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Lecture

MGEA01H3 Lecture Notes - Ceteris Paribus, Price Ceiling, Price Floor


Department
Economics for Management Studies
Course Code
MGEA01H3
Professor
v

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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 = Y/X) 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: PD = 120 – 0.2QDSupply: PS = 30 + 0.1QS (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 = PS we simply equate the right-hand side of each
equation to find equilibrium.
Equilibrium => PD = PS => 120 – 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.
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Principles of Microeconomics: Market Equilibrium
Demand for and Supply of an Economics Book
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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
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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
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Floor
Qs
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Surplus
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 – 0.2QD=> Qd = (120 – 70)/0.2 = 250
$70 = 30 + 0.1QS => 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:
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