IMBA: Introductory Microeconomics: Market Equilibrium

This unit covers market equilibrium and the Effects of tax on Equilibrium.

When the supply and demand curves intersect, the market is in equilibrium.  This is where the quantity demanded and quantity supplied are equal.  The corresponding price is the equilibrium price or market-clearing price, the quantity is the equilibrium quantity.

IMBA: Introductory Microeconomics: Market Equilibrium 1

Putting the supply and demand curves from the previous sections together. These two curves will intersect at Price = $6, and Quantity = 20.

In this market, the equilibrium price is $6 per unit, and equilibrium quantity is 20 units.

At this price level, market is in equilibrium. Quantity supplied is equal to quantity demanded ( Qs = Qd).

Market is clear.

 

Surplus and shortage:

If the market price is above the equilibrium price, quantity supplied is greater than quantity demanded, creating a surplus.  Market price will fall.

Example: if you are the producer, you have a lot of excess inventory that cannot sell. Will you put them on sale? It is most likely yes. Once you lower the price of your product, your product’s quantity demanded will rise until equilibrium is reached. Therefore, surplus drives price down.

If the market price is below the equilibrium price, quantity supplied is less than quantity demanded, creating a shortage. The market is not clear. It is in shortage. Market price will rise because of this shortage.

Example: if you are the producer, your product is always out of stock. Will you raise the price to make more profit? Most for-profit firms will say yes. Once you raise the price of your product, your product’s quantity demanded will drop until equilibrium is reached.  Therefore, shortage drives price up.

If a surplus exist, price must fall in order to entice additional quantity demanded and reduce quantity supplied until the surplus is eliminated.  If a shortage exists, price must rise in order to entice additional supply and reduce quantity demanded until the shortage is eliminated.

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If the market price (P) is higher than $6 (where Qd = Qs),
for example,  P=8, Qs=30, and Qd=10.
Since  Qs>Qd, there are excess quantity supplied  in the
market, the market is not clear. Market is in surplus.
THE PRICE WILL DROP BECAUSE OF THIS SURPLUS.
 

If the market price is lower than equilibrium price,  $6,

for example,  P=4, Qs=10, and Qd=30.
Since Qs<Qd, There are excess quanitty demanded in the
market. Market is not clear. Market is in shortage.
THE PRICE WILL RISE DUE TO THIS SHORTAGE.

 

Government regulations will create surpluses and shortages in the market.  When a price ceiling is set, there will be a shortage. When there is a price floor, there will be a surplus.

Price Floor: is legally imposed minimum price on the market. Transactions below this price is prohibited.

  • Policy makers set floor price above the market equilibrium price which they believed is too low.
  • Price floors are most often placed on markets for goods that are an important source of income for the sellers, such as labor market.  •Price floor  generate surpluses on the market. Example: minimum wage.

 

  • Price Ceiling: is legally imposed maximum price on the market. Transactions above this price is prohibited. •Policy makers set ceiling price below the market equilibrium price which they believed is too high. •Intention of price ceiling is keeping stuff affordable for poor people. •Price ceiling generates shortages on the market. Example: Rent control.
Changes in equilibrium price and quantity:

Equilibrium price and quantity are determined by the intersection of supply and demand. A change in supply, or demand, or both, will necessarily change the equilibrium price, quantity or both. It is highly unlikely that the change in supply and demand perfectly offset one another so that equilibrium remains the same.

Example: This example is based on the assumption of Ceteris Paribus.

1) If there is an exporter who is willing to export oranges from Florida to Asia, he will increase the demand for Florida’s oranges. An increase in demand will create a shortage, which increases the equilibrium price and equilibrium quantity.

2) If there is an importer who is willing to import oranges from Mexico to Florida, he will increase the supply for Florida’s oranges. An increase in supply will create a surplus, which lowers the equilibrium price and increase the equilibrium quantity.

3) What will happen if the exporter and importer enter the Florida’s orange market at the same time? From the above analysis, we can tell that equilibrium quantity will be higher. But the import and exporter’s impact on price is opposite. Therefore, the change in equilibrium price cannot be determined unless more details are provided. Detail information should include the exact quantity the exporter and importer is engaged in. By comparing the quantity between importer and exporter, we can determine who has more impact on the market.

This supply and demand factor exercises may help you better apply these concepts.

Effects of tax on Equilibrium

  1. How do taxes affect equilibrium prices and the gains from trade?

Consider first a fixed, per-unit tax such as a 20-cent tax on gasoline. The tax could either be imposed on the buyer or the supplier. It is imposed on the buyer if the buyer pays a price for the good and then also pays the tax on top of that. Similarly, if the tax is imposed on the seller, the price charged to the buyer includes the tax. In the United States, sales taxes are generally imposed on the buyer—the stated price does not include the tax—while in Canada, the sales tax is generally imposed on the seller.

