1. 1 Chapter 10 THE PARTIAL EQUILIBRIUM COMPETITIVE MODEL: -Market demand -Market supply Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved.

2. 2 Market Demand We start by studying the demand of the market

3. 3 Market Demand Assume that there are only two goods (x and y) –An individual’s demand for x is Quantity of x demanded = x(p x,p y, I ) –If we use i to reflect each individual in the market, then the market demand curve is

4. 4 Market Demand To construct the market demand curve, P X is allowed to vary while P y and the income of each individual are held constant If each individual’s demand for x is downward sloping, the market demand curve will also be downward sloping

5. 5 Market Demand xxx pxpx pxpx pxpx x1*x1* x2*x2* px*px* To derive the market demand curve, we sum the quantities demanded at every price x1x1 Individual 1’s demand curve x2x2 Individual 2’s demand curve Market demand curve X*X* X x 1 * + x 2 * = X*

6. 6 Shifts in the Market Demand Curve The market demand summarizes the ceteris paribus relationship between X and p x –changes in p x result in movements along the curve (change in quantity demanded) –changes in other determinants of the demand for X cause the demand curve to shift to a new position (change in demand) –See example 10.1 in the book to see how to do it mathematically

7. 7 Elasticity of Market Demand The price elasticity of market demand is measured by Market demand is characterized by whether demand is elastic (e X,Px e X,Px > -1)

8. 8 Elasticity of Market Demand The cross-price elasticity of market demand is measured by The income elasticity of market demand is measured by

9. 9 We will study supply of the market and the market equilibrium The way the equilibrium is determined depends on whether we are studying short run, or long run From the time being, we will focus our attention on studying the equilibrium in perfectly competitive industries

10. 10 Perfect Competition A perfectly competitive industry is one that obeys the following assumptions: –each firm attempts to maximize profits –there are a large number of firms, each producing the same homogeneous product –each firm is a price taker its actions have no effect on the market price –information is perfect Product characteristics, technology, prices are common knowledge –transactions are costless Buyers and sellers incur no costs in making exchanges

11. 11 Timing of the Supply Response In the analysis of competitive pricing, the time period under consideration is important The time period will be important to determine the supply curve –very short run (not very interesting, we will not study it…) –short run existing firms can alter their quantity supplied by altering the quantity of the variable input (labour), but quantity of fixed inputs cannot be changed, hence no new firms can enter the industry –long run new firms may enter an industry

12. 12 Market Supply in the short run The quantity of output supplied to the entire market in the short run is the sum of the quantities supplied by each firm –the amount supplied by each firm depends on price The short-run market supply curve will be upward-sloping because each firm’s short-run supply curve has a positive slope

13. 13 Determination of the eq. Price in the short run The number of firms in an industry is fixed These firms are able to adjust the quantity they are producing –they can do this by altering the levels of the variable inputs they employ

14. 14 Short-Run Market Supply Function The short-run market supply function shows total quantity supplied by each firm to a market Firms are assumed to face the same market price and the same prices for inputs

15. 15 Short-Run Market Supply Curve quantityQuantityquantity P PP q1Aq1A q1Bq1B P1P1 To derive the market supply curve, we sum the quantities supplied at every price sAsA Firm A’s supply curve sBsB Firm B’s supply curve Market supply curve Q1Q1 S q 1 A + q 1 B = Q 1

16. 16 Short-Run Supply Elasticity The short-run supply elasticity describes the responsiveness of quantity supplied to changes in market price Because price and quantity supplied are positively related, e S,P > 0 See example 10.2 in the book

17. 17 Equilibrium Price Determination in the SR We have studied the market demand We have studied the short run supply curve So, we can study the short run market equilibrium

18. 18 Equilibrium Price Determination in the SR An equilibrium price is one at which quantity demanded is equal to quantity supplied In an equilibrium price: –suppliers are supplying the optimal quantity given the price and constraints, and demanders are demanding their optimal quantity… –neither suppliers nor demanders have an incentive to alter their economic decisions An equilibrium price (P*) solves the equation:

