1. Chapter 9 The Analysis of Competitive Markets

2. ©2005 Pearson Education, Inc. Chapter 92 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

3. ©2005 Pearson Education, Inc. Chapter 93 Consumer and Producer Surplus Between 0 and Q 0 producers receive a net gain from selling each product-- producer surplus. Consumer Surplus Quantity Price S D Q0Q0 5 9 Between 0 and Q 0 consumer A receives a net gain from buying the product-- consumer surplus. Producer Surplus 3 QDQD QSQS

4. ©2005 Pearson Education, Inc. Chapter 94 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

5. ©2005 Pearson Education, Inc. Chapter 95 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

6. ©2005 Pearson Education, Inc. Chapter 96 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

7. ©2005 Pearson Education, Inc. Chapter 97 The loss to producers is the sum of rectangle A and triangle C B A C Consumers that can buy the good gain A Price Control and Surplus Changes Quantity Price S D P0P0 Q0Q0 P max Q1Q1 Q2Q2 Consumers that cannot buy, lose B Triangles B and C are losses to society – dead weight loss

8. ©2005 Pearson Education, Inc. Chapter 98 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

9. ©2005 Pearson Education, Inc. Chapter 99 B A P max C Q1Q1 With inelastic demand, triangle B can be larger than rectangle A and consumers suffer net losses from price controls. S D Price Controls With Inelastic Demand Quantity Price P0P0 Q2Q2

10. ©2005 Pearson Education, Inc. Chapter 910 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

11. ©2005 Pearson Education, Inc. Chapter 911 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

12. ©2005 Pearson Education, Inc. Chapter 912 Types of Market Failures 1.Externalities  Costs or benefits that are not reflected in market supply and demand (e.g. pollution)  Costs or benefits are experienced by a third party not involved in transaction 2.Lack of Information  Imperfect information prevents consumers from making utility-maximizing decisions Government intervention may be desirable in these cases

13. ©2005 Pearson Education, Inc. Chapter 913 B A C Price Control and Surplus Changes Quantity Price S D P0P0 Q0Q0 P min Q1Q1 Q2Q2 When price is regulated to be no lower than P min, the deadweight loss given by triangles B and C results.

14. ©2005 Pearson Education, Inc. Chapter 914 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: Q S = 8,000 + 0.2P  Demand: Q D = 16,000 - 0.2P

15. ©2005 Pearson Education, Inc. Chapter 915 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

16. ©2005 Pearson Education, Inc. Chapter 916 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 ‘producer’ loss of A + C = $200 million

17. ©2005 Pearson Education, Inc. Chapter 917 The Market for Human Kidneys Recipients:  Since they do not have to pay for the kidney, they gain rectangle A ($160 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

18. ©2005 Pearson Education, Inc. Chapter 918 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

19. ©2005 Pearson Education, Inc. Chapter 919 D A and D measure the total value of kidneys when supply is constrained. A C The loss to suppliers is seen in areas A & C. The Market for Kidneys Quantity Price 4,000 0 $10,000 $30,000 $40,000 8,000 S’ B If kidneys are zero cost, consumer gain would be A minus B. S D 12,000 $20,000

20. ©2005 Pearson Education, Inc. Chapter 920 The Market for Human Kidneys Arguments in favor of prohibiting the sale of organs: 1.Imperfect information about donor’s health and screening 2.Unfair to allocate according to the ability to pay Holding price below equilibrium will create shortages Organs versus artificial substitutes

21. ©2005 Pearson Education, Inc. Chapter 921 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

22. ©2005 Pearson Education, Inc. Chapter 922 B A The change in producer surplus will be A - C - D. Producers may be worse off. C D Minimum Prices Quantity Price S D P0P0 Q0Q0 Q3Q3 Q2Q2 P min If producers produce Q 2, the amount Q 2 - Q 3 will go unsold. D measures total cost of increased production not sold.

23. ©2005 Pearson Education, Inc. Chapter 923 B The deadweight loss is given by triangles B and C. C A L1L1 L2L2 Unemployment w min Firms are not allowed to pay less than w min. This results in unemployment. S D w0w0 L0L0 The Minimum Wage L w A is gain to workers who find jobs at higher wage.

24. ©2005 Pearson Education, Inc. Chapter 924 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

25. ©2005 Pearson Education, Inc. Chapter 925 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

26. ©2005 Pearson Education, Inc. Chapter 926 Price Supports Producers  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 = (Q 2 -Q 1 )P S

27. ©2005 Pearson Education, Inc. Chapter 927 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 – (Q 2 -Q 1 )P S Society is worse off overall Less costly to simply give farmers the money

28. ©2005 Pearson Education, Inc. Chapter 928 B D A To maintain a price P s the government buys quantity Q g. D + Q g QgQg Price Supports Quantity Price S D P0P0 Q0Q0 PsPs Q2Q2 Q1Q1 E Net Loss to society is E + B.

29. ©2005 Pearson Education, Inc. Chapter 929 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

30. ©2005 Pearson Education, Inc. Chapter 930 B A CS reduced by A + B Change in PS = A - C Deadweight loss = BC C Supply Restrictions Quantity Price D P0P0 Q0Q0 S S’ PSPS Q1Q1 Supply restricted to Q 1 Supply shifts to S’ & Q 1

31. ©2005 Pearson Education, Inc. Chapter 931 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

32. ©2005 Pearson Education, Inc. Chapter 932 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

33. ©2005 Pearson Education, Inc. Chapter 933 QSQS QDQD PWPW A BC Quota of zero pushes domestic price to P 0 and imports go to zero. Import Tariff to Eliminate Imports Quantity Price Q0Q0 D P0P0 S In a free market, the domestic price equals the world price P W. Imports Loss to consumers is A+B+C. Gain to producers is A. Dead weight loss: B +C.

