Recap

1. Recap Lecture 17 – academic year 2013/14 Introduction to Economics Fabio Landini

2. Micro

3. Market of cheese The market for cheese is characterized by the following demand and supply curve: Demand: QD= 9 – P Supply: QS= 3P – 3 where P represent the price (in Euro per Kg.) and Q represent the quantity (in Kg.).

4. Market of cheese 1) Compute the elasticity of demand with respect to price, for Δp=2 and assuming that p0 = 3. Formula for the elasticity of demand: ED(p) = – [Δ q / q0] / [Δ p / p0] = = – [(q1 – q0) / q0] / [(p1 – p0) / p0]

5. Market of cheese p0 = 3 ; p1 = p0+ Δp = 5 Given our demand function QD= 9 – P we can compute q0 and q1. In particular: p0 = 3 -> q0 = 6 p1 = 5 -> q1 = 4

6. Market of cheese Now we can apply the formula: ED(p) = – [Δ q / q0] / [Δ p / p0] = = – [(q1 – q0) / q0] / [(p1 – p0) / p0] = – [(4– 6) / 6] / [(5– 3) /3] = – [– 1 / 3] / [2 /3] =1/2 Final result: ED(p) = 1/2 High or low? Low…

7. Market of cheese 2) Draw the demand & supply graph and find the equilibrium price and quantity Price of cheese 9 S 5 D 1 12 9 Quantity of cheese

8. To find the equilibrium price and quantity we impose the equilibrium condition: QD = QS for QD = 9 – P and QS= 3P – 3 Therefore, 9 – P = 3P – 3, from which we get: P= 3 and Q = 6 Market of cheese 8

9. Market of cheese Graphically, Price of cheese 9 S 3 D 1 6 9 Quantity of cheese

10. Market of cheese 2) Suppose the EU imposes a minimum price equal to 5. i) What is the effect on the market? Show graphically and analytically. ii) Will the farmers agree with this intervention?

11. Market of cheese i) Graphically, Price of cheese 9 Excess supply S 5 3 D 1 QS 6 QD 9 Quantity of cheese

12. Market of cheese We can use the supply and demand function to compute the size of excess supply QD = 9 – P -> P=5 -> QD = 4 QS= 3P – 3 -> P=5 -> QS = 12 The size of excess supply is 12 – 4 = 8.

13. Market of cheese ii) To verify whether farmers agree with this intervention we compute the TR before and after the intervention Before: TR = P x Q = 3 x 6 = 18 After: TR = P x Q = 5 x 4 = 20 Yes, farmers will support the intervention.

14. Market of cheese 3) In order to avoid excess supply the EU decides to introduce a tax T on producers. Which is the value of T such that excess supply is avoided? • Show the effect of the tax graphically • Find the correct value of T

15. Market of cheese i) Graphically, Price of cheese S’ 9 S 5 3 D 1 12 6 4 9 Quantity of cheese

16. Market of cheese ii) To find the correct value of T we write our new supply function QD = 9 – P QS= 3(P-T) – 3 To eliminate excess supply we have to satisfy the equilibrium condition QD = QS when P=5.

17. Market of cheese Two steps: First, we impose the equilibrium condition QD = QS -> 9 – P = 3(P-T) – 3 Second, we replace P=5 and solve for T: 9 – 5 = 3(5-T) – 3 7 = 15 - 3T T = 8/3

18. Market of cheese 4) How is the tax burden shared ? Show it graphically and analytically

19. Market of cheese i) Graphically, Price of cheese Portion paid by consumers.. S’ 9 S 5 3 Portion paid by producers.. D 1 12 6 4 9 Quantity of cheese

20. Market of cheese The portion paid by consumers is simply the difference between the new equilibrium price and the equilibrium price before the intervention, i.e. 5 – 3 = 2 For producer is the difference between the old equilibrium price and the new price that they receive, i.e.: 3 – (5 – 8/3) = 3 – 7/3 = 2/3 Obviously, the sum of the two portion gives us the tax burden, i.e. 2 + 2/3 = 8/3