19. 19 Equilibrium Price Determination The equilibrium price depends on many exogenous factors: –Demand curves depend on other goods prices, income, preferences (utility function) –Supply curves depend on inputs prices –changes in any of these factors will likely result in a new equilibrium price Economists predict the new situation by computing the new equilibrium. The equilibrium is an economist’s prediction of the new situation after a change has taken place

20. 20 Equilibrium Price Determination Quantity Price S D Q1Q1 P1P1 The interaction between market demand and market supply determines the equilibrium price

21. 21 Market Reaction to a Shift in Demand Quantity Price S D Q1Q1 P1P1 Q2Q2 P2P2 Equilibrium price and equilibrium quantity will both rise If many buyers experience an increase in their demands, the market demand curve will shift to the right D’D’

22. 22 Market Reaction to a Shift in Demand Quantity Price SMC q1q1 P1P1 This is the short-run supply response to an increase in market price q2q2 P2P2 If the market price rises, firms will increase their level of output SAC

23. 23 Shifts in Supply and Demand Curves Demand curves shift because –incomes change –prices of substitutes or complements change –preferences change Supply curves shift because –input prices change –technology changes –number of producers change

24. 24 Shifts in Supply and Demand Curves When either a supply curve or a demand curve shift, equilibrium price and quantity will change The relative magnitudes of these changes depends on the shapes of the supply and demand curves (elasticity is very important !!!!) See example 10.3 in the book

25. 25 Shifts in Supply Quantity Price S S’S’ S S’S’ D D P P Q P’P’ Q’Q’ P’P’ QQ’Q’ Elastic DemandInelastic Demand Small increase in price, large drop in quantity Large increase in price, small drop in quantity

26. 26 Shifts in Demand Quantity Price S S DD P P Q P’P’ Q’Q’ P’P’ QQ’Q’ Elastic SupplyInelastic Supply Small increase in price, large rise in quantity Large increase in price, small rise in quantity D’D’ D’D’

27. 27 Putting it together… Using econometrics, we can estimate the demand and supply curve, and how they depend on other factors (input prices, other goods’ prices…) Compute the new equilibrium when these other factors change This would be our prediction… However, it could be enough to estimate the different elasticities rather than the whole new curves

28. 28 Mathematical Model of Supply and Demand Suppose that the demand function is represented by Q D = D(P,  ) –  is a parameter that shifts the demand curve  D/  = D  can have any sign –  D/  P = D P < 0

29. 29 Mathematical Model of Supply and Demand The supply relationship can be shown as Q S = S(P,  ) –  is a parameter that shifts the supply curve  S/  = S  can have any sign –  S/  P = S P > 0 Equilibrium requires that Q D = Q S

30. 30 Mathematical Model of Supply and Demand To analyze the comparative statics of this model, we need to use the total differentials of the supply and demand functions: dQ D = D P dP + D  d  dQ S = S P dP + S  d  Maintenance of equilibrium requires that dQ D = dQ S

31. 31 Mathematical Model of Supply and Demand Suppose that the demand parameter (  ) changed while  remains constant The equilibrium condition requires that D P dP + D  d  = S P dP Because S P - D P > 0,  P/  will have the same sign as D 

32. 32 Mathematical Model of Supply and Demand We can convert our analysis to elasticities Dividing numerator and denominator by Q…

33. 33 Long-Run Analysis So far, we have studied short run… In the long run, a firm may adapt all of its inputs to fit market conditions –profit-maximization for a price-taking firm implies that price is equal to long-run MC Firms can also enter and exit an industry in the long run –perfect competition assumes that there are no special costs of entering or exiting an industry

34. 34 Long-Run Analysis New firms will be lured into any market for which economic profits are greater than zero –entry of firms will cause the short-run industry supply curve to shift outward –market price and profits will fall –the process will continue until economic profits are zero

