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Fernando & Yvonn Quijano
Prepared by:
The Analysisof Competitive
Markets
9
CHA
P
TE
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Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e.
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CHAPTER 9 OUTLINE
9.1 Evaluating the Gains and Losses fromGovernment Policies
9.2 The Efficiency of a Competitive Market
9.3 Minimum Prices
9.4 Price Supports and Production Quotas
9.5 Import Quotas and Tariffs
9.6 The Impact of a Tax or Subsidy
9.7 Numerical examples
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EVALUATING THE GAINS AND LOSSESFROM GOVERNMENT POLICIESCONSUMER AND PRODUCER SURPLUS
9.1
Review of Consumer and Producer Surplus
ConsumerAwould pay $10for a good whose market
price is $5 and thereforeenjoys a benefit of $5.
Consumer Benjoys abenefit of $2,
and Consumer C, whovalues the good at exactlythe market price, enjoys no
benefit.
Consumer surplus, whichmeasures the total benefit toall consumers, is the yellow-shaded area between thedemand curve and themarket price.
Consumer and ProducerSurplus
Figure 9.1
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EVALUATING THE GAINS AND LOSSESFROM GOVERNMENT POLICIESCONSUMER AND PRODUCER SURPLUS
9.1
Review of Consumer and Producer Surplus
Producer surplus measuresthe total profits of producers,
plus rents to factor inputs.It is the green-shaded areabetween the supply curveand the market price.
Together, consumer andproducer surplus measurethe welfare benefit of a
competitive market.
Consumer and ProducerSurplus (continued)
Figure 9.1
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EVALUATING THE GAINS AND LOSSESFROM GOVERNMENT POLICIESCONSUMER AND PRODUCER SURPLUS
9.1
Application of Consumer and Producer Surplus
welfare effects Gains and losses to consumers and producers.
The price of a good has beenregulated to be no higher thanPmax, which is below themarket-clearing price P0.
The gain to consumers is thedifference between rectangleA
and triangle B.
The loss to producers is thesum of rectangleAand triangleC.
Triangles Band Ctogethermeasure the deadweight lossfrom price controls.
Change in Consumer and Producer
Surplus from Price Controls
Figure 9.2deadweight loss Net loss of total
(consumer plus producer) surplus.
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EVALUATING THE GAINS AND LOSSESFROM GOVERNMENT POLICIESCONSUMER AND PRODUCER SURPLUS
9.1
Application of Consumer and Producer Surplus
If demand is sufficientlyinelastic, triangle Bcan be
larger than rectangleA. In thiscase, consumers suffer a netloss from price controls.
Effect of Price Controls WhenDemand Is Inelastic
Figure 9.3
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THE EFFICIENCY OF A COMPETITIVE MARKET9.2
Market Failure
There are two important instances in which market failure can occur:1. Externalities: Pollution.
2. Lack of Information: Truth in labeling.
economic efficiency Maximization of aggregate
consumer and producer surplus.
market failure Situation in which an unregulated
competitive market is inefficient because prices fail toprovide proper signals to consumers and producers.
externality Action taken by either a producer or a
consumer which affects other producers or consumersbut is not accounted for by the market price.
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THE EFFICIENCY OF A COMPETITIVE MARKET9.2
When price is regulated to beno lower than P2, only Q3willbe demanded.
If Q3is produced, thedeadweight loss is given bytriangles Band C.
At price P2, producers wouldlike to produce more than Q3.If they do, the deadweight
loss will be even larger.
Welfare Loss When Price is HeldAbove Market-Clearing Level
Figure 9.5
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MINIMUM PRICES9.3
Although the market-clearingwage is w0,
firms are not allowed to pay lessthan wmin.
This results in unemployment ofan amount L2 L1
and a deadweight loss given bytriangles Band C.
The Minimum Wage
Figure 9.8
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PRICE SUPPORTS AND PRODUCTION QUOTAS9.4
To maintain a price Psabove themarket-clearing price P0, thegovernment can restrict supply toQ1, either by imposing productionquotas (as with taxicab medallions)or by giving producers a financial
incentive to reduce output (as withacreage limitations in agriculture).
For an incentive to work, it must beat least as large as B+ C+ D,which would be the additional profitearned by planting, given the higherprice Ps. The cost to the
government is therefore at least B+C+ D.
Supply Restrictions
Figure 9.11
Welfare = A B+A+ B+ D B C D= B C
Production Quotas
CS = A B
PS =A C+ Payments for not producing
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PRICE SUPPORTS AND PRODUCTION QUOTAS9.4
1981 Supply: QS
= 1800 + 240P
1981 Demand: QD= 3550 266P
To increase the price to$3.70, the governmentmust buy a quantity ofwheat Qg.
By buying 122 millionbushels of wheat, thegovernment increased
the market-clearingprice from $3.46 perbushel to $3.70.
The Wheat Market in 1981
Figure 9.12
1981 Total demand: QDT= 3550 266P + Qg
Qg= 506P 1750
Qg= (506)(3.70) 1750 = 122 million bushels
Loss to consumers =A+ B= $624 million
Cost to the government = $3.70 x 122 million = $451.4 million
Total cost of the program = $624 million + $451.4 million = $1075 million
Gain to producers =A+ B+ C= $638 million
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PRICE SUPPORTS AND PRODUCTION QUOTAS9.4
1985 Supply: QS
= 1800 + 240P
1985 Demand: QD= 2580 194P
In 1985, the demand forwheat was much lowerthan in 1981, becausethe market-clearing pricewas only $1.80.
