Competitive Equilibrium and

Economic Efficiency

Dr. Gong Jie

Agenda

v Review of Homework 1
v Economic Efficiency
♦  Perfectly competitive equilibrium attains economic
efficiency.
♦  Deadweight Loss
v Government Interventions
♦  Price Ceilings and Floors
♦  Excise Tax
♦  Incidence
Homework 1, Q4

v 
y First, draw the indifference curve: For perfectly
substitutable goods, MRS is constant.
Second, draw the budget line.
Last, find the point (bundle of x and y) that (1) in the
budget set, and (2) on the highest indifference curve.

Constant Slope

IC1 IC2 IC3

0 x
y Budge line: Y = I/Py – Px/Py*X

If Px/Py < 1:
optimal bundle is X=I/Px, Y=0

Optimal bundle

IC1 IC2 IC3

0 x
y Optimal bundle Budge line: Y = I/Py – Px/Py*X

If Px/Py > 1:
optimal bundle is X=0, Y = I/Py

IC1 IC2 IC3

0 x
y Budge line: Y = I/Py – Px/Py*X

IC1 IC2 IC3

0 x
 Perfect Complements
y U=min(3X, 2Y)

How to draw indifference

curves?

Y = (3/2)X

6 U = 12

3 U=6

0 2 4 x
 Perfect Complements
y U=min(3X, 2Y)

Y = (3/2)X

Demand for X:

IC2 Px*X+Py*(3/2)X = I
X= I/(Px+3Py/2)

IC1
Optimal bundle

0 x
Homework 1, Q6

v Which option provides more consumer surplus? $4

per unit or $18 for 5 units?
v Common answer
♦  Assume consumers purchase 5 units for both options
♦  Treat the package option as 18/5=$3.6 per unit
v Correct way
♦  First determine how many quantity would be purchased
♦  Then calculate the consumer surplus from the purchase
§  CS=total benefit – total cost
 Demand: P = 12 – 2Q
P
12 At $4/unit, consumers purchase 4 bottles.
The consumer surplus is given by the area
of the blue triangle. CS = 4 × 8 ÷ 2 = 16

The benefit from the 5th unit is 2, lower

than the price 4.
Consumers will NOT purchase the 5th unit!

4 5 6 Q
 Demand: P = 12 – 2Q
P
Having 5 bottles of coke, consumers
12 receive a total benefit TB = (2 +12) × 5 ÷ 2 = 35
They pay 18 dollars, so the consumer
surplus will be 35-18=17.

It is NOT equivalent to $3.6/unit!

They would buy 4.8 units, but (1) They can
only purchase 1 package, 2 packages, etc;
(2) The average unit price is $3.6 only
when they buy in packages.
3.6
2

4.8 5 6 Q
 Where Are We?
Introduction

Demand and Supply

Determination of
Prices
Consumer Theory

Production and Cost Theory

Competitive Markets
Managerial Economics Market Structure &
Profit-Maximizing Market Power & Monopoly
Pricing Decisions
Pricing with Market Power

Game Theory& Simultaneous-Move Game

Oligopoly Markets Sequential-Move Game
How to measure welfare?

v Net benefit consumers receive

♦  measured by consumer surplus
v Net benefit producers receive
♦  measured by producer surplus
v Net benefit for the market as a whole
♦  Consumer surplus + producer surplus
v Welfare analysis is useful to evaluate policy.
♦  How do interventions affect the net economic benefit for
the society?
Consumer Surplus: Review

v Definition: The net economic benefit to the consumer

due to a purchase (i.e. the willingness to pay of the
consumer net of the actual expenditure on the good)
P
♦  The area under an ordinary
demand curve: the benefit
from certain consumption
♦  The area under an ordinary
demand curve and above the
market price provides a
P* measure of consumer
D
surplus.
Q
Q*
Producer Surplus: Review
v Definition: The net benefit to the producer from
supplying a product.(i.e. the amount that a firm
actually receives from selling a good net of the
minimum amount the firm must receive to be willing
to supply)
P ♦  The area under an ordinary
S supply curve: the cost from
P* certain production
♦  The area under the market
price and above an ordinary
supply curve provides a
measure of producer surplus.

