Download Chapter 9

Chapter 9
The Analysis of Competitive
Markets
Topics to be Discussed
 Evaluating the Gains and Losses from
Government Policies
 The Efficiency of a Competitive Market
 Minimum Prices
 Price Supports and Production Quotas
 Import Quotas and Tariffs
 The Impact of a Tax or Subsidy
©2005 Pearson Education, Inc.
Chapter 9
2
Consumer and Producer
Surplus
 When government controls price, some
people are better off
May be able to buy a good at a lower price
 But what is the effect on society as a
whole?
Is total welfare higher or lower and by how
much?
 A way to measure gains and losses from
government policies is needed
©2005 Pearson Education, Inc.
Chapter 9
3
Consumer and Producer
Surplus
1. Consumer surplus is the total benefit
or value that consumers receive beyond
what they pay for the good
 Assume market price for a good is $5
 Some consumers would be willing to pay
more than $5 for the good
 If you were willing to pay $9 for the good
and pay $5, you gain $4 in consumer
surplus
©2005 Pearson Education, Inc.
Chapter 9
4
Consumer and Producer
Surplus
 The demand curve shows the willingness
to pay for all consumers in the market
 Consumer surplus can be measured by
the area between the demand curve and
the market price
 Consumer surplus measures the total net
benefit to consumers
©2005 Pearson Education, Inc.
Chapter 9
5
Consumer and Producer
Surplus
2. Producer surplus is the total benefit or
revenue that producers receive beyond
what it costs to produce a good
 Some producers produce for less than
market price and would still produce at a
lower price
 A producer might be willing to accept $3 for
the good but get $5 market price
 Producer gains a surplus of $2
©2005 Pearson Education, Inc.
Chapter 9
6
Consumer and Producer
Surplus
 The supply curve shows the amount that
a producer is willing to take for a certain
amount of a good
 Producer surplus can be measured by
the area between the supply curve and
the market price
 Producer surplus measures the total net
benefit to producers
©2005 Pearson Education, Inc.
Chapter 9
7
Consumer and Producer
Surplus
Price
9
Consumer
Surplus
S
Between 0 and Q0
consumer A receives
a net gain from buying
the product-consumer surplus.
5
Producer
Surplus
3
D
QD
©2005 Pearson Education, Inc.
QS
Q0
Chapter 9
Between 0 and Q0
producers receive
a net gain from
selling each product-producer surplus.
Quantity
8
Consumer and Producer
Surplus
 To determine the welfare effect of a
governmental policy, we can measure the
gain or loss in consumer and producer
surplus
 Welfare Effects
Gains and losses to producers and
consumers
©2005 Pearson Education, Inc.
Chapter 9
9
Consumer and Producer
Surplus
 When government institutes a price
ceiling, the price of a good can’t go
above that price
 With a binding price ceiling, producers
and consumers are affected
 How much they are affected can be
determined by measuring changes in
consumer and producer surplus
©2005 Pearson Education, Inc.
Chapter 9
10
Consumer and Producer
Surplus
 When price is held too low, the quantity
demanded increases and quantity
supplied decreases
 Some consumers are worse off because
they can no longer buy the good
Decrease in consumer surplus
 Some consumers are better off because
they can buy it at a lower price
Increase in consumer surplus
©2005 Pearson Education, Inc.
Chapter 9
11
Consumer and Producer
Surplus
 Producers sell less at a lower price
 Some producers are no longer in the
market
 Both of these producer groups lose and
producer surplus decreases
 The economy as a whole is worse off
since surplus that used to belong to
producers or consumers is simply gone
©2005 Pearson Education, Inc.
Chapter 9
12
Price Control and Surplus
Changes
Price
Consumers that
cannot buy, lose B
Consumers that can
buy the good gain A
S
The loss to producers
is the sum of
rectangle A and
triangle C
B
P0
A
C
Triangles B and C are
losses to society –
dead weight loss
Pmax
D
Q1
©2005 Pearson Education, Inc.
Q0
Chapter 9
Q2
Quantity
13
Price Controls and Welfare
Effects
 The total loss is equal to area B + C
 The deadweight loss is the inefficiency
of the price controls – the total loss in
surplus (consumer plus producer)
 If demand is sufficiently inelastic, losses
to consumers may be fairly large
This can have effects in political decisions
©2005 Pearson Education, Inc.
Chapter 9
14
Price Controls With Inelastic
Demand
D
Price
S
B
P0
Pmax
A
Q1
©2005 Pearson Education, Inc.
With inelastic demand,
triangle B can be larger
than rectangle A and
consumers suffer net
losses from price controls.
C
Q2
Chapter 9
Quantity
15
Price Controls and
Natural Gas Shortages
 From example in Chapter 2, 1975 Price
controls created a shortage of natural
gas
 What was the effect of those controls?
Decreases in surplus and overall loss for
society
We can measure these welfare effects from
the demand and supply of natural gas
©2005 Pearson Education, Inc.
