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Chapter 11
Applying the
Competitive Model
© 2006 Thomson Learning/South-Western
Consumer Surplus
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In Figure 11-1, 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 11-1: Competitive Equilibrium
and Consumer/Producer Surplus
Price
A
S
P*
E
D
B
0
3
Q*
Quantity
per period
Consumer Surplus
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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 11-1.
FIGURE 11-1: Competitive Equilibrium
and Consumer/Producer Surplus
Price
A
S
P*
E
D
B
0
5
Q*
Quantity
per period
Producer Surplus
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At the equilibrium shown in Figure 11-1,
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.
Thus, producer surplus the the area P*EB
shaded in green in Figure 11-1.
FIGURE 11-1: Competitive Equilibrium and
Consumer/Producer Surplus
Price
A
S
P*
E
D
B
0
7
Q*
Quantity
per period
Short-Run Producer Surplus
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The positive slope of the short-run supply
curve, S, in Figure 11-1 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
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Producer surplus, the area P*EB, reflects
the sum of total short-run profits and shortrun 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
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Consider the area P*EB in Figure 11-1 as
long-run 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
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The market equilibrium price and quantity,
P*, Q*, are shown in Figure 11-2 (d).
Low-cost farms, Figure 11-2 (a) and
medium-cost farms, Figure 11-2 (b), earn
long-run economic profits.
Marginal farms, Figure 11-2 (c) earn zero
economic profits
FIGURE 11-2 (d): The Market
Price
S
P*
E
D
B
Q*
12
Q per
period
FIGURE 11-2 (a): Low-Cost Farm
Price
MC
AC
P*
q*
13
q per
period
FIGURE 11-2 (b): Medium-Cost Farm
MC
AC
Price
P*
q*
14
q per
period
FIGURE 11-2 (c): Marginal Farm
Price
MC
AC
P*
q*
15
q per
period
FIGURE 11-2: 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*
(c) Marginal Farm
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q per
period
Q*
(d) The Market
Q per
period
Ricardian Rent
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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
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The competitive equilibrium is efficient in
that it produces the largest surplus equal to
the sum of producer and consumer surplus.
In Figure 11-1, an output level of Q1 results
in a loss of surplus equal to the area FEG.
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Consumers would be willing to pay P1 for a
good that producers are willing to produce for
P2, so mutually beneficial transactions exit.
FIGURE 11-1: Competitive Equilibrium
and Consumer/Producer Surplus
Price
A
S
P1
F
P*
E
P2
G
D
B
0
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Q1
Q*
Quantity
per period
A Numerical Example
Demand : Q  10  P
Supply : Q  P  2
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11.1
11.2
The market equilibrium is P* = $6 and Q* = 4.
The equilibrium is shown as point E in Figure 113.
At point E consumers are spending $24 ($6·4).
A Numerical Example
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At point E in Figure 11-3, 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 11-3: Efficiency in CD Sales
Price
10
S
6
E
D
2
1
22
2
3
4
5
Tapes
per period
Price Controls and Shortages
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In Figure 11-4 the market initially is in
equilibrium at P1, Q1 (point E).
Then demand increases from D to D’.
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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 11-4: Price Controls and
Shortages
SS
Price
LS
P
2
P
3
P
1
E’
E
D’
D
Q1
24
Q2 Q3
Quantity
per period
Price Controls and Shortages
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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
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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.
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This is a direct transfer of surplus from
producers to consumers with no gain in total
surplus.
FIGURE 11-4: Price Controls and
Shortages
Price
SS
A
LS
P
2
P
3
P
1
C
E’
E
D’
D
Q1
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Q3 Q4
Quantity
per period
Price Controls and Shortages
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If output had expanded, consumers would
gain the area AE’C.
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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.
Tax Incidence
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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 11-5
FIGURE 11-5: 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
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Output
0
Q3 Q2 Q1 Quantity
per week
(b) The Market
Tax Incidence
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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.
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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
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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
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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
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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 longrun demand curve inward to D’ (as shown
in Figure 11-6) which causes the price to
fall from P1 to P2 as some firms exit and
input prices fall.
FIGURE 11-6: Tax Incidence in an
Increasing Cost Industry
Price
P3
LS
A
P1
P2
B
E1
E2
Tax
D
D’
Q2 Q1
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Quantity
per period
Long-Run Incidence with
Increasing Costs
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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
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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.
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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.
Taxation and Efficiency
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In Figure 11-6, 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.
Gains from International Trade
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Figure 11-7 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
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The quantity supplied by domestic
producers will fall to Q2 with shoe imports
of Q1 - Q2.
Consumer surplus increases by the area
PDE0E1PW.
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Part, PDE0APW, comes as a transfer from
domestic producers, and the rest is an
unambiguous gain in welfare (E0E1A).
FIGURE 11-7: Opening of International
Trade Increases Total Welfare
Price
LS
P
E0
D
E1
PW
A
D
Q
2
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Q
D
Q
1
Quantity
per period
Tariff Protection
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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 11-8.
FIGURE 11-8: Effects of a Tariff
Price
P
LS
E2
B
R
E1
PW
A
C
F
D
Q2
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Q4
Q3
Q1
Quantity
per period
Tariff Protection
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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.
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Quantity demanded falls to Q3 while domestic
production expands to Q4.
Tariff revenue is the area BE2FC, equal to
t(Q3 - Q4).
Tariff Protection
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Total consumer surplus is reduced by the
area PRE2E1PW.
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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
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A quota that limits imports to Q3 - Q4 (in
Figure 11-8) would have a similar effect to
a tariff.
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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
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However, with a quota, no tax revenue is
generated.
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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 11-8.