Download Applying the Competitive Model

Chapter 9
Applying the
Competitive
Model
© 2004 Thomson Learning/South-Western
Consumer Surplus


2
Consumer surplus is the extra value
individuals receive from consuming a good
over what they pay for it.
Alternatively, it is what people would be willing
to pay for the right to consume a good at its
current price.
Consumer Surplus



3
In Figure 9.1, the equilibrium price and quantity
are P* and Q*.
The demand curve, D, shows what people are
willing to pay for the good.
The total value of the good to buyers is given
by the area below the demand curve from Q =
0 to Q = Q* (AEQ*0).
FIGURE 9.1: Competitive Equilibrium and
Consumer/Producer Surplus
Price
A
S
P*
E
D
B
4
0
Q*
Quantity
per period
Consumer Surplus


5
Consumers expenditures for Q* are given by
the area P*EQ*0.
Consumers receive a “surplus” (total value less
what they pay) equal to the area AEP*, which
is shaded gray in Figure 9.1.
FIGURE 9.1: Competitive Equilibrium and
Consumer/Producer Surplus
Price
A
S
P*
E
D
B
6
0
Q*
Quantity
per period
Producer Surplus


7
Producer surplus is the extra value producers
get for a good in excess of the opportunity
costs they incur for producing it.
It can also be defined as what all producers
would pay for the right to sell a good at its
current market price.
Producer Surplus


8
At the equilibrium shown in Figure 9.1,
producers receive total revenue equal to the
area P*EQ*0.
If producers sold one unit at a time at the
lowest possible price, producers would have
been willing to produce Q* for the payment of
BEQ*0.
Producer Surplus

9
Thus, producer surplus the the area P*EB
shaded in green in Figure 9.1.
FIGURE 9.1: Competitive Equilibrium and
Consumer/Producer Surplus
Price
A
S
P*
E
D
B
10
0
Q*
Quantity
per period
Short-Run Producer Surplus


11
The positive slope of the short-run supply
curve, S, in Figure 9.1 results from the
diminishing returns to variable inputs that are
encountered as output is increased.
For production up to Q*, price exceeds
marginal cost, so total short-run profits equal
the area P*EB less fixed costs
Short-Run Producer Surplus



12
Producer surplus, the area P*EB, reflects the
sum of total short-run profits and short-run
fixed costs.
Short-run producer surplus is the part of total
profits that is in excess of the profits firms
would have if they chose to produce nothing at
all.
As such, it is similar to consumer surplus.
Long-Run Producer Surplus


13
Since long-run economic profits are zero and
there are no fixed costs in the long-run,
producer surplus is much different in the long
run.
The positive slope of the long-run supply curve
reflects increasing input costs as output is
expanded.
Long-Run Producer Surplus



14
Consider the area P*EB in Figure 9.1 as longrun producer surplus.
It measures all of the increased payments
relative to the situation in which the industry
produces no output.
The inputs would have received lower prices if
this industry had not produced output.
Ricardian Rent




15
Ricardian rent is the long-run profits earned
by owners of low-cost firms.
It may be capitalized into the prices of these
firms’ inputs.
Assume there are many parcels of land on
which tomatoes might be grown.
These farms range from very fertile land (low
cost) to poor, dry land (high cost).
Ricardian Rent



16
At low prices, only the most fertile land is used.
As output increases, higher-cost plots of land
are brought into production because higher
prices make this land profitable.
The long-run supply curve is positively sloped
because of the increasing costs associated
with using less fertile land.
Ricardian Rent



17
The market equilibrium price and quantity, P*,
Q*, are shown in Figure 9.2 (d).
Low-cost farms, Figure 9.2 (a) and mediumcost farms, Figure 9.2 (b), earn long-run
economic profits.
Marginal farms, Figure 9.2 (c) earn zero
economic profits
FIGURE 9.2 (d): The Market
Price
S
P*
E
D
B
Q*
18
Q per
period
FIGURE 9.2 (a): Low-Cost Farm
Price
MC
AC
P*
q*
19
q per
period
FIGURE 9.2 (b): Medium-Cost Farm
MC
AC
Price
P*
q*
20
q per
period
FIGURE 9.2 (c): Marginal Farm
Price
MC
AC
P*
q*
21
q per
period
FIGURE 9.2: Ricardian Rent
Price
Price
MC AC
MC AC
P*
P*
q*
q per
period
q*
q per
period
(b) Medium-Cost Farm
(a) Low-Cost Farm
Price
Price
MC AC
S
P*
P*
E
D
B
q*
22
(c) Marginal Farm
q per
period
Q*
(d) The Market
Q per
period
Ricardian Rent



