ARE 100A

Problem Set #3 – Market Equilibrium – Solutions

1. Assume there are only two consumers – Ellen and Mattie – in a market for a good. Ellen has the
following demand function:

𝑦𝑦
𝑞𝑞𝑑𝑑 (𝑝𝑝, 𝑝𝑝𝑠𝑠 , 𝑝𝑝𝑐𝑐 , 𝑦𝑦) = 6 − 𝑝𝑝 + 2 ⋅ 𝑝𝑝𝑠𝑠 − 2 ⋅ 𝑝𝑝𝑐𝑐 +
100

Mattie on the other hand, has the following demand:

2𝑦𝑦
𝑞𝑞𝑑𝑑 (𝑝𝑝, 𝑝𝑝𝑠𝑠 , 𝑝𝑝𝑐𝑐 , 𝑦𝑦) = 2 − 2𝑝𝑝 + 6𝑝𝑝𝑠𝑠 − 2𝑝𝑝𝑐𝑐 +
100

Assume both Ellen and Mattie have the same income (𝑦𝑦 = 1,000 for both). In addition, they are
both price takers and face the same prices (𝑝𝑝𝑠𝑠 = 1, 𝑝𝑝𝑐𝑐 = 4).

a. Solve for the aggregate quantity demanded as a function of the price (𝑝𝑝).

𝑞𝑞𝑑𝑑𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 (𝑝𝑝) = 6 − 𝑝𝑝 + 2(1) − 2(4) + 10 = 10 − 𝑝𝑝

𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 (𝑝𝑝)
𝑞𝑞𝑑𝑑 = 2 − 2𝑝𝑝 + 6(1) − 2(4) + 2(10) = 20 − 2𝑝𝑝

𝑄𝑄 𝑑𝑑 (𝑝𝑝) = 𝑞𝑞𝑑𝑑𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 (𝑝𝑝) + 𝑞𝑞𝑑𝑑𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 (𝑝𝑝) = 10 − 𝑝𝑝 + 20 − 2𝑝𝑝

𝑸𝑸𝒅𝒅 (𝒑𝒑) = 𝟑𝟑𝟑𝟑 − 𝟑𝟑𝟑𝟑

b. Suppose the aggregate supply function for the good is given by 𝑄𝑄 𝑠𝑠 (𝑝𝑝) = 5 + 2𝑝𝑝. What will be
the equilibrium price (𝑝𝑝𝑐𝑐 ) and quantity (𝑄𝑄 𝑐𝑐 )?

𝑄𝑄 𝑑𝑑 (𝑝𝑝𝑐𝑐 ) = 𝑄𝑄 𝑠𝑠 (𝑝𝑝𝑐𝑐 )
30 − 3𝑝𝑝𝑐𝑐 = 5 + 2𝑝𝑝𝑐𝑐
5𝑝𝑝𝑐𝑐 = 25
𝒑𝒑𝒄𝒄 = 𝟓𝟓

𝑄𝑄 𝑑𝑑 (𝑝𝑝𝑐𝑐 ) = 𝑄𝑄 𝑠𝑠 (𝑝𝑝𝑐𝑐 ) = 𝑄𝑄 𝑐𝑐
𝑸𝑸𝒄𝒄 = 𝟑𝟑𝟑𝟑 − 𝟑𝟑(𝟓𝟓) = 𝟏𝟏𝟏𝟏

c. At the equilibrium price, how much will Ellen purchase and how much will Mattie purchase?
(Note: make sure the sum of their individual levels of consumption add up to the aggregate
quantity produced and consumed in the equilibrium outcome solved for in part (b).)

𝑞𝑞𝑑𝑑𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 (5) = 10 − 5 = 5
𝑞𝑞𝑑𝑑𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 (5) = 20 − 2(5) = 10

2. Assume the aggregate demand and supply for a good are given by the following expressions:

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1
𝑄𝑄 𝑑𝑑 (𝑝𝑝) = � � ⋅ (25 − 𝑝𝑝) and 𝑄𝑄 𝑠𝑠 (𝑝𝑝) = 2 ⋅ 𝑝𝑝 − 10
2

a. Solve for the competitive equilibrium price (𝑝𝑝𝑐𝑐 ) and quantity (𝑄𝑄 𝑐𝑐 ).

