Chapter 9
Chapter 9
Properties and Applications Of
The Competitive Market
Chapter Outline
•
•
•
•
•
Consumer Welfare
Producer Welfare
How Competition Maximizes Welfare
Policies that shift Supply Curve
Policies that create a wedge between Supply
and Demand
• Comparing both types of Policies: Trade
Evaluating the Gains and Losses from
Government Policies
• Welfare tools are helpful in predicting the
impact of government policies and other
events that alter a competitive equilibrium.
• When we evaluate the gains and losses from
government policies, such as price ceilings,
price floors, import tariffs, minimum wages
etc., consumer surplus and producer surplus
are the standard tools for the analyses.
Consumer Surplus
• Consumer welfare from a good is the benefit a
consumer gets from consuming that good minus
what the consumer paid to buy the good.
• Rephrasing the above, consumer surplus is the
consumers’ maximum willingness to pay minus
the total expenditures on the good.
• The demand curve reflects a consumer’s
marginal willingness to pay:
– the maximum amount a consumer will spend for an extra
unit.
– the marginal value the consumer places on the last unit of
output.
Consumer Surplus
• An individual’s consumer surplus is the area
under the demand curve and above the market
price up to the quantity the consumer buys.
Consumer Surplus for an individual consumer
(a) David ’s Consumer Surplus
p, $ per magazine
5
a
b
4
CS1 = $2 CS2 = $1
c
3
Price = $3
2
E 1 = $3
E2 = $3
E 3 = $3
Demand
1
0
1
2
3
4
5
q, Magazines per week
Consumer Surplus for the market
(b) Steven’s Consumer Surplus
p, $ per
trading card
Consumer
surplus, CS
p1
Expenditure, E
Demand
Marginal willingness to
pay for the last unit of output
q1
q, Trading cards per year
Fall in Consumer Surplus as Price Rises
p, ¢ per stem
57.8
A = $149.64 million
b
32
30
B = $23.2 million
C = $0.9 million
a
Demand
0
1.16 1.25
Q, Billion rose stems per year
SOME REAL WORLD DATA
Effect of a 10% Increase in Price on Consumer Surplus
(Revenue and Consumer Surplus in Billions of 1999 Dollars)
p, $ per unit
Relatively inelastic demand (at e 1)
p2
In general, as the price
increases, consumer surplus
falls more:
1. the greater the initial
revenues spent on the
good and
2. the less elastic the
demand curve
B
A
C
e3
D
e2
e
p1
1
Relatively elastic demand (at e 1)
Q3
Q2 Q 1
Q, Units per week
Producer Surplus
• PS: The difference between the amount for
which a good sells and the minimum amount
necessary for the seller to be willing to
produce the good
• Producer surplus is used to evaluate the
producers’ welfare. It is the benefit that
lower-cost producers enjoy by selling at the
market price.
Producer Surplus
• It is the sum over all the units produced of
difference between market price of the good
and marginal cost of production
A Firm’s Producer Surplus
’
p, $ per unit
Supply
4
p
PS1 = $3 PS 2 = $2 PS 3 = $1
3
Actual benefits above
costs that producers
receive
2
1
MC1 = $1 MC2 = $2 MC3 = $3 MC4 = $4
0
1
2
3
4
q, Units per week
A Market’s Producer Surplus
p, Price per unit
The total producer
surplus is the area
above the supply
curve and below the
market price up to the
quantity actually
produced.
Market supply curve
Market price
p*
Producer surplus, PS
Variable cost, VC
Q*
Q, Units per year
Change in Producer Surplus due to a price change
p, ¢ per stem
E = $4.05 million
30
Supply
a
D = $104.4 million
21
b
F
0
1.16
1.25
Q, Billion rose stems per year
Producer Surplus
Original Price
P=$0.30
New Lower Price
P=$0.21
Change in PS
(in $ millions)
D+E+F
F
– D – E = $108.45
Consumer Surplus and Producer Surplus on a
Demand-Supply diagram
S
Price
Welfare is
maximized at the
competitive market
equilibrium P and
Q. (This, of course,
assumes that there
are no market
failures or
externalities.)
