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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 Failures
Achieving Policy Goals
Politics
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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
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Chapter 10: Competitive Markets:
Applications
In this chapter we will cover:
10.1 Maximum Efficiency
10.2 Policy: Excise Tax
10.2.1 Tax Incidence
10.3 Policy: Subsidy
10.4 Policy: Price Ceiling
10.5 Policy: Price Floor
10.6 Policy: Production Quotas
10.7 Agricultural Support
10.8 Policy: Import Quotas and Tariffs
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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
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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
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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= $6
Producer Surplus
=$14-$10= $4
Total Surplus
=$20-$10= $10
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Consumer and Producer Surplus
P
A
Consumer Surplus
C
P* B
D
Supply
Producer Surplus
Q1
Q*
Demand
Q
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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)
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Example: Excise Tax
S+T
P
S
T
Pd
P*
Ps
Q*=Original Q
P*=Original P
Pd=Price Paid
by buyers
Ps=Price
received by
sellers
T(ax)=Pd-Ps
Demand
Q1 Q*
Q
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Consumer and Producer Surplus
P
A
Old
Consumer Surplus
S+T
S
P* B
C
D
Old Producer Surplus
Q1
Q*
D
Q
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Consumer and Producer Surplus
P
A
New
Consumer Surplus
S+T
Government Income
S
Pd
P* B
C
Deadweight
Loss
Ps
D
New Producer Surplus
Q1
Q*
D
Q
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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
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lost – this triangle is the deadweight loss
Deadweight loss – reduction in net economic
benefit due to inefficient allocation of
resources
Taxes create inefficiencies!!
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Sales Tax Imposed on the Sellers
Price (dollars per player)
Supply is affected
S + tax
S
110
$10 tax
105
100
95
Tax
revenue
After Tax
Market Price
DA
3
4
5
6
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Quantity (thousands of CD players per week)
Price (dollars per player)
Tax applied to buyer: Same Effect
as tax on seller
S
110
D-tax
105
100
Original Market Price
95
DA
3
4
5
6
Quantity (thousands of CD players per week)15
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:
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The Sales Tax: Who Pays?
Demand Relatively Inelastic
Price (dollars per player)
S + tax
110
108
105
S
$10 tax
100
98
Consumer
Price Rises
from 100
to 108
95
DA
3
4
5
6
Quantity (thousands of CD players per week)17
The Sales Tax: Who Pays? Demand
Relatively More Elastic.
Price (dollars per player)
S + tax
S
110
$10 tax
DA
105
103
Consumer
Price Rises
from 100
to 103
Original Market Price
100
95
93
3
4
5
6
Quantity (thousands of CD players per week)
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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
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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…
20
•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 21
Subsidies
P
A
OLD
Consumer Surplus
S
Ps
P*
S-T
B
C
Pd
D
OLD Producer Surplus
Q*
Q1
D
Q
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Subsidies
P
A
New
Consumer Surplus
S
Ps
P*
S-T
B
C
Pd
D
D
Q1
Q*
Q
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Subsidies
P
S
A
Ps
P*
S-T
B
C
Pd
D
New Producer Surplus
Q1
Q*
D
Q
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Subsidies
P
S
A
Ps
P*
S-T
B
C
Government Cost
Pd
D
D
Q1
Q*
Q
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Subsidies
P
A
S
New
Consumer Surplus Government Cost
Ps
P*
S-T
B
C
Deadweight Loss
Pd
D
New Producer Surplus
Q1
Q*
D
Q
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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.
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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
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Price Ceiling
P
A
P* B
Old
Consumer Surplus
Supply
C
Price Ceiling
D
Old
Producer Surplus
Q*
Demand
Q
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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)
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Price Ceiling: Maximize Consumer Surplus
P
A
New
Consumer Surplus
Supply
Deadweight Loss
C
P* B
Price Ceiling
D
Excess
Demand
Qs
Qs
Demand
Qd
New
Producer Surplus
Q
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Price Ceiling: Minimize Consumer Surplus
P
Supply
A
New
Consumer Surplus
C
P* B
Price Ceiling
Qs
D
Excess
Demand
Qs
Demand
Qd
New
Producer Surplus
Q
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Price Ceiling: Minimize Consumer Surplus
P
Supply
Deadweight Loss=A-B
A
P*
B
Qs
Price Ceiling
Excess
Demand
Qs
Demand
Qd
Q
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•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
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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.