35. 35 Long-Run Analysis Existing firms will leave any industry for which economic profits are negative –exit of firms will cause the short-run industry supply curve to shift inward –market price will rise and losses will fall –the process will continue until economic profits are zero

36. 36 Long-Run Competitive Equilibrium A perfectly competitive industry is in long-run equilibrium if there are no incentives for profit-maximizing firms to enter or to leave the industry –That is, if profits are are zero in the long- run equilibrium –this will occur when the number of firms is such that P = MC = AC and each firm operates at minimum AC

37. 37 Long-Run Competitive Equilibrium We will assume that all firms in an industry have identical cost curves –no firm controls any special resources or technology The equilibrium long-run position requires that each firm earn zero economic profit

38. 38 Long-Run Equilibrium: Constant-Cost Case Assume that the entry of new firms in an industry has no effect on the cost of inputs –no matter how many firms enter or leave an industry, a firm’s cost curves will remain unchanged This is referred to as a constant-cost industry (Example 10.5)

39. 39 Long-Run Equilibrium: Constant-Cost Case A Typical FirmTotal Market Quantity SMC MC AC S D q1q1 P1P1 Q1Q1 This is a long-run equilibrium for this industry P = MC = AC Price

40. 40 Long-Run Equilibrium: Constant-Cost Case A Typical FirmTotal Market q1q1 Quantity SMC MC AC S D P1P1 Q1Q1 P2P2 Market price rises to P 2 Q2Q2 Suppose that market demand rises to D’ D’D’ Price

41. 41 Long-Run Equilibrium: Constant-Cost Case A Typical FirmTotal Market q1q1 Quantity SMC MC AC S D P1P1 Q1Q1 D’D’ P2P2 Economic profit > 0 Q2Q2 In the short run, each firm increases output to q 2 q2q2 Price

42. 42 Long-Run Equilibrium: Constant-Cost Case A Typical FirmTotal Market q1q1 Quantity SMC MC AC S D P1P1 Q1Q1 D’D’ Economic profit will return to 0 Q3Q3 In the long run, new firms will enter the industry S’S’ Price

43. 43 Long-Run Equilibrium: Constant-Cost Case A Typical FirmTotal Market q1q1 Quantity SMC MC AC S D P1P1 Q1Q1 D’D’ Q3Q3 S’S’ The long-run supply curve will be a horizontal line (infinitely elastic) at p 1 LS Price

44. 44 Shape of the Long-Run Supply Curve The zero-profit condition is the factor that determines the shape of the long-run cost curve –if average costs are constant as firms enter, long-run supply will be horizontal –if average costs rise as firms enter, long-run supply will have an upward slope –if average costs fall as firms enter, long-run supply will be negatively sloped

45. 45 Long-Run Equilibrium: Increasing-Cost Industry The entry of new firms may cause the average costs of all firms to rise –prices of scarce inputs may rise –new firms may impose “external” costs on existing firms –new firms may increase the demand for tax-financed services

46. 46 Long-Run Equilibrium: Increasing-Cost Industry A Typical Firm (before entry)Total Market q1q1 Quantity SMC MC AC S D P1P1 Q1Q1 Suppose that we are in long-run equilibrium in this industry P = MC = AC Price

47. 47 Long-Run Equilibrium: Increasing-Cost Industry A Typical Firm (before entry)Total Market q1q1 Quantity SMC MC AC S D P1P1 Q1Q1 Suppose that market demand rises to D’ D’D’ P2P2 Market price rises to P 2 and firms increase output to q 2 Q2Q2 q2q2 Price

48. 48 Long-Run Equilibrium: Increasing-Cost Industry A Typical Firm (after entry)Total Market Quantity SMC’ MC’ AC’ S D P1P1 Q1Q1 D’D’ q3q3 P3P3 Entry of firms causes costs for each firm to rise Q3Q3 Positive profits attract new firms and supply shifts out S’S’ Price

