1 Ch 10: Competitive Markets: Applications Often government intervene in markets, even perfectly competitive markets, for a variety of reasons Equity (instead.

1

Ch 10: Competitive Markets: Applications

Often government intervene in markets, even perfectly competitive markets, for a variety of reasons

Equity (instead of efficiency)Fixing Market FailuresAchieving Policy GoalsPolitics

2

Sidenote: Partial Equilibrium Analysis

•In this chapter we’ll use

partial equilibrium analysis

we’ll assume government intervention only affects 1 market

•We will also assume no externalities exist – no extra results will arise from these programs

3

Chapter 10: Competitive Markets: Applications

In this chapter we will cover:

10.1 Maximum Efficiency10.2 Policy: Excise Tax

10.2.1 Tax Incidence10.3 Policy: Subsidy10.4 Policy: Price Ceiling10.5 Policy: Price Floor10.6 Policy: Production Quotas10.7 Agricultural Support10.8 Policy: Import Quotas and Tariffs

4

In 1776, Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations mentioned an “Invisible Hand” that guided competitive markets to maximize efficiency.

Although no “Invisible Hand” actually exists, perfectly competitive markets do work to maximize producer and consumer surplus

5

For any given good:

Consumer Surplus is difference between the consumer’s willingness to pay and the price

Producer Surplus is the difference between the price and the producer’s willingness to provide

Total Surplus is the difference between the consumer’s willingness to pay and the producer’s willingness to provide

6

For example:

Jacob is willing to pay $20 for the assignment answers, and Beth is willing to sell her answers for $10. The PC market price for answers is $14.

Consumer Surplus =$20-$14= $6Producer Surplus =$14-$10= $4Total Surplus =$20-$10= $10

7

Consumer and Producer Surplus

Demand

Consumer Surplus

Q

P

Q*

P*

A

B C

D

Q1

Producer Surplus

Supply

8

Definition: An excise tax is an amount paid by either the consumer or the producer per unit of the good at the point of sale.

(The amount paid by the demanders exceeds the total amount received by the sellers by amount T)

9

Example: Excise Tax

T

S+T

S

Q

P

Q1 Q*

Pd

Ps

Demand

P*

Q*=Original Q

P*=Original PPd=Price Paid

by buyers

Ps=Price received by sellers

T(ax)=Pd-Ps

10

Consumer and Producer Surplus

D

OldConsumer Surplus

Q

P

Q*

P*

A

B C

D

Q1

Old Producer Surplus

S

S+T

11

Consumer and Producer Surplus

D

NewConsumer Surplus

Q

P

Q*

P*

A

B C

D

Q1

New Producer Surplus

S

S+T

Government Income

Deadweight Loss

Pd

Ps

12

Originally, efficiency was maximized.

After the tax was imposed, portions of consumer and producer surplus was transferred to the government

-this transfer is still efficient-WHO gets the surplus is irrelevant

After the tax, production decreases, and a small triangle of producer and consumer surplus is lost – this triangle is the deadweight loss

13

Deadweight loss – reduction in net economic benefit due to inefficient allocation of resources

Taxes create inefficiencies!!

14

S + tax

Sales Tax Imposed on the Sellers

Quantity (thousands of CD players per week)

Pric

e (d

olla

rs p

er p

laye

r)

3 4 5 6

95

100

105

110 S

DA

Taxrevenue

$10 tax

After Tax Market Price

Supply is affected

15

D-tax

Tax applied to buyer: Same Effect as tax on seller

Quantity (thousands of CD players per week)

Pric

e (d

olla

rs p

er p

laye

r)

3 4 5 6

95

100

105

110 S

DA

$10

tax

Original Market Price

16

Summary:

• Taxes discourage market activity

• Tax incidence measures the effect of a tax on buyers’ and sellers’ prices

•Tax burden falls most heavily on the side of the market that is least elastic in its response to a price change:

17

S + tax

The Sales Tax: Who Pays? Demand Relatively Inelastic

Quantity (thousands of CD players per week)

Pric

e (d

olla

rs p

er p

laye

r)

3 4 5 6

95

100

105

110 S

DA

98

108 $10 tax

Consumer Price Rises

from 100 to 108

18

S + tax

The Sales Tax: Who Pays? Demand Relatively More Elastic.

Quantity (thousands of CD players per week)

Pri

ce (

dolla

rs p

er

pla

yer)

3 4 5 6

95

100

105

110 S

DA $10 tax

Original Market Price

103

93

Consumer Price Rises

from 100 to 103

19

The relationship between tax incidence and elasticity is as follows:

Pd/Ps = /

where: is the own-price elasticity of supply is the own-price elasticity of demand

20

Example: Let = -.5 and = 2. What is the relative incidence of a specific tax on consumers and producers?

