Changing absolute prices ---Inflation

What is inflation?
The absolute prices of all stuffs jump up.

Example: If there are only two goods, X and Y, in the economy. If the absolute prices of both goods increases by 5%, then
the inflation rate is 5%.

Do Xs and Ys relative prices change?

Market
Demand Supply Equilibrium
Price Quantity

Effects of sales tax on market equilibrium Effects of subsidy on market equilibrium

Demand
Demand is a relation between price and quantity demanded.
expressed by a demand function or a demand curve.

Note that Quantity demand is just a number, not a function. Demand is very different from quantity demanded.

Law of demand
When the price of a commodity goes up, people will buy less of it. Demand for beef:
Q = 100 - 2P
Price $12 $10 $8 $6 $4 $2 $0

Law of demand: the slope of the demand curve is negative:

Q/P = -2 <0

76 80 84 88 94
Q a tityd m n e un e add

Change in Demand
Fall in demand: A decision by consumers to buy a smaller quantity at each given price. In other words, for each quantity, the tag price that the consumer is willing to take decreases. the demand curve shifts downward.
Mad Cow Crisis
Price ($/pound) Quantity New quantity demanded demanded (pounds) (pounds)

12 8 6 2

76 80 84 88

50 60 62 70

The tag price

 Examples:
Mad cow effects Tariff on beef A $.10 sales tax on latt per cup (the city of Seattle, 2003 August)

16 14 12 10 8 6 4 2 0 50 60 70 80 Old Demand New Demand

The effect of a sales tax on demand

Demand for latte without tax Tag Price $0.2 0.3 0.4 0.5 Quantity demanded 5 4 3 2
Tag price (P) 0.6 0.5 0.4 0.3 0.2 0.1 0 2 3 4 5 quantity demanded No tax Latta tax

A sales tax is the tax paid to the government by consumers P is referred to as the tag price or pretax price.
Effect of the latta tax on demand

Demand for latte under the latte tax (sales tax of $.10/cup) Tag Price $0.1 0.2 0.3 0.4 Quantity demanded 5 4 3 2

Using demand functions

Suppose the old demand function is: Q=7-10P Now the government charges a 10c/cup latte tax from buyers. Whats the new demand function: Q=7-10(P+0.1)
Paid to sellers Given to govnt

Effect of subsidy on demand

Suppose the old demand function is: Q=7-10P Now the government charges a 10c/cup latte subsidy from buyers. the demand curve shifts upward and the demand function becomes Q=7-10(P-0.1)

Supply
Supply is a family numbers giving the quantities supplied at each possible price. Supply is often expressed by a supply function or a supply curve. E.g. Q = 100 + 2P Remark: Quantity of supply is the amount of goods that firms will provide at a given price.

Law of supply
When the price of a good goes up, the quantity supplied goes up. Supply of beef: Q = 100 + 3P Law of supply: the slope of the supply curve is positive Q/P=3 >0
Price $12 $10 $8 $6 $4 $2 $0

10 12 14 16 18
Q a tityd m n e un e add

Change in supply
South Pacific cruise tours TsunamiA decrease in the number of tours that cruise Price Original New companies would like to quantity of quantity of supply provide at any given price. supply Falls in supply 120 5 1
Supply curve shifts to the left (I.e. shifts downward)

Tsunam i

80 60 20

4 3 2

.5 0 0

 Example: Tsunami A $3000 lump-sum property tax whenever people sell their houses

A Change in Home Supply Curve

20000 15000 10000 5000 0 90 110 130 150

Quantity of supply Old Supply New Supply

The effect of excise tax on supply Supply of latte without tax curve An excise tax is a tax that paid to the
P $0.2 0.3 0.4 0.5 Q 100 300 400 500
0.8 0.6 0.4 0.2 0 2 3 4 5 quantity of supply N o tax Latta tax Tag price (P) incl excise tax

government by producers. Recall that price (P) is referred to as the tag price (now the tag price is the posttax price because the seller adds the excise tax into the sale price).

Effect of the latta tax on supply

Supply of latte with excise tax of $0.1 per cup P $0.3 0.4 0.5 0.6 Q 100 300 400 500

Using supply functions

Suppose the old supply function for latte is: Q= 100 P Now the government asks for 10 c latte tax per cup from sellers. Whats the new supply function? Q= 100(P-0.1)

Equilibrium
Equilibrium point is the point where the supply and demand curves intersect. The equilibrium price and quantity are derived at the point where Quantity Demanded=Quantity of Supply Remark
Equilibrium price always includes tax (or subsidy if any)

Derive the equilibrium price and quantity

Example The demand curve: Q = -200P+1000 The supply curve: Q = 800P What is the equilibrium price and quantity? P=1, Q=800

Applications
Demand is Q= -300P+1000. Supply is: Q= 700P. 1. Suppose that an excise tax of $.05 /unit is imposed. What are the new demand and supply functions? What are the new equilibrium price and quantity? 2. Suppose that a $.05 sales tax is imposed. What are the new demand and supply functions? What are the new equilibrium price and quantity? Intuition: a sales tax and an excise tax have identical effects on equilibrium.

1. Demand is Q= -300P+1000. Supply is: Q= 700P. Suppose that an excise tax of $.05 /unit is imposed. What are the new demand and supply functions? What are the new equilibrium price and quantity? Solution: The demand curve doesnt change, while the new supply curve is Q = 700*(P-.05). To solve for equilibrium:
Quantity demanded = Quantity of supply

-300P +1000 = 700(P-.05) Equilibrium price: P = $1.035 Equilibrium quantity: Q = 700*(1.035-.05)=689.5.

2. Demand is Q= -300P+1000. Supply is: Q= 700P. Suppose that an sales tax of $.05 /unit is imposed. What are the new demand and supply functions? What are the new equilibrium price and quantity? Solution:
Quantity demanded = Quantity of supply

-300(P+0.05) +1000 = 700P. Thus P=.985 Equilibrium price: .985+.05=$1.035 Equilibrium quantity: Q = 700*.985 =689.5.

The effect of sales tax ($.05) on equilibrium

The sales tax shifts P down the demand curve by $.05. pd =1.035 Equilibrium quantity p =1 ps =.985 falls (q-->q). Equilibrium price rises from $1 to $1.035 --by less than $.05.
S E E A 0.05 D D q=689.5 q=700 Q

The effect of excise tax ($.05) on equilibrium

Imposing an excise tax S S P shifts down the demand curve by $.05. 0.05 pd=1.035 Equilibrium quantity p =1 0.05 E falls. ps =.985 E D Equilibrium price rises from $1 to $1.035 ---- by less q=689.5 q=700 Q than $.05.

A Sales Tax vs. an Excise Tax:

The sales tax and the excise tax have an identical effect on equilibrium.