax and the salestax are of the same amount,but only one is imposed,we would end up at Q2.

Pd is what consumers takeout of pocket, Ps is what sellers keep and Pd - Ps is the tax(all on a per unit basis).

Pd

Ps

The economic incidence of a marketplace tax is independent of its legal incidence. In other words, sales or excise taxes have the same real impact on the market.

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Hey you ever heard of a wedgie, or what is sometimes called a herman? Well, I am not going to talk about that now. I wanted to talk about a wedge. In our supply and demand graph we have seen that when a per unit tax is imposed on the buyer the demand shifts down by the amount of the tax and when a tax is imposed on the seller the supply shifts up by the amount of the tax.

This vertical line here is the amount of the tax. I have shown my right hand as well because I am going to push the line with my hand into a supply and demand graph on the next few slides and WEDGE the tax into the S & D curves. Here goes.

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Q

PS

D

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Q

PS

D

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Q

PS

D

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Q

PS

D

So, you can see by the graph, when we wedge the tax into the graph we can see either the demand shifts down by this amount or the supply shifts up by this amount. We end up at the same market quantity and our story is the same as before.