49. 49 Long-Run Equilibrium: Increasing-Cost Industry A Typical Firm (after entry)Total Market q3q3 Quantity SMC’ MC’ AC’ S D p1p1 Q1Q1 D’D’ p3p3 Q3Q3 S’S’ The long-run supply curve will be upward-sloping LS Price

50. 50 Long-Run Equilibrium: Decreasing-Cost Industry The entry of new firms may cause the average costs of all firms to fall –new firms may attract a larger pool of trained labor –entry of new firms may provide a “critical mass” of industrialization permits the development of more efficient transportation and communications networks

51. 51 Long-Run Equilibrium: Decreasing-Cost Case A Typical Firm (before entry)Total Market q1q1 Quantity SMC MC AC S D P1P1 Q1Q1 Suppose that we are in long-run equilibrium in this industry P = MC = AC Price

52. 52 Long-Run Equilibrium: Decreasing-Cost Industry A Typical Firm (before entry)Total Market q1q1 Quantity SMC MC AC S D P1P1 Q1Q1 Suppose that market demand rises to D’ D’D’ P2P2 Market price rises to P 2 and firms increase output to q 2 Q2Q2 q2q2 Price

53. 53 Long-Run Equilibrium: Decreasing-Cost Industry A Typical Firm (before entry)Total Market q1q1 Quantity SMC’ MC’ AC’ S D P1P1 Q1Q1 D’D’ P3P3 Entry of firms causes costs for each firm to fall Q3Q3 q3q3 Positive profits attract new firms and supply shifts out S’S’ Price

54. 54 Long-Run Equilibrium: Decreasing-Cost Industry A Typical Firm (before entry)Total Market q1q1 Quantity SMC’ MC’ AC’ S D P1P1 Q1Q1 The long-run industry supply curve will be downward-sloping D’D’ P3P3 Q3Q3 q3q3 S’S’ LS Price

55. 55 Classification of Long-Run Supply Curves Constant Cost –entry does not affect input costs –the long-run supply curve is horizontal at the long-run equilibrium price Increasing Cost –entry increases inputs costs –the long-run supply curve is positively sloped

56. 56 Classification of Long-Run Supply Curves Decreasing Cost –entry reduces input costs –the long-run supply curve is negatively sloped

57. 57 Long-Run Elasticity of Supply The long-run elasticity of supply (e LS,P ) records the proportionate change in long- run industry output to a proportionate change in price e LS,P can be positive or negative –the sign depends on whether the industry exhibits increasing or decreasing costs

58. 58 Comparative Statics Analysis of Long-Run Equilibrium Comparative statics analysis of long-run equilibria can be conducted using estimates of long-run elasticities of supply and demand Remember that, in the long run, the number of firms in the industry will vary from one long-run equilibrium to another

59. 59 Comparative Statics Analysis of Long-Run Equilibrium Assume that we are examining a constant-cost industry Suppose that the initial long-run equilibrium industry output is Q 0 and the typical firm’s output is q* (where AC is minimized) The equilibrium number of firms in the industry (n 0 ) is Q 0 /q*

60. 60 Comparative Statics Analysis of Long-Run Equilibrium A shift in demand that changes the equilibrium industry output to Q 1 will change the equilibrium number of firms to n 1 = Q 1 /q* The change in the number of firms is –completely determined by the extent of the demand shift and the optimal output level for the typical firm

61. 61 Comparative Statics Analysis of Long-Run Equilibrium The effect of a change in input prices can also be studied –See example 10.6 in the book

62. 62 Important Points to Note: In the short run, equilibrium prices are established by the intersection of what demanders are willing to pay (as reflected by the demand curve) and what firms are willing to produce (as reflected by the short-run supply curve) –these prices are treated as fixed in both demanders’ and suppliers’ decision-making processes

63. 63 Important Points to Note: A shift in either demand or supply will cause the equilibrium price to change –the extent of such a change will depend on the slopes of the various curves Firms may earn positive profits in the short run –because fixed costs must always be paid, firms will choose a positive output as long as revenues exceed variable costs