21. Market of cheese 5) Finally, evaluate the effect of the intervention in terms of allocative efficiency. Does the intervention improve social welfare? Show it graphically and analytically

22. Market of cheese i) Graphically, Price of cheese S’ 9 S 5 Consumer surplus 3 Producer surplus D 1 12 6 4 9 Quantity of cheese

23. Market of cheese i) Graphically, Price of cheese S’ 9 S Consumer surplus 5 Producer surplus 3 D 1 12 6 4 9 Quantity of cheese

24. Market of cheese Value of Consumer Surplus (CS) and Producer Surplus (PS) Before the intervention: CS = (6 x 6) /2 = 18 PS = (6 x 2) /2 = 6 -> Total = 18+6 = 24 After the intervention: CS = (4 x 4) /2 = 8 PS = {4 x [5 – (1+8/3)]} /2 = {4 x [5 – 11/3]} /2 = ={4 x 4/3} /2 = 8/3 -> Total = 6 + 8/3 = 26/3

25. Macro

26. Macroeconomic Equilibrium Consider an economy characterized by the following equations: • C = 1000 + 0,4YD • I = 1000 – 5.000i + 0,1Y • T = 1000 • G = 1200 • MS/P = 600 • MD = 0,2Y – 3.000i Find the equilibrium level of income and interest rate.

27. Macroeconomic Equilibrium The equilibrium condition in the goods market requires Y=Z: Y = C + I + G Y = 1.000 + 0,4YD + 1.000 – 5.000i + 0,1Y + 1.200 Y = 3.200 + 0,4(Y-1.000) – 5.000i + 0,1Y Y = 2.800 + 0,5Y – 5.000i 0,5 Y = 2.800 – 5.000i Y = 5.600 – 10.000i

28. Macroeconomic Equilibrium The equilibrium condition in the financial market requires MS/P = MD: 600 = 0,2Y – 3.000i 0,2Y = 600 + 3.000i Y = 3.000+ 15.000i

29. Macroeconomic Equilibrium Two equations with two unknowns: Y = 5.600 – 10.000i-> Goods Market Y = 3.000 + 15000i -> Financial Market We can solve the system of equation to find the value of Y and i that satisfy the equilibrium conditions in both markets.

30. Macroeconomic Equilibrium First we solve for i: 3.000 + 15000i = 5.600– 10.000i 25.000i = 2.600 i = 0,1 We substitute for i in one of the goods market equation: Y = 5.600 – 10.000 i Y = 5.600 – 10.000 x 0,1 Y = 4.600

31. Increase in public expenditure 2) Using the AS-AD investigate the consequences of a fiscal policy in which public expenditure are increased. Explain the effect in the short period, during the transition, and in the medium period.

32. Increase in public expenditure Increase in public expenditure( G ) Initially, let’s assume Y = Yn Then, government reduces G What are the short-period effects on equilibrium prices (P) and quantities (Y)? An what about the medium-period effects?

33. Expansive monetary policy AS -> P= PE(1+m) F( , z) - + AD -> + + -

34. G ->AD shifts rightward Equilibrium A->A’ -> Y (YA -> YA’) P (PA -> PA’) In A’ Y>Yn -> P>PE -> PE->the transition starts P AS A’ PA’ A PA AD’ AD Y YA’ Yn

35. PE ->AS shifts upward When Y=Yn the adjustment process stops P A’’ PA’’ AS PA’ A’ A PA AD Y YA’ Yn

36. During the transition -> Y and P • In the medium period -> YA’’ =Yn=YA and PA’’ >PA P A’’ PA’’ AS PA’ A’ A PA AD Y YA’ Yn

37. Reduction of public deficit Total effects of the intervention: • Short period -> Y P • Transition -> Y P • Medium period -> Y= P This is usually meant when it is argued that expansionary fiscal policy are inflationary in the medium period. This result however is obtained under fairly stringent assumptions. For instance, G does not affect Yn (think of public investments in scientific research)