23
Profits earned by the intramarginal farms can
persist in the long run because they reflect the
returns to a scarce resource, low-cost land.
Entry can not erode these profits because of
the scarcity of the low-cost land.
The sum of these long run profits (P*EB) is the
producer surplus ( Ricardian rent).
Economic Efficiency


The competitive equilibrium is efficient in that it
produces the largest surplus equal to the sum
of producer and consumer surplus.
In Figure 9.1, an output level of Q1 results in a
loss of surplus equal to the area FEG.
–
24
Consumers would be willing to pay P1 for a good
that producers are willing to produce for P2, so
mutually beneficial transactions exit.
FIGURE 9.1: Competitive Equilibrium and
Consumer/Producer Surplus
Price
A
S
P1
F
P*
E
P2
G
D
B
25
0
Q1
Q*
Quantity
per period
APPLICATION 9.1: Does Buying Things
on the Internet Improve Welfare?

Transaction costs associated with conducting
business on the internet have been reduced
due to
–
–

26
Technical innovations
significant network externalities.
Prior to this, transaction costs exceed the
difference between consumers’ willingness to
pay and producers costs.
APPLICATION 9.1: Does Buying Things
on the Internet Improve Welfare?


27
Prior to the decline in internet costs,
transaction costs exceeded P2 - P1 in Figure 1,
so no transactions occurred.
Assuming transaction costs fell to zero, trading
would start and a competitive equilibrium would
occur at P*, Q*.
FIGURE 1: Reduced Transaction Costs
Promote Internet Commerce
Price
P
2
S
P*
P
1
D
28
Q*
Quantity
APPLICATION 9.1: Does Buying Things
on the Internet Improve Welfare?

Some early evidence
–
–
–
29
Electronic retailing directly to consumers totaled
about $20 billion in 2001.
Business to business sales represented another
$50 to $75 billion.
Most sales are in travel-related goods, on-line
financial services, and some narrow categories of
consumer goods such as books.
APPLICATION 9.1: Does Buying Things
on the Internet Improve Welfare?

Retailers as Infomediaries
–
The role for retailing “middlemen” on the internet is
to provide information to the consumer.
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
30
Internet automobile sellers provide comparative information
about the features of cars and point to dealers with the best
price.
Internet airline services search for the lowest price or most
convenient departure.
A Numerical Example
Demand : Q  10  P
Supply : Q  P  2


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31
The market equilibrium is P* = $6 and Q* = 4.
The equilibrium is shown as point E in Figure 9.3.
At point E consumers are spending $24 ($6·4).
A Numerical Example



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32
At point E in Figure 9.3, consumer surplus is
$8 (= ½·$4·4).
Producers also gain a producer surplus of $8
at point E.
Total consumer and producer surplus is $16.
If price stays at $6 but output falls to 3, total
surplus falls to $15.
FIGURE 9.3: Efficiency in Tape Sales
Price
10
S
6
E
D
2
33
1
2
3
4
5
Tapes
per period
A Numerical Example


34
For any output level, total surplus is the area
between the demand and supply curves out to
that level of output.
Once output is specified, the price affects the
distribution of the surplus between producers
and consumers, but does not affect the total
amount of the surplus.
A Numerical Example

If output > 4 tapes per period with P = $6, total
surplus is less than $16.
–
At Q = 5, consumer surplus falls to $7.50.


