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Chapter 9
The Analysis of Competitive
Markets
The Analysis of Competitive
Markets
Chapter 9 Slide 2
Topics to be Discussed
Evaluating the Gains and Losses from Government Policies--Consumer and Producer Surplus
The Efficiency of a Competitive Market
Minimum Prices
Chapter 9 Slide 3
Topics to be Discussed
Price Supports and Production Quotas
The Impact of a Tax or Subsidy
Chapter 9 Slide 4
Evaluating the Gains and Losses fromGovernment Policies--Consumer and Producer Surplus
ReviewConsumer surplus is the total benefit or
value that consumers receive beyond what they pay for the good.
Producer surplus is the total benefit or revenue that producers receive beyond what it cost to produce a good.
ProducerSurplus
Between 0 and Q0 producers receive
a net gain from selling each product--
producer surplus.
ConsumerSurplus
Consumer and Producer Surplus
Quantity0
Price
S
D
5
Q0
Consumer C
10
7
Consumer BConsumer A
Between 0 and Q0 consumers A and B
receive a net gain from buying the product--consumer surplus
Chapter 9 Slide 6
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 caused by government intervention in the market.
Evaluating the Gains and Losses fromGovernment Policies--Consumer and Producer Surplus
Chapter 9 Slide 7
The loss to producers isthe sum of rectangle
A and triangle C. TriangleB and C together measure
the deadweight loss.
B
A C
The gain to consumers isthe difference betweenthe rectangle A and the
triangle B.
Deadweight Loss
Change in Consumer andProducer Surplus from Price Controls
Quantity
Price
S
D
P0
Q0
Pmax
Q1 Q2
Suppose the governmentimposes a price ceiling Pmax
which is below the market-clearing price P0.
Chapter 9 Slide 8
Observations:The total loss is equal to area B + C.
The total change in surplus =
(A - B) + (-A - C) = -B - C
The deadweight loss is the inefficiency of the price controls or the loss of the producer surplus exceeds the gain from consumer surplus.
Change in Consumer andProducer Surplus from Price Controls
Chapter 9 Slide 9
ObservationConsumers can experience a net loss in
consumer surplus when the demand is sufficiently inelastic
Change in Consumer andProducer Surplus from Price Controls
Chapter 9 Slide 10
B
APmax
C
Q1
If demand is sufficientlyinelastic, triangle B can be larger than rectangle
A and the consumer suffers a net loss from
price controls.
ExampleOil price controls
and gasoline shortagesin 1979
S
D
Effect of Price ControlsWhen Demand Is Inelastic
Quantity
Price
P0
Q2
Chapter 9 Slide 11
The Efficiency ofa Competitive Market
When do competitive markets generate an inefficient allocation of resources or market failure?
1) ExternalitiesCosts or benefits that do not show up as
part of the market price (e.g. pollution)
Chapter 9 Slide 12
The Efficiency ofa Competitive Market
When do competitive markets generate an inefficient allocation of resources or market failure?
2) Lack of Information
Imperfect information prevents consumers from making utility-maximizing decisions.
Chapter 9 Slide 13
Government intervention in these markets can increase efficiency.
Government intervention without a market failure creates inefficiency or deadweight loss.
The Efficiency ofa Competitive Market
Chapter 9 Slide 14
P1
Q1
A
B
C
When price is regulated to be no higher than P1, the
deadweight loss given by triangles B and C results.
Welfare Loss When PriceIs Held Below Market-Clearing Level
Quantity
Price
S
D
P0
Q0
Chapter 9 Slide 15
P2
Q3
A B
C
Q2
What would the deadweightloss be if QS = Q2?
When price is regulated to be no
lower than P2 only Q3
will be demanded. Thedeadweight loss is given
by triangles B and C
Welfare Loss When PriceIs Held Above Market-Clearing Level
Quantity
Price
S
D
P0
Q0
Chapter 9 Slide 16
Minimum Prices
Periodically government policy seeks to raise prices above market-clearing levels.
We will investigate this by looking at a price floor and the minimum wage.
Chapter 9 Slide 17
BA
The change in producersurplus will be
A - C - D. Producersmay be worse off.
C
D
Price Minimum
Quantity
Price
S
D
P0
Q0
Pmin
Q3 Q2
If producers produce Q2, the amount Q2 - Q3
will go unsold.
Chapter 9 Slide 18
B The deadweight lossis given by
triangles B and C.C
A
wmin
L1 L2
Unemployment
Firms are not allowed topay less than wmin. This
results in unemployment.
S
D
w0
L0
The Minimum Wage
L
w
Chapter 9 Slide 19
Price Supports andProduction Quotas
Much of agricultural policy is based on a system of price supports.
This is support price is set above the equilibrium price and the government buys the surplus.
