The Analysis of Competitive Markets Chapter 9 The Analysis of Competitive Markets

Topics to be Discussed Evaluating the Gains and Losses from Government Policies The Efficiency of a Competitive Market Minimum Prices Price Supports and Production Quotas Import Quotas and Tariffs The Impact of a Tax or Subsidy Chapter 9 2

Consumer and Producer Surplus When government controls price, some people are better off May be able to buy a good at a lower price But what is the effect on society as a whole? Is total welfare higher or lower and by how much? A way to measure gains and losses from government policies is needed Chapter 9

Consumer and Producer Surplus Consumer surplus is the total benefit or value that consumers receive beyond what they pay for the good Assume market price for a good is $5 Some consumers would be willing to pay more than $5 for the good If you were willing to pay $9 for the good and pay $5, you gain $4 in consumer surplus Chapter 9 5

Consumer and Producer Surplus The demand curve shows the willingness to pay for all consumers in the market Consumer surplus can be measured by the area between the demand curve and the market price Consumer surplus measures the total net benefit to consumers Chapter 9

Consumer and Producer Surplus Producer surplus is the total benefit or revenue that producers receive beyond what it costs to produce a good Some producers produce for less than market price and would still produce at a lower price A producer might be willing to accept $3 for the good but get $5 market price Producer gains a surplus of $2 Chapter 9

Consumer and Producer Surplus The supply curve shows the amount that a producer is willing to take for a certain amount of a good Producer surplus can be measured by the area between the supply curve and the market price Producer surplus measures the total net benefit to producers Chapter 9

Consumer and Producer Surplus Price D 5 9 Consumer Surplus S Between 0 and Q0 consumer A receives a net gain from buying the product-- consumer surplus. 3 Producer Surplus Between 0 and Q0 producers receive a net gain from selling each product-- producer surplus. QD QS Q0 Quantity Chapter 9

Consumer and Producer Surplus To determine the welfare effect of a governmental policy, we can measure the gain or loss in consumer and producer surplus Welfare Effects Gains and losses to producers and consumers Chapter 9 10

Consumer and Producer Surplus When government institutes a price ceiling, the price of a good can’t go above that price With a binding price ceiling, producers and consumers are affected How much they are affected can be determined by measuring changes in consumer and producer surplus Chapter 9

Consumer and Producer Surplus When price is held too low, the quantity demanded increases and quantity supplied decreases Some consumers are worse off because they can no longer buy the good Decrease in consumer surplus Some consumers are better off because they can buy it at a lower price Increase in consumer surplus Chapter 9

Consumer and Producer Surplus Producers sell less at a lower price Some producers are no longer in the market Both of these producer groups lose and producer surplus decreases The economy as a whole is worse off since surplus that used to belong to producers or consumers is simply gone Chapter 9

Price Control and Surplus Changes Consumers that can buy the good gain A Consumers that cannot buy, lose B B The loss to producers is the sum of rectangle A and triangle C P0 Q0 A C Triangles B and C are losses to society – dead weight loss Pmax Q1 Q2 Chapter 9 Quantity 13

Price Controls and Welfare Effects The total loss is equal to area B + C The deadweight loss is the inefficiency of the price controls – the total loss in surplus (consumer plus producer) If demand is sufficiently inelastic, losses to consumers may be fairly large This can have effects in political decisions Chapter 9 14

Price Controls With Inelastic Demand Q1 B P0 Q2 With inelastic demand, triangle B can be larger than rectangle A and consumers suffer net losses from price controls. C A Pmax Quantity Chapter 9 17

Price Controls and Natural Gas Shortages From example in Chapter 2, 1975 Price controls created a shortage of natural gas What was the effect of those controls? Decreases in surplus and overall loss for society We can measure these welfare effects from the demand and supply of natural gas Chapter 9 18

Price Controls and Natural Gas Shortages QS = 14 + 2PG + 0.25PO Quantity supplied in trillion cubic feet (Tcf) QD = -5PG + 3.75PO Quantity demanded (Tcf) PG = price of natural gas in $/mcf PO = price of oil in $/b Chapter 9 19

