Chapter 3 Equilibrium analysis in Economics

Chapter 3 Equilibrium Analysis in Economics ---------------------------------------------------------------------

Studies or analysis of Economics 1. Static Analysis Studies focus only on a particular period of time. 2. Comparative Analysis Studies focus on the external forces that make equilibrium move to a new one. 3. Dynamic Analysis Studies focus on the change of time and how the equilibrium change with time.

P E

S Static Analysis

P*

D Q* Q

P P1 P0 E E

S Comparative Analysis D D Q0 Q1 Q

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Chapter 3 Equilibrium analysis in Economics

Dynamic Analysis P P1 P2 P3 D Q 0 1 2 3 S1 S2 S3 Pt Time Price

Variable

Converge

Time

Variable

Diverge

Time Example of dynamic analysis: Cobb-web Theorem St (Pt-1)

P P1 P2

P P1

St (Pt-1)

Dt (Pt)

P2 Dt (Pt)

Q2

Q1

Q2

Q1

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Chapter 3 Equilibrium analysis in Economics

3.1

Partial Market Equilibrium - A linear model Identify equilibrium price & equilibrium quantity (endogenous) Constructing the model 1. Equilibrium condition Conditional equation Qd = Qs

2. Demand equation: a decreasing linear function of P (P , Qd ) Behavioral equation Qd = a bP (a, b > 0) 3. Supply equation: an increasing linear function of P (P , Qs ) Behavioral equation Qs = -c + dP (c, d > 0)

Qd= a - bP

Qs= -c + dP

The solution values are P* and Q*

Q*

P*

Solution Qd = a bP QS = -c + dP The equilibrium condition Qd = Qs a bP = -c + dP a + c = bP + dP a + c = (b + d)P a+c P* = b+d

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Chapter 3 Equilibrium analysis in Economics

a bP* a+c ) = ab( b+d a(b+d) - b(a+c) = b+d ab+ad - ba-bc = b+d ad - bc = b+d Since b+d > 0 (ad - bc) must be positive in order to have positive Q* ad bc > 0 ad > bc (Restriction)

What happen if (b + d) = 0, can an equilibrium solution be found by using P*,Q* why or why not ? - No, there will be division by zero. The solution is undefined

Substitute P* into Qd = Q*

What can you conclude regarding the position of D & S curve? - D & S would be parallel, with no equilibrium

3.2

Partial Market Equilibrium: A nonlinear model

Quadratic function: numerical example Qd = Qs Qd = 4 P2 Qs = 4P 1 4 P2 = 4P - 1 P2 + 4P - 5 = 0 The Quadratic formula

ax2 + bx + c = 0

a 0

The roots are

* x1 , x * = 2

-b b 2 -4ac 2a
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Chapter 3 Equilibrium analysis in Economics

According to the above equation P2 + 4P - 5 = 0

* The equilibrium price = P1* ,P2 =

-4 42 -4(1)(-5) 2(1)

-46 2 = -5, 1 * The equilibrium quantity = Q = Qs = 4P*- 1 = 4(1) - 1 =3 =

Qs = 4P - 1

(1, 3) 3 -5 1 (-5, -25) -25

Q Example: Qd = 4 P2 P

Qd Qd Qs 2P2

= = =

Qs 8 P2 P2 2 P2 2 10 0 Q* = 3

8 - P2 = =

(P- 5)(P+ 5) = P* = 5

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Chapter 3 Equilibrium analysis in Economics

3.3

General Market Equilibrium

Last 2 sections: an isolated market. consider only 1 good In the real world, there are more than one good in the economy

Consider more than 1 good market

General Equilibrium with n commodities, the equilibrium conditions are Ei Qdi Qsi = 0 (i = 1, 2, .. n)

Two commodity mkt. model

Qd1 Qs1 Qd2 Qs2 Q

d 1

= = = = = =

10 2P1 + P2 -2 + 3P1 15 + P1 P2 -1 + 2P2 Q1 Qs2

s

. (1) . (2) . (3) . (4)

Qd2 (1) = (2) (3) = (4)

10 2P1 + P2 = -2 + 3P1 P2 15 + P1 - P2 P1 = -12 + 5P1 = -1 + 2P2 = -16 + 3P2 .(5) . (6)

Substitute (6) into (5) P2 14P2 P2* = = = = -12 + 5 (-16 +3P2) -12 80 + 15P2 92 92 14
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Chapter 3 Equilibrium analysis in Economics

Substitute P2* into (6) P1* = -16 + 3P2* 92 = -16 + 3 ( ) 14 52 = 14 -2 + 3P1* 52 -2 + 3( ) 14 64 7 -1 + 2P2* 92 -1 + 2( ) 14 85 7

Q1*

= = =

Q2*

= = =

Good 1 Q1 Q s1 Q2

Good 2 Q s2

64 7
Q d1

85 7
Q d2

52 14

P1

92 14

P2

Solution of a General Equilibrium System

To guarantee that the model yields a unique solution, the equations should have the following properties. 1. Consistency The satisfaction of any one equation in the model will not preclude the satisfaction of another x+y =8 x+y =9 2. Functional independence

