Download ECMA04H – Week 10

ECMA04H – Week 9
Efficiency in competitive and monopolistic
markets. Regulating natural monopoly.
Objectives this week:
- Review Consumer Surplus and Producer
Surplus
- Define Gain to Society (GTS) as summary
measure of net economic benefits
- Discuss allocative efficiency in
competitive and monopolistic markets
- Discuss ways to regulate natural
monopolies, including marginal cost pricing
and average cost pricing
1
From Week 3, what is consumer surplus?….
Price
$20
Demand
$10
P = 20 – 2Q
$6
0
5
7
Fred’s Demand2 for Hamburgers
10
Quantity
Per month
We can interpret areas under the Demand curve as
Total Utility (measured in dollars)
Expenditure (P x Q)
Consumer Surplus U(Q) – [P x Q]
Fred maximizes CS by choosing Q, such that P = 20
– 2Q (price equals marginal utility)
We can interpret the height of the curve as:
Marginal Utility (dU/dQ)
Willingness to pay for this unit (= marginal value or
marginal benefit)
3
1.
Individuals consume because they gain utility
2.
Consumers seek to maximize consumer
surplus by choosing amount to consume
3.
Consumer surplus is dollar value of utility
received by consumers above cost of
purchase
4.
Consumers max CS by following OPR and
choosing amount of good such that MU = P or
dU/dQ = P. This is the individual demand
curve.
4
Consumer Surplus, Producer Surplus
How much does society gain from the
activities of producing and consuming?
Different answers depending on the situation.
Simple situation (normal) when there are no
(a) taxes or tariffs
(b) external benefits
(c) external costs
(d) public goods
In the simple situation, the benefits to
society are the benefits to the individuals
that are participating in consuming and
producing.
i.e., consumer surplus and producer surplus
(or profit).
5
Remember definition of economics:
Economics is the science that studies the
allocation of scarce resources to alternative
uses to satisfy unlimited human wants
“Efficiency” is achieved when those resources
are allocated in a way that delivers the most
gain to society
Allocative Efficiency
6
Consumer surplus (CS) is dollar value of utility
received by consumers above cost of purchase
CS represents extra “willingness to pay” above
the current price. It is a measure of the
“satisfaction” that consumers get above what
they have to pay for a good.
Increasing CS represents a social gain – a gain to
society
7
What is producer surplus?
Producer surplus (PS) is the dollar value of
revenue received by producers above the
minimum amount they require to be willing to
supply the good.
It is a form of “surplus” received by
producers, and therefore can also be
considered a gain to society
8
In the short run, the minimum amount
producers require is to cover their TVC – the
total variable costs of production.
Therefore, PS = TR – TVC
But, Π = TR – TC = TR – (TFC + TVC)
So, TR – TVC = Π + TFC
Or, PS = Π + TFC
If TFC = 0, PS = Π
9
So PS is a concept very similar to profit (a
surplus received by producers above what
they require to supply the good). In the SR,
PS is bigger than profit by the amount of
fixed costs.
(As you will see, we often use profit [instead
of producer surplus] when calculating Gain To
Society).
Look at CS and PS on graph
10
Price
$60
Supply
$30
$25
$15
$11
0
Demand
100,000
300,000
350,000
11
Market for 4’ x 8’ sheets of ¾” plywood
475,000
450,000
Quantity
Per month
Price
$60
Supply
$30
$25
$15
$11
0
Demand
100,000
300,000
350,000
Market for 4’ x 8’ sheets of ¾” plywood
12
475,000
450,000 Quantity
Per month
Price
$60
Supply
$30
$25
$15
$11
0
Demand
100,000
300,000
350,000
Market for 4’ x 8’ sheets of ¾” plywood
13
475,000
450,000 Quantity
Per month
Define Gain to Society (GTS) as the sum of
Consumer Surplus plus Profit
GTS = CS + Π
Use this to compare competitive and monopoly
results (allocative efficiency in competitive
and monopoly markets)
14
Imagine there are 100 firms in a perfectly
competitive market. In the long run, in this
constant cost industry, supply is given by P =
100 (horizontal long run supply at a price of
$100).
Consumer demand in the industry is given by P
= 1000 – Q
What is the equilibrium in this industry in the
LR, and what is the GTS?
15
Draw the diagram
16
GTS = CS + Π
17
Imagine that a monopoly firm is able to buy up
all 100 firms and establish some barrier to
new firms entering the industry (e.g., a
government licence as exclusive supplier).
The monopolist keeps all the 100 plants
separate and operates as many as he needs to
supply the good. In effect the SLR becomes
the MC curve (and the AC curve) of the
monopolist.
18
The Gain To Society in the monopoly situation
is given by
GTS = CS + Π
19
How do perfect competition and monopoly
compare?
Under PC, GTS = $405,000 (and all of it
goes to the consumers). Producers receive
just enough to keep them in the industry
and producing, but not more.
Under monopoly, GTS = $303,750 (lower by
$101,250), and there has been a transfer of
surplus so that the producer receives the
biggest part ($202,500) and consumers
receive $101,250.
20
Perfect competition maximizes the sum of
the surpluses to consumers and to
producers. Therefore, PC has the largest
Gain to Society and is efficient.
There is a loss of Gain To Society under
monopoly. In other words, there is a loss of
efficiency under monopoly. We call this a
“deadweight” loss or efficiency loss.
“Deadweight” because it is completely lost
to society (rather than transferred to
someone else). Note: not all losses are
deadweight losses.
21
There is also a transfer of surplus under
monopoly, which we might well object to
(but it is not part of our calculation of
GTS).
Two concepts: Efficiency and Equity
We notice equity, but focus on efficiency.
22
Look at this problem graphically:
23
What should government policy be towards
monopoly?
It depends:
(a) is allocative efficiency the only
measure? What about dynamic
efficiency? (Schumpeter – waves of
creative destruction)
(b) Why does the monopoly exist? What is
the nature of the “barrier to entry”?
Is it a government patent? Is it a
economies of scale (i.e., natural
monopoly)?
(c) What can government do? Can
government restore competition? Can it
regulate the monopolist? Will the
results be better?
24
In case of natural monopoly (electricity,
telephone, roads, bridges, etc.),
governments may regulate the monopolist.
(Another alternative is to take firm into
public sector).
Rate of return regulation
Control monopolist by forcing it to charge a
certain price that will affect the profits
and production of the monopolist.
2 choices:
(a) Regulate monopolist to charge P = MC
(b) Regulate monopolist to charge P = AC
25
Diagramatically, what are these
alternatives?
26
What are the effects of P = MC?
27
What are the effects of P = AC?
28
What will happen if the government does
nothing?
29
What are the strengths and weaknesses of
these different solutions?
30
An algebraic example:
Highway 407.
Privately owned and operated highway.
Demand: P = 300 - .5Q, where Q is
measured in trips per day
FC = $1,950 per day
VC = $100 per trip
TC = $1,950 + 100Q
31
What will unregulated monopolist do and
what is the GTS?
32
What if government regulates the
monopolist to charge P = MC? What
happens and what is the GTS?
33
What if government regulates the
monopolist to charge P = AC? What happens
and what is the GTS?
34
Conclusions?
35