Consumer
surplus
PEQ
Producer
surplus
D
QEQ
Welfare or Total Surplus = CS + PS
Output
Deadweight Loss
• deadweight loss (DWL) - the net reduction in
welfare from a loss of surplus by one group
that is not offset by a gain to another group
from an action that alters a market
equilibrium.
Why Reducing Output from the Competitive Level
Lowers Welfare
p, $ per unit
Supply
A
p
MC
1
e2
2
= p1
B
D
C
E
e1
Demand
MC 2
F
Q2
Q 1 Q , Units per year
The deadweight loss
results because
consumers value extra
output by more than the
marginal cost of
producing it.
Why Increasing Output from the Competitive
Level Lowers Welfare
p, $ per unit
Supply
MC 2
A
e
1
MC 1 = p 1
p2
C
B
DE
e2
the cost of producing
this extra output
exceeds the value
consumers place on it.
Demand
F
G
H
Q1
Q2
Q, Units per year
Why Increasing/Decreasing Output from the
Competitive Level Lowers Welfare
• The reason that competition maximizes
welfare is that price equals marginal cost at
the competitive equilibrium.
• Consumers value the last unit of output by
exactly the amount that it costs to produce it
• market failure - inefficient production or
consumption, often because a price exceeds
marginal cost
•
All government actions affect a competitive
equilibrium in one of two ways.
1. by shifting the supply curve (barriers to entry)
2. by creating create a wedge between SUPPLY and
DEMAND so that they are not equal, as they
were in the original competitive equilibrium.
1.
2.
3.
4.
taxes,
price ceilings,
price floors, and
tariffs
Policies that shift the Supply Curve
•
The two most common types of government
policies that shift the supply curve are:
– limits on the number of firms in a market and
– quotas or other limits on the amount of output
that firms may produce.
Policies that shift the Supply Curve
•
Governments, other organizations, and
social pressures limit the number of firms in
at least three ways:
– explicitly in some markets, such as the one for
taxi service.
– barring some members of society from owning
firms or performing certain jobs or services.
– by raising the cost of entry.
Restricting the Number of Firms
• A limit on the number of firms causes a shift
of the supply curve to the left, which raises
the equilibrium price and reduces the
equilibrium quantity.
– Consumers are harmed since they don’t buy as
much as they would at lower prices.
– Firms that are in the market when the limits are
first imposed benefit from higher profits.
Restricting the Number of Firms:
Example
• Regulation of taxicabs.
– Countries throughout the world regulate taxicabs.
• To operate a cab in these cities legally, you must
possess a city-issued permit, which may be a piece of
paper or a medallion.
Effect of a Restriction on the Number of Cabs
Welfare Effects of a Sales Tax/Subsidy
• A new sales tax:
– causes the price consumers pay to rise
• resulting in a loss of consumer surplus
– a fall in the price firms receive
• resulting in a drop in producer surplus
• However, the new tax provides the government
with new tax revenue
Welfare Effects of a Sales
Tax/Subsidy
• Assuming that the government does
something useful with the tax revenue, we
should include tax revenue in our definition of
welfare:
W = CS + PS + T.
• As a result, the change in welfare is
ΔW = ΔCS + ΔPS + ΔT.
Welfare Effects of a Sales Tax
• 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
Welfare Effects of a Sales Tax
• For simplicity we will consider a specific tax on a good
• Specific tax: A tax of a certain amount of money per unit sold.
 This tax can be levied on either producers or consumers. If
this is levied on producers, they have to pay the tax to the
government for each unit they sell. If the tax is levied on
consumers, they have to pay the tax the government for each
unit they purchase.
• Suppose that government imposes a tax of t-cents per unit on
widgets; The government must receive t-cents for every
widget sold.
• First, notice that this means that price the buyer pays must
exceed the net price the seller receives by t-cents
Welfare Effects of a Sales Tax
• We want to know the effects of the specific tax on the
market quantity, prices, consumer surplus and producer
surplus.