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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
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Price Floor
P (W)
A
P* B
D
Old
Consumer Surplus
Supply
Price Floor
(min. wage)
C
Old
Producer Surplus
Q*
Demand
Q (L)
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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)
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Price Floor: Maximize Producer Surplus
P (W)
A
New
Consumer Surplus
Supply
Price Floor
Ie: Min. Wage
C
P* B
Deadweight Loss
D
Qd
Excess
Supply
Demand
Qs
New
Producer Surplus
Q (L)
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Price Floor: Minimize Producer Surplus
P
A
New
Consumer Surplus
Supply
Price Floor
Ie: Min. Wage
C
P* B
Qs=Qd
D
Excess
Supply
Qd
Demand
New
Producer Surplus
Q
40
Price Floor: Minimize Producer Surplus
P
Supply
Price Floor
Ie: Min. Wage
X
P*
Y
Deadweight Loss=Y-X
Qs=Qd
Excess
Supply
Qd
Demand
Q
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• The attempt of a union to increase wages has
two effects:
1)Some workers receive a higher wage
2)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)
42
• 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
43
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
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• There will be a deadweight loss
Production Quota
Production Quota
P
A
Old
Consumer Surplus
Supply
P1
P* B
D
C
Old
Producer Surplus
Q*
Demand
Q
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Production Quota: Maximize Producer Surplus
P (W) Production Quota
New
Consumer Surplus
A
Supply
P1
C
P* B
Deadweight Loss
D
Qd
Demand
Qs
New
Producer Surplus
Q (L)
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Quota: Minimize Producer Surplus
P
Quota
A
New
Consumer Surplus
Supply
P1
C
P* B
Qs=Qd
D
Demand
Qd
New
Producer Surplus
Q
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Quota: Minimize Producer Surplus
P
Quota
Supply
P1
X
P*
Y
Deadweight Loss=Y-X
Qs=Qd
Demand
Qd
Q
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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
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•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
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•Government Purchase Programs
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:
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Acreage Limitation
P
A
Old
Consumer Surplus
Supply
P1
P* B
D
C
Old
Producer Surplus
Production Limit
Demand
Q
52
Acreage Limitation
P
A
New
Consumer Surplus
Supply
P1
P* B
D
C
New
Producer Surplus
Production Limit
Demand
Q
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Acreage Limitation
P
A
New
Consumer Surplus
Supply
P1
P* B
D
C
New
Producer Surplus
Production Limit
Government
Cost
Demand
Q
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Acreage Limitation
P
A
New
Consumer Surplus
Supply
P1
P* B
D
C
New
Producer Surplus
Production Limit
Government
Cost
Deadweight
Loss
Demand
Q
55
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:
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Gov. Purchase Programs
P
Old
Consumer Surplus
Supply
A
P1
C
P* B
D
Old
Producer Surplus
Q1
Q*
Q1+G
Demand + Gov.
Purchases
Demand
Q
57
Gov. Purchase Programs
P
New
Consumer Surplus
Note: Change
In Consumer
And Producer
Surplus is
Equal to Acre
Limitation
Supply
A
P1
C
P* B
D
New
Producer Surplus
Q1
Q*
Q1+G
Demand + Gov.
Purchases
Demand
Q
58
Gov. Purchase Programs
P
New
Consumer Surplus
Note: Gov.
Costs are
Greater
Supply
A
P1
C
P* B
Gov.
Cost
D
Demand + Gov.
Purchases
Demand
Q1
Q*
Q1+G
Q
59
Gov. Purchase Programs
P
New
Consumer Surplus
Note:
Deadweight
Loss is
Greater
Supply
A
P1
C
P* B
D
Deadweight
Loss
Q1
Q*
Demand + Gov.
Purchases
Demand
Q1+G
Q
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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.
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•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
62
Free Trade
P
Old
Consumer Surplus
At world prices,
only a small
amount of
domestic
industry can
survive
Supply
P*
PW
Old Domestic
Producer Surplus
QDom
Demand
Q
63
Trade Prohibition (Zero Imports)
P
New
Consumer Surplus
Supply
Deadweight
Loss
P*
PW
New Domestic
Producer Surplus
Demand
Q
QDom
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Import Quota
P
New
Consumer Surplus
Supply
Deadweight
Loss
P*
Pq
PW
New Domestic
Producer Surplus
Demand
Q
QDom
QDom+Quota
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Import Tarrif (t)
P
New
Consumer Surplus
Deadweight
Loss
Supply
Government
Revenue
P*
PW+t
PW
New Domestic
Producer Surplus
Demand
Q
QDom
QDom+Quota
66
•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 67
•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 something68 for
free?
Chapter 10 Summary
Under Perfect Competition, efficiency is
maximized
All government intervention in Perfect
Competition cause deadweight loss
Lump-sum cash transfers have the least
distortion, but are unpopular
Whenever government intervenes, it must
be asked if
Benefit > Deadweight Loss
69