–
35
$8 for four tapes less $.50 because the fifth tapes sells for
more than people want to pay for the fifth tape.
Producer surplus also equals $7.50 reflecting the loss of
$.50 on the production of the fifth tape.
Total surplus is $15 for Q = 5 tapes per week.
Price Controls and Shortages


In Figure 9.4 the market initially is in
equilibrium at P1, Q1 (point E).
Then demand increases from D to D’.
–
–
36
This would cause price to rise to P2 encouraging
entry in the short-run.
Eventually entry would bring the price down to P3
and the market would be in long-run equilibrium.
FIGURE 9.4: Price Controls and
Shortages
Price
SS
LS
P
1
E
D
37
Q1
Quantity
per period
FIGURE 9.4: Price Controls and
Shortages
SS
Price
LS
P
2
P
3
P
1
E’
E
D’
D
38
Q1
Q2 Q3
Quantity
per period
Price Controls and Shortages



39
Suppose the government imposed a price
control at the below equilibrium price of P1
when demand increased.
Firms would only supply Q1 and no entry would
take place.
Since customers would demand Q4 at this
price, there would be a shortage of Q4 - Q1.
Price Controls and Shortages


The welfare consequences of price control can
be analyzed using consumer and producer
surplus.
Consumers would gain surplus of P3CEP1
(colored in gray) due to the lower price.
–
40
This is a direct transfer of surplus from producers to
consumers with no gain in total surplus.
FIGURE 9.4: Price Controls and
Shortages
Price
SS
A
LS
P
2
P
3
P
1
C
E’
E
D’
D
41
Q1
Q3 Q4
Quantity
per period
Price Controls and Shortages

If output had expanded, consumers would gain
the area AE’C.
–


42
Since output is reduced by the price control, this is a
loss of surplus to consumers.
Similarly, producers don’t gain the area CE’E
that would have resulted from increased
output.
The area AE’E is the total welfare loss.
Application 9.2: Rent Control: Why This
Bad Idea Never Dies

History of Rent Control
–
–
–
43
Controls were adopted in man U.S. and European
cities in response to rapidly rising rents during
World War II which continued after the war in
several European countries and New York City.
Inflation of the 1970s resulted in several U.S.
cities introducing more “flexible” rent controls
More than 10 percent of U.S. rentals are
controlled.
Application 9.2: Rent Control: Why This
Bad Idea Never Dies

Rent Control and Housing Quality
–
–
44
Studies have confirmed the prediction that rent
controls will benefit current tenants and harm
landlords and new tenants.
However, the most important effect is that landlords
effectively reduce the supply of housing by reducing
the quality of their units.
Application 9.2: Rent Control: Why This
Bad Idea Never Dies

Effects of the “New” Rent Control Laws
–
–
–
45
By allowing landlords to pass on increases in
taxes or utility costs, post World War II laws were
more flexible.
Many also allow rents to be increased to market
levels when current tenants leave.
Some economists suggest that such laws help to
deal with the landlords market power, but few
economists support this position.
Tax Incidence


46
The study of the final burden of a tax after
considering all market reactions to it is tax
incidence theory.
The incidence of a “specific tax” of a fixed
amount per unit of output that is imposed on all
firms in a constant cost industry is illustrated in
Figure 9.5
FIGURE 9.5: Effect of the Imposition of a Specific Tax
on a Perfectly Competitive Constant Cost Industry
Price
Price
SMC MC
AC
S’
S
P4
P3
P1
LS
P2
Tax
D
D’
0
q2 q1
(a) Typical Firm
47
Output
0
Q3 Q2 Q1 Quantity
per week
(b) The Market
Tax Incidence

Since for any price, P, consumers pay the
firm gets to keep P - t (where t is the per unit
tax), the effect of the tax on firms can be
shown as a decrease in demand.
–

48
The vertical distance between the demand
curves is t.
It creates a wedge between the consumers’
price, P, and the price firms receive.
Short-Run Tax Incidence


49
The short-run effect is to decrease output from
Q1 to Q2, where firms receive P2 and
consumers pay P3 (P3 - P2 = t).
So long as P2 is above minimum variable
costs, the firm continues to produce and the
tax incidence is shared by consumers, whose
price increased to P3, and by firm’s who now
receive only P2 rather than P1.
Long-Run Tax Incidence



50
Firms will not operate at a loss in the long run,
so exit will take place shifting the short-run
supply curve back to S’.
In the new long-run equilibrium, output will
return to Q3 where the firm’s will receive P1
again and consumers will pay P4.
The long-run tax incidence is all on the
consumer although the firms pays the tax.
Long-Run Incidence with
Increasing Costs


51
When the long-run supply curve has a positive
slope, both consumers and firms pay a portion
of the tax.
The imposition of the tax shifts the long-run
demand curve inward to D’ (as shown in Figure
9.6) which causes the price to fall from P1 to P2
as some firms exit and input prices fall.
FIGURE 9.6: Tax Incidence in an
Increasing Cost Industry
Price
P3
LS
A
P1
P2
B
E1
E2
Tax
D
D’
52
Q2 Q1
Quantity
per period
Long-Run Incidence with
Increasing Costs