• Suppose for simplicity that this tax is levied on producers so
that for each unit sold, the producers should pay t-cents to
the government
Welfare Effects of a Sales Tax
A
S1
C
t
Pb
1. The market quantity after the imposition
of tax. To figure out the market quantity,
first, shift the supply curve vertically by tcents to S1. Then, the market quantity
after the imposition of tax is determined by
where new supply curve S1 and the
demand curve D0 intersect. Therefore,Q1
will be the new market quantity. We shift
the supply curve upward by t-cents
because the producers have to pay t-cents
for each unit sold and this increase
marginal cost.
S0
.
P0
Ps
D0
Q1 Q0
Before the tax is imposed, equilibrium market
price and quantity are Q0 and P0
2. The price that consumers pay
 This is given by Pb in the graph.
3.
The net price that producers receive.
 This is given by Ps. This is because,
even if the producers receive Pb from
consumers, they have to pay t-cents per
unit sold.
Welfare Effects of a Sales Tax
4. Burden of tax for producers.
 This is given by (P0  Ps). Producers are burdened by the tax in the
sense that they are receiving a lower net price (Ps) compared to the
initial market equilibrium price (P0).
5. Burden of tax for consumers.
 This is given by (Pb  P0). Consumers are burdened by the tax in the
sense that they have to pay higher price (Pb) compared to the initial
market equilibrium price P0.
Important: From (iv) and (v), notice that, even if the tax is levied on
producers as in this case, the burden of tax is split between consumers
and producers (or sellers).
• [Exercise] What is the net welfare effect of this tax?
Welfare Effects of a Sales Tax
• Next we consider the case where specific tax is levied on
consumers.
• We will see that regardless of whether it is levied on
producers and consumers, the results will be the same: that
is, the price that consumers pay, and price that producers
receive, market quantity and welfare effects are the same.
• Suppose for this tax is levied on consumers so that for each
unit purchased, the consumers should pay t-cents to the
government.
Welfare Effects of a Sales Tax
Before the tax is imposed, the
market equilibrium quantity is
Q0.
S0
Pb
P0
1. The market quantity after the tax is imposed.
We can figure this out, first by shifting the
demand curve down by t-cents. We shift the
demand curve downward since for every unit
purchased, the consumers have to pay tcents. (You may think of this as the tax
reducing the marginal utility b/c demand
curve is basically the marginal utility curve).
Then, the market quantity is given by the
intersection between the new demand curve
D1 and S0.
2. Price that the producer receives. This is given
by the intersection between D1 and S0
Ps
t
D1
Q1
Q0
D0
3. Net Price that the consumer pays. This is
given by Pb because, even if the producer
offers the price Ps, the consumers have to pay
tax of t-cents to government.
Welfare Effects of a Sales Tax
• Notice that regardless of whether the specific tax is levied
on producers or consumers, the price for consumers, price
for producers and the market quantity will be the same.
• We can simply find those by finding the market quantity
where the distance between demand and supply curves is
exactly t-cents. Then the price for consumers and
producers are given in the graph below.
Welfare Effects of a Sales Tax
S0
Price
Pb
P0
Find the output quantity
where the distance
between S0 and D0 is tcents
t
PS
D0
Q1
Price that consumers
pay
Price that producers receive
Quantity
Welfare Effects of a Specific Tax on Roses
Supply
p, ¢ per stem
A
B
32
30
t = 11
D
e2
C
e1
E
Demand
21
F
0
1.16
1.25
Q, Billion rose stems per year
Impact of Elasticities on Tax Burdens
Price
Burden on Buyer
Price
Burden on Seller
D
S
Pb
S
t
Pb
P0
P0
PS
t
D
PS
Q1 Q 0
Quantity
Q1 Q0
Quantity
Welfare Effects of a Sales Tax
• 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
(Ed = 0), the pass-through fraction is 1 –
consumers bear 100% of tax
Welfare 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
Welfare Effects of a Subsidy
• Suppose that the government gives rose
producers a specific subsidy of s = 11¢ per
stem. What is the effect of the subsidy on the
equilibrium prices and quantity, consumer
surplus, producer surplus, government
expenditures, welfare, and deadweight loss?
Effects of a Subsidy
Price
D is the
deadweight loss
from subsidy
S
Like a tax, the benefit
of a subsidy is split
between buyers and
sellers, depending
upon the elasticities of
supply and demand.