𝑄𝑄 𝑑𝑑 (𝑝𝑝𝑐𝑐 ) = 𝑄𝑄 𝑠𝑠 (𝑝𝑝𝑐𝑐 )
1
� � (25 − 𝑝𝑝𝑐𝑐 ) = 2𝑝𝑝𝑐𝑐 − 10
2
25 − 𝑝𝑝𝑐𝑐 = 4𝑝𝑝𝑐𝑐 − 20
5𝑝𝑝𝑐𝑐 = 45
𝒑𝒑𝒄𝒄 = 𝟗𝟗

𝑄𝑄 𝑑𝑑 (𝑝𝑝𝑐𝑐 ) = 𝑄𝑄 𝑠𝑠 (𝑝𝑝𝑐𝑐 ) = 𝑄𝑄 𝑐𝑐
𝑸𝑸𝒄𝒄 = 𝟐𝟐(𝟗𝟗) − 𝟏𝟏𝟏𝟏 = 𝟖𝟖

b. At the competitive equilibrium, what is the elasticity of demand (𝜖𝜖)?

𝜕𝜕𝑄𝑄 𝑑𝑑 (𝑝𝑝) 𝑝𝑝
𝜖𝜖 = ⋅ 𝑑𝑑
𝜕𝜕𝜕𝜕 𝑄𝑄 (𝑝𝑝)
1 9 𝟗𝟗
𝜖𝜖 = − ⋅ = −
2 8 𝟏𝟏𝟏𝟏

The elasticity of demand is -9/16. This is closer to zero than -1, which means we are at an
inelastic point on the demand curve.

c. At the competitive equilibrium, what is the elasticity of supply (𝜂𝜂)?

𝜕𝜕𝑄𝑄 𝑠𝑠 (𝑝𝑝) 𝑝𝑝
𝜂𝜂 = ⋅ 𝑠𝑠
𝜕𝜕𝜕𝜕 𝑄𝑄 (𝑝𝑝)
9 𝟗𝟗
𝜂𝜂 = 2 ⋅ =
8 𝟒𝟒

The elasticity of supply is 9/4=2.25. This is greater than 1, which means we are at an elastic point
on the supply curve.

d. Suppose the government imposes a per-unit (specific) tax of 𝜏𝜏 = 5 on each unit of the good
produced. What would be the resulting equilibrium quantity? What price would consumers pay
(𝑝𝑝𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 ) and what price would sellers receive (𝑝𝑝 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 )?

𝑄𝑄 𝑑𝑑 (𝑝𝑝𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 ) = 𝑄𝑄 𝑠𝑠 �𝑝𝑝 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 � = 𝑄𝑄 𝑠𝑠 (𝑝𝑝𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 − 𝜏𝜏)

1
� � (25 − 𝑝𝑝𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 ) = 2(𝑝𝑝𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 − 5) − 10
2
25 − 𝑝𝑝𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 4𝑝𝑝𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 − 40
5𝑝𝑝𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 65

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𝒑𝒑𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 = 𝟏𝟏𝟏𝟏
𝒑𝒑𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔 = 𝟏𝟏𝟏𝟏 − 𝝉𝝉 = 𝟏𝟏𝟏𝟏 − 𝟓𝟓 = 𝟖𝟖

1
𝑄𝑄 𝑑𝑑 (𝑝𝑝𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 ) = � � (25 − 13) = 6
2
𝑠𝑠 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠
𝑄𝑄 �𝑝𝑝 � = 2(8) − 10 = 6

With a tax of 5, the consumers end up paying a price of 13, the sellers receive a price of 8, and at
those new prices, the quantity demanded and quantity supplied will both be equal to the new
equilibrium quantity of 6. Note, the quantity falls relative to the competitive equilibrium with no
tax and the price consumers pay goes up while the price sellers receive goes down.

e. Which group (producers or consumers) paid a larger share of the tax? (That is, which impact was
more pronounced, the increase in the price consumers pay or the decrease in the price sellers
receive?)

The tax incidence (i.e. the burden imposed by the tax) is higher or the group that is more
inelastic. Recall from parts (B) and (C) above, the consumers are at an inelastic point on the
demand curve while the producers are at an elastic point. Therefore, the tax should impose a
larger burden on the consumers. Indeed that is exactly what we found in part (D) above. The
price consumers pay goes from 9 to 13 while the price the sellers receive goes from 9 to 8. So
80% of the tax burden falls on consumers.

