Chapter 9 The Analysis of Competitive Markets
Microeconomics Lecture analysis of competitive market
Nov 17, 2014
The Law of Equi-Marginal Utility is an extension to the law of diminishing marginal utility. The principle of equi-marginal utility explains the behavior of a consumer in distributing his limited income among various goods and services. This law states that how a consumer allocates his money income between various goods so as to obtain maximum satisfaction. Assumptions The principle of equi-marginal utility is based on the following assumptions: (a) The wants of a consumer remain unchanged. (b) He has a fixed income. (c) The prices of all goods are given and known to a consumer. (d) He is one of the many buyers in the sense that he is powerless to alter the market price. (e) He can spend his income in small amounts. (f) He acts rationally in the sense that he want maximum satisfaction (g) Utility is measured cardinally. This means that utility, or use of a good, can be expressed in terms of units or utils. This utility is not only comparable but also quantifiable. Principle Suppose there are two goods 'x' and 'y' on which the consumer has to spend his given income. The consumer’s behavior is based on two factors: (a) Marginal Utilities of goods 'x' and 'y' (b) The prices of goods 'x' and 'y' The consumer is in equilibrium position when marginal utility of money expenditure on each good is the same. The Law of Equi-Marginal Utility states that the consumer will distribute his money income in such a way that the utility derived from the last rupee spent on each good is equal. The consumer will spend his money income in such a way that marginal utility of each good is proportional to its rupee. The consumer is in equilibrium in respect of the purchases of goods 'x' and 'y' when: MUx = MUy Where MU is Marginal Utility and P equals Price Px Py If MUx / Px and MUy / Py are not equal and MUx / Px is greater than MUy / Py, then the consumer will substitute good 'x' for good 'y'. As a result the marginal utility of good 'x' will fall. The consumer will continue substituting good 'x' for good 'y' till MUx/Px = MUy/Py where the consumer will be in equilibrium. Thus this is also known as the law of substitution. Table Let us illustrate the law of Equi-Marginal Utility with the help of a table: The side table shows marginal utilities of goods 'x' and 'y'. Let us suppose that the price of goods 'x' and 'y' are Rs. 2/- and Rs.3/-. Then MUx/Px & MUy/Py are as follows: With a given income a rupee has certain utility to him. This is the Marginal Utility for him. Now the consumer will go on purchasing goods till the marginal utility of expenditure on each good becomes equal to the marginal utility of money to him. Thus the consumer will be in equilibrium at a point where: MUx = MUy = MUm MUm refers to Marginal Utility of Money Px Py Let us suppose that the given income of a consumer is Rs.19/-. With the given income suppose the marginal utility of money is constant at Rs. 1 = 6 utils. By looking at the above table, it is clear that MUx/Px = 6 utils when he buys 5 units of good 'x' and MUy/Py = 6 utils when he purchases 3 units of good 'y'. Therefore the consumer will be in equilibrium when he is buying 5 units of good 'x' and 3 units of good 'y' and will be spending Rs.19/- on them. MUx/Px = MUy/Py = MUm 12/2 = 18/3 = 6 Graph This law can be explained with the help of the following diagram: In the above diagram marginal utility curves of good 'x' & 'y' slope downwards. Marginal Utility of Money is confident at OM. MUx/Px = OM when OK amount of good 'x' is purchases and MUy/Py = OM when OH amount of good 'y' is purchased. Thus the consumer will be in equilibrium when he purchases OK amount of good 'x' and OH amount of good 'y' and then: MUx/Px = MUy/Py = MUm Limitations This law is based on the assumption that utility can be cardinally measurable. But in actual practices it cannot be measured in such cardinal numbers. It is also assumed that marginal utility of money is constant. But this is not true because when the quantity of money increases,
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Transcript
Chapter 9
The Analysis of Competitive
Markets
©2005 Pearson Education, Inc. Chapter 9 2
Consumer and Producer
Surplus
1. Consumer surplus is the total benefit or
value that consumers receive beyond
what they pay for the good.
Assume market price for a good is $5
Some consumers would be willing to pay
more than $5 for the good
If you were willing to pay $9 for the good
and pay $5, you gain $4 in consumer
surplus
©2005 Pearson Education, Inc. Chapter 9 3
Consumer and Producer
Surplus
The demand curve shows the willingness
to pay for all consumers in the market
Consumer surplus can be measured by
the area between the demand curve and
the market price
Consumer surplus measures the total net
benefit to consumers
©2005 Pearson Education, Inc. Chapter 9 4
Consumer and Producer
Surplus
2. Producer surplus is the total benefit or
revenue that producers receive beyond
what it cost to produce a good.