PS
Subsidy
P0
D
Pb
D
Q0
Q1
Quantity
44
Chapter 9
Price Floors or minimum wages
wage
S
E
A
D
Minimum
wage
B
C
D
Qd
Qs
Quantity
of Labor
In the labor market, workers are
suppliers, and firms are consumers.
At the market equilibrium, CS =
A+B+E
PS = C+D
Welfare = A+B+C+D+E
With the minimum wage, CS = E
PS = A+D
Welfare = A+D+E
Change in welfare due to minimum
wage = – B – C =deadweight loss
Workers would like to supply Qs, however, firms only want to hire Qd at
the minimum wage. Therefore, the difference Qs - Qd is
“unemployment”.
General price floor (for commodities, like
agricultural)
At the price floor (artificially high price),
quantity demanded is Qd, but producers (by
setting p = MC) decide to produce Qs.
There is excess supply.
At the market equilibrium, CS = A+B+E
PS = C+D
Welfare =A+B+C+D+E
With the price floor,
CS = E
PS = A + D – F1 – F2
Welfare = A + D + E – F1 – F2
PMIN
Q0
Where – F1 – F2 represents the costs of
production of unsold output.
Change in welfare with price floor
(compared to equilibrium)= – B – C – F1 – F2
= DWL
Effect of Price Supports in Soybeans
p, $ per bushel
Supply
A
p = 5.00
Price support
D
B
C
E
F
e
p1 = 4.59
Demand
G
3.60
0
MC
Qd = 1.9
Q 1= 2.1 Qs = 2.2
Q g = 0.3
Q, Billion bushels of soybeans per year
PRICE SUPPORT
The government
sets a minimum
price, and buys all
of the excess
supply.
This is big
expenditure for the
government!!!
Alternative Subsidy Program
• What are the effects in the soybean market of
a $5-per-bushel price support using a
deficiency payment on the equilibrium price
and quantity, consumer surplus, producer
surplus, and deadweight loss?
Here, the
government pays
the price
difference= $5 $4.39
Incentive Programs
• Incentive Programs
– Government may try to encourage a reduction in
quantity (by making a payment) to producers in
order to raise price to a target price
– For example, government gives farmers financial
incentives to restrict supply
• Acreage limitation programs
– Quantity decreases and price increases for the
crop
Incentive Programs
S’
Price
S
E
Ptarget
•CS reduced by A + B
F
A
Cost to government =
B+C+F
= additional profit
made if producing
Qhigh at Ptarget
B
P0
C
D
D
Qtarget
Q0
•Change in PS
=A+B+F
Qhigh Quantity
Incentive Programs
At the target price, producers will be tempted to produce Qhigh.
Therefore, the government payment to producers must give them PS
+ payment (when they produce Q target) equivalent to PS they would
have received from producing Qhigh.
Minimum payment needed for producers to supply Q target rather than
Qhigh is B+C+F.
As before, at the market equilibrium, CS = A+B+E, PS = C+D, and
Welfare = A+B+C+D+E
With the incentive program, CS = E
PS = A+D + B+C+F
Change in welfare = Change in CS + Change in PS – Cost to
Government = – C – B
Welfare Effects of a Price Ceiling
• price ceiling - the highest price that a firm can
legally charge.
• If the government sets the ceiling below the
precontrol competitive price,
– consumers demand more than the precontrol
equilibrium quantity and
– firms supply less than that quantity
• Producer surplus must fall because firms receive a
lower price and sell fewer units.
Welfare Effects of a Price Ceiling
• We will show the welfare effects by going over some exercise
questions.
– Suppose that government imposes a ceiling price. What is the
quantity supplied in the market? A price ceiling is a government
policy such that the government makes it illegal for producers to
charge more than the ceiling price. The price ceiling is the maximum
price allowed. [Producers are allowed, however to charge less than
the ceiling price.]
– What is the consumer surplus under this price ceiling policy? Show
graphically.
– What is the producer surplus under this price ceiling policy?
– What is the sum of producer surplus and consumer surplus under
the price ceiling policy? Show graphically?
– What is the change in the sum of consumer surplus and producer
surplus compared to the market equilibrium??