Pd/Ps = 2/-.5 = -4

interpretation: "consumers pay 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 $.80 and a decrease in price received by producers of $.20"

Note: Subsidies are negative taxes…

21

•Subsidies work as a negative tax, increasing the seller’s price by T (or reducing the buyer’s price by T, to the same effect)

•Subsidies will:•Encourage overproduction•Increase Consumer Surplus•Increase Producer Surplus•Be a government cost

•The cost to the government is always greater than gained consumer and producer surplus

22

Subsidies

D

OLDConsumer Surplus

Q

P

Q1

P*

A

B C

D

Q*

OLD Producer Surplus

S-T

S

Ps

Pd

23

Subsidies

D

NewConsumer Surplus

Q

P

Q*

P*

A

B C

D

Q1

S-T

S

Ps

Pd

24

Subsidies

D

Q

P

Q*

P*

A

B C

D

Q1

New Producer Surplus

S-T

S

Ps

Pd

25

Subsidies

D

Q

P

Q*

P*

A

B C

D

Q1

Government Cost

S-T

S

Ps

Pd

26

Subsidies

D

Q

P

Q*

P*

A

B C

D

Q1

Deadweight Loss

S-T

S

Ps

Pd

Government Cost

New Producer Surplus

NewConsumer Surplus

27

Definition: A price ceiling is a legal maximum on the price per unit that a producer can receive. If the price ceiling is below the pre-control competitive equilibrium price, then the ceiling is called binding.

28

A price ceiling always has the following effects:

• Excess demand will exist• The market will underproduce• Producer surplus will decrease• Some producer surplus is transferred to

the consumer• Consumer surplus may increase or

decrease• There will be a deadweight loss

29

Price Ceiling

Demand

OldConsumer Surplus

Q

P

Q*

P*

A

B C

DOldProducer Surplus

Supply

Price Ceiling

30

The impact of a price ceiling depends on which consumer receive the available good. We will examine the 2 extreme cases:

•Consumers with greatest willingness to pay receive good (maximize consumer surplus)

•Consumers with least willingness to pay receive good (minimize consumer surplus)

31

Price Ceiling: Maximize Consumer Surplus

Demand

NewConsumer Surplus

Q

P

Qd

P*

A

B C

D

Qs

NewProducer Surplus

Supply

Price Ceiling

ExcessDemandQs

Deadweight Loss

32

Price Ceiling: Minimize Consumer Surplus

Demand

NewConsumer Surplus

Q

P

Qd

P*

A

B C

D

Qs

NewProducer Surplus

Supply

Price Ceiling

ExcessDemand

Qs

33

Price Ceiling: Minimize Consumer Surplus

Demand

Q

P

Qd

P*A

B

Qs

Supply

Price Ceiling

ExcessDemand

Qs

Deadweight Loss=A-B

34

•It is generally assumed that the consumers with the greatest willingness to pay receive the good, but this does not always occur

•Price ceilings are only effective if resale (black market) is prevented

•Price ceilings can also cause a reliance on imports to meet excess demand

35

Definition: A price floor is a legal minimum on the price per unit that a producer can receive. (ie: minimum wage) If the price floor is above the pre-control competitive equilibrium price, then the floor is called binding.

36

A price floor always has the following effects:

• Excess supply will exist• The market will underconsume• Consumer surplus will decrease• Some consumer surplus is transferred to

the producer• Producer surplus may increase or

decrease• There will be a deadweight loss

37

Price Floor

Demand

OldConsumer Surplus

Q (L)

P (W)

Q*

P*

A

B C

DOldProducer Surplus

Supply

Price Floor(min. wage)

38

The impact of a price floor depends on which producer will sell the good (which worker works). We will examine the 2 extreme cases:

•Producers with greatest efficiency supply good (maximize producer surplus)

•Producers with least efficiency supply good (minimize producer surplus)

39

Price Floor: Maximize Producer Surplus

Demand

NewConsumer Surplus

Q (L)

P (W)

P*

A

B C

D

Qs

NewProducer Surplus

Supply

Price FloorIe: Min. Wage

ExcessSupplyQd

Deadweight Loss

40

Price Floor: Minimize Producer Surplus

Demand

NewConsumer Surplus

Q

P

=Qd

P*

A

B C

D

Qd

NewProducer Surplus

Supply

Price FloorIe: Min. Wage

ExcessSupply

Qs

41

Price Floor: Minimize Producer Surplus

Demand

Q

P

=Qd

P* YX

Qd

Supply

Price FloorIe: Min. Wage

ExcessSupply

Qs

Deadweight Loss=Y-X

42

• The attempt of a union to increase wages has two effects:

1)Some workers receive a higher wage2)Some workers lose their jobs

• Note that there is a difference between negotiating a higher wage (a union’s publicized goal) and ensuring wages keep up with inflation (often a union’s achieved goal)

43

• In place of a price floor, the government can instead impose a PRODUCTION QUOTA

• Production Quotas restrict the quantity supplied of any good• Ie: Taxi Cabs• Ie: Bear hunting permits

44

Production Quotas have similar effects to price floors:

• There will be excess supply (some will want to supply but be prevented)

• Quantity purchased will decrease• Consumer surplus will decrease• Some consumer surplus will transfer to

producers• Producer surplus may increase or

decrease• There will be a deadweight loss

45

Production Quota

Demand

OldConsumer Surplus

Q

P

Q*

P*

A

B C

DOldProducer Surplus

Supply

Production Quota

P1

46

Production Quota: Maximize Producer Surplus

Demand

NewConsumer Surplus

Q (L)