Some producers produce for less than
market price and would still produce at a
lower price
A producer might be willing to accept $3 for
the good but get $5 market price
Producer gains a surplus of $2
©2005 Pearson Education, Inc. Chapter 9 5
Consumer and Producer
Surplus
The supply curve shows the amount that
a producer is willing to take for a certain
amount of a good
Producer surplus can be measured by
the area between the supply curve and
the market price
Producer surplus measures the total net
benefit to producers
©2005 Pearson Education, Inc. Chapter 9 6
Consumer and Producer
Surplus
Between 0 and Q0
producers receive
a net gain from
selling each product--
producer surplus.
Consumer
Surplus
Quantity
Price
S
D
Q0
5
9
Between 0 and Q0
consumer A receives
a net gain from buying
the product--
consumer surplus
Producer
Surplus3
QD QS
©2005 Pearson Education, Inc. Chapter 9 7
Consumer and Producer
Surplus
To determine the welfare effect of a
governmental policy we can measure the
gain or loss in consumer and producer
surplus.
Welfare Effects
Gains and losses to producers and
consumers.
©2005 Pearson Education, Inc. Chapter 9 8
The loss to producers
is the sum of
rectangle A and
triangle C. B
A C
Consumers that can
buy the good gain A
Price Control and Surplus
Changes
Quantity
Price
S
D
P0
Q0
Pmax
Q1 Q2
Consumers that
cannot buy, lose B
Triangles B and C are
losses to society –
dead weight loss
©2005 Pearson Education, Inc. Chapter 9 9
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
This has greater effects in political decisions
©2005 Pearson Education, Inc. Chapter 9 10
B
APmax
C
Q1
With inelastic demand,
triangle B can be larger
than rectangle A and
consumers suffer net
losses from price controls.
S
D
Price Controls With Inelastic
Demand
Quantity
Price
P0
Q2
©2005 Pearson Education, Inc. Chapter 9 11
BA
C
Price Control and Surplus
Changes
Quantity
Price
S
D
P0
Q0
Pmin
Q1 Q2
When price is
regulated to be no
lower than Pmin, the
deadweight loss given
by triangles B and C
results.
©2005 Pearson Education, Inc. Chapter 9 12
The Efficiency of a Competitive
Market
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
©2005 Pearson Education, Inc. Chapter 9 13
The Market for Human Kidneys
Many countries have laws prohibiting the sale of organs for transplantation. E.g. India, Malaysia, and the United States
What has been the impact such laws?
We can measure this using the supply and demand for kidneys. Consider the following example.
Supply: QS = 8,000 + 0.2P
Demand: QD = 16,000 - 0.2P
©2005 Pearson Education, Inc. Chapter 9 14
The Market for Human Kidneys
Since sale of organs is not allowed, the
amount available depends on the amount
donated
Supply of donated kidneys is limited to 8000
The welfare effect of this supply
constraint can be analyzed using
consumer and producer surplus in the
kidney market
©2005 Pearson Education, Inc. Chapter 9 15
The Market for Human Kidneys
Suppliers:
Those who supply them are not paid the
market price estimated at $20,000
Loss of surplus equal to area A = $160 million
Some who would donate for the equilibrium
price do not in the current market
Loss of surplus equal to area C = $40 million
Total consumer loss of A + C = $200 million
©2005 Pearson Education, Inc. Chapter 9 16
The Market for Human Kidneys
Recipients:
Since they do not have to pay for the kidney,
they gain rectangle A ($140 million) since
price is $0
Those who cannot obtain a kidney lose
surplus equal to triangle B ($40 million)
Net increase in surplus of recipients of $160
- $40 = $120 million
Dead Weight Loss of C + B = $80 million
©2005 Pearson Education, Inc. Chapter 9 17
The Market for Human Kidneys
Other Inefficiency Cost
Allocation is not necessarily to those who
value the kidney’s the most.
Price may increase to $40,000, the
equilibrium price, with hospitals getting the
price.
©2005 Pearson Education, Inc. Chapter 9 18
D
A and D measure
the total value of
kidneys when supply
is constrained.A
C
The loss to suppliers
Is areas A & C.