64. 64 Important Points to Note: In the long run, the number of firms is variable in response to profit opportunities –the assumption of free entry and exit implies that firms in a competitive industry will earn zero economic profits in the long run (P = AC) –because firms also seek maximum profits, the equality P = AC = MC implies that firms will operate at the low points of their long-run average cost curves

65. 65 Important Points to Note: The shape of the long-run supply curve depends on how entry and exit affect firms’ input costs –in the constant-cost case, input prices do not change and the long-run supply curve is horizontal –if entry raises input costs, the long-run supply curve will have a positive slope

66. 66 Important Points to Note: Changes in long-run market equilibrium will also change the number of firms –precise predictions about the extent of these changes is made difficult by the possibility that the minimum average cost level of output may be affected by changes in input costs or by technical progress

67. 67 Important Points to Note: If changes in the long-run equilibrium in a market change the prices of inputs to that market, the welfare of the suppliers of these inputs will be affected –such changes can be measured by changes in the value of long-run producer surplus

68. 68 Chapter 11 APPLIED COMPETITIVE ANALYSIS Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved.

69. 69 Economic Efficiency and Welfare Analysis The area between the demand and the supply curve represents the sum of consumer and producer surplus –measures the total additional value obtained by market participants by being able to make market transactions This area is maximized at the competitive market equilibrium

70. 70 Economic Efficiency and Welfare Analysis Quantity Price P *P * Q *Q * S D Consumer surplus is the area above price and below demand Producer surplus is the area below price and above supply

71. 71 At output Q 1, total surplus will be smaller Economic Efficiency and Welfare Analysis Quantity Price P *P * Q *Q * S D Q1Q1 At outputs between Q 1 and Q*, demanders would value an additional unit more than it would cost suppliers to produce

72. 72 Economic Efficiency and Welfare Analysis This tell us that under the assumptions that we have used (competitive industry), the government must argue why she was to alter the equilibrium price through policy

73. 73 Welfare Loss Computations Use of consumer and producer surplus notions makes possible the explicit calculation of welfare losses caused by restrictions on voluntary transactions –in the case of linear demand and supply curves, the calculation is simple because the areas of loss are often triangular

74. 74 Welfare Loss Computations Suppose that the demand is given by Q D = 10 - P and supply is given by Q S = P - 2 Market equilibrium occurs where P* = 6 and Q* = 4

75. 75 Welfare Loss Computations Restriction of output to Q 0 = 3 would create a gap between what demanders are willing to pay (P D ) and what suppliers require (P S ) P D = 10 - 3 = 7 P S = 2 + 3 = 5

76. 76 The welfare loss from restricting output to 3 is the area of a triangle Welfare Loss Computations Quantity Price S D 6 4 7 5 3 The loss = (0.5)(2)(1) = 1

77. 77 Welfare Loss Computations The welfare loss will be shared by producers and consumers In general, it will depend on the price elasticity of demand and the price elasticity of supply to determine who bears the larger portion of the loss –the side of the market with the smallest price elasticity (in absolute value)

78. 78 Price Controls and Shortages Sometimes governments may seek to control prices at below equilibrium levels –this will lead to a shortage We can look at the changes in producer and consumer surplus from this policy to analyze its impact on welfare

79. 79 Price Controls and Shortages Quantity Price SS D LS P1P1 Q1Q1 Initially, the market is in long-run equilibrium at P 1, Q 1 Demand increases to D’ D’D’

80. 80 Price Controls and Shortages Quantity Price SS D LS P1P1 Q1Q1 D’D’ Firms would begin to enter the industry In the short run, price rises to P 2 P2P2 The price would end up at P 3 P3P3

81. 81 Price Controls and Shortages Quantity Price SS D LS P1P1 Q1Q1 D’D’ P3P3 There will be a shortage equal to Q 2 - Q 1 Q2Q2 Suppose that the government imposes a price ceiling at P 1