3. Suppose the aggregate demand and supply for a good are given by the following expressions:

𝑄𝑄𝑑𝑑 (𝑝𝑝) = 20 − 𝑝𝑝 and 𝑄𝑄 𝑠𝑠 (𝑝𝑝) = 𝑝𝑝

a. What is the competitive equilibrium price and quantity?

𝑄𝑄 𝑑𝑑 (𝑝𝑝𝑐𝑐 ) = 𝑄𝑄 𝑠𝑠 (𝑝𝑝𝑐𝑐 )
20 − 𝑝𝑝𝑐𝑐 = 𝑝𝑝𝑐𝑐
𝒑𝒑𝒄𝒄 = 𝟏𝟏𝟏𝟏

𝑸𝑸𝒄𝒄 = 𝑄𝑄 𝑑𝑑 (10) = 𝑄𝑄 𝑠𝑠 (10) = 𝟏𝟏𝟏𝟏

The competitive equilibrium quantity is 10 and the price is 10.

b. Suppose the production of this good results in the creation of harmful pollution. To reduce the
amount of pollution being created, the government decides to charge a per unit tax of 𝜏𝜏 on each
unit of the good produced. If the government wants to reduce the amount of the good being
produced by 50% (i.e. they want to get output to half of the competitive equilibrium level), at
what level must they set the tax 𝜏𝜏?

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The government wants to reduce the quantity to half of 10 – so they want 𝑄𝑄 = 5. To figure out
how large the tax must be, we could simply figure out what price consumers must pay if the
quantity demanded is 5 and what price sellers receive if the quantity supplied is also 5. The tax
must be the difference between these two prices.

𝑄𝑄 𝑑𝑑 (𝑝𝑝𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 ) = 20 − 𝑝𝑝𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 5
𝑝𝑝𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 15

𝑄𝑄 𝑠𝑠 �𝑝𝑝 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 � = 𝑝𝑝 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 5

𝑝𝑝 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 5

So the price consumer pay must be 15 and the price the sellers receive must be 5. We also know
that a tax just creates a wedge between these to prices such that:

𝑝𝑝𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝑝𝑝 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 + 𝜏𝜏

Therefore, we know that the per unit tax that reduces output to 5 must be 𝜏𝜏 = 10:

15 = 5 + 𝜏𝜏
𝝉𝝉 = 𝟏𝟏𝟏𝟏

𝑑𝑑𝑄𝑄 𝑑𝑑
4. Assume that the aggregate demand curve for a good is downward sloping (i.e. 𝑑𝑑𝑑𝑑
< 0). In addition,
𝑑𝑑𝑄𝑄 𝑠𝑠
assume the aggregate supply curve is upward sloping (i.e. 𝑑𝑑𝑑𝑑
> 0). Below on the left are four
different events that could occur. On the right are four resulting changes in the equilibrium price
and quantity that could occur. Match each event to its resulting outcome:

Event Outcome

The price of a substitute increases The equilibrium price and quantity fall

The price of an input to production increases The equilibrium price falls, quantity increases

The price of a complement increases The equilibrium price and quantity increase

The production technology improves, The equilibrium price increases, quantity falls
reducing the cost of production

𝑑𝑑𝑄𝑄 𝑑𝑑
5. Assume that the aggregate demand curve for a good is downward sloping (i.e. 𝑑𝑑𝑑𝑑
< 0). In addition,
𝑑𝑑𝑄𝑄 𝑠𝑠
assume the aggregate supply curve is upward sloping (i.e. 𝑑𝑑𝑑𝑑
> 0).

a. Suppose the equilibrium quantity increased but the equilibrium price remained the same. What
must have happened to supply and demand?

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The only way for this outcome to occur is if both the demand and the supply curves shift out to
the right (i.e. both demand and supply increase).

b. Suppose the equilibrium quantity remained the same but the equilibrium price increased. What
must have happened to supply and demand?

The only way for this outcome to occur is if the supply curve shifts to the left (i.e. supply
decreases) and the demand curve shifts to the right (i.e. demand increases).