The Market for Kidneys
Quantity
Price
4,0000
$10,000
$30,000
$40,000
8,000
S’
B
If kidneys are zero
cost, consumer gain
would be A minus B.
S
D
12,000
$20,000
©2005 Pearson Education, Inc. Chapter 9 19
The Market for Human Kidneys
Arguments in favor of prohibiting the
sale of organs:
1. Imperfect information about donor’s health
and screening
2. Unfair to allocate according to the ability to
pay
Holding price below equilibrium will create
shortages
Organs versus artificial substitutes
©2005 Pearson Education, Inc. Chapter 9 20
BA
The change in producer
surplus will be
A - C - D. Producers
may be worse off.
C
D
Minimum Prices
Quantity
Price
S
D
P0
Q0Q3 Q2
Pmin
If producers produce
Q2, the amount Q2 - Q3
will go unsold.
D measures total cost
of increased
production not sold
©2005 Pearson Education, Inc. Chapter 9 21
B
The deadweight loss
is given by
triangles B and C.
C
A
L1 L2
Unemployment
wmin
Firms are not allowed to
pay less than wmin. This
results in unemployment.
S
D
w0
L0
The Minimum Wage
L
w
A is gain to workers
who find jobs at
higher wage
©2005 Pearson Education, Inc. Chapter 9 22
B
A
•CS reduced by A + B
•Change in PS = A - C
•Deadweight loss = BC
C
Supply Restrictions
Quantity
Price
D
P0
Q0
S
S’
PS
Q1
•Supply restricted to Q1
•Supply shifts to S’ @ Q1
©2005 Pearson Education, Inc. Chapter 9 23
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
Costs to consumers is high
©2005 Pearson Education, Inc. Chapter 9 24
Import Quotas and Tariffs
With lower world price, domestic consumers have incentive to purchase from abroad.
Domestic price falls to world price and imports equal difference between quantity supplied and quantity demanded
Domestic industry might convince government to protect industry by eliminating imports
Quota of zero or high tariff
©2005 Pearson Education, Inc. Chapter 9 25
QS QD
PW
AB C
Quota of zero pushes
domestic price to P0 and
imports go to zero.
Import Tariff To Eliminate
Imports
Quantity
Price
Q0
D
P0
S
In a free market, the
domestic price equals the
world price PW.
Imports
Loss to consumers is
A+B+C.
Gain to producers is A.
Dead weight loss: B +C.
©2005 Pearson Education, Inc. Chapter 9 26
Import Tariff (general case)
The increase in price can
be achieved by a tariff.
QS increases and QD
decreases
Area A is the gain to
domestic producers.
The loss to consumers is
A + B + C + D.
DWL = B + C
Government Revenue is D
= tariff * imports
DCB
QS QDQ’S Q’D
AP*
Pw
Q
P
D
S
©2005 Pearson Education, Inc. Chapter 9 27
Import Quota (general case)
If a quota is used,
rectangle D becomes
part of the profits to
foreign producers
Consumers lose
A+B+C+D
Producers gain A
Net domestic loss is
B + C + D.
DCB
QS QDQ’S Q’D
AP*
Pw
Q
P
D
S
©2005 Pearson Education, Inc. Chapter 9 28
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?
©2005 Pearson Education, Inc. Chapter 9 29
The Impact of a Tax or Subsidy
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.
©2005 Pearson Education, Inc. Chapter 9 30
•Buyers lose A + B
Incidence of a Specific Tax
D
S
B
D
A
C
Quantity
Price
P0
Q0Q1
PS price
producers
get
Pb price
buyers pay
Tax =
$1.00 •Government gains A
+ D in tax revenue.
•Sellers lose D + C
•The deadweight
loss is B + C.
Impact of Elasticities on Tax Burdens
Quantity Quantity
Price Price
S
D S
D
Q0
P0 P0
Q0Q1
Pb
PS
t
Q1
Pb
PS
t
Burden on Buyer Burden on Seller
©2005 Pearson Education, Inc. Chapter 9 32
The Effects of a Tax or 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
©2005 Pearson Education, Inc. Chapter 9 33
D
S
Effects of a Subsidy
Quantity
Price
P0
Q0 Q1
PS
Pb
Like a tax, the benefit
of a subsidy is split
between buyers and
sellers, depending
upon the elasticities of
supply and demand.
Subsidy
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