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Recap Lecture 27 – academic year 2013/14 Introduction to Economics Fabio Landini

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Micro

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

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Market of cheese 1) Compute the elasticity of demand with respect to price, for Δp=2 and assuming that p 0 = 3. Formula for the elasticity of demand: E D (p) = – [Δ q / q 0 ] / [Δ p / p 0 ] = = – [(q 1 – q 0 ) / q 0 ] / [(p 1 – p 0 ) / p 0 ]

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Market of cheese p 0 = 3 ; p 1 = p 0 + Δp = 5 Given our demand function Q D = 9 – P we can compute q 0 and q 1. In particular: p 0 = 3 -> q 0 = 6 p 1 = 5 -> q 1 = 4

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Market of cheese Now we can apply the formula: E D (p) = – [Δ q / q 0 ] / [Δ p / p 0 ] = = – [(q 1 – q 0 ) / q 0 ] / [(p 1 – p 0 ) / p 0 ] = – [(4 – 6) / 6] / [(5 – 3) /3] = – [– 1 / 3] / [2 /3] =1/2 Final result: E D (p) = 1/2 High or low? Low…

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

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

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

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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?

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Market of cheese i) Graphically, Price of cheese Quantity of cheese 9 9 D 1 S 3 6 QSQS 5 QDQD Excess supply

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

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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.

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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? i)Show the effect of the tax graphically ii)Find the correct value of T

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

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

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Market of cheese Two steps: First, we impose the equilibrium condition Q D = Q S -> 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

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

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

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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

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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

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

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

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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

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Macro

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

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Macroeconomic Equilibrium The equilibrium condition in the goods market requires Y=Z: Y = C + I + G Y = 1,000 + 0.4Y D + 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 = 1,400 – 2,500i

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Macroeconomic Equilibrium The equilibrium condition in the financial market requires M S /P = M D : 600 = 0.2Y – 3,000i 0.2Y = 600 + 3,000i Y = 120 + 600i

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Macroeconomic Equilibrium Two equations with two unknowns: Y = 1,400 – 2,500i -> Goods Market Y = 120 + 600i -> 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.

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Macroeconomic Equilibrium First we solve for i: 120 + 600i = 1.400 – 2.500i 3.100i = 1.280 i = 0.4129 We substitute for i in one of the goods market equation: Y = 1,400 – 2,500i Y = 1,400 – 2,500 x 0.4129 Y = 367.75

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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.

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

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

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AS AD P Y A YnYn AD’ A’A’ YA’YA’ PA’PA’ PAPA G -> AD shifts rightward Equilibrium A->A’ -> Y (Y A -> Y A ’) P (P A -> P A ’) In A’ Y>Y n -> P>P E -> P E -> the transition starts

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Y P E -> AS shifts upward When Y=Y n the adjustment process stops AS AD P A YnYn A’A’ YA’YA’ PA’PA’ PAPA P A’’ A’’

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Y During the transition -> Y and P In the medium period -> Y A ’’ =Y n =Y A and P A ’’ >P A AS AD P A YnYn A’A’ YA’YA’ PA’PA’ PAPA P A’’ A’’

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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 Y n (think of public investments in scientific research) Reduction of public deficit

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Interesting readings Economic development in the long-run - Acemoglu & Robinson, “Why nations fail?”

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