Performance and Strategy in Competitive Markets Chapter 8.

Performance and Strategy in Performance and Strategy in Competitive MarketsCompetitive Markets

Chapter 8Chapter 8

Competitive Market Efficiency

Why is it Called Perfect Competition? Competitive markets balance supply and demand. Competitive markets maximize social welfare

Deadweight Loss Problem Deadweight losses occur when market

imperfections reduce transaction volume. Any benefit enjoyed by consumers or producers

that is not transferred but lost due to market imperfections is a deadweight loss.

Consumer Surplus

the difference between the maximum price a consumer is will to pay for something & its market price is called consumer surplus

one of the key elements in cost-benefit analysis

0

10

20

30

40

50

60

70

D=MBD=MBQQ

market pricemarket price

Q*Q*

Consumer Surplus

Mary’s consumer surplusMary’s consumer surplus

0

10

20

30

40

50

60

70

D=MBD=MBQQ

market pricemarket price

amountamountpaidpaid

Q*Q*

total consumer surplustotal consumer surplus

Consumer Surplus

Producer Surplus

Producer Surplus

the increase in the economic well-being of producers who are able to sell the product at a market price higher than the lowest price that would have drawn out their supply.

The difference between total revenues and total costs

QQ

PP

D=MBD=MB

PPcc

QQcc

S = MCS = MC

consumerconsumersurplussurplus

producerproducersurplussurplus

efficientefficientoutputoutput

efficientefficientoutputoutput

outcomes withoutcomes withpure competitionpure competitionoutcomes withoutcomes with

pure competitionpure competition

AA restriction in market supply restriction in market supply

Market Failure

Situation when competitive market outcomes fail to efficiently allocate economic resources.

Failure by market structure Failure can occur in markets with few participants.

Failure by incentive Externalities create incentive problems due to

differences between private and social costs or benefits.

A negative externality is an unpaid cost. A positive externality is an unrewarded

benefit.

Role for Government

How Government Influences Competitive Markets Tax policy or regulation is efficient if expected benefits

exceed expected costs. Fairness must be carefully weighed.

Broad Social Considerations Consumer sovereignty is an important benefit of

competitive markets. Public policy can control unfairly gained market power. Tax and regulatory policy limit concentration of

economic and political power.

© 2009, 2006 South-Western, a © 2009, 2006 South-Western, a part of Cengage Learningpart of Cengage Learning

Subsidy and Tax Policy Subsidy Policy

Subsidies can be indirect, like government highway spending that benefits the trucking industry.

Subsidies can be direct, as in agricultural programs.

Deadweight Loss From Taxes Taxes reduce economic activity and cause deadweight

losses. Pollution taxes explicitly recognize the public's right to a

clean environment.

How Taxes on Buyers (and Sellers) Affect Market Outcomes

Taxes discourage market activity. When a good is taxed, the

quantity sold is smaller. Buyers and sellers share

the tax burden.

How Taxes on Buyers Affect Market Outcomes

Elasticity and tax incidence Tax incidence is the manner in which the

burden of a tax is shared among participants in a market.

How Taxes on Buyers Affect Market Outcomes

Elasticity and Tax Incidence Tax incidence is the study of who bears

the burden of a tax. Taxes result in a change in market

equilibrium. Buyers pay more and sellers receive less,

regardless of whom the tax is levied on.

A Tax on Buyers

Quantity ofIce-Cream Cones

0

Price ofIce-Cream

Cone

Pricewithout

tax

Pricesellersreceive

Equilibrium without taxTax ($0.50)

Pricebuyers

pay

D1

D2

Supply, S1

A tax on buyersshifts the demandcurve downwardby the size ofthe tax ($0.50).

$3.30

90

Equilibriumwith tax

2.803.00

100

A Tax on Buyers

2.80

Quantity ofIce-Cream Cones

0

Price ofIce-Cream

Cone

Pricewithout

tax

Pricesellersreceive

Equilibriumwith tax

Equilibrium without tax

Tax ($0.50)

Pricebuyers

payS1

S2

Demand, D1

A tax on sellersshifts the supplycurve upwardby the amount ofthe tax ($0.50).

3.00

100

$3.30

90

A Tax on Sellers

Elasticity and Tax Incidence

What was the impact of tax? Taxes discourage market

activity. When a good is taxed, the

quantity sold is smaller. Buyers and sellers share

the tax burden.

Figure 8 A Payroll Tax

Quantityof Labor

0

Wage

Labor demand

Labor supply

Tax wedge

Wage workersreceive

Wage firms pay

Wage without tax

Elasticity and Tax Incidence

In what proportions is the burden of the tax divided?

How do the effects of taxes on sellers compare to those levied on buyers?

The answers to these questions depend on the elasticity of demand and the elasticity of supply.

Quantity0

Price

Demand

Supply

Tax

Price sellersreceive

Price buyers pay

(a) Elastic Supply, Inelastic Demand

2. . . . theincidence of thetax falls moreheavily onconsumers . . .

1. When supply is more elasticthan demand . . .

Price without tax

3. . . . than on producers.

How the Burden of a Tax Is Divided

How the Burden of a Tax Is Divided

Quantity0

Price

Demand

Supply

Tax

Price sellersreceive

Price buyers pay

(b) Inelastic Supply, Elastic Demand

3. . . . than onconsumers.