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Chapter 3 Equilibrium analysis in Economics

No equation is redundant which means that one can be derived from the other. 2(2x + y) = 2(12) 4x + 2y = 24

(Try exercise 3.4 in the text book)

3.4

Equilibrium in National Income Analysis

Keynesian national income model Y=C+I+G C = a + bY I = I0 G = G0 Y (1 - b)Y Y* Then C* = = = = = = = = (a > 0, 0 < b < 1)

C+I+G a + bY + I0 + G0 a + I0 + G0 1 ( ) (a + I0 + G0) 1-b a + b Y* 1 a+b( ) (a + I0 + G0) 1-b a(1 - b) + ba + bI0 + bG 0 1-b a + b(I0 + G 0 ) 1-b

restriction

b 1

IS LM Framework

Equilibrium in good market IS Equilibrium in money market - LM

a. Good market C = = Yd T =

a + bYd YT T0 + tY
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; [a > 0, 0 < b < 1] ; [0 < t < 1]


Chapter 3 Equilibrium analysis in Economics

I G X M

= = = =

I0 er G X M

; [e > 0]

Conditional equation (Equilibrium) = = = = (1 b + bt)Y = Y* Y* = = Y C + I + G + X M a + bYd + I0 er + G0 + X0 M0 a + b (Y T0 - tY) + I0 er + G0 + X0 M0 a + bY bT0 btY + I0 + er +G0 + X0 M0 a bT0 + I0 + G0 + X0 M0 er a bT0 + I0 + G 0 + X 0 M 0 er 1- b + bt 1 - b + bt 0 1 r

According to the expression of Y*, National income has a negative relationship with interest
r

IS b. Money market

Money demand 1. Transaction Demand 2. Precautionary Demand 3. Speculative Demand Md = N0 + myY mrr Money Supply Monetary policy (constant) Ms = Mo Conditional equation (Equilibrium) Md N0 + myY mrr = = Ms M0 ; my , mr > 0

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Chapter 3 Equilibrium analysis in Economics

r* rewrite Y

= =

N0 + m y Y - M0 mr
M0 - N0 mr +( )r my my

Y*

0 + 1r

According to the expression of Y*, National income has a positive relationship with interest.
r LM

Y c. IS LM Framework

IS 0 1 r (1 + 1 ) r r*

= = = =

LM 0 + 1r 0 - 0
0 - 0 1 + 1 0 1 r* 0 1 0 - 0 1 + 1

From IS

Y*

= =

= Substitute r* = 0 , 1 , 0 , 1

01 + 1 0 1 + 1 by their expressions

m y [a - bT0 + I0 + G 0 + X 0 - M 0 ] - [1 - b + bt](M 0 - N 0 ) (1 - b + bt)m r + em y

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Chapter 3 Equilibrium analysis in Economics

Y*

m r [a - bT0 + I0 + G 0 + X 0 - M 0 ] + e(M 0 - N 0 ) (1 - b + bt)m r + em y

r LM

r* =

0 - 0 1 + 1
IS

+ 1 0 Y= 0 1 1 + 1
*

Exercise Chapter 3

1. Let the demand and supply functions be as follow: (a) Qd = 51 3P (b) Qd = 30 2P find P*and Q* Qs = -10 + 6P Qs = -6 + 5P

2. Find the zeros of the following functions graphically: (a) f(x) = x2 8x + 15 (b) g(x) = 2x2 4x 16 3. Find the equilibrium solution for each of the models: Qd = Qs (a) Qd = 3 P2 (b) Qd = 8 P2 Qs = 6P 4 Qs = P2 2

4. The demand and supply functions of a two-commodity market model are as follows: Qd1 = 18 3P1 + P2 Qd2 = 12 + P1 P2 Qs1 = -2 + 4P1 Qs2 = -2 + 3P2 Find and Pi* and Q* i 5. Given the following model: Y = C + I0 + G0 C = a + b(Y T) T = d + tY (a > 0, 0 < b < 1) (d > 0, 0 < t < 1)
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Chapter 3 Equilibrium analysis in Economics

(a) How many endogenous variables are there? (b) Find Y*, T* and C* 6. Let the national-income model be: Y = C + I0 + G C = a + b(Y T0) G = gY (a) (b) (c) (d) (a > 0, 0 < b < 1) (0 < g < 1)

Identify the endogenous variables. Give the economic meaning of the parameter g Find the equilibrium national income. What restriction on the parameters is needed for a solution to exist?

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Chapter 3 Equilibrium analysis in Economics

7. Using the following money market information to derive an equation of LM:

M d = 1375 + 0.25Y 25r M s = 2500 Md = Ms

8. Find national-income and aggregate consumption at the equilibrium of the following model
Y = C + I 0 + G0 C = 25 + 6Y I 0 = 16 G0 = 14
1 2

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