Price Controls and Natural Gas Shortages Using PO = $8/b and gives equilibrium values for natural gas PG = $2/mcf and QG = 20 Tcf Price ceiling was set at $1/mcf Showing this graphically, we can see and measure the effects on producer and consumer surplus Chapter 9 20

Price Controls and Natural Gas Shortages 2.40 Price ($/mcf) S D The gain to consumers is rectangle A minus triangle B, and the loss to producers is rectangle A plus triangle C. B 2.00 A C (Pmax)1.00 Quantity (Tcf) 5 10 15 20 25 30 18 Chapter 9 25

Price Controls and Natural Gas Shortages Measuring the Impact of Price Controls A = (18 billion mcf) x ($1/mcf) = $18 billion B = (1/2) x (2 b. mcf) x ($0.40/mcf) = $0.4 billion C = (1/2) x (2 b. mcf) x ($1/mcf) = $1 billion Chapter 9 26

Price Controls and Natural Gas Shortages Measuring the Impact of Price Controls in 1975 Change in consumer surplus = A - B = 18 - 0.4 = $17.6 billion Gain Change in producer surplus = A + C = 18 + 1 = $19.0 billion Loss Dead Weight Loss = B + C = 0.4 + 1 = $1.4 billion Loss Chapter 9 27

The Efficiency of a Competitive Market In the evaluation of markets, we often talk about whether it reaches economic efficiency Maximization of aggregate consumer and producer surplus Policies such as price controls that cause dead weight losses in society are said to impose an efficiency cost on the economy Chapter 9 30

The Efficiency of a Competitive Market If efficiency is the goal, then you can argue that leaving markets alone is the answer However, sometimes market failures occur Prices fail to provide proper signals to consumers and producers Leads to inefficient unregulated competitive market Chapter 9

Types of Market Failures Externalities Costs or benefits that do not show up as part of the market price (e.g. pollution) Costs or benefits are external to the market Lack of Information Imperfect information prevents consumers from making utility-maximizing decisions Government intervention may be desirable in these cases Chapter 9 30

The Efficiency of a Competitive Market Other than market failures, unregulated competitive markets lead to economic efficiency What if the market is constrained to a price higher than the economically efficient equilibrium price? Chapter 9

Price Control and Surplus Changes Pmin Q1 A B Q2 When price is regulated to be no lower than Pmin, the deadweight loss given by triangles B and C results. P0 Q0 C Quantity Chapter 9 13

The Efficiency of a Competitive Market Deadweight loss triangles B and C give a good estimate of the efficiency cost of policies that force price above or below market clearing price Measuring effects of government price controls on the economy can be estimated by measuring these two triangles Chapter 9

The Market for Human Kidneys The 1984 National Organ Transplantation Act prohibits the sale of organs for transplantation What has been the impact of the Act? We can measure this using the supply and demand for kidneys from estimated data Supply: QS = 8,000 + 0.2P Demand: QD = 16,000 - 0.2P Chapter 9 38

The Market for Human Kidneys Since the sale of organs is not allowed, the amount available depends on the amount donated Supply of donated kidneys is limited to 8,000 The welfare effect of this supply constraint can be analyzed using consumer and producer surplus in the kidney market Chapter 9

The Market for Human Kidneys Suppliers: Those who supply them are not paid the market price, estimated at $20,000 Loss of surplus equal to area A = $160 million Some who would donate for the equilibrium price do not donate in the current market Loss of surplus equal to area C = $40 million Total consumer loss of A + C = $200 million Chapter 9

The Market for Human Kidneys Recipients: Since they do not have to pay for the kidney, they gain rectangle A ($140 million) since price is $0 Those who cannot obtain a kidney lose surplus equal to triangle B ($40 million) Net increase in surplus of recipients of $160 - $40 = $120 million Dead Weight Loss of C + B = $80 million Chapter 9

The Market for Human Kidneys Other Inefficiency Costs Allocation is not necessarily to those who value the kidneys the most Price may increase to $40,000, the equilibrium price, with hospitals getting the price Chapter 9 46