1. When demand is more elasticthan supply . . .

Price without tax

2. . . . theincidence of the tax falls more heavily on producers . . .

Elasticity and Tax Incidence

So, how is the burden of the tax divided?

The burden of a tax falls more heavily on the side of the market that is less elastic.

Summary: Tax Incidence and Burden

Tax Incidence and Burden Tax incidence is the point of tax collection. Tax burden is borne by party who ultimately pays the tax.

Role of Elasticity Who pays the economic burden of a tax or operating control

depends on the elasticities of supply and demand. The burden of a tax falls more heavily on the side of the

market that is less elastic. Elasticity affects the deadweight loss of taxation.

Deadweight loss is small when supply (or demand) is inelastic.

Deadweight loss is large when supply (or demand) is elastic.

CONTROLS ON PRICES

Price Ceiling A legal maximum on the price at which a

good can be sold. Price Floor

A legal minimum on the price at which a good can be sold.

How Price Ceilings Affect Market Outcomes

Two outcomes are possible when the government imposes a price ceiling: The price ceiling is not binding if set above

the equilibrium price. The price ceiling is binding if set below the

equilibrium price, leading to a shortage.

A Market with a Price Ceiling(a) A Price Ceiling That Is Not Binding

Quantity ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

Equilibriumquantity

$4 Priceceiling

Equilibriumprice

Demand

Supply

3

100

The market clears at $3 and the price ceiling is ineffective.

A Market with a Price Ceiling(b) A Price Ceiling That Is Binding

Quantity ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

Demand

Supply

2 PriceceilingShortage

75

Quantitysupplied

125

Quantitydemanded

Equilibriumprice

$3

How Price Ceilings Affect Market Outcomes

Effects of Price Ceilings A binding price ceiling creates

Shortages because QD > QS. Example: Gasoline shortage of the 1970s

Nonprice rationing Examples: Long lines, discrimination by

sellers

CASE STUDY: Lines at the Gas Pump

Economists blame government regulations that limited the price oil companies could charge for gasoline.

In 1973, OPEC raised the price of crude oil in world markets. Crude oil is the major input in gasoline, so the higher oil prices reduced the supply of gasoline.

What was responsible for the long gas lines?

The Market for Gasoline with a Price Ceiling(a) The Price Ceiling on Gasoline Is Not Binding

Quantity ofGasoline

0

Price ofGasoline

1. Initially,the priceceilingis notbinding . . . Price ceiling

Demand

Supply, S1

P1

Q1

The Market for Gasoline with a Price Ceiling(b) The Price Ceiling on Gasoline Is Binding

Quantity ofGasoline

0

Price ofGasoline

Demand

S1

S2

Price ceiling

QS

4. . . . resultingin ashortage.

3. . . . the priceceiling becomesbinding . . .

2. . . . but whensupply falls . . .

P2

QD

P1

Q1

CASE STUDY: Rent Control in the Short Run and Long Run

Rent controls are ceilings placed on the rents that landlords may charge their tenants.

The goal of rent control policy is to help the poor by making housing more affordable.

One economist called rent control “the best way to destroy a city, other than bombing.”

Rent Control in the Short Run and in the Long Run

(a) Rent Control in the Short Run(supply and demand are inelastic)

Quantity ofApartments

0

Supply

Controlled rent

RentalPrice of

Apartment

Demand

Shortage

Rent Control in the Short Run and in the Long Run

(b) Rent Control in the Long Run(supply and demand are elastic)

0

RentalPrice of

Apartment

Quantity ofApartments

Demand

Supply

Controlled rent

Shortage

How Price Floors Affect Market Outcomes

When the government imposes a price floor, two outcomes are possible. The price floor is not binding if set below

the equilibrium price. The price floor is binding if set above the

equilibrium price, leading to a surplus.

A Market with a Price Floor(a) A Price Floor That Is Not Binding

Quantity ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

Equilibriumquantity

2

Pricefloor

Equilibriumprice

Demand

Supply

$3

100

The government says that ice-cream cones must sell for at least $2; this legislation is ineffective at the current market price.

A Market with a Price Floor(b) A Price Floor That Is Binding

Quantity ofIce-Cream

Cones

0

Price ofIce-Cream

Cone

Demand

Supply

$4Pricefloor

80

Quantitydemanded

120

Quantitysupplied

Equilibriumprice

Surplus

3

How Price Floors Affect Market Outcomes

A binding price floor causes . . . a surplus because QS > QD. nonprice rationing is an alternative

mechanism for rationing the good, using discrimination criteria.

Examples: The minimum wage, agricultural price supports

CASE STUDY: The Minimum Wage

An important example of a price floor is the minimum wage.

Minimum wage laws dictate the lowest price possible for labor that any employer may pay.

How the Minimum Wage Affects the Labor Market

Quantity ofLabor

Wage

0

Labordemand

LaborSupply

Equilibriumemployment

Equilibriumwage

How the Minimum Wage Affects the Labor Market

Quantity ofLabor

Wage

0

LaborSupplyLabor surplus

(unemployment)

Labordemand

Minimumwage

Quantitydemanded

Quantitysupplied