Changing absolute prices ---Inflation

1. Changing absolute prices ---Inflation • What is inflation? • The absolute prices of all stuffs jump up. • Example: If there are only two goods, X and Y, in the economy. If the absolute prices of both goods increases by 5%, then • the inflation rate is 5%. • Do X’s and Y’s relative prices change?

2. Market • Demand • Supply • Equilibrium • Price • Quantity • Effects of sales tax on market equilibrium • Effects of subsidy on market equilibrium

3. Demand • Demand is a relation between price and quantity demanded. • expressed by a demand function or a demand curve. • Note that Quantity demand is just a number, not a function. • Demand is very different from quantity demanded.

4. Law of demand • When the price of a commodity goes up, people will buy less of it. • Demand for beef: Q = 100 - 2P • Law of demand: the slope of the demand curve is negative: Q/P = -2 <0 76 80 84 88 94

5. Change in Demand • Fall in demand: • A decision by consumers to buy a smaller quantity at each given price. • In other words, for each quantity, the tag price that the consumer is willing to take decreases. • the demand curve shifts downward. Mad Cow Crisis The tag price

6. Examples: • Mad cow effects • Tariff on beef • A $.10 sales tax on latté per cup (the city of Seattle, 2003 August)

7. A sales tax is the tax paid to the government by consumers ‘P’ is referred to as the tag price or pretax price. The effect of a sales tax on demand

8. Suppose the old demand function is: Q=7-10P Now the government charges a 10c/cup latte tax from buyers. Using demand functions • What’s the new demand function: • Q=7-10(P+0.1) Paid to sellers Given to govn’t

9. Suppose the old demand function is: Q=7-10P Now the government charges a 10c/cup latte subsidy from buyers. the demand curve shifts upward and the demand function becomes Q=7-10(P-0.1) Effect of subsidy on demand

10. Supply • Supply is a family numbers giving the quantities supplied at each possible price. • Supply is often expressed by a supply function or a supply curve. E.g. Q = 100 + 2P Remark: Quantity of supply is the amount of goods that firms will provide at a given price.

11. When the price of a good goes up, the quantity supplied goes up. Supply of beef: Q = 100 + 3P Law of supply: the slope of the supply curve is positive Q/P=3 >0 Law of supply 10 12 14 16 18

12. South Pacific cruise tours TsunamiA decrease in the number of tours that cruise companies would like to provide at any given price. Falls in supply Supply curve shifts to the left (I.e. shifts downward) Change in supply Tsunami

13. Example: Tsunami A $3000 lump-sum property tax whenever people sell their houses

14. An excise tax is a tax that paid to the government by producers. Recall that price (P) is referred to as the tag price (now the tag price is the post-tax price because the seller adds the excise tax into the sale price). The effect of excise tax on supply curve

15. Suppose the old supply function for latte is: Q= 100 P Now the government asks for 10 c latte tax per cup from sellers. Using supply functions • What’s the new supply function? • Q= 100(P-0.1)

16. Equilibrium • Equilibrium point is the point where the supply and demand curves intersect. • The equilibrium price and quantity are derived at the point where Quantity Demanded=Quantity of Supply • Remark • Equilibrium price always includes tax (or subsidy if any)

17. Derive the equilibrium price and quantity • Example The demand curve: Q = -200P+1000 The supply curve: Q = 800P What is the equilibrium price and quantity? P=1, Q=800

18. Applications Demand is Q= -300P+1000. Supply is: Q= 700P. • Suppose that an excise tax of $.05 /unit is imposed. What are the new demand and supply functions? What are the new equilibrium price and quantity? • Suppose that a $.05 sales tax is imposed. What are the new demand and supply functions? What are the new equilibrium price and quantity? Intuition: a sales tax and an excise tax have identical effects on equilibrium.

19. 1. Demand is Q= -300P+1000. Supply is: Q= 700P. Suppose that an excise tax of $.05 /unit is imposed. What are the new demand and supply functions? What are the new equilibrium price and quantity? Solution: The demand curve doesn’t change, while the new supply curve is Q = 700*(P-.05). To solve for equilibrium: Quantity demanded = Quantity of supply -300P +1000 = 700(P-.05) Equilibrium price: P = $1.035 Equilibrium quantity: Q = 700*(1.035-.05)=689.5.

20. 2. Demand is Q= -300P+1000. Supply is: Q= 700P. Suppose that an sales tax of $.05 /unit is imposed. What are the new demand and supply functions? What are the new equilibrium price and quantity? Solution: Quantity demanded = Quantity of supply -300(P+0.05) +1000 = 700P. Thus P=.985 Equilibrium price: .985+.05=$1.035 Equilibrium quantity: Q = 700*.985 =689.5.

21. The sales tax shifts down the demand curve by $.05. Equilibrium quantity falls (q-->q’). Equilibrium price rises from $1 to $1.035 --- by less than $.05. The effect of sales tax ($.05) on equilibrium S P E’ pd =1.035 E p =1 ps =.985 0.05 A D D’ q=700 q’=689.5 Q

22. Imposing an excise tax shifts down the demand curve by $.05. Equilibrium quantity falls. Equilibrium price rises from $1 to $1.035 ---- by less than $.05. The effect of excise tax ($.05) on equilibrium S’ S P 0.05 pd=1.035 E p =1 0.05 ps =.985 E’ D q’=689.5 q=700 Q

23. A Sales Tax vs. an Excise Tax: • The sales tax and the excise tax have an identical effect on equilibrium.