1. Recap Lecture 27 – 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: 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.).

4. 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 ]

5. 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

6. 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…

7. 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

8. 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

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

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 Quantity of cheese 9 9 D 1 S 3 6 QSQS 5 QDQD Excess supply

12. 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.

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

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

16. 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.

17. 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

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 Quantity of cheese 9 9 D 1 S 3 6 12 5 4 S’S’ Portion paid by consumers.. Portion paid by producers..

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 Quantity of cheese 9 9 D 1 S 3 6 12 5 4 S’S’ Producer surplus Consumer surplus

23. 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

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 + 0,4Y 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.

27. 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

28. 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

29. 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.

30. 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

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( 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

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

34. 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

35. 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’’

36. 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’’

37. 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

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