The Market for Kidneys S’ S $40,000 D B $30,000 $20,000 C A $10,000 D 8,000 S’ Price S D 12,000 $20,000 The loss to suppliers is seen in areas A & C. $40,000 D B $30,000 If kidneys are zero cost, consumer gain would be A minus B. A and D measure the total value of kidneys when supply is constrained. A C $10,000 Quantity 4,000 Chapter 9 43

The Market for Human Kidneys Arguments in favor of prohibiting the sale of organs: Imperfect information about donor’s health and screening Unfair to allocate according to the ability to pay Holding price below equilibrium will create shortages Organs versus artificial substitutes Chapter 9 47

Minimum Prices Periodically, government policy seeks to raise prices above market-clearing levels Minimum wage law Regulation of airlines Agricultural policies We will investigate this by looking at the minimum wage legislation Chapter 9 49

Minimum Prices When price is set above the market clearing price: Quantity demanded falls Suppliers may, however, choose to increase quantity supplied in face of higher prices This causes additional producer losses equal to the total cost of production above quantity demanded Chapter 9

Minimum Prices Losses in consumer surplus are still the same Increased price leading to decreased quantity equals area A Those priced out of the market lose area B Producer surplus similar Increases from increased price for units sold equal to A Losses from drop in sales equal to C Chapter 9

Minimum Prices What if producers expand production to Q2 from the increased price? Since they only sell Q3, there is no revenue to cover the additional production (Q2-Q3) Supply curve measures MC of production so total cost of additional production is area under the supply curve for the increased production (Q2-Q3) = area D Total change in producer surplus = A – C – D Chapter 9

D measures total cost of increased production not sold. Minimum Prices Price S D P0 Q0 If producers produce Q2, the amount Q2 - Q3 will go unsold. Pmin A Q3 B D Q2 D measures total cost of increased production not sold. C The change in producer surplus will be A - C - D. Producers may be worse off. Quantity Chapter 9 52

Minimum Wages Wage is set higher than market clearing wage Decreased quantity of workers demanded Those workers hired receive higher wages Unemployment results, since not everyone who wants to work at the new wage can Chapter 9

The Minimum Wage S D w0 L0 wmin L1 L2 w Firms are not allowed to pay less than wmin. This results in unemployment. S D w0 L0 wmin A is gain to workers who find jobs at higher wage. A L1 B L2 C The deadweight loss is given by triangles B and C. Unemployment L Chapter 9 55

Airline Regulation Before 1970, the airline industry was heavily regulated by the Civil Aeronautics Board (CAB) During 1976-1981, the airline industry in the U.S. changed dramatically as deregulation led to major changes Some airlines merged or went out of business as new airlines entered the industry Chapter 9 56

Airline Regulation Although prices in the industry fell considerably (helping consumers), profits did not. Regulation caused significant inefficiencies and artificially high costs We can show the effects of this regulation by looking at the effects on surplus from the controlled prices Chapter 9

Effect of Airline Regulation S D P0 Q0 Price Pmin Prior to deregulation price was at Pmin. Production was Q3 hoping to outsell competitors. A Q1 B Q2 C D Q3 Area D is the cost of unsold output. After deregulation: Prices fell to PO. The change in consumer surplus is A + B. Quantity Chapter 9 59

Airline Industry Data Chapter 9

Airline Industry Data Airline industry data show: Long-run adjustment as the number of carriers increased and prices decreased Higher load factors indicating more efficiency Falling rates Real cost increased slightly (adjusted fuel cost) Large welfare gain Chapter 9 61

Price Supports Much of agricultural policy is based on a system of price supports Prices set by government above free-market level and maintained by governmental purchases of excess supply Government can also increase prices through restricting production, directly or through incentives to producers Chapter 9 63

Price Supports What are the impacts on consumers, producers and the federal budget? Consumers Quantity demanded falls and quantity supplied increases Government buys surplus Consumers must pay higher price for the good Loss in consumer surplus equal to A+B Chapter 9

Price Supports Producers Government Gain since they are selling more at a higher price Producer surplus increases by A+B+D Government Cost of buying the surplus, which is funded by taxes, so indirect cost on consumers Cost to government = (Q2-Q1)PS Chapter 9