34. ©2005 Pearson Education, Inc. Chapter 934 Import Tariff (General Case) The increase in price can be achieved by a tariff Q S increases and Q D 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 CB QSQS QDQD Q’ S Q’ D A P* PwPw Q P D S

35. ©2005 Pearson Education, Inc. Chapter 935 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 CB QSQS QDQD Q’ S Q’ D A P* PwPw Q P D S

36. ©2005 Pearson Education, Inc. Chapter 936 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

37. ©2005 Pearson Education, Inc. Chapter 937 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

38. ©2005 Pearson Education, Inc. Chapter 938 Impact of Sugar Quota The data can be used to fit the US supply and demand curves  Q S = -8.70 + 1.21P  Q D = 26.53 - 0.29P  This situation led 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

39. ©2005 Pearson Education, Inc. Chapter 939 Sugar Quota in 1997 C D B A The cost of the quotas to consumers was A + B + C + D = $2.4b. The gain to producers was area A = $1b. S US D US Price (cents/lb.) 4 8 11 16 20 P W = 8.3 before quota P US = 21.5 after quota Quantity (billions of pounds) 24.2 1.4 17.420.4

40. ©2005 Pearson Education, Inc. Chapter 940 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?

41. ©2005 Pearson Education, Inc. Chapter 941 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

42. ©2005 Pearson Education, Inc. Chapter 942 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

43. ©2005 Pearson Education, Inc. Chapter 943 Buyers lose A + B Incidence of a Specific Tax D S B D A C Quantity Price P0P0 Q0Q0 Q1Q1 P S price producers get P b price buyers pay Tax = $1.00 Government gains A + D in tax revenue. Sellers lose D + C The deadweight loss is B + C.

44. ©2005 Pearson Education, Inc. Chapter 944 Effect of an Output Tax on Industry Output Price ($ per unit of output) Output D P1P1 SS1SS1 Q1Q1 P2P2 Q2Q2 S S 2 = S 1 + t t Tax shifts S 1 to S 2 and output falls to Q 2. Price increases to P 2.

45. ©2005 Pearson Education, Inc. Chapter 945 Incidence of a Specific Tax Four conditions that must be satisfied after the tax is in place: 1.Quantity sold and buyer’s price, P b, must be on the demand curve Buyers only concerned with what they must pay 2.Quantity sold and seller’s price, P S, must be on the supply curve Sellers only concerned with what they receive

46. ©2005 Pearson Education, Inc. Chapter 946 Incidence of a Specific Tax Four conditions that must be satisfied after the tax is in place (cont.): 3.Q D = Q S 4.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 P B, P S, Q D and Q S

47. ©2005 Pearson Education, Inc. Chapter 947 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

48. Impact of Elasticities on Tax Burdens Quantity Price S D S D Q0Q0 P0P0 P0P0 Q0Q0 Q1Q1 PbPb PSPS t Q1Q1 PbPb PSPS t Burden on Buyer Burden on Seller

49. ©2005 Pearson Education, Inc. Chapter 949 The Impact of a Tax or Subsidy We can calculate the percentage of a tax borne by consumers using pass-through fraction  E S /(E S - E d )  Tells fraction of tax “passed through” to consumers through higher prices  For example, when demand is perfectly inelastic (E d = 0), the pass-through fraction is 1 – consumers bear 100% of tax

50. ©2005 Pearson Education, Inc. Chapter 950 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

51. ©2005 Pearson Education, Inc. Chapter 951 D S Effects of a Subsidy Quantity Price P0P0 Q0Q0 Q1Q1 PSPS PbPb Like a tax, the benefit of a subsidy is split between buyers and sellers, depending upon the elasticities of supply and demand. Subsidy

52. ©2005 Pearson Education, Inc. Chapter 952 Effects of a Subsidy The benefit of the subsidy accrues mostly to buyers if E D /E S is small The benefit of the subsidy accrues mostly to sellers if E D /E S 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

53. ©2005 Pearson Education, Inc. Chapter 953 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

54. ©2005 Pearson Education, Inc. Chapter 954 A Tax on Gasoline Measuring the Impact of a 50 Cent Gasoline Tax  Intermediate-run E P of demand = -0.5 Q D = 150 - 50P  E P of supply = 0.4 Q S = 60 + 40P  Q S = Q D at $1 and 100 billion gallons per year (bg/yr)

55. ©2005 Pearson Education, Inc. Chapter 955 A Tax on Gasoline With a 50 cent tax: Q D = Q S 150 - 50P b = 60 + 40P S 150 - 50(P S + 0.50) = 60 + 40P S P S =.72 P b = P S + 0.50 = $1.22 Q D = Q S = 89 bg/yr

56. ©2005 Pearson Education, Inc. Chapter 956 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 28 cents per gallon less  Both producers and consumers were opposed to the tax  Government revenue would be significant at $44.5 billion per year

57. ©2005 Pearson Education, Inc. Chapter 957 C D A The Impact of a 50 Cent Gasoline Tax Quantity (billion gallons per year) Price ($ per gallon) 50150 100 P 0 = 1.00 P b = 1.22 P S =.72 89 11 The buyer pays 22 cents of the tax, and the producer pays 28 cents. SD 60 $0.50 Tax Consumer Loss = A + B Producer Loss = C + D Government revenue = A + D = 0.50(89) = $44.5 billion. B