This is often combined with incentives to reduce or restrict production
Chapter 9 Slide 20
B
DA
To maintain a price Ps
the government buys quantity Qg . The change inconsumer surplus = -A - B,
and the change in producer surplus is A + B + D
D + Qg
Qg
Price Supports
Quantity
PriceS
D
P0
Q0
Ps
Q2Q1
Chapter 9 Slide 21
D + Qg
Qg
BA
Price Supports
Quantity
PriceS
D
P0
Q0
Ps
Q2Q1
The cost to the government is the speckled rectangle
Ps(Q2-Q1)
D
TotalWelfare
Loss
Total welfare lossD-(Q2-Q1)ps
Chapter 9 Slide 22
Price Supports
Question:Is there a more efficient way to increase
farmer’s income by A + B + D?
Chapter 9 Slide 23
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.
We will consider a specific tax which is a tax of a certain amount of money per unit sold.
Chapter 9 Slide 24
D
S
B
D
ABuyers lose A + B, andsellers lose D + C, and
the government earns A + D in revenue. The deadweight
loss is B + C.C
Incidence of a SpecificTax
Quantity
Price
P0
Q0Q1
PS
Pb
t
Pb is the price (includingthe tax) paid by buyers.
PS is the price sellers receive,net of the tax. The burdenof the tax is split evenly.
Chapter 9 Slide 25
Incidence of a Specific Tax
Four conditions that must be satisfied after the tax is in place:
1) Quantity sold and Pb must be on the demand line: QD = QD(Pb)
2) Quantity sold and PS must be on the supply line: QS = QS(PS)
Chapter 9 Slide 26
Incidence of a Specific Tax
Four conditions that must be satisfied after the tax is in place:
3) QD = QS
4) Pb - PS = tax
Impact of a Tax Dependson Elasticities of Supply and Demand
Quantity Quantity
Price Price
S
D S
D
Q0
P0 P0
Q0Q1
Pb
PS
t
Q1
Pb
PS
t
Burden on Buyer Burden on Seller
Chapter 9 Slide 28
Pass-through fractionES/(ES - Ed)
For example, when demand is perfectly inelastic (Ed = 0), the pass-through fraction is 1, and all the tax is borne by the consumer.
The Impact of a Tax or Subsidy
Chapter 9 Slide 29
The Effects of a Tax or Subsidy
A subsidy can be analyzed in much the same way as a tax.
It can be treated as a negative tax.
The seller’s price exceeds the buyer’s price.
Chapter 9 Slide 30
D
S
Subsidy
Quantity
Price
P0
Q0 Q1
PS
Pb
s
Like a tax, the benefitof a subsidy is split
between buyers and sellers, depending
upon the elasticities ofsupply and demand.
Chapter 9 Slide 31
Subsidy
With a subsidy (s), the selling price Pb is below the subsidized price PS so that:s = PS - Pb
Chapter 9 Slide 32
Subsidy
The benefit of the subsidy depends upon Ed /ES.If the ratio is small, most of the benefit
accrues to the consumer.If the ratio is large, the producer benefits
most.
Chapter 9 Slide 33
A Tax on Gasoline
Measuring the Impact of a 50 Cent Gasoline TaxIntermediate-run EP of demand = -0.5
QD = 150 - 50P
EP of supply = 0.4
QS = 60 + 40P
QS = QD at $1 and 100 billion gallons per year (bg/yr)
Chapter 9 Slide 34
A Tax on Gasoline
With a 50 cent taxQD = 150 - 50Pb = 60 + 40PS = QS
150 - 50(PS+ .50) = 60 + 40PS
PS = .72
Pb = .5 + PS
Pb = $1.22
Chapter 9 Slide 35
A Tax on Gasoline
With a 50 cent taxQ = 150 -(50)(1.22) = 89 bg/yr
Q falls by 11%
Chapter 9 Slide 36
D
A
Lost ConsumerSurplus
Lost ProducerSurplus
PS = .72
Pb = 1.22
Impact of a 50 Cent Gasoline Tax
Quantity (billiongallons per year)
Price($ pergallon)
0 50 150
.50
100
P0 = 1.00
1.50
89
t = 0.50
11
The annual revenue from the tax is .50(89)
or $44.5 billion. The buyerpays 22 cents of the tax, andthe producer pays 28 cents.
SD
60
Chapter 9 Slide 37
D
A
Lost ConsumerSurplus
Lost ProducerSurplus
PS = .72
Pb = 1.22
Impact of a 50 Cent Gasoline Tax
Price($ pergallon)
0 50 150
.50
100
P0 = 1.00
1.50
89
t = 0.50
11
SD
60
Deadweight loss = $2.75 billion/yr
Quantity (billiongallons per year)
Chapter 9 Slide 38
Summary
Simple models of supply and demand can be used to analyze a wide variety of government policies.
In each case, consumer and producer surplus are used to evaluate the gains and losses to consumers and producers.
Chapter 9 Slide 39
Summary
When government imposes a tax or subsidy, price usually does not rise or fall by the full amount of the tax or subsidy.
Government intervention generally leads to a deadweight loss.
Chapter 9 Slide 40
Summary
Government intervention in a competitive market is not always a bad thing.
End of Chapter 9
The Analysis of Competitive
Markets
The Analysis of Competitive
Markets