Business Economics MECO 6303 Fall 2014 Instructor: Alejandro Zentner

Business Economics Lecture Notes Demand, Supply, and Equilibrium. Engel Curves. Policy Applications: Taxes, Subsidies.

Law of demand: when the price goes up the quantity demanded goes down Demand for Coffee Price Quantity Demanded 20 cents a cup 5 cups/day 30 cents a cup 4 cups/day 40 cents a cup 2 cups/day 50 cents a cup 1 cups/day Law of demand: when the price goes up the quantity demanded goes down

The demand curve Important to notice the difference between the demand function and the quantity demanded at each price. Notice the difference between the demand curve and the quantity demanded at any given price. The quantity demanded is a number and the demand curve is a function that for any given price lists the quantity demanded.

Changes in Demand Price Quantity Demanded 20 cents a cup 5 cups/day Two consumers with different demand curves Changes in Demand Price Quantity Demanded 20 cents a cup 5 cups/day 6 cups/day 30 cents a cup 4 cups/day 40 cents a cup 2 cups/day 3 cups/day 50 cents a cup 1 cups/day

Changes in the demand curve Coffee and Cream: The price of cream increases D’ Price per cup Coffee and Tea: The price of tea increases D D’’ Income changes: you win the lottery P Changes in income, prices of complements, prices of substitutes, etc. shift the demand curve. For example, if this was the market for coffee, an increase in the price of tea would shift the demand for coffee from D to D’ (tea and coffee are substitutes). Q’’ Q Q’ Quantity

Engel Curves Quantity Inferior Good Normal Good Income A good is normal if the quantity consumed increases when income increases. A good is inferior if the quantity consumed decreases when income increases. A good can be normal for one consumer and inferior for another. Also, a good can be normal for a low level of income and inferior when income reaches a certain threshold level. Use a graph to characterize your Engel curve for the Honda Civic. Income

Application: Demand for Crime Probability of Being Caught (per crime committed) P* Thieves demand crimes (they commit crimes and they pay a price for these crimes: the probability of going to prison is the price). A higher probability of being caught reduces the number of crimes committed (D is downward slopping). The probability of being caught can be seen as the price that criminals face for committing crimes. Note that the “price” that criminal pay is per crime committed. For example, if the probability of being caught is 0.3 (30%) they commit 2 crimes, if the probability of being caught is 0.25 (25%) they commit 3 crimes, and so on. As suggested in class, not only the probability of being caught matters when deciding to commit a crime, but also the punishment that criminals face if they are caught. D shifts to D’ if the punishment if caught is lower. For a fixed probability of being caught (P*), criminals are willing to commit more crimes (Q* to Q**). Alternatively, they are willing to commit the same quantity of crimes Q* for a higher probability of being caught (P* to P’). D shifts to D’’ if the punishment when caught is higher. Q* Q** Number of Crimes Committed

Application: Job Market and Discrimination Firms demand labor D Wage per hour (white) D’ (black) Firms demand labor. If the wage per hour is high firms demand less labor (they can use more machines instead of workers or some projects are just not undertaken because their costs are higher than their revenues). Note that the wage in the vertical axis is the wage per hour. Discrimination against black workers may be defined as black workers having a lower demand for their services. To test discrimination some researchers sent two identical resumes to companies. However, the name on one of the resumes was a name very common among black people and on the other a name very common among white people. Guess who got more calls? “Are Emily and Greg more employable than Lakisha and Jamal?” (Bertrand and Mullainathan). Why did they get more calls? (If interested in this topic you can read more about it in a book called Freakonomics, by Levitt and Dubner). Hours

Quiz 1- When the price goes up, do we expect to see a change in demand or a change in quantity demanded? Do we expect to see a movement along the demand curve or a shift of the demand curve itself? 2- How do you think the demand for fast food shift with an increase in income? 3- How does the demand for popcorn change with a decrease in the price of theater tickets? 4- How might an increase in the price of Big Macs affects the demand for Whoppers?

