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University of Toronto Mississauga

Principles of Microeconomics: Market Equilibrium MARKET EQUILIBRIUM Linear Equations We can analyze Demand and Supply and Market equilibrium with linear equations. These are equations of the form Y = a + bX where a is the Y-intercept, i.e., the value of Y when X is zero, and b is the slope (rise/run = ΔY/ΔX) of the function. We know that the function is linear, i.e., a line, because the slope is constant. The slope is negative the Y falls with an increase in X and is positive if Y increases with an increase in X. Example: Suppose that the following equations describe the market Demand for and Supply of a Economics book. Demand: P = D20 – 0.2Q D Supply: P S 30 + 0.1Q S (P is in $s and Q is in units) We don’t need to label these equations Demand and Supply since the negative slope of the first one and the positive slope of the second one tell us that they are Demand and Supply respectively. Since equilibrium implies that PD= P Se simply equate the right-hand side of each equation to find equilibrium. Equilibrium => P =DP =>S120 – 0.2Q = 30 + 0.1Q 90 = 0.3Q => Q = 300 Q = 300 => P = 120 – 0.2*30 = $60 or P = 30 + 0.2*30 = $60 (P must be the same for Demand and Supply at equilibrium Q) The following diagram depicts these equations and this equilibrium. Note that 120 is the vertical (Y) intercept for Demand and that 30 is the vertical intercept for Supply. The horizontal intercept for Demand is 120/0.2 = 600. - 1 - Principles of Microeconomics: Market Equilibrium Demand for and Supply of an Economics Book Price ($s) 140 120 100 Supply 80 Po 60 40 20 Demand 0 Do 0 2 4 6 8 1 1 1 1 1 2 2 2 2 2 3 3 3 3 3 4 4 4 4 4 5 5 5 5 5 64 6 8 0 Qo Quantity GOVERNMENT IMPACT ON MARKETS 1. Fixed Prices The government can fix prices to achieve policy objectives but there are economic ramifications. a) Price Floors (Minimum Prices) A government may wish to protect producers against low prices by establishing a minimum price (price floor) for a commodity. The classic commodities for price floors have been agricultural products such as eggs, milk, or peanuts, but minimum wages and minimum exchange rates are also common historically. A price floor is effective only if it is above the equilibrium price since the market would move to the equilibrium price. Governments assume or hope that the minimum price is a temporary measure to help producers in a depressed market but the existence of a price floor above the equilibrium price at that point results in surplus (unsold) commodities. It is difficult to simply decree minimum prices since some producers will sell below minimum price on the black market thereby driving down the - 2 - Principles of Microeconomics: Market Equilibrium price. Governments usually have to establish the price floor, therefore, by purchasing surplus commodities. Example #1. Suppose that the government enacts a minimum price on textbooks by promising to buy any surplus commodities at $70. The following diagram depicts this situation. Goverment Price Floor Price ($s) 140 120 100 Supply 80 PFloor Po 60 40 Demand 20 Surplus 0 0 2 4 6 8 01 1 1 1 1 2 2 2 2 2 3 3 3 3 3 4 4 4 4 4 5 5 5 5 5 62 4 6 8 0 Qd Qs We can find the specific amount of the surplus and the cost to the government of the price floor by calculating the surplus as the difference between the quantity demanded and the quantity supplied in the market at $70 $70 = 120 – 0.2Q D => Qd = (120 – 70)/0.2 = 250 $70 = 30 + 0.1Q S => Qs = (70 – 30)/0.1 = 400 => Surplus = Qd – Qs = 400 – 250 = 150 Cost to the Government in buying this surplus = 150*70 = $10,500 Total Revenue of Firms = 400 * 70 = $28,000 Total Expenditure of Consumers = 250*70 = $17,500 NOTE: Price floors supported by government purchases have two problems: - 3 - Principles of Microeconomics: Market Equilibrium 1.Governments must purchase the unsold surplus. 2.Consumers must pay a higher price. Example #2. What is the effect of Minimum Wage Laws? Economists use Demand/Supply analysis of price floors to criticize minimum wage laws (but we will see later that this is a simplistic analysis). The diagram below depicts the Demand for and Supply of unskilled labour in Ontario with the market at an initial equilibrium at Wo (e.g., $8/hour), the price of labour and employment of Qo, the quantity of labour . Suppose that the government imposes a minimum wage of W MIN(e.g., $9/hour) to increase incomes of unskilled labour. What is the effect on unskilled workers of a minimum wage? Wage ($s) Supply W MIN Wo Demand Qd Qo Qs Labour Surplus The diagram above depicts the initial equilibrium and the quantity demanded (Qd) and quantity supplied (Qs) at the minimum wage. Notice that the increase in minimum wage decreases the quantity demanded of labour by firms, resulting in a loss of unskilled jobs from Qo to Qd. The loss of jobs for unskilled labour is even worse than this, however, since the minimum wage attracts Qs – Qo workers into unskilled labour. Since these entrants probably have better skills than the original workers, the ac
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