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CHAPTER 3 - THE ANALYSIS OF COMPETITIVE MARKETS

Key Concepts and Topics


• Evaluating the Gains and Losses from Government Policies
• The Efficiency of a Competitive Market
• Minimum Prices
• Price Supports and Production Quotas
• Import Quotas and Tariffs
• The Impact of a Tax or Subsidy

Evaluating the Gains and Losses from Government Policies –


Consumer and Producer Surplus
• When government controls price, some people are better off
– May be able to buy a good at a lower price or sell a good at a higher price
• But, what is the effect on society as a whole?
– Is total welfare higher or lower and by how much?
• Use consumer surplus and producer surplus to study the welfare effects of a
government policy – who gains and who losses, and how much?

• Consumer Surplus (CS)


– Measures the total benefit that consumers receive beyond what they pay for
the good in a competitive market
 Consumer A would pay $10 for a good but pays a market price of $5, and
therefore gains $5 in consumer surplus
– Measured by the area between the demand curve and the market price
 The demand curve shows how much of a good consumers are willing to
buy as the price per unit changes
• Producer Surplus (PS)
– Measures the total profits that producers receive beyond what it costs to
produce a good
 A producer may be willing to accept $3 for the good but get $5 market
price
 Producer gains a surplus of $2
– Measured by the area between the supply curve and the market price
 The supply curve shows the amount that producers are willing to take for
a certain amount of a good

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 1
Price Consumer surplus, which measures
the total benefits to all consumers, is
the area between the demand curve
and the market price

Producer surplus, which measures


P0 the total profits of producers, is the
area between the supply curve and
the market price

The welfare benefit of a competitive


market = consumer surplus +
producer surplus

0 Q0 Quantity

• Welfare benefit of a competitive market = consumer surplus + producer surplus


– Welfare Effects – gains and losses to producers and consumers
– Deadweight Loss – net loss of total (consumer plus producer) surplus

• When government institutes a price ceiling (Pmax), the price of a good cannot 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

• Price Control and Surplus Changes


– When price is held too low, the QD increases and QS decreases
 Some consumers are worse off because can no longer buy the good
 Decrease in consumer surplus

 Some consumers better off because can buy it at a lower price


 Increase in consumer surplus

 Producers sell less at a lower price and some producers are no longer in
the market
 Producers 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

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 2
Price
Consumers that can buy the good, gain A
Consumers that cannot buy, lose B
Change in CS (CS) = + A – B

The loss to producers is the sum of A and C


P0 Change in PS (PS) = – A – C

Pmax ΔWelfare = CS + PS = (+ A – B) + (– A – C)


=–B–C
= Deadweight Loss

Q1 Q0 Q2 Quantity

• 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

Price

With inelastic demand, triangle B can be


larger than rectangle A and consumers
suffer net losses from price controls

P0

Pmax

Q1 Q2 Quantity

• Price Controls and Natural Gas Shortages: An Example


– During the 1970s, price controls created a shortage of natural gas
– What was the effect of those controls?
 Decreases in surplus and overall loss for society
 We can measure these welfare effects from the demand and supply of
natural gas

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 3
– QS = 15.90 + 0.72PG + 0.05PO and QD = 0.02 –1.8PG + 0.69PO
 Q = quantity is measured in trillion cubic feet (Tcf)
 PG = price of natural gas in dollars per thousand cubic feet ($/mcf)
 PO = price of oil in dollars per barrel ($/bl)

– Using PO = $50/b and QD = QS gives equilibrium values for natural gas


 PG = $6.40/mcf and Q = 23 Tcf

– Price ceiling was set at $3/mcf


– Showing this graphically, we can see and measure the effects of natural gas
price controls on producer and consumer surplus
PG ($/mcf)

6.40

(Pmax) 3.00

0
23 Quantity (Tcf)

– Pmax=$3, Shortage = = 8.56 Tcf

– Measuring the Impact of Price Controls


 A= = $69.904 billion
 B= = $1.654 billion
 C= = $4.148 billion
 ΔCS = = $68.25 billion (Net gain)
 ΔPS = = –$74.052 billion (Loss)
 DWL = ΔCS + ΔPS = = –$5.802 billion

The Efficiency of a Competitive Market


• To evaluate a market outcome, we often ask whether it achieves economic
efficiency
– Maximization of aggregate consumer and producer surplus

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 4
• Policies such as price controls that cause deadweight losses in society are said
to impose an efficiency cost on the economy
• If efficiency is the goal, then you can argue leaving markets alone is the answer
• However, sometimes a market failure occurs
– Prices fail to provide proper signals to consumers and producers
– Leads to inefficient unregulated competitive market

• Two important types of market failures


– Externalities
 Action taken by either a producer or a consumer which affects other
producers or consumers but is not accounted for by the market price
 Costs or benefits are “external” to the market (e.g. pollution)

– Lack of Information
 Lack information about the quality or nature of a product prevents
consumers from making utility-maximizing purchasing decisions

– Government intervention may be desirable in these cases (e.g., setting


emissions standard, requiring “truth in labeling”)
– In the absence of market failures, unregulated competitive markets do lead to
economic efficiency

• What if the market is constrained to a price above market-clearing level?