Market Demand Price D2 D1+D2 D1 P Q1 Q1 Q2 Q1+Q2 Quantity The market demand is the horizontal sum of the demands of all the individuals (two individuals in this example) in that market. For each price, the quantity demanded in the market is the sum of the quantity demanded by each individual. Q1 Q1 Q2 Q1+Q2 Quantity

Elasticity of Demand Price D2 D1 P P’ Q Q’1 Q’2 Quantity A given change in prices changes the quantity demanded by consumer 2 more than the quantity demanded by consumer 1. Consumer 2 is more “elastic” to price than consumer 1. If you are running a firm, and you are deciding what prices to charge, you might want to know how elastic is the demand in your market. This will tell you how many fewer units you will sell when you increase the price by a certain amount. Q Q’1 Q’2 Quantity

Why do we use the elasticity and not just the slope? $ D D’ The slope changes with changes in the units of measurement of the variables on the axes. The elasticity, on the other hand, is invariant to changes in these units of measurements. Cups per month Cups per week

Why do we use the elasticity and not just the slope? $ D Euros D’ The slope changes with changes in the units of measurement of the variables on the axes. The elasticity, on the other hand, is invariant to changes in these units of measurements. Cups per month

Elasticity To compare how responsive is the demand to a change in prices we use elasticities instead of slopes. Elasticity=Percentage change in quantity/Percentage change in price Elasticity=

Elasticity of Demand D Elasticity=0 $ Infinite Elasticity D’ Cups per month Think about elasticities of parallel demands and linear demands

Law of Supply: when the price goes up the quantity supplied goes up Supply of Coffee Price Quantity Supplied 20 cents a cup 100 cups/day 30 cents a cup 300 cups/day 40 cents a cup 400 cups/day 50 cents a cup 500 cups/day Law of Supply: when the price goes up the quantity supplied goes up We will see that how much a single firm supplies derives from its costs. In the market there is also entry and exit of new firms. If the salary of accountants increases more people will intend to enter into that profession.

Supply curve Changes in costs or technology shift the supply curve Price S’’ S S’ P’ P Reduction in price of an input Firms are willing to supply a higher quantity when the price is higher (the slope of the supply curve is positive). The supply curve shifts when the costs of production change. For example, a reduction in a price of an input shifts the supply to S’. An increase in wages, on the other hand, shifts the supply to S’’ (firms have higher production costs and they are only willing to supply Q’’ at price P). Q’’ Q Q’ Quantity

Elasticity Elasticity is a mathematical concept and can be applied to any function. Elasticity= Elasticity of supply=Percentage change in quantity divided by percentage change in price Elasticity of an Engel Curve=Percentage change in quantity divided by the percentage change in income (is a steep Engel curve elastic or inelastic?)

Quiz 1- How do you think an innovation that reduces the cost of producing corn shift the supply of corn? 2- How might predicted bad weather affect the supply of corn?

Equilibrium Numerical problem The demand curve for oranges is Q=500-50P and the supply curve for oranges is Q=800P+250. Compute the equilibrium price and quantities. Price D Excess Supply S P P* P’ What determines the actual price and quantities in a given market? At price P the quantity supplied is higher than the quantity demanded. Some suppliers will not be able to sell all the production and they will reduce the price in order to sell these goods. At that lower price, P*, more consumers are willing to buy these products and the market reaches an equilibrium when the two curves intersect. Analogously, at price P’ the quantity demanded is higher than the quantity supplied. Consumers are willing and will offer higher prices for these products and this will induce suppliers to produce more. Numerical problem The demand curve for oranges is Q=500-50P and the supply curve for oranges is Q=800P+250. Compute the equilibrium price and quantities. Excess Demand Q’s QD Q* QD=QS Q’D QS Quantity

Numerical Example of Equilibrium Qd=100–20p Qs=20+20p Two equations in two unknowns Qd=Qs 100-20p=20+20p 80=40p p=2 Q=100-20*2=60=20+20*2 {p=2; Q=60}

Equilibrium S D D Qd=100–20p then P=100/20-Qd/20 Qs=20+20p then If the price is 5, the quantity demanded is 0. When the price is 0, the quantity demanded is 100. If the price is 0, firms offer 20 units. If the price is 5, firms offer 120 units. Demand and supply intersect each other at price: 2. The equilibrium quantity is 60.