82. 82 This gain in consumer surplus is the shaded rectangle Price Controls and Shortages Quantity Price SS D LS P1P1 Q1Q1 D’D’ P3P3 Q2Q2 Some buyers will gain because they can purchase the good for a lower price

83. 83 The shaded rectangle therefore represents a pure transfer from producers to consumers Price Controls and Shortages Quantity Price D P1P1 Q1Q1 D’D’ SS LS P3P3 Q2Q2 The gain to consumers is also a loss to producers who now receive a lower price No welfare loss there

84. 84 This shaded triangle represents the value of additional consumer surplus that would have been attained without the price control Price Controls and Shortages Quantity Price SS D LS P1P1 Q1Q1 D’D’ P3P3 Q2Q2

85. 85 This shaded triangle represents the value of additional producer surplus that would have been attained without the price control Price Controls and Shortages Quantity Price SS D LS P1P1 Q1Q1 D’D’ P3P3 Q2Q2

86. 86 This shaded area represents the total value of mutually beneficial transactions that are prevented by the government Price Controls and Shortages Quantity Price SS D LS P1P1 Q1Q1 D’D’ P3P3 Q2Q2 This is a measure of the pure welfare costs of this policy

87. 87 Disequilibrium Behavior Notice that there are customers willing to pay more to buy the good This could lead to a black market

88. 88 Tax Incidence To discuss the effects of a per-unit tax (t), we need to make a distinction between the price paid by buyers (P D ) and the price received by sellers (P S ) P D - P S = t In terms of small price changes, we wish to examine dP D - dP S = dt

89. 89 Tax Incidence Maintenance of equilibrium in the market requires dQ D = dQ S or D P dP D = S P dP S Substituting, we get D P dP D = S P dP S = S P (dP D - dt)

90. 90 Tax Incidence We can now solve for the effect of the tax on P D : Similarly,

91. 91 Tax Incidence Because e D  0 and e S  0, dP D /dt  0 and dP S /dt  0 If demand is perfectly inelastic (e D = 0), the per-unit tax is completely paid by demanders If demand is perfectly elastic (e D =  ), the per-unit tax is completely paid by suppliers

92. 92 Tax Incidence In general, the actor with the less elastic responses (in absolute value) will experience most of the price change caused by the tax

93. 93 Tax Incidence Quantity Price S D P*P* Q*Q* PDPD PSPS A per-unit tax creates a wedge between the price that buyers pay (P D ) and the price that sellers receive (P S ) t Q**

94. 94 Buyers incur a welfare loss equal to the shaded area Tax Incidence Quantity Price S D P*P* Q*Q* PDPD PSPS Q** But some of this loss goes to the government in the form of tax revenue

95. 95 Sellers also incur a welfare loss equal to the shaded area Tax Incidence Quantity Price S D P*P* Q*Q* PDPD PSPS Q** But some of this loss goes to the government in the form of tax revenue

96. 96 Therefore, this is the dead- weight loss from the tax Tax Incidence Quantity Price S D P*P* Q*Q* PDPD PSPS Q**

97. 97 Deadweight Loss and Elasticity All nonlump-sum taxes involve deadweight losses –the size of the losses will depend on the elasticities of supply and demand A linear approximation to the deadweight loss accompanying a small tax, dt, is given by DW = -0.5(dt)(dQ)

98. 98 Deadweight Loss and Elasticity From the definition of elasticity, we know that dQ = e D dP D  Q 0 /P 0 This implies that dQ = e D [e S /(e S - e D )] dt Q 0 /P 0 Substituting, we get

99. 99 Deadweight Loss and Elasticity Deadweight losses are zero if either e D or e S are zero –the tax does not alter the quantity of the good that is traded Deadweight losses are smaller in situations where e D or e S are small

100. 100 Transactions Costs Transactions costs can also create a wedge between the price the buyer pays and the price the seller receives –real estate agent fees –broker fees for the sale of stocks If the transactions costs are on a per-unit basis, these costs will be shared by the buyer and seller –depends on the specific elasticities involved