Price
When price is regulated to be no lower
than Pmin, only Q1 will be demanded.

If Q1 is produced:
Pmin ΔCS = – A – B
ΔPS = + A – C
P0 Deadweight loss = B + C

At Pmin, producers would like to


produce Q2. If they do, the
deadweight loss will be even larger.

Q1 Q0 Q2 Quantity

• 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

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 5
Minimum Prices
• Government policy seeks to raise prices above market-clearing levels
– Minimum wage law
– Agricultural policies
• When price is set above the market-clearing price
– QD falls
– Suppliers may, however, choose to increase QS in face of higher prices
– This causes additional producer losses equal to the total cost of production
above QD
Price Price is regulated to be no lower than Pmin.
Producers would like to supply Q2, but
consumers will buy only Q3
Pmin
 P  QD 
ΔCS = – A – B
P0 ΔPS = + A – C

If producers expand production to Q2 from the


increased price
– (Q2 – Q3) will go unsold
– Trapezoid D measures total cost of
additional production Q2 – Q3
– ΔPS = + A – C – D
– D can be large, a minimum price can even
Q3 Q0 Q2 Quantity result in a net loss of surplus to producers

• Minimum 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
w

wmin Firms are not allowed to pay less than wmin.


This results in unemployment

ΔCS = – A – B (the firm)


w0
ΔPS = + A – C (the worker)

Deadweight loss = – B – C

Unemployment = L2 – L1

L1 L0 L2 Labor

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 6
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
• What are the impacts on consumers, producers and the federal budget?

Price To maintain a price PS, the government


buys a quantity Qg.

ΔCS = – A – B (Loss)
PS ΔPS = + A + B + D (Gain)

P0 Government cost = PS(Q2 – Q1)

ΔWelfare = ΔCS + ΔPS – Govt. cost


= D – PS(Q2 – Q1)

Q1 Q0 Q2 Quantity

• Welfare effects of a price support policy


– Consumers
 Consumers must pay higher price for the good
 Loss in consumer surplus equal to A + B
– Producers
 Gain since they are selling more at a higher price
 Producer surplus increases by A + B + D
– Government
 Cost to government = (Q2 – Q1)PS
– Total welfare effect of policy
CS + PS – Govt. cost = D – (Q2 – Q1)PS
– Society as a whole is worse off
– Less costly to simply give farmers the money

Production Quotas
• The government can restrict supply either by imposing production quotas or by
giving producers a financial incentive to reduce output
– Taxi medallions
– Required liquor licenses for restaurants

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 7
Price
To maintain price at PS, government can
PS restrict supply to S’ at Q1

By imposing production quotas:


ΔCS = – A – B
P0 ΔPS = + A – C
Deadweight loss = B + C

By giving a financial incentive:


Cost to the government = B + C + D

Q1 Q0 Quantity

• Incentive Programs
– 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

– Change in PS
 From increased price = + A – C
 Government pays farmers not to produce = B + C + D
 Total PS = + A – C + Govt. payments = A + B + D

– Change in CS
 CS = – A – B

– Change in welfare
 Welfare = CS + PS – cost to government
= – A – B + A + B + D – (B + C + D) = – B – C
• 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

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 8
Supporting the Price of Wheat: An Example
• In 1981, the supply and demand curves for wheat were:
– QS = 1800 + 240P and QD = 3550 – 266P
– P* = $3.4585/bushel and Q* = 2,630.04 million bushels
– Government raised the price to $3.70 through government purchases
– How much would the government had to buy (QG) to keep price at $3.70
 QDTotal = QD + QG =
 QS = QDTotal
 Set 1800 + 240P =  QG =
 At a price of $3.70, QG = = 122.2 million bushels

Price ($)

PS=3.70

P0=3.46

2630 Quantity

– Loss to consumers: CS = – A – B


 A= = $619.64 million
 B= = $7.757 million
 CS =
– Cost to the government = = –$452.14 million
– Total cost of program = = $1,079.537 million
– Gain to producers: PS = A + B + C

C= = $14.7557 million
 PS =
– Welfare = CS + PS – Cost of govt.
= = – $437.3843 million

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 9
Import Quotas and Tariffs
• Many countries use import quotas and tariffs to keep the domestic price of a
product above world levels
– Import quotas: Limit on the quantity of a good that can be imported
– Tariff: Tax on an imported good
• This allows domestic producers to enjoy higher profits, but costs to consumers
is high
• In a free market, the domestic price equals the world price PW. Domestic
consumers have incentive to purchase from abroad
– Domestic price falls to PW and imports equal (QD – QS)
• Domestic industry might convince government to protect industry by
eliminating imports
– Quota of zero or high tariff  (P0 – PW)

Price ($) If there were no imports, domestic price and


quantity would P0 and Q0
In a free market, the domestic price equals
the world price PW  demand = QD and
supply = QS

P0 Imports = QD – QS
Quota of zero (or import tariff) pushes
PW domestic price to P0 and imports go to zero