CS + PS – Govt. cost = D – (Q2-Q1)PS Price Supports Government may be able to “dump” some of the goods in the foreign markets Hurts domestic producers that government is trying to help in the first place Total welfare effect of policy CS + PS – Govt. cost = D – (Q2-Q1)PS Society is worse off overall Less costly to simply give farmers the money Chapter 9

Net Loss to society is E + B. Price Supports Price S D P0 Q0 D + Qg Qg To maintain a price Ps the government buys quantity Qg . Ps Q2 Q1 A D B E Net Loss to society is E + B. Quantity Chapter 9 66

Production Quotas The government can also cause the price of a good to rise by reducing supply Limitations of taxi medallions in New York City Limitation of required liquor licenses for restaurants Chapter 9 69

Supply Restrictions S’ D P0 Q0 S PS Q1 Price A B Supply restricted to Q1 Supply shifts to S’ & Q1 C CS reduced by A + B Change in PS = A - C Deadweight loss = BC Quantity Chapter 9 71

Supply Restrictions Incentive Programs US agricultural policy uses production incentives instead of direct quotas Government gives farmers financial incentives to restrict supply Acreage limitation programs Quantity decreases and price increases for the crop Chapter 9

Supply Restrictions Incentive Program Gain in PS of A from increased price of amount sold Loss of PS of C from decreased production Government pays farmers not to produce Total PS = A – C + payments from Govt. Government must pay enough to keep producers from producing more at the higher price Equals B+C+D Chapter 9

Supply Restrictions S’ Q1 D P0 Q0 S PS D Price CS reduced by A + B A B Cost to government = B + C + D = additional profit made if producing Q0 at PS C Change in PS = A + B + D Quantity Chapter 9 71

Supply Restrictions Which program is more costly? Both programs have same loss to consumers Producers are indifferent between programs because end up with same amount in both Typically, acreage limitation programs cost society less than price supports maintained by government purchases However, society is better off if government would just give farmers cash Chapter 9

Supporting the Price of Wheat From previous example, the supply and demand for wheat in 1981 was Supply: QS = 1,800 + 240P Demand: QD = 3,550 - 266P Equilibrium price and quantity was $3.46 and 2,630 million bushels Government raised the price to $3.70 through government purchases Chapter 9 75

Supporting the Price of Wheat How much would the government have had to buy to keep price at $3.70? QDTotal = QD + Qg = 3,550 - 266P + Qg QS = QDT 1,800 + 240P = 3,550 - 266P + Qg Qg = 506P - 1,750 At a price of $3.70, government would buy Qg = (506)(3.70) - 175 = 122 million bushels Chapter 9 76

The Wheat Market in 1981 S Price AB consumer loss ABC producer gain D 2,630 1,800 D + Qg Qg By buying 122 million bushels, the government increased the market-clearing price. PS = $3.70 A B 2,566 C 2,688 Quantity Chapter 9 80

Supporting the Price of Wheat We can quantify the effects on CS The change in consumer surplus = (-A -B) A = (3.70 - 3.46)(2,566) = $616 million B = (1/2)(3.70 - 3.46)(2,630 - 2,566) = $8 million CS = -$624 million Chapter 9 77

Supporting the Price of Wheat Cost to the government: $3.70 x 122 million bushels = $451.4 million Total cost of program = $624 + 451 = $1,075 million Gain to producers A + B + C = $638 million Government also paid 30 cents/bushel = $806 million Chapter 9 78

Supporting the Price of Wheat In 1985, the situation became worse Export demand fell and the market clearing price of wheat fell to $1.80/bushel Equilibrium quantity was 2231 The actual price, however, was $3.20 To keep price at $3.20, the government had to purchase excess wheat Government also imposed a production quota of about 2425 million bushels Chapter 9 81

Supporting the Price of Wheat 1985 Government Purchase: 2,425 = 2,580 - 194P + Qg Qg = -155 + 194P P = $3.20 -- the support price Qg = -155 + 194($3.20) = 466 million bushels Chapter 9 85

The Wheat Market in 1985 S’ S Qg D + Qg D Price 2,425 1,800 P0 = $1.80 2,232 D + Qg Qg To increase the price to $3.20, the government bought 466 million bushels and imposed a production quota of 2,425 bushels. PS = $3.20 1,959 Quantity Chapter 9 83

