1. Chapter 11 © 2006 Thomson Learning/South-Western Applying the Competitive Model

2. 2 Consumer Surplus In Figure 11-1, the equilibrium price and quantity are P * and Q *. The demand curve, D, shows what people are willing to pay for the good. The total value of the good to buyers is given by the area below the demand curve from Q = 0 to Q = Q* (AEQ*0).

3. 3 Price P* S D E A B Quantity per period Q*0 FIGURE 11-1: Competitive Equilibrium and Consumer/Producer Surplus

4. 4 Consumer Surplus Consumers expenditures for Q* are given by the area P*EQ*0. Consumers receive a “surplus” (total value less what they pay) equal to the area AEP*, which is shaded gray in Figure 11-1.

5. 5 Price P* S D E A B Quantity per period Q*0 FIGURE 11-1: Competitive Equilibrium and Consumer/Producer Surplus

6. 6 Producer Surplus At the equilibrium shown in Figure 11-1, producers receive total revenue equal to the area P*EQ*0. If producers sold one unit at a time at the lowest possible price, producers would have been willing to produce Q* for the payment of BEQ*0. Thus, producer surplus the the area P*EB shaded in green in Figure 11-1.

7. 7 Price P* S D E A B Quantity per period Q*0 FIGURE 11-1: Competitive Equilibrium and Consumer/Producer Surplus

8. 8 Short-Run Producer Surplus The positive slope of the short-run supply curve, S, in Figure 11-1 results from the diminishing returns to variable inputs that are encountered as output is increased. For production up to Q*, price exceeds marginal cost, so total short-run profits equal the area P*EB less fixed costs

9. 9 Short-Run Producer Surplus Producer surplus, the area P*EB, reflects the sum of total short-run profits and short- run fixed costs. Short-run producer surplus is the part of total profits that is in excess of the profits firms would have if they chose to produce nothing at all. As such, it is similar to consumer surplus.

10. 10 Long-Run Producer Surplus Consider the area P*EB in Figure 11-1 as long-run producer surplus. It measures all of the increased payments relative to the situation in which the industry produces no output. The inputs would have received lower prices if this industry had not produced output.

11. 11 Ricardian Rent The market equilibrium price and quantity, P*, Q*, are shown in Figure 11-2 (d). Low-cost farms, Figure 11-2 (a) and medium-cost farms, Figure 11-2 (b), earn long-run economic profits. Marginal farms, Figure 11-2 (c) earn zero economic profits

12. 12 FIGURE 11-2 (d): The Market Price P* B E S D Q per period Q*

13. 13 FIGURE 11-2 (a): Low-Cost Farm Price P* MC AC q per period q*

14. 14 FIGURE 11-2 (b): Medium-Cost Farm Price P* MC AC q per period q*

15. 15 FIGURE 11-2 (c): Marginal Farm q per period Price P* q* MC AC

16. 16 Price P* MC AC q per period q* (a) Low-Cost Farm Price P* MC AC q per period q* (b) Medium-Cost Farm Price P* MC AC q per period q* (c) Marginal Farm Price P* B E S D Q per period Q* (d) The Market FIGURE 11-2: Ricardian Rent

17. 17 Ricardian Rent Profits earned by the intramarginal farms can persist in the long run because they reflect the returns to a scarce resource, low-cost land. Entry can not erode these profits because of the scarcity of the low-cost land. The sum of these long run profits (P*EB) is the producer surplus ( Ricardian rent).

18. 18 Economic Efficiency The competitive equilibrium is efficient in that it produces the largest surplus equal to the sum of producer and consumer surplus. In Figure 11-1, an output level of Q 1 results in a loss of surplus equal to the area FEG. Consumers would be willing to pay P 1 for a good that producers are willing to produce for P 2, so mutually beneficial transactions exit.