An important insight of supply and demand theory is that it doesn’t matter—to anyone—whether the tax is imposed on the supplier or the buyer. The reason is that ultimately the buyer cares only about the total price paid, which is the amount the supplier gets plus the tax; and the supplier cares only about the net to the supplier, which is the total amount the buyer pays minus the tax. Thus, with a a 20-cent tax, a price of $2.00 to the buyer is a price of $1.80 to the seller. Whether the buyer pays $1.80 to the seller and an additional 20 cents in tax, or pays $2.00, produces the same outcome to both the buyer and the seller. Similarly, from the seller’s perspective, whether the seller charges $2.00 and then pays 20 cents to the government, or charges $1.80 and pays no tax, leads to the same profit.

First, consider a tax imposed on the seller. At a given price p, and tax t, each seller obtains pt, and thus supplies the amount associated with this net price. Taking the before-tax supply to be SBefore, the after-tax supply is shifted up by the amount of the tax. This is the amount that covers the marginal value of the last unit, plus providing for the tax. Another way of saying this is that, at any lower price, the sellers would reduce the number of units offered. The change in supply is illustrated in Figure below “Effect of a tax on supply”.

IMBA: Introductory Microeconomics: Market Equilibrium 3

Now consider the imposition of a tax on the buyer, as illustrated in Figure  “Effect of a tax on demand”. In this case, the buyer pays the price of the good, p, plus the tax, t. This reduces the willingness to pay for any given unit by the amount of the tax, thus shifting down the demand curve by the amount of the tax.

 

 

 

 

Effect of a tax on demand

IMBA: Introductory Microeconomics: Market Equilibrium 4

In both cases, the effect of the tax on the supply-demand equilibrium is to shift the quantity toward a point where the before-tax demand minus the before-tax supply is the amount of the tax. This is illustrated in Figure 5.3 “Effect of a tax on equilibrium”. The quantity traded before a tax was imposed was qB*. When the tax is imposed, the price that the buyer pays must exceed the price that the seller receives, by the amount equal to the tax. This pins down a unique quantity, denoted by qA*. The price the buyer pays is denoted by pD* and the seller receives that amount minus the tax, which is noted as pS*. The relevant quantities and prices are illustrated in Figure “Effect of a tax on equilibrium”.

Figure Effect of a tax on equilibrium

 

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Also noteworthy in this figure is that the price the buyer pays rises, but generally by less than the tax. Similarly, the price that the seller obtains falls, but by less than the tax. These changes are known as the incidence of the tax—a tax mostly borne by buyers, in the form of higher prices, or by sellers, in the form of lower prices net of taxation.

There are two main effects of a tax: a fall in the quantity traded and a diversion of revenue to the government. These are illustrated in Figure 5.4 “Revenue and deadweight loss”. First, the revenue is just the amount of the tax times the quantity traded, which is the area of the shaded rectangle. The tax raised, of course, uses the after-tax quantity qA* because this is the quantity traded once the tax is imposed.

Figure 5.4 Revenue and deadweight loss

 

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In addition, a tax reduces the quantity traded, thereby reducing some of the gains from trade. Consumer surplus falls because the price to the buyer rises, and producer surplus (profit) falls because the price to the seller falls. Some of those losses are captured in the form of the tax, but there is a loss captured by no party—the value of the units that would have been exchanged were there no tax.

The value of those units is given by the demand, and the marginal cost of the units is given by the supply. The difference, shaded in black in the figure, is the lost gains from trade of units that aren’t traded because of the tax.

These lost gains from trade are known as a deadweight loss. That is, the deadweight loss is the buyer’s values minus the seller’s costs of units that are not economic to trade only because of a tax or other interference in the market. The net lost gains from trade (measured in dollars) of these lost units are illustrated by the black triangular region in the figure.

The deadweight loss is important because it represents a loss to society much the same as if resources were simply thrown away or lost. The deadweight loss is value that people don’t enjoy, and in this sense can be viewed as an opportunity cost of taxation; that is, to collect taxes, we have to take money away from people, but obtaining a dollar in tax revenue actually costs society more than a dollar. The costs of raising tax revenues include the money raised (which the taxpayers lose), the direct costs of collection, like tax collectors and government agencies to administer tax collection, and the deadweight loss—the lost value created by the incentive effects of taxes, which reduce the gains for trade. The deadweight loss is part of the overhead of collecting taxes. An interesting issue, to be considered in the subsequent section, is the selection of activities and goods to tax in order to minimize the deadweight loss of taxation.

Without more quantification, only a little more can be said about the effect of taxation. First, a small tax raises revenue approximately equal to the tax level times the quantity, or tq. Second, the drop in quantity is also approximately proportional to the size of the tax. Third, this means the size of the deadweight loss is approximately proportional to the tax squared. Thus, small taxes have an almost zero deadweight loss per dollar of revenue raised, and the overhead of taxation, as a percentage of the taxes raised, grows when the tax level is increased. Consequently, the cost of taxation tends to rise in the tax level.

For further reading on market equilibrium

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