Supporting the Price of Wheat 1985 Government Cost: Purchase of Wheat = $3.20 x 466 = $1,491 million 80 cent subsidy = .80 x 2,425 = $1,940 million Total government program cost = $3.5 billion Chapter 9 86

Supporting the Price of Wheat In 1996, Congress passed the Freedom to Farm law Goal was to reduce the role of government and make agriculture more market-oriented Eliminated production quotas, gradually reduced government purchases and subsidies through 2003 Chapter 9 88

Supporting the Price of Wheat In 2002, Congress and President Bush reversed the effects of the 1996 bill by reinstating subsidies for most crops Calls for “fixed direct payments” New bill would cost taxpayers almost $1.1 billion in annual payments to wheat producers alone 2002 farm bill expected to cost taxpayers $190 billion over 10 years Estimated $83 billion over existing programs Chapter 9

Import Quotas and Tariffs Many countries use import quotas and tariffs to keep the domestic price of a product above world levels Import quotas: Limit on the quantity of a good that can be imported Tariff: Tax on an imported good This allows domestic producers to enjoy higher profits Cost to consumers is high Chapter 9 89

Import Quotas and Tariffs With lower world price, domestic consumers have incentive to purchase from abroad Domestic price falls to world price and imports equal difference between quantity supplied and quantity demanded Domestic industry might convince government to protect industry by eliminating imports Quota of zero or high tariff Chapter 9

Import Tariff to Eliminate Imports Price In a free market, the domestic price equals the world price PW. D P0 S Quota of zero pushes domestic price to P0 and imports go to zero. Q0 A B C Loss to consumers is A+B+C. Gain to producers is A. Dead weight loss: B +C. PW QS QD Imports Quantity Chapter 9 92

Import Tariff (General Case) The increase in price can be achieved by a tariff QS increases and QD decreases Area A is the gain to domestic producers The loss to consumers is A + B + C + D DWL = B + C Government Revenue is D = tariff * imports D C B QS QD Q’S Q’D A P* Pw Q P S Chapter 9 94

Import Quota (General Case) If a quota is used, rectangle D becomes part of the profits to foreign producers Consumers lose A+B+C+D Producers gain A Net domestic loss is B + C + D D C B QS QD Q’S Q’D A P* Pw Q P S Chapter 9 94

The Sugar Quota Example The world price of sugar has been as low as 4 cents per pound, while in the U.S. the price has been 20-25 cents per pound Sugar quotas have protected the sugar industry but driven up prices Domestic producers have been better off and so have some foreign producers that have quota rights Consumers are worse off Chapter 9 96

The Sugar Quota Example The Impact of a Sugar Quota in 2001 US production = 17.4 billion pounds US consumption = 20.4 billion pounds US price = 21.5 cents/pound World price = 8.3 cents/pound Price elasticity of US supply = 1.5 Price elasticity of US demand = –0.3 Chapter 9 97

Impact of Sugar Quota The data can be used to fit the US supply and demand curves QS = -8.70 + 1.21P QD = 26.53 - 0.29P World price was 24.2 million pounds, leading to little domestic supply and most domestic consumption coming from large imports Government restricted imports to 3 billion pounds raising price to 21.5 cents/pound Chapter 9 98

Sugar Quota in 1997 SUS DUS A D B Price 4 8 11 16 20 17.4 20.4 (cents/lb.) 4 8 11 16 20 17.4 20.4 PUS = 21.5 after quota A B D C The cost of the quotas to consumers was A + B + C + D = $2.4b. The gain to producers was area A = $1b. PW = 8.3 before quota 1.4 24.2 Quantity (billions of pounds) Chapter 9

The Impact of a Tax or Subsidy The government wants to impose a $1.00 tax on movies. It can do it two ways: Make the producers pay $1.00 for each movie ticket they sell Make consumers pay $1.00 when they buy each movie In which option are consumers paying more? Chapter 9

The Impact of a Tax or Subsidy The burden of a tax (or the benefit of a subsidy) falls partly on the consumer and partly on the producer How the burden is split between the parties depends on the relative elasticities of demand and supply Chapter 9 103

