1. Chapter 9 The Analysis of Competitive Markets

2. ©2005 Pearson Education, Inc. Chapter 92 Topics to be Discussed Evaluating the Gains and Losses from Government Policies The Efficiency of a Competitive Market Minimum Prices The Impact of a Tax or Subsidy

3. ©2005 Pearson Education, Inc. Chapter 93 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

4. ©2005 Pearson Education, Inc. Chapter 94 Consumer and Producer Surplus 1.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

5. ©2005 Pearson Education, Inc. Chapter 95 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

6. ©2005 Pearson Education, Inc. Chapter 96 Consumer and Producer Surplus 2.Producer surplus is the total benefit or revenue that producers receive beyond what it cost 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

7. ©2005 Pearson Education, Inc. Chapter 97 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

8. ©2005 Pearson Education, Inc. Chapter 98 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

9. ©2005 Pearson Education, Inc. Chapter 99 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.

10. ©2005 Pearson Education, Inc. Chapter 910 Consumer and Producer Surplus When government institutes a price ceiling, the price of a good can’t to 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

11. ©2005 Pearson Education, Inc. Chapter 911 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. Some consumers better off because they can buy it at a lower price.

12. ©2005 Pearson Education, Inc. Chapter 912 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

13. ©2005 Pearson Education, Inc. Chapter 913 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

14. ©2005 Pearson Education, Inc. Chapter 914 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

15. ©2005 Pearson Education, Inc. Chapter 915 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

16. ©2005 Pearson Education, Inc. Chapter 916 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

17. ©2005 Pearson Education, Inc. Chapter 917 The Efficiency of a Competitive Market If efficiency is the goal, then you can argue 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

18. ©2005 Pearson Education, Inc. Chapter 918 Types of Market Failures 1.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 2.Lack of Information  Imperfect information prevents consumers from making utility-maximizing decisions. Government intervention may be desirable in these cases

19. ©2005 Pearson Education, Inc. Chapter 919 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?

20. ©2005 Pearson Education, Inc. Chapter 920 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.

21. ©2005 Pearson Education, Inc. Chapter 921 The Efficiency of a Competitive Market Deadweight loss triangles, B and C, give a good estimate of 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

22. ©2005 Pearson Education, Inc. Chapter 922 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

23. ©2005 Pearson Education, Inc. Chapter 923 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

24. ©2005 Pearson Education, Inc. Chapter 924 Minimum Prices Loses 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

25. ©2005 Pearson Education, Inc. Chapter 925 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

26. ©2005 Pearson Education, Inc. Chapter 926 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

27. ©2005 Pearson Education, Inc. Chapter 927 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

28. ©2005 Pearson Education, Inc. Chapter 928 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

29. ©2005 Pearson Education, Inc. Chapter 929 Price Supports Much of agricultural policy is based on a system of price supports.  Price 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

30. ©2005 Pearson Education, Inc. Chapter 930 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

31. ©2005 Pearson Education, Inc. Chapter 931 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

32. ©2005 Pearson Education, Inc. Chapter 932 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 over all Less costly to simply give farmers the money

33. ©2005 Pearson Education, Inc. Chapter 933 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

34. ©2005 Pearson Education, Inc. Chapter 934 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

35. ©2005 Pearson Education, Inc. Chapter 935 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

36. ©2005 Pearson Education, Inc. Chapter 936 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

37. ©2005 Pearson Education, Inc. Chapter 937 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

38. ©2005 Pearson Education, Inc. Chapter 938 B A CS reduced by A + B C Supply Restrictions Quantity Price D P0P0 Q0Q0 S S’ Q1Q1 Cost to government = B + C + D = additional profit made if producing Q 0 at P S PSPS D Change in PS = A + B + D

39. ©2005 Pearson Education, Inc. Chapter 939 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 program costs society less than price supports maintained by government purchases  However, society better off if government would just give farmers cash

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 Incidence of a Specific Tax Four conditions that must be satisfied after the tax is in place: 1.Quantity sold and buyers price, P b, must be on the demand curve Buyers only concerned with what they must pay 2.Quantity sold and sellers price, P S, must be on the supply curve Sellers only concerned with what they receive

45. ©2005 Pearson Education, Inc. Chapter 945 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

46. ©2005 Pearson Education, Inc. Chapter 946 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

47. 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

48. ©2005 Pearson Education, Inc. Chapter 948 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 (Ed = 0), the pass-through fraction is 1 – consumers bear 100% of tax.

49. ©2005 Pearson Education, Inc. Chapter 949 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

50. ©2005 Pearson Education, Inc. Chapter 950 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

51. ©2005 Pearson Education, Inc. Chapter 951 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.