19. 19 Price P2P2 P* S D E F G P1P1 A B Quantity per period Q*Q1Q1 0 FIGURE 11-1: Competitive Equilibrium and Consumer/Producer Surplus

20. 20 A Numerical Example The market equilibrium is P* = $6 and Q* = 4. The equilibrium is shown as point E in Figure 11-3. At point E consumers are spending $24 ($6·4).

21. 21 A Numerical Example At point E in Figure 11-3, consumer surplus is $8 (= ½·$4·4). Producers also gain a producer surplus of $8 at point E. Total consumer and producer surplus is $16. If price stays at $6 but output falls to 3, total surplus falls to $15.

22. 22 Price S D E6 10 2 Tapes per period 43512 FIGURE 11-3: Efficiency in CD Sales

23. 23 Price Controls and Shortages In Figure 11-4 the market initially is in equilibrium at P 1, Q 1 (point E). Then demand increases from D to D’. This would cause price to rise to P 2 encouraging entry in the short-run. Eventually entry would bring the price down to P 3 and the market would be in long-run equilibrium.

24. 24 Price P 1 P 3 SS E E’ LS P 2 Quantity per periodQ 1 Q 3 D’ D Q 2 FIGURE 11-4: Price Controls and Shortages

25. 25 Price Controls and Shortages Suppose the government imposed a price control at the below equilibrium price of P 1 when demand increased. Firms would only supply Q 1 and no entry would take place. Since customers would demand Q 4 at this price, there would be a shortage of Q 4 - Q 1.

26. 26 Price Controls and Shortages The welfare consequences of price control can be analyzed using consumer and producer surplus. Consumers would gain surplus of P 3 CEP 1 (colored in gray) due to the lower price. This is a direct transfer of surplus from producers to consumers with no gain in total surplus.

27. 27 Price P 1 P 3 SS A C E E’ LS P 2 Quantity per period Q 1 Q 3 D’ D Q 4 FIGURE 11-4: Price Controls and Shortages

28. 28 Price Controls and Shortages If output had expanded, consumers would gain the area AE’C. Since output is reduced by the price control, this is a loss of surplus to consumers. Similarly, producers don’t gain the area CE’E that would have resulted from increased output. The area AE’E is the total welfare loss.

29. 29 Tax Incidence The study of the final burden of a tax after considering all market reactions to it is tax incidence theory. The incidence of a “specific tax” of a fixed amount per unit of output that is imposed on all firms in a constant cost industry is illustrated in Figure 11-5

30. 30 Price P 1 P 2 SMC MC AC Output (a) Typical Firm q2q2 q1q1 0 Price P 4 P 3 Quantity per week (b) The Market Q 3 Q 2 Q 1 D S’ S D’ Tax LS 0 FIGURE 11-5: Effect of the Imposition of a Specific Tax on a Perfectly Competitive Constant Cost Industry

31. 31 Tax Incidence Since for any price, P, consumers pay the firm gets to keep P - t (where t is the per unit tax), the effect of the tax on firms can be shown as a decrease in demand. The vertical distance between the demand curves is t. It creates a wedge between the consumers’ price, P, and the price firms receive.

32. 32 Short-Run Tax Incidence The short-run effect is to decrease output from Q 1 to Q 2, where firms receive P 2 and consumers pay P 3 (P 3 - P 2 = t). So long as P 2 is above minimum variable costs, the firm continues to produce and the tax incidence is shared by consumers, whose price increased to P 3, and by firm’s who now receive only P 2 rather than P 1.

33. 33 Long-Run Tax Incidence Firms will not operate at a loss in the long run, so exit will take place shifting the short-run supply curve back to S’. In the new long-run equilibrium, output will return to Q 3 where the firm’s will receive P 1 again and consumers will pay P 4. The long-run tax incidence is all on the consumer although the firms pays the tax.