Q
Q*
 Total surplus = CS + PS
Price

Consumer Surplus S

P*

Producer Surplus D

Q* Quantity
Price Underproduction

Consumer Surplus
S

Ph

Producer Surplus D

Q Q* Quantity
Price Overproduction

P*

Q* Q Quantity
Perfectly Competitive Equilibrium Attains
Economic Efficiency
v Total Surplus is maximized at competitive market
equilibrium.
v How does the competitive market achieve economic
efficiency? “Invisible Hand”!
♦  No central planner: Each consumer maximizes his/her own
utility. Each firm maximizes its own profit.
♦  One price rule and “The right price”: Every consumer who is
willing to pay more than the cost of producing extra output is
able to buy; every consumer who is not willing to pay the cost of
the extra output does not buy.
Economic Efficiency and Deadweight Loss

v Benchmark: A market outcome (quantity and price) is

efficient if the total surplus is maximized.
v If a market outcome is not efficient, then the market
suffers from deadweight loss.
v A deadweight loss is the net loss in total surplus
resulting from an inefficient allocation of resources.
v Where does deadweight loss come from?
Price Restrictions

v Price Ceilings
♦  The maximum legal price that can be charged
♦  Examples:
§  Gasoline prices in the 1970s
§  Rent control in New York City
v Price Floors
♦  The minimum legal price that can be charged
♦  Examples:
§  Minimum wage
§  Agricultural price supports
Welfare Without Price Restrictions
Price CS S

P*

PS
Quantity
Q*
Impact of a Price Ceiling
Price S

P*

P Ceiling

Shortage D

Qs Qd Quantity
Q*
Impact of a Price Ceiling

Price CS S

Deadweight Loss
P*

P Ceiling

Shortage D

PS
Qs Qd Quantity
Q*
Impact of a Price Floor
Price
Surplus S
PF

P*

Qd Q* QS Quantity
Impact of a Price Floor
Price
Surplus
CS S
PF

Deadweight Loss
P*

PS D

Qd Q* QS Quantity
Comments on minimum wage

v Minimum wage law is an example of price floor.

v In the labor market, the “product” is labor and the
“price” is the wage.
v Raising wage above the market clearing level will
result in more quantity of labor supplied than the
quantity demanded, i.e., unemployment.
v How many people a minimum wage adds to the
number of unemployed and the size of the
deadweight loss depend on the elasticity of labor
supply and demand.
 Benefits and costs of minimum wage laws
v Supporters
♦  Help the poorest class
♦  Encourage people to join
workforce rather than
pursuing money through
illegal means.
♦  Increase work ethic
♦  Remove low pay jobs and
encourage automation
v Opponents
♦  Increase unemployment
♦  Benefit some workers at
the expense of the poorest
and least productive
♦  Increase labor cost (hurt
small business more)
♦  Jobs move to low-labor
-cost areas.
No minimum wage in Singapore
No minimum wage in Singapore
v Parliament debate in 2011: overwhelming majority of
MPs did not support minimum wage law to help low
-skilled and low-wage workers.
v The MP for Bishan-Toa Payoh, Ms Josephine Teo,
pointed out that to be meaningful, a minimum wage must
force some employers to pay more than the market rate.
v “Companies that do not wish to engage in the illegal
practice (of paying below minimum wage) and find it too
costly to operate in Singapore will close shop or
relocate.”
Excise Tax

v Excise or specific tax: tax of a certain amount of

money per unit sold.
♦  Without tax, the price that consumers pay(Pd) equals
the price producers receive (Ps).
♦  With an excise tax, what buyers actually pay exceeds
what sellers actually receive.
§  Pd=Ps+T
v What’s the difference between buyer pay vis-à-vis
seller pay?
 Excise Tax Paid by Sellers

P S’
CS
S
Deadweight Loss
T

A
Pd
P*
Tax
Ps

D
Q1 Q* Q

PS
When the tax is paid by sellers

v Without the tax, equilibrium is at point (P*, Q*)

v With tax, the sellers have to pay T per unit sold to the
government.
♦  At a given price P, it is “as if” the market price is P-T to the
sellers. Supply curve shifts upward by T.
♦  The equilibrium is at A, where consumers pay Pd per unit
to the sellers, sellers pay T per unit to the government and
keep Pd – T= Ps per unit. There are Q1 units sold in total.
♦  Consumer and producer surplus both decrease. Part of the
reduction becomes tax revenue, part is deadweight loss.
 Excise Tax Paid by Buyers

P CS
S
Deadweight Loss

Pd
P*
Tax
Ps
B
T
D
Q1 Q* Q

PS
When the tax is paid by buyers

v Without the tax, equilibrium is at point (P*, Q*)

v With tax, the buyers have to pay T per unit purchased
to the government.
♦  At a given price P, it is “as if ” the market price is P+T to
the buyers. Demand curve shifts downward by T.
♦  The equilibrium is at B, where consumers pay Ps per unit to
the sellers and T per unit to the government, a total of Ps +
T=Pd per unit. There are Q1 units sold in total.
♦  Consumer and producer surplus both decrease. Part of the
reduction becomes tax revenue, part is deadweight loss.
 Comparison

P S’
S

T
A It does not matter if we shift
Pd the supply or the demand
curve: The market outcome is
P*
the same!
Ps
B T
D
Q1 Q* Q
Who bears the tax burden?

v It does not matter who literally pays the tax.

