1. Competitive Markets:
Applications

2. 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

3. 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:

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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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.

11. 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.

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

13. 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*

14. 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“

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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.

22. 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