Changes in Equilibrium Quantities Music Market and File Sharing Price of a CD S D D’ P P’ A lower price induces people to buy more music (the slope of the demand is negative). A higher price induces the industry to produce more music (the slope of the supply is positive). File sharing may shift the demand to D’. Some consumer are now willing to pay a lower price for the original. Q’ Q Quantity of CDs

Tax on Consumers Total Amount Consumers Pay=Consumers Pay to the Government (tax)+Consumers Pay to the Firm Quantity Total Amount Consumers Pay Consumers Pay to the Government (tax) Consumers Pay to the Firm Q* P* 5 cents Pf P*=Pf+5cents Q** P** 5 cents Pff P**=Pff+5 cents

Policy Application Tax on Consumers Price D D’ P** 5 cents Pff P* 5 cents Pf Consumers are willing to pay a maximum total amount of P* per units to demand Q* units. When a tax of 5 cents is imposed, if consumers pay a total amount of P* per unit firms only get Pf=P*-5 cents per unit. Consumers are willing to pay a total amount of P** per units to demand Q** units. When a tax of 5 cents is imposed, if consumers pay a total amount of P** firms only get Pff=P**-5 cents. The new demand curve that firms face shifts to the left. The tax creates a difference between the price that consumers pay and the price that firms receive. Quantity Q** Q*

Tax on Firms Quantity Total Amount Firms Receive from Consumers Firms Pay to the Government (tax) Net Amount Firms Keep Q** Pcc 5 cents P**

Policy Application Tax on Firms Price S Pcc 5 cents P** At the price P* producers supply Q* units. A tax of 5 cents is imposed on producers. In order to receive a net price of P* producers have to charge consumers a price of P*+5 cents. Only if they receive this price from consumers they are willing to supply Q*. The supply curve shifts from S to S’. Quantity Q**

Policy Application Tax on Suppliers Vs Tax on Consumers Price D S D’ Pc 5 cents P* Pf A tax on consumers shifts the demand form D to D’ and reduces the equilibrium quantity from Q* to Q’. A tax on firms shifts the supply from S to S’ and also reduce the equilibrium quantity from S to S’. Both taxes produce the same effect!! - firms receive the same price, consumers pay the same price and the equilibrium quantity is the same!!). Quantity Q’ Q*

Incidence on Firms and on Consumers Price D’ S Pc 5 cents P* We have seen that a tax on consumers and a tax on firms produce the same effect. Independently of the legal incidence (who the law says has to pay the tax: consumers or firms), the shapes of the supply and demand determine what fraction of the tax is paid by consumers and what fraction is paid by firms. If the demand curve is relatively steep compare to the supply, consumers pay a larger fraction of the tax (Pc-P*) per unit sold at the new equilibrium. We can use only the relative slope (and we do not need the elasticities) because the demand and supply are measured using the same units. Pf Q’ Q* Quantity

Incidence on Firms and on Consumers Price S Pc P* 5 cents D Pf If the supply function is relatively steep compare to the demand, firms pay a larger fraction of the tax. Firms were receiving P* before the tax is imposed. When the tax is imposed they receive Pc from consumers, but they pay Pc-Pf to the government as a tax. They keep a net price per unit of Pf. Therefore, firms pay P*-Pf of the tax per unit sold at the new equilibrium. D’ Quantity Q’ Q*