To increase the price to$3.20, the governmentbought 466 millionbushels and alsoimposed a productionquota of 2425 millionbushels.
The Wheat Market in 1985
Figure 9.13
2425 = 2580 194P + Qg
Qg= 155 + 194P
Qg= 155 + 194($3.20) = 466 million bushels
Cost to the government = ($3.20)(466) = $1491 million
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IMPORT QUOTAS AND TARIFFS9.5
In a free market, the domestic
price equals the world price Pw.
A total Qdis consumed, of whichQsis supplied domestically andthe rest imported.
When imports are eliminated,the price is increased to P0.
The gain to producers istrapezoidA.
The loss to consumers isA+ B+ C, so the deadweight loss is B+ C.
Import Tariff or Quota ThatEliminates Imports
Figure 9.14
import quota Limit on the quantity of a good that can be
imported.
tariff Tax on an imported good.
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IMPORT QUOTAS AND TARIFFS9.5
When imports are reduced, thedomestic price is increased fromPwto P*.
This can be achieved by aquota, or by a tariff T= P* Pw.
TrapezoidAis again the gain todomestic producers.
The loss to consumers isA+ B+ C+ D.
If a tariff is used, thegovernment gains D, the
revenue from the tariff. The netdomestic loss is B+ C.
If a quota is used instead,rectangle Dbecomes part of theprofits of foreign producers, andthe net domestic loss is B+ C+D.
Import Tariff or Quota (General Case)
Figure 9.15
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IMPORT QUOTAS AND TARIFFS9.5
U.S. supply: QS
= 7.48 + 0.84P
U.S. demand: QD= 26.7 0.23P
At the world price of 12cents per pound, about23.9 billion pounds of sugarwould have beenconsumed in the United
States in 2005, of which allbut 2.6 billion poundswould have been imported.
Restricting imports to 5.3billion pounds caused theU.S. price to go up by 15cents.
Sugar Quota in 2005
Figure 9.16
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IMPORT QUOTAS AND TARIFFS9.5
U.S. supply: QS
= 7.48 + 0.84P
U.S. demand: QD= 26.7 0.23P
The gain to domesticproducers was trapezoidA,about $1.3 billion.
Rectangle D, $795 million,
was a gain to those foreignproducers who obtainedquota allotments.
Triangles Band Crepresent the deadweightloss of about $1.2 billion.
The cost to consumers,A+
B+ C+ D, was about $3.3billion.
Sugar Quota in 2005 (continued)
Figure 9.16
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THE IMPACT OF A TAX OR SUBSIDY9.6
Pbis the price (including thetax) paid by buyers. Psis theprice that sellers receive, lessthe tax.
Here the burden of the tax is
split evenly between buyersand sellers.
Buyers loseA+ B.
Sellers lose D+ C.
The government earnsA+ Din revenue.
The deadweight loss is B+ C.
Incidence of a Tax
Figure 9.17
specific tax Tax of a certain amount of money per unit sold.
Market clearing requires four conditionsto be satisfied after the tax is in place:QD= QD(Pb) (9.1a)
QS= QS(Ps) (9.1b)
QD= QS (9.1c)
Pb
Ps
= t (9.1d)
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THE IMPACT OF A TAX OR SUBSIDY9.6
(a)If demand is very inelastic relativeto supply, the burden of the tax fallsmostly on buyers.
Impact of a Tax Depends on Elasticities of Supply and Demand
Figure 9.18
(b)If demand is very elastic relative tosupply, it falls mostly on sellers.
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THE IMPACT OF A TAX OR SUBSIDY9.6
A subsidy can be thought ofas a negative tax. Like a tax,the benefit of a subsidy issplit between buyers and
sellers, depending on therelative elasticities of supplyand demand.
Subsidy
Figure 9.19
The Effects of a Subsidy
Conditions needed for the market to clear with a subsidy:
QD= QD(Pb) (9.2a)
QS= QS(Ps) (9.2b)
QD= QS (9.2c)
Ps Pb= s (9.2d)
subsidy Payment reducing the buyers price below the
sellers price; i.e., a negative tax.
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THE IMPACT OF A TAX OR SUBSIDY9.6
Effect of a $1-per-gallon tax:QD= 150 25Pb (Demand)
QS= 60 + 20Ps (Supply)
QD= QS (Supply must equal demand)PbPs= 1.00 (Government must receive $1.00/gallon)
150 25Pb = 60 + 20Ps
Pb= Ps+ 1.00
150 25(Ps+ 1)= 60 + 20Ps20Ps + 25Ps= 1502560
45Ps= 65, or Ps= 1.44Q = 150(25)(2.44) = 15061, or Q = 89 bg/yr
Annual revenue from the tax tQ = (1.00)(89) = $89 billion per year
Deadweight loss: (1/2) x ($1.00/gallon) x (11 billion gallons/year = $5.5 billion
per year
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THE IMPACT OF A TAX OR SUBSIDY9.6
Gasoline demand: QD= 150 25P
Gasoline supply: QS= 60 + 20P
The price of gasoline atthe pump increases from$2.00 per gallon to
$2.44, and the quantitysold falls from 100 to 89bg/yr.
Annual revenue from thetax is (1.00)(89) = $89billion (areasA+ D).
The two triangles show
the deadweight loss of$5.5 billion per year.
Impact of $1 Gasoline Tax
Figure 9.20