53
Consumers pay a portion of the tax since the
gross price of P3 exceeds the pre-tax price.
Total tax collection is the gray area
P3ARE2P2.
The inputs to the firm pay the remainder of
the tax as they are not paid based on a lower
net price of P2.
Incidence and Elasticity

The economic actor who has the most elastic
curve will be able to avoid more of the tax
leaving the actor with the more inelastic curve
to pay most of the tax.
–
–
54
If demand is relatively inelastic and supply is elastic,
demanders will pay most of the tax.
If supply is relatively inelastic and demand is elastic,
suppliers will pay most of the tax.
APPLICATION 9.3: The Tobacco
Settlement Is Just a Tax


In November 1998 most U.S. states reached
agreements with the tobacco companies that
amounted to about $200 billion.
The Tobacco Settlement as a Tax Increase.
–
–
55
This can be treated as an increase in cigarette
taxes.
The settlement added about $0.30 per pack, a 15
percent increase on the initial $3.00 price.
The Tobacco Settlement as a Tax
Increase


56
With an elasticity of demand of -0.35 (Table
4.4), the quantity of cigarettes sold would be
expected to fall by about 5.25 percent
(0.350.15) from 24 billion packs per year to
22.75 billion packs.
Total “tax collections” would be about $6.8
billion per year.
The Tobacco Settlement as a Tax
Increase



57
If tobacco companies continue to earn about
$0.25 per pack, the 1.25 billion reduction in
sales will cost them about $300 million per
year.
Thus, consumers pay most of the “tax”
resulting from this settlement.
Since tobacco consumers tend to have
relatively low incomes, the tax is regressive.
Other Effects of the Settlements

Empirical evidence suggests that young
smokers may have a larger price elasticity.
–
–
–
58
The goal of a decline in smoking by young people
may be obtained.
Also, studies suggest that individuals who do not
smoke as teenagers are much less likely to smoke
later.
In addition, advertising aimed at young people
was sharply restricted.
Other Effects of the Settlements

Special interest also benefited.
–
–
–
59
Many states adopted programs to aid tobacco
farmers who were affected by the decline in
tobacco sales.
The smallest tobacco company (Liggett) provided
evidence for the states, and the higher cigarette
prices will increase its profits.
The lawyers who represented the states each
received between $1 - $2 million per year.
Taxation and Efficiency


60
Taxes reduce output of the taxed commodities
and a reallocation of production to other areas.
Reallocation means that some mutually
beneficial transactions will be foregone so
economic welfare will decline.
Taxation and Efficiency



61
In Figure 9.6, the total loss of consumer
surplus is the area P3AE1P1.
The area P3ABP1 is transferred into tax
revenue and the area AE1B is simply lost.
The loss in producer surplus is P1E1E2P2 of
which P1BE2P2 is tax revenue and BE1E2 lost.
Taxation and Efficiency



62
The effect of the transfer into tax revenue on
welfare is ambiguous since consumers and
producers may benefit from government
expenditures.
However, the deadweight loss is the losses
of consumer and producer surplus that are
not transferred to other parties.
This is also called the “excess burden” of a
tax.
A Numerical Illustration

Using the supply-demand equilibrium in the market for
cassette tapes, suppose the government implements a
$2 per tape tax that retailers add to the sales price of
each tape sold.
The supply function remains
Supply : Q  P  2
where P is the net price received by the seller.
63
A Numerical Illustration

Demanders, on the other hand, must pay P + t
for each tape so the demand function
becomes:
Demand : Q  10  ( P  t )
Q  10  ( P  2)  8  P
64
A Numerical Illustration
Equilibrium requires supply equal demand.
Supply  P  2  Demand  8  P


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65
or P* = 5, Q* =3.
Consumers pay $7 for each tape and total tax
collections are $6 per week.
Total consumer and producer surplus is decreased by
$6 of tax revenue and the excess burden is $1.
Transactions Costs


66
Transaction costs, such as a real estate broker
fee, also cause a wedge between buyers’ and
sellers’ prices.
To the extent that transaction costs are on a
per-unit basis, the same analysis as with a tax
applies, so both parties bear some of the cost
and output will be reduced.
Transactions Costs