P (W)

P*

A

B C

D

Qs

NewProducer Surplus

Supply

Production Quota

Qd

Deadweight Loss

P1

47

Quota: Minimize Producer Surplus

Demand

NewConsumer Surplus

Q

P

=Qd

P*

A

B C

D

Qd

NewProducer Surplus

Supply

Quota

Qs

P1

48

Quota: Minimize Producer Surplus

Demand

Q

P

=Qd

P* YX

Qd

SupplyQuota

Qs

Deadweight Loss=Y-X

P1

49

Production Quotas effect on producer surplus depends on which producers are allowed to produce:

• Producers with lowest willingness to produce (lowest costs – most efficient) – producer surplus is maximized

• Producers with highest (valid) willingness to produce (highest costs – most inefficient) – producer surplus is minimized

50

•Agriculture is one area often receiving government support

•Often it is argued that farming is no longer a viable profession at market-clearing wages

•The government works to raise the price of agricultural outputs through 2 policies:

•Acre Limitation Programs•Government Purchase Programs

51

Since demand is downward sloping, prices can be raised by reducing output.

However, supply and demand will force quantity up and price down.

In order to keep quantity down and price up, the government can pay farmers to reduce production:

52

Acreage Limitation

Demand

OldConsumer Surplus

Q

P

P*

A

B C

DOldProducer Surplus

Supply

Production Limit

P1

53

Acreage Limitation

Demand

NewConsumer Surplus

Q

P

P*

A

B C

DNewProducer Surplus

Supply

Production Limit

P1

54

Acreage Limitation

Demand

NewConsumer Surplus

Q

P

P*

A

B C

DNewProducer Surplus

Supply

Production Limit

Government Cost

P1

55

Acreage Limitation

Demand

NewConsumer Surplus

Q

P

P*

A

B C

DNewProducer Surplus

Supply

Production Limit

Government Cost

Deadweight Loss

P1

56

Critics may criticize acreage limitation programs as being wasteful – if the land is there, why not use it?

Alternately, the government can purchase agricultural output in order to benefit farmers:

57

Gov. Purchase Programs

Demand

OldConsumer Surplus

Q

P

P*

A

B C

DOldProducer Surplus

Supply

Demand + Gov.Purchases

Q*Q1 Q1+G

P1

58

Gov. Purchase Programs

Demand

NewConsumer Surplus

Q

P

P*

A

B C

DNewProducer Surplus

Supply

Demand + Gov.Purchases

Q*Q1 Q1+G

Note: ChangeIn Consumer And ProducerSurplus is Equal to AcreLimitation

P1

59

Gov. Purchase Programs

Demand

NewConsumer Surplus

Q

P

P*

A

B C

D

Supply

Demand + Gov.Purchases

Q*Q1 Q1+G

Note: Gov.Costs areGreater

Gov.Cost

P1

60

Gov. Purchase Programs

Demand

NewConsumer Surplus

Q

P

P*

A

B C

D

Supply

Demand + Gov.Purchases

Q*Q1 Q1+G

Note:DeadweightLoss is Greater

DeadweightLoss

P1

61

As seen previously, government purchase programs have greater deadweight loss than acreage limitation programs.

But acreage limitation programs also have deadweight loss.

The most efficient program is to simply give the farmers money. (No deadweight loss)

Often however, politics overrules economics.

62

•Often foreign countries can produce a good cheaper than domestic industries

Pw<P*

•In order to protect domestic industries, governments often impose import quotas or tariffs

•These policies cause deadweight loss

63

Free Trade

Demand

OldConsumer Surplus

Q

P

P*

Old DomesticProducer Surplus

Supply

QDom

PW

At world prices, only a small amount of domestic industry can survive

64

Trade Prohibition (Zero Imports)

Demand

NewConsumer Surplus

Q

P

P*

New DomesticProducer Surplus

Supply

QDom

PW

DeadweightLoss

65

Import Quota

Demand

NewConsumer Surplus

Q

P

P*

New DomesticProducer Surplus

Supply

PW

DeadweightLoss

Pq

QDom QDom+Quota

66

Import Tarrif (t)

Demand

NewConsumer Surplus

Q

P

P*

New DomesticProducer Surplus

Supply

PW

DeadweightLoss

PW+t

QDom QDom+Quota

GovernmentRevenue

67

•The greater the import quota, the smaller the benefit to domestic industries and the smaller the deadweight loss

•Import tariffs are better for the domestic economy as government revenue decreases deadweight loss

•This increased government revenue is equal to foreign producer surplus under a quota; worldwide surplus is simply transferred

68

•Under normal perfectly competitive conditions, any government intervention will cause DEADWEIGHT LOSS

•The most efficient manner of government intervention is lump sum payments to the segment of society is desires to aid

•This however, is politically undesirable – Why should one segment of society get something for free?

69

Chapter 10 SummaryUnder Perfect Competition, efficiency is maximizedAll government intervention in Perfect Competition cause deadweight lossLump-sum cash transfers have the least distortion, but are unpopularWhenever government intervenes, it must be asked if

Benefit > Deadweight Loss