101. 101 Gains from International Trade Quantity Price S D Q*Q* P*P* In the absence of international trade, the domestic equilibrium price would be P* and the domestic equilibrium quantity would be Q*

102. 102 Gains from International Trade Quantity Price Q*Q* P*P* S D Quantity demanded will rise to Q 1 and quantity supplied will fall to Q 2 Q1Q1 Q2Q2 If the world price (P W ) is less than the domestic price, the price will fall to P W PWPW Imports = Q 1 - Q 2 imports

103. 103 Consumer surplus rises Producer surplus falls There is an unambiguous welfare gain Gains from International Trade Quantity Price Q*Q* P*P* S D Q2Q2 Q1Q1 PWPW

104. 104 Effects of a Tariff Quantity Price S D Q1Q1 Q2Q2 PWPW Quantity demanded falls to Q 3 and quantity supplied rises to Q 4 Q4Q4 Q3Q3 Suppose that the government creates a tariff that raises the price to P R PRPR Imports are now Q 3 - Q 4 imports

105. 105 Consumer surplus falls Producer surplus rises These two triangles represent deadweight loss The government gets tariff revenue Effects of a Tariff Quantity Price S D Q1Q1 Q2Q2 PWPW Q4Q4 Q3Q3 PRPR

106. 106 Quantitative Estimates of Deadweight Losses Estimates of the sizes of the welfare loss triangle can be calculated Because P R = (1+t)P W, the proportional change in quantity demanded is

107. 107 The areas of these two triangles are Quantitative Estimates of Deadweight Losses Quantity Price S D Q1Q1 Q2Q2 PWPW Q4Q4 Q3Q3 PRPR

108. 108 Other Trade Restrictions A quota that limits imports to Q 3 - Q 4 would have effects that are similar to those for the tariff –same decline in consumer surplus –same increase in producer surplus One big difference is that the quota does not give the government any tariff revenue –the deadweight loss will be larger

109. 109 Trade and Tariffs If the market demand curve is Q D = 200P -1.2 and the market supply curve is Q S = 1.3P, the domestic long-run equilibrium will occur where P* = 9.87 and Q* = 12.8

110. 110 Trade and Tariffs If the world price was P W = 9, Q D would be 14.3 and Q S would be 11.7 –imports will be 2.6 If the government placed a tariff of 0.5 on each unit sold, the world price will be P W = 9.5 –imports will fall to 1.0

111. 111 Trade and Tariffs The welfare effect of the tariff can be calculated DW 1 = 0.5(0.5)(14.3 - 13.4) = 0.225 DW 2 = 0.5(0.5)(12.4 - 11.7) = 0.175 Thus, total deadweight loss from the tariff is 0.225 + 0.175 = 0.4

112. 112 Important Points to Note: The concepts of consumer and producer surplus provide useful ways of analyzing the effects of economic changes on the welfare of market participants –changes in consumer surplus represent changes in the overall utility consumers receive from consuming a particular good –changes in long-run producer surplus represent changes in the returns product inputs receive

113. 113 Important Points to Note: Price controls involve both transfers between producers and consumers and losses of transactions that could benefit both consumers and producers

114. 114 Important Points to Note: Tax incidence analysis concerns the determination of which economic actor ultimately bears the burden of a tax –this incidence will fall mainly on the actors who exhibit inelastic responses to price changes –taxes also involve deadweight losses that constitute an excess burden in addition to the burden imposed by the actual tax revenues collected

115. 115 Important Points to Note: Transaction costs can sometimes be modeled as taxes –both taxes and transaction costs may affect the attributes of transactions depending on the basis on which the costs are incurred

116. 116 Important Points to Note: Trade restrictions such as tariffs or quotas create transfers between consumers and producers and deadweight losses of economic welfare –the effects of many types of trade restrictions can be modeled as being equivalent to a per-unit tariff