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67
If the wedge is a lump-sum amount per
transaction, such as the cost of driving to the
supermarket to buy groceries, the individual
will seek to reduce the number of transactions.
While prices will not change significantly,
persons will hold larger inventories to reduce
their transaction costs.
Gains from International Trade



68
Figure 9.7 shows the domestic demand and
supply curves for a particular good, say shoes.
Without international trade, the equilibrium
price and quantity would be PD, QD.
If the world shoe price is PW, the opening of
trade will cause prices to fall causing quantity
to increase to Q1.
Gains from International Trade


The quantity supplied by domestic producers
will fall to Q2 with shoe imports of Q1 - Q2.
Consumer surplus increases by the area
PDE0E1PW.
–
69
Part, PDE0APW, comes as a transfer from domestic
producers, and the rest is an unambiguous gain in
welfare (E0E1A).
FIGURE 9.7: Opening of International Trade
Increases Total Welfare
Price
LS
P
E0
D
E1
PW
A
D
70
Q
2
Q
D
Q
1
Quantity
per period
Tariff Protection



71
Producers will resist their losses, and since the
loss is spread over fewer producers than the
gain for consumers, they have a stronger
incentive to organize for trade protection.
A major trade protection is a tariff which is a
tax on an imported good.
Effects of a tariff are shown in Figure 9.8.
FIGURE 9.8: Effects of a Tariff
Price
P
LS
E2
B
R
E1
PW
A
C
F
D
72
Q2
Q4
Q3
Q1
Quantity
per period
Tariff Protection

Compared to the free trade equilibrium E1, the
imposition of a per-unit tariff in the amount of t
raises the effective price to PW + t = PR.
–
–
73
Quantity demanded falls to Q3 while domestic
production expands to Q4.
Tariff revenue is the area BE2FC, equal to t(Q3 Q4).
Tariff Protection

Total consumer surplus is reduced by the area
PRE2E1PW.
–
–
74
Part becomes tariff revenue and part is transferred
into domestic producer’s surplus (area PRBAPW).
The two colored triangles BCA and E2E1F represent
losses that are not transferred; these are the
deadweight losses from the tariff.
Other Types of Trade Protection


75
Because of the General Agreement on Tariffs
and Trade (GATT), there has been a decline in
tariffs.
However, other restrictive measures including
quotas, “voluntary” export restrains, and a
series of nonquantitative restrictions have been
used for protectionism.
Other Types of Trade Protection

A quota that limits imports to Q3 - Q4 (in Figure
9.8) would have a similar effect to a tariff.
–
–
–
76
Market price would rise to PR.
Consumer surplus would be transferred to domestic
producers (area PRBAPW).
A deadweight loss equal to the areas of the colored
triangles would also occur.
Other Types of Trade Protection

However, with a quota, no tax revenue is
generated.
–

77
The area BE2FC can go to foreign producers or to
windfall gains to owners of import licenses.
Nonquantitative restrictions such as health or
other inspections also impose costs like a a
tariff on imports, and can be analyzed in a
similar manner using Figure 9.8.
APPLICATION 9.4: The Endless Saga of
Steel Protectionism



78
On March 6, 2002, President Bush announced
that the U.S. would adopt a “temporary” tariff
on steel imports.
This tariff amounted to 30% on many major
steel products.
Other products were taxed at somewhat lower
rates (8 to 15 percent).
APPLICATION 9.4: The Endless Saga of
Steel Protectionism


It would be hard to find an industry that has had
the degree of special protection from trade
pressures that has characterized the U.S. steel
industry.
Over the past 30 years, the industry has
succeeded in obtaining the following
protectionist measures:
–
–
–
79
Import quotas
Minimum price agreements with exporters
“Voluntary” export restraints by nations that import
into the U.S.
APPLICATION 9.4: The Endless Saga of
Steel Protectionism



80
Economists concluded that the costs of the 2002 tariffs
to the overall economy could be quite large.
Estimated tariff revenues are about $900 million
annually; gains in domestic producer surplus might
amount to another $700 million.
Balanced against this would be estimated losses of
about $2.5 billion in consumer surplus. There might
then be an annual deadweight loss of perhaps $900
million from the tariffs.