♦  Buyers and sellers share the tax on each unit of the product.
v We care about who bears the actual tax burden.
v Incidence: change in price for buyer/seller resulting
from changes in demand or supply
♦  The amount by which the price paid by buyers, Pd, rises
over the non-tax equilibrium price, P*, is the incidence of
the tax on consumers; the amount by which the price
received by sellers, PS, falls below P* is the incidence of
the tax on producers.
 If demand is relatively inelastic at (P*, Q*)

P S’
S
Increase in T
consumers’ price Consumers bear most
Pd of the tax burden.

P*
Ps
Decrease in
producers’ price

D
Q2 Q* Q
 If demand is relatively elastic at (P*, Q*)

P S’
S
Increase in T
consumers’ price Producers bear most
of the tax burden.
Pd
P*
Decrease in
producers’ price Ps
D

Q3 Q* Q
 P Incidence of a Tax in Two Extreme Cases

Pd=P*+T S’ Tax burden falls

T completely on consumers.
Ps = P* S

D
Q

P S

Tax burden falls

completely on producers.
Pd = P*
T
Ps = P*-T
D
Q
Incidence of a tax depends on the price
elasticity of demand and supply
v If demand is less elastic than supply at the
competitive equilibrium, the tax will have a larger
impact on consumers’ price.
v If demand is more elastic than supply at the
competitive equilibrium, the tax will have a larger
impact on producers’ price.
v The side of the market that is relatively less sensitive
to price changes will bear the larger portion of the
tax.
“Pass-through” rule
ΔP d η
v  s
= where
ΔP ε
♦  η, ε is the own price elasticity of supply and demand,
s s d d
respectively. η = ΔQ / Q ΔQ / Q
,ε =
ΔP s / P s ΔP d / P d
v Proof (optional):
♦  Consider equilibrium (P*,Q*), Ps = Pd = P*, Qs = Qd = Q*
♦  A tax increases Pd and decreases Ps. Both Qs and Qd drop.
♦  For market to clear, the change in quantity demanded and
supplied should be the same. ΔQ s / Q* = ΔQ d / Q *
d d d
♦  Thus η ΔP / P ΔP
= =
ε ΔP s / P s ΔP s
Example: Incidence of a Tax

v Let ε = -.5 and η = 2. What is the relative incidence

of a specific tax on consumers and producers?
♦  ΔPd/ΔPs = 2/(-.5) = -4
v Interpretation:
♦  The increase in the price consumers pay will be four times
as much as the decrease in price producers receive. Hence,
an excise tax of $1 results in an increase in consumer price
of $.8 and a decrease in price received by producers of $.2.
v Impact of taxes on alcohol and tobacco?
The Important Lessons We Learned

v When firms experience negative supply shock

(marginal cost increases), the cost increase cannot be
fully shifted to consumers.
v When firms experience positive supply shock
(marginal cost decreases), the cost reduction cannot
fully accrue to consumers.
Applications

v  “(March 9, 2006, The Wall Street Journal) …

Soaring fuel prices were bad news for all airlines
last year, .… The airline (Cathay Pacific) said
passenger and cargo fuel surcharges only partly
offset this additional cost…”
♦  Why do passenger and cargo fuel surcharges only partly
offset this additional cost?
v  Manufacturer Promotion
♦  Cents-off coupons to consumers vs. Wholesale price-cut
to retailers
♦  Which makes more sale?
Takeaways

v An "invisible hand" guides the competitive market to

the efficient level of production and consumption.
Although the buyers and sellers act selfishly, the net
outcome is at least as good as the best efforts of the
most enlightened and well-informed central planner.

v We obtained the above conclusion for a single market

only and under the assumption that price fully reflects
all costs and benefits to the market and that there is
perfect information. We will relax these assumptions
in subsequent lectures.
v Government policies such as price ceilings, price
floors, and taxes cause deadweight losses and impede
economic efficiency.
v Who pays a tax does not determine who bears the tax.
v Even though all policies resulted in a reduction in
total surplus, each had a "constituency" in the form of
consumers, producers or the government (effect on
budget). If total surplus maximization is not the goal
of policy-makers, each policy can be argued for on
economic grounds.