Welfare Effects of a Price Ceiling
p, $ per pound
Price Ceiling is likely to reduce the
sum of the consumer surplus and
producer surplus
A
Supply
B
p1
D
p2
F
C
e1
E
e2
p, Price ceiling
Demand
Qs = Q2
Q1
Qd
Q, Pounds per year
Welfare Effects of a Price Ceiling
We can interpret D as welfare gain due to the
decreased price, and C as the welfare loss due to the
decreased consumption. If D is greater than C, then
consumer surplus increases due to the price ceiling.
But if D is smaller than C, then consumer surplus falls
due to the price ceiling.
A price ceiling always decreases producer surplus
Comparing Both Types of Policies:
Imports
• The government of the (potentially) importing
country can use one of four import policies:
– Allow free trade.
– Ban all imports.
– Set a positive quota.
– Set a tariff.
• a tax on only imported goods
Comparing Both Types of Policies: Imports
• If there is no restriction on imports, a country will import a good
when the world price is below the (domestic) market price that
would prevail if there were no imports.
• P0 is the price that would prevail if there were no imports. Q0 is
the corresponding market equilibrium output if there were no
imports. (see the graph on the next slide)
• Suppose that the world price for this good is Pw, which is lower
than P0. Then if the country imports the good, the producers in
the country will have to sell their product at the world price Pw,
not P0. This is because, if domestic producers sold their
products higher than Pw, they would lose all their customers
(assuming that world supply is unlimited and products are
identical). This forces domestic producers to sell at the world
price Pw.
Comparing Both Types of Policies: Imports
S
Price
P0
PW
As can be seen, when the country imports the goods,
the price of the good will be Pw, and therefore,
quantity supplied will be Qs, and quantity demanded
will be Qd. Qs is the amount which is domestically
supplied. However, the quantity demanded (Qd)
exceeds quantity supplied domestically (Qs).
Therefore, the country will import the difference
(QdQs).
D
Qs
Q0
Qd
Quantity
[Exercise] In the figure, graphically show the consumer surplus and producer
surplus when the country imports the good.
Comparing Both Types of Policies: Imports
Price
In the diagram, to eliminate the
import, how big should the tariff
be?
Pw
Qs
Qd
Quantity
Notice that if government impose import tariff that is big
enough to eliminate the imports, the revenue from the
tariff would be zero since there is no imports.
Comparing Both Types of Policies: Imports
• Import Quotas: Import quotas restrict the quantity of
the good to be imported.
• As an exercise, we will consider the special case of zero
import quotas. That is, forbidding any importation of the
good.
• The next diagram shows the demand and supply
diagram when the country imports the good. What
would happen to the consumer and producer surplus if
the government eliminates all imports? Imports could
be reduced to zero either by setting a quota = zero or by
imposing a sufficiently high import tariff.
Loss from Eliminating Free Trade
9-62
Free Trade Versus a Tariff
• There are two common types of tariffs:
– specific tariffs — τ dollars per unit and
– ad valorem tariffs — α percent of the sales price.
• Tariffs are just taxes.
– If the only goods sold were imported, the effect of
a tariff in the importing country is the same as we
showed for a sales tax.
Import tariff. More general case
• Suppose that the government imposes an
import tariff, amount of which is equal to T in
the diagram below. Then price of the good in
the market will be P*.
• We will see the effects of the import tariff by
going over some exercise questions.
Import Tariff: Exercise
Q1. What is the quantity demanded and
supplied before the import tariff is
imposed?
Price
Q2. What is the producer surplus and
consumer surplus before the import tariff is
imposed.
S
Tariff “t”
Q3. What is the quantity demanded and
supplied after the import tariff is imported?
P*
Pw
D
Output
Q4. What is the producer surplus and
consumer surplus after the import tariff is
imposed?
Q5. What is the tax revenue from this
import tariff?
Q6. What is the net welfare effect of this
tariff?
Effect of a Tariff (or Quota)
p, 1988 dollars
per barrel
Sa = S 2
A
29.04
e2
e3
S3
19.70
t = 5.00
B
14.70
F
D
C
e1
E
G
S1, World price
H
Demand
0
8.2 9.0
11.8
13.1
Imports = 2.8
Q, Million barrels of oil per day