Competitive Markets: Applications

Overview Deadweight Loss A Perfectly Competitive Market Without Intervention Maximizes Total Surplus" Government Intervention – Who Wins and Who Loses? Examples of Various Government Polices Excise Taxes and Subsidies Price Ceilings and Price Floors Production Quotas Import Tariffs and Import Quotas

Economic Efficiency Definition: Economic Efficiency means that the total surplus is maximized. "All gains from trade (between buyers and suppliers) are exhausted at the efficient point." The perfectly competitive equilibrium attains economic efficiency. Note:

Surplus Maximization in Competitive Equilibrium Supply F Pd E B C P* Ps G D Demand Q Q1 Q*

Surplus Maximization in Competitive Equilibrium At the Perfectly Competitive Equilibrium, (Q*,P*), Total Surplus is maximized. Consumer's Surplus at (Q*,P*): ABC Producer's Surplus at (Q*,P*) : DBC Total Surplus at (Q*,P*): ADC

Deadweight Loss Definition: A deadweight loss is a reduction in net economic benefits resulting from an inefficient allocation of resources. Consumer's Surplus at (Q1,Pd): AEF Producer's Surplus at (Q1,Pd) : EFGD Total Surplus at (Q1,Pd): AFGD Deadweight Loss at (Q1,Pd): GFC

Policy: Excise Tax : Key Definitions An excise tax (or a specific tax) is an amount paid by either the consumer or the producer per unit of the good at the point of sale. Incidence of a tax is a measure of the effect of a tax on the prices consumers pay and sellers receive in a market. Incidence of tax on consumers Incidence of tax on producers

Policy: Excise Tax Pd is the price (including the tax) paid by buyers. INCIDENCE OF A TAX Pd is the price (including the tax) paid by buyers. Ps is the price that sellers receive, less the tax. Consumers lose B + C + E. Producers lose G + F. The government earns B + C + G in revenue. The deadweight loss is E + F. Market clearing requires four conditions to be satisfied after the tax is in place: QD = QD(Pb) QS = QS(Ps) QD = QS Pb − Ps = t

Policy: Excise Tax With No Tax With Tax Impact of Tax Consumer Surplus A + B + C + E A - B - C - E Producer Surplus F + G + H H - F - G Government Receipts from Tax Zero B + C + G Net Benefits A + B + C + E + F + G + H A + B + C + G + H - E – F Deadweight Loss E + F

A TAX ON GASOLINE IMPACT OF $1 GASOLINE TAX The price of gasoline at the pump increases from $2.00 per gallon to $2.44, and the quantity sold falls from 100 to 89 bg/yr. Annual revenue from the tax is (1.00)(89) = $89 billion (areas A + D). The two triangles show the deadweight loss of $5.5 billion per year.

IMPACT OF A TAX DEPENDS ON ELASTICITIES OF SUPPLY AND DEMAND (a) If demand is very inelastic relative to supply, the burden of the tax falls mostly on buyers. (b) If demand is very elastic relative to supply, it falls mostly on sellers.

Incidence of Tax in Two Extreme Cases P Pd=P*+T S’ T Ps = P* S Case II P S D Q Case I Pd = P* T Ps = P*-T Q D

Back of the Envelope Pd/Ps = / "Back of the Envelope" method to calculate the incidence of a specific tax Pd/Ps = / where:  is the own-price elasticity of supply  is the own-price elasticity of demand Consider a small tax applied to an economy at point (Q*,P*)  =(Q/Q*)/(Pd/P*)… Q/Q*=Pd/P*  =(Q/Q*)/(Ps/P*)… Q/Q*=Ps/P* but for market to clear, Q/Q* must be the same for demand and supply, hence Pd/P* = Ps/P*

Tax Effect: Example Let  = -.5 and  = 2. What is the relative incidence of a specific tax on consumers and producers? Pd/Ps = 2/-.5 = - 4 Interpretation: "consumers pay four times as much as the decrease in price producers receive. Hence, an excise tax of $1 results in an increase in consumer price of $.8 and a decrease in price received by producers of $.2“

Subsidies Subsidy Payment reducing the buyer’s price below the seller’s price; i.e., a negative tax. A subsidy can be thought of as a negative tax. Like a tax, the benefit of a subsidy is split between buyers and sellers, depending on the relative elasticities of supply and demand. Conditions needed for the market to clear with a subsidy: QD = QD(Pb) QS = QS(Ps) QD = QS Ps − Pb = s or Ps = Pb + s

Subsidies With No Subsidy With Subsidy Impact of Subsidy Consumer Surplus A + B A + B + E + G + K E + G + K Producer Surplus E + F B + C + E + F B + C Impact on Government Budget Zero - B - C - E - G - K - J Net Benefits A + B + E + F A + B + E + F – J -J Deadweight Loss J

Policy: Price Ceilings Definition: A price ceiling is a legal maximum on the price per unit that a producer can receive. If the price ceiling is below the pre-control competitive equilibrium price, then the ceiling is called binding. E.G: Housing and Rent controls or Ceilings and shortages for Food

Policy: Price Ceilings With No Price Ceiling With Price Ceiling Impact of Ceiling Consumer Surplus Area YAV = 36M Area YTWS = 40M + 4M Producer Surplus Area AVZ = 18M Area SWZ = 8M - 10M Net Benefits Area YZV = 54M Area YTWZ = 48M - 6M Deadweight Loss Zero Area TWV = 6M

Policy: Price Floor Definition: A price floor is a minimum price that consumers can legally pay for a good. Price floors sometimes are referred to as price supports. If the price floor is above the pre-control competitive equilibrium price, it is said to be binding. E.G: Minimum wage law

Policy: Price Floor With No Price Floor With Price Floor Impact of Price Floor Consumer Surplus Area YAV = 36M Area YTR = 16M -20M Producer Surplus Area AVZ =18M Area RTWZ = 32M + 14M Net Benefits Area YZV = 54M Area YTWZ = 48M -6M Deadweight Loss Zero Area TWV = 6M

Policy: Production Quotas Definition: A production quota is a limit on either the number of producers in the market or on the amount that each producer can sell. The quota usually has a goal of placing a limit on the total quantity that producers can supply to the market.

Policy: Production Quotas With No Quota With Quota Impact of Quota Consumer Surplus A + B + F F - A - B Producer Surplus C + E A + E A - C Net Benefits A + B + C + E + F A + E + F - B - C Deadweight Loss Zero B + C