CS = – A – B – C (loss)
PS = A (gain)
Deadweight loss = B + C

QS Q0 QD Quantity

• Import Tariff (General Case)


– Government Revenue = D = tariff * imports
– PS = A (gain) P
– CS = – A – B – C – D (loss)
– DWL = B + C
• Import Quota (General Case) P*
– D becomes part of the profits of PW
foreign producers
– CS = – A – B – C – D (loss)
– PS = A (gain)
– Net domestic loss = B + C + D
QS → Q’S Q’D ← QD Q
Better off using tariff than quota

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 10
The Sugar Quota: An Example
• The U.S. Sugar Market in 2010
– U.S. production = 15.9 billion pounds
– U.S. consumption = 22.8 billion pounds
– U.S. price = 36 cents/pound
– World price = 24 cents/pound
– Price elasticity of U.S. supply = 1.5
– Price elasticity of U.S. demand = –0.3

• The data can be used to fit the U.S. supply and demand curves
– QS =
– QD =

– At the 24-cent world price


 U.S. production =
 U.S. consumption =
 Imports =

– Government restricted imports to 6.9 billion pounds raising price by 12


cents/pound
 QD – QS = = 6.9 billion pounds
 P = 36 cents/pounds

Price
(cents/lb.)
The cost of the quotas to consumers:
CS = – A – B – C – D
PUS = 36 The gain to producers:
after quota
PS = A

The gain to foreign producers = D

PW = 24
before quota Deadweight loss = B + C

15.9 22.8 Quantity (billions of lbs.)

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 11
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?
– 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 (i.e., the shapes of the curves)

• The Effects of a Specific Tax


– For simplicity we will consider a specific tax on a good
 Tax of a certain amount of money per unit sold
 Federal and provincial taxes on gas and cigarettes
– For example, consider a specific tax of $t per widget sold

Price
Pb = price paid by buyers
Ps = price received by sellers
t = tax

Buyers loss = A + B
P0 Sellers loss = C + D
Government gain = A + D (tax revenue)

Deadweight loss = B + C

Q1 Q0 Quantity

– Four conditions that must be satisfied after the tax is in place


1. Quantity sold and buyers price, Pb, must be on the demand curve
 QD = QD(Pb)

 Buyers only concerned with what they must pay

2. Quantity sold and sellers price, Ps, must be on the supply curve
 QS = QS(Ps)

 Sellers only concerned with what they receive

3. Quantity demanded must equal quantity supplied (i.e., QD = QS)


4. Difference between Pb and Ps is the tax (i.e., Pb – Ps = t)
– If we know the demand and supply curves as well as the tax, we can solve
for Pb, Ps, QD and QS

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 12
– Share of Tax Burdens
 If demand is relatively inelastic, burden of tax will fall mostly on buyers
 Cigarettes

 If supply is relatively inelastic, burden of tax will fall mostly on sellers


– Impact of Elasticities on Tax Burdens
Burden on Buyer Burden on Seller
Price
Price

P0 P0

Q1 Q0 Quantity Q1 Q0 Quantity

– We can calculate the percentage of a tax borne by consumers using


Pass-through fraction = ES/(ES – ED)
 Tells fraction of tax “passed through” to consumers through higher prices
 For example, when demand is perfectly inelastic (i.e., ED = 0), the pass-
through fraction is 1 – consumers bear 100% of tax
• The Effects of a 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
Price Pb = price paid by buyers
Ps = price received by sellers
s = subsidy
ΔPS = A + B (gain)
ΔCS = C + E (gain)
P0 Govt. cost = A + B + C + E + F
Δwelfare = F = deadweight loss
Like a tax, the benefit of a subsidy is
split between buyers and sellers,
depending upon the elasticities of
supply and demand
Q0 Q1 Quantity

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 13
– The benefit of the subsidy accrues mostly to buyers if ED/ES is small
– The benefit of the subsidy accrues mostly to sellers if ED /ES is large

Price Price

P0

P0

Q0 Q1 Quantity Q0 Q1 Quantity
– As with a tax, the four conditions must be satisfied when the subsidy is in
place
– Using supply and demand curves, and the size of the subsidy, we can solve
for resulting prices and quantities

A Tax on Gasoline: An Example


• The goal of a large gasoline tax is
– Raise government revenue
– Reduce oil consumption and reduce U.S. dependence on oil imports
• Measuring the impact of a $1gasoline tax in the market during 2005–2010
– Given E PD = – 0.5, E pS = 0.4, P* = $2 and Q* = 100 billion gallons per year
 QD = Price
 QS = ΔCS = – A – B
ΔPS = – C – D
• With a $1 tax (Pb – Ps = 1)
– Set QD = QS Govt revenue
P0=2.00 =A+D
=
(PS+ 1) = ΔWelfare = DWL
PS = =–B–C
Pb = PS + 1 =
QD = QS = billion gallons/year
100 Quantity
– Q falls by %
– Price to consumers increase by cents per gallon
– Producers receive about cents per gallon less
– Government revenue would be significant at billion per year

Source: Pindyck and Rubinfeld (2018), Microeconomics, 9th Ed., Pearson Prentice Hall. 14

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