Policy Application: Labor Market Tax on Firms Vs Tax on Workers Wage per hour D S D’ What fraction of the tax is paid by workers and employers, respectively? w firms 5 cents w* w worker Firms demand labor and workers supply labor. A labor tax on firms shifts the demand for labor from D to D’. Firms are willing to pay a maximum of w*(including tax) to hire Q* hours of work. However, this would imply that workers would get w* minus the tax per hour for Q* hours of work. The new equilibrium quantity is Q’. At Q’, the net hourly wage that workers get is the same to the amount they want to receive in order to supply Q’ hours of work. A labor tax on workers shifts the supply of labor from S to S’. If they have to pay the tax, they are only willing to accept a higher gross wage from the firm in order to work the same number of hours. Hours Q’ Q*

$1 tax an hour is imposed on employers A tax on labor hd=100–20w hs=20+20w {hs=hd=60, w=2} $1 tax an hour is imposed on employers Compute the new equilibrium quantity, the wage the employer pays after the tax is imposed, and the wage that workers receive.

Tax Imposed on Employers hd=100–20w 20w=100-hd w=100/20-hd/20 A tax of $1 an hour w=(100/20-hd/20)-1 w=(5-hd/20)-1 w=4-hd/20 From the supply function hs=20+20w w=-1+(1/20)hs

Tax Imposed on Employers 4-h/20=-1+(1/20)h 5=h/20+h/20=(2h)/20 100=2h h=50 w=4-hd/20 w=1.5 Employers pay 1.5+1 Employees receive 1.5

Policy Application: A Subsidy Price per unit D’ S’ D Pf P* Pc A subsidy is the opposite of a tax. If the government gives a subsidy of 5 cents per unit to consumers, the demand curve shifts to the right. Consumers pay a price Pc out of their pocket and 5 cents coming from the government to consume Q** units. Producers get Pf=Pc+5 cents. That is the minimum price they want to receive in order to supply Q** units. The same equilibrium quantities and prices (received by firms and paid by consumers) prevail if the government gives 5 cents per unit sold to firms instead of giving them to consumers. Q* Q** Quantity

Policy problems Should taxes be imposed on producers or on consumers? How is the demand curve for cars affected by a $100 sales tax on cars? How is the supply curve affected by a $100 tax on suppliers of cars? Subsidies: Show in a graph the effect of giving a subsidy of 5 cents per pound to orange farmers. Labor Market: Use a graph to show that it is equivalent to impose a tax on workers and on firms. What is more fair: a tax on workers or on firms?

Questions from Previous Exams True/False The price of gas went up and the quantity sold went down, therefore the law of supply has been violated. Multiple Choice If the supply of oil falls and all other relevant factors remain unchanged, then a) the demand for oil will fall b) the quantity demanded for oil will fall c) the demand for oil will rise d) the quantity demanded of oil will rise

____ 3. An increase in the price of corn will cause a rise in the supply of corn. ____ 4. If the price and quantity exchanged of a good simultaneously rise, then the law of demand has been violated. ____ 6. Suppose the price of a commodity is $15 per unit. At that price, consumers wish to purchase 6,000 units weekly and producers wish to sell 4,000 units weekly. In this situation, a.unsatisfied consumers will bid up the market price. b.the market price will fall because producers are unsatisfied. c.the price will rise and the demand will fall to bring the market to equilibrium. d.supply will increase by 2,000 units in order to satisfy consumers.

10. To make child daycare more affordable, government advisors are debating two possible options. Plan A is to give daycare centers a $100 subsidy per month per child. Plan B is to give the parents $100 reduction in taxes per month per child in daycare. Which plan benefits parents more? a.Plan A because it will increase the supply of childcare and decrease the price. b.Plan B because the $100 goes directly to the parents. c.The plans are equivalent in terms of their impact on the price minus subsidy paid by parents. d.Plan A because the price will fall, while under Plan B the price will rise.

____ 14. Comparing the elasticity of demand when the price is 12 and when the price is 4, when is the elasticity bigger? a.They are equal. b.The elasticity is bigger when the price is 12. c.The elasticity is bigger when the price is 8. d.More information is needed to answer this question.