34. 34 Long-Run Incidence with Increasing Costs When the long-run supply curve has a positive slope, both consumers and firms pay a portion of the tax. The imposition of the tax shifts the long- run demand curve inward to D’ (as shown in Figure 11-6) which causes the price to fall from P 1 to P 2 as some firms exit and input prices fall.

35. 35 Price P 2 P 3 P 1 Quantity per periodQ 2 Q 1 D LS A B E 1 E 2 D’ Tax FIGURE 11-6: Tax Incidence in an Increasing Cost Industry

36. 36 Long-Run Incidence with Increasing Costs Consumers pay a portion of the tax since the gross price of P 3 exceeds the pre-tax price. Total tax collection is the gray area P 3 ARE 2 P 2. The inputs to the firm pay the remainder of the tax as they are not paid based on a lower net price of P 2.

37. 37 Incidence and Elasticity The economic actor who has the most elastic curve will be able to avoid more of the tax leaving the actor with the more inelastic curve to pay most of the tax. If demand is relatively inelastic and supply is elastic, demanders will pay most of the tax. If supply is relatively inelastic and demand is elastic, suppliers will pay most of the tax.

38. 38 Taxation and Efficiency In Figure 11-6, the total loss of consumer surplus is the area P 3 AE 1 P 1. The area P 3 ABP 1 is transferred into tax revenue and the area AE 1 B is simply lost. The loss in producer surplus is P 1 E 1 E 2 P 2 of which P 1 BE 2 P 2 is tax revenue and BE 1 E 2 lost.

39. 39 Gains from International Trade Figure 11-7 shows the domestic demand and supply curves for a particular good, say shoes. Without international trade, the equilibrium price and quantity would be P D, Q D. If the world shoe price is P W, the opening of trade will cause prices to fall causing quantity to increase to Q 1.

40. 40 Gains from International Trade The quantity supplied by domestic producers will fall to Q 2 with shoe imports of Q 1 - Q 2. Consumer surplus increases by the area P D E 0 E 1 P W. Part, P D E 0 AP W, comes as a transfer from domestic producers, and the rest is an unambiguous gain in welfare (E 0 E 1 A).

41. 41 Price P W P D Quantity per period Q 2 Q 1 E 1 E 0 Q D D A LS FIGURE 11-7: Opening of International Trade Increases Total Welfare

42. 42 Tariff Protection Producers will resist their losses, and since the loss is spread over fewer producers than the gain for consumers, they have a stronger incentive to organize for trade protection. A major trade protection is a tariff which is a tax on an imported good. Effects of a tariff are shown in Figure 11-8.

43. 43 Price P W P R Quantity per period Q 2 Q 3 Q 1 E 1 E 2 Q 4 D B A CF LS FIGURE 11-8: Effects of a Tariff

44. 44 Tariff Protection Compared to the free trade equilibrium E 1, the imposition of a per-unit tariff in the amount of t raises the effective price to P W + t = P R. Quantity demanded falls to Q 3 while domestic production expands to Q 4. Tariff revenue is the area BE 2 FC, equal to t(Q 3 - Q 4 ).

45. 45 Tariff Protection Total consumer surplus is reduced by the area P R E 2 E 1 P W. Part becomes tariff revenue and part is transferred into domestic producer’s surplus (area P R BAP W ). The two colored triangles BCA and E 2 E 1 F represent losses that are not transferred; these are the deadweight losses from the tariff.

46. 46 Other Types of Trade Protection A quota that limits imports to Q 3 - Q 4 (in Figure 11-8) would have a similar effect to a tariff. Market price would rise to P R. Consumer surplus would be transferred to domestic producers (area P R BAP W ). A deadweight loss equal to the areas of the colored triangles would also occur.

47. 47 Other Types of Trade Protection However, with a quota, no tax revenue is generated. The area BE 2 FC can go to foreign producers or to windfall gains to owners of import licenses. Nonquantitative restrictions such as health or other inspections also impose costs like a a tariff on imports, and can be analyzed in a similar manner using Figure 11-8.