The Effects of a Specific Tax For simplicity we will consider a specific tax on a good Tax of a particular amount per unit sold Federal and state taxes on gas and cigarettes For our example, consider a specific tax of $t per widget sold Chapter 9

Incidence of a Specific Tax Price D S Pb price buyers pay Buyers lose A + B Tax = $1.00 Q1 A B Sellers lose D + C P0 Q0 Government gains A + D in tax revenue. D C PS price producers get The deadweight loss is B + C. Quantity Chapter 9 106

Incidence of a Specific Tax Four conditions that must be satisfied after the tax is in place: Quantity sold and buyer’s price, Pb, must be on the demand curve Buyers only concerned with what they must pay Quantity sold and seller’s price, PS, must be on the supply curve Sellers only concerned with what they receive Chapter 9 107

Incidence of a Specific Tax Four conditions that must be satisfied after the tax is in place (cont.): QD = QS Difference between what consumers pay and what buyers receive is the tax If we know the demand and supply curves as well as the tax, we can solve for PB, PS, QD and QS Chapter 9 108

Incidence of a Specific Tax In the previous example, the tax was shared almost equally by consumers and producers If demand is relatively inelastic, however, burden of tax will fall mostly on buyers Cigarettes If supply is relatively inelastic, the burden of tax will fall mostly on sellers Chapter 9

Impact of Elasticities on Tax Burdens Burden on Buyer Burden on Seller S D Price Price Q1 Pb PS t Q1 Pb PS t Q0 P0 Quantity Quantity 110

The Impact of a Tax or Subsidy We can calculate the percentage of a tax borne by consumers using pass-through fraction ES/(ES - Ed) Tells fraction of tax “passed through” to consumers through higher prices For example, when demand is perfectly inelastic (Ed = 0), the pass-through fraction is 1 – consumers bear 100% of tax Chapter 9 111

The Effects of a Tax or Subsidy A subsidy can be analyzed in much the same way as a tax Payment reducing the buyer’s price below the seller’s price It can be treated as a negative tax The seller’s price exceeds the buyer’s price Quantity increases Chapter 9 112

upon the elasticities of Effects of a Subsidy Price D S Like a tax, the benefit of a subsidy is split between buyers and sellers, depending upon the elasticities of supply and demand. PS Subsidy Q1 P0 Q0 Pb Quantity Chapter 9 114

Effects of a Subsidy The benefit of the subsidy accrues mostly to buyers if ED /ES is small The benefit of the subsidy accrues mostly to sellers if ES /ES is large As with a tax, using supply and demand curves, and the size of the subsidy, one can solve for resulting prices and quantities Chapter 9 115

A Tax on Gasoline We can measure the effects of a tax by looking at an example of a gasoline tax The goal of a large gasoline tax is to: Raise government revenue Reduce oil consumption and reduce US dependence on oil imports We will consider a gas tax in the market during mid-1990’s Chapter 9

A Tax on Gasoline Measuring the Impact of a 50 Cent Gasoline Tax Intermediate-run EP of demand = -0.5 QD = 150 - 50P EP of supply = 0.4 QS = 60 + 40P QS = QD at $1 and 100 billion gallons per year (bg/yr) Chapter 9 116

A Tax on Gasoline With a 50 cent tax: QD = QS 150 - 50Pb = 60 + 40PS 150 - 50(PS+ 0.50) = 60 + 40PS PS = .72 Pb = PS + 0.50 = $1.22 QD = QS = 89 bg/yr Chapter 9 117

A Tax on Gasoline With a 50 cent tax: Q falls by 11% Price to consumers increases by 22 cents per gallon Producers receive about 20 cents per gallon less Both producers and consumers were opposed to the tax Government revenue would be significant at $44.5 billion per year Chapter 9 118

The Impact of a 50 Cent Gasoline Tax D 60 Price ($ per gallon) Consumer Loss = A + B B Producer Loss = C + D Pb = 1.22 $0.50 Tax A 89 The buyer pays 22 cents of the tax, and the producer pays 28 cents. 100 P0 = 1.00 D C PS = .72 Government revenue = A + D = 0.50(89) = $44.5 billion. 11 Quantity (billion gallons per year) 50 150 Chapter 9 122