Chapter 9
16
Price Controls and
Natural Gas Shortages
 QS = 14 + 2PG + 0.25PO
Quantity supplied in trillion cubic feet (Tcf)
 QD = -5PG + 3.75PO
Quantity demanded (Tcf)
 PG = price of natural gas in $/mcf
 PO = price of oil in $/b
©2005 Pearson Education, Inc.
Chapter 9
17
Price Controls and
Natural Gas Shortages
 Using PO = $8/b and QDG  QSG gives
equilibrium values for natural gas
PG = $2/mcf and QG = 20 Tcf
 Price ceiling was set at $1/mcf
 Showing this graphically, we can see and
measure the effects on producer and
consumer surplus
©2005 Pearson Education, Inc.
Chapter 9
18
Price Controls and
Natural Gas Shortages
Price
($/mcf)
D
S
The gain to consumers is
rectangle A minus triangle
B, and the loss to
producers is rectangle A
plus triangle C.
2.40
B
2.00
C
A
(Pmax)1.00
0
5
©2005 Pearson Education, Inc.
10
15 18 20
Chapter 9
25
30 Quantity (Tcf)
19
Price Controls and
Natural Gas Shortages
 Measuring the Impact of Price Controls
A = (18 billion mcf) x ($1/mcf) =
$18 billion
B = (1/2) x (2 b. mcf) x ($0.40/mcf) =
$0.4 billion
C = (1/2) x (2 b. mcf) x ($1/mcf) =
$1 billion
©2005 Pearson Education, Inc.
Chapter 9
20
Price Controls and
Natural Gas Shortages
 Measuring the Impact of Price Controls in
1975
Change in consumer surplus
=A-
B = 18 - 0.4 = $17.6 billion Gain
Change in producer surplus
=A+
C = 18 + 1 = $19.0 billion Loss
Dead Weight Loss
=
B + C = 0.4 + 1 = $1.4 billion Loss
©2005 Pearson Education, Inc.
Chapter 9
21
The Efficiency of
a Competitive Market
 In the evaluation of markets, we often talk
about whether it reaches economic
efficiency
Maximization of aggregate consumer and
producer surplus
 Policies such as price controls that cause
dead weight losses in society are said to
impose an efficiency cost on the
economy
©2005 Pearson Education, Inc.
Chapter 9
22
The Efficiency of
a Competitive Market
 If efficiency is the goal, then you can
argue that leaving markets alone is the
answer
 However, sometimes market failures
occur
Prices fail to provide proper signals to
consumers and producers
Leads to inefficient unregulated competitive
market
©2005 Pearson Education, Inc.
Chapter 9
23
Types of Market Failures
1. Externalities
 Costs or benefits that do not show up as
part of the market price (e.g. pollution)
 Costs or benefits are external to the market
2. Lack of Information
 Imperfect information prevents consumers
from making utility-maximizing decisions
 Government intervention may be
desirable in these cases
©2005 Pearson Education, Inc.
Chapter 9
24
The Efficiency of a Competitive
Market
 Other than market failures, unregulated
competitive markets lead to economic
efficiency
 What if the market is constrained to a
price higher than the economically
efficient equilibrium price?
©2005 Pearson Education, Inc.
Chapter 9
25
Price Control and Surplus
Changes
Price
S
Pmin
A
When price is
regulated to be no
lower than Pmin, the
deadweight loss given
by triangles B and C
results.
B
P0
C
D
Q1
©2005 Pearson Education, Inc.
Q0
Chapter 9
Q2
Quantity
26
The Efficiency of a Competitive
Market
 Deadweight loss triangles B and C give a
good estimate of the efficiency cost of
policies that force price above or below
market clearing price
 Measuring effects of government price
controls on the economy can be
estimated by measuring these two
triangles
©2005 Pearson Education, Inc.
Chapter 9
27
The Market for Human Kidneys
 The 1984 National Organ Transplantation
Act prohibits the sale of organs for
transplantation
 What has been the impact of the Act?
 We can measure this using the supply
and demand for kidneys from estimated
data
Supply: QS = 8,000 + 0.2P
Demand: QD = 16,000 - 0.2P
©2005 Pearson Education, Inc.
Chapter 9
28
The Market for Human Kidneys
 Since the sale of organs is not allowed,
the amount available depends on the
amount donated
Supply of donated kidneys is limited to 8,000
 The welfare effect of this supply
constraint can be analyzed using
consumer and producer surplus in the
kidney market
©2005 Pearson Education, Inc.
Chapter 9
29
The Market for Human Kidneys
 Suppliers:
Those who supply them are not paid the
market price, estimated at $20,000
 Loss
of surplus equal to area A = $160 million
Some who would donate for the equilibrium
price do not donate in the current market
 Loss
of surplus equal to area C = $40 million
Total consumer loss of A + C = $200 million
©2005 Pearson Education, Inc.
Chapter 9
30
The Market for Human Kidneys
 Recipients:
Since they do not have to pay for the kidney,
they gain rectangle A ($140 million) since
price is $0
Those who cannot obtain a kidney lose
surplus equal to triangle B ($40 million)
Net increase in surplus of recipients of $160
- $40 = $120 million
 Dead Weight Loss of C + B = $80 million
©2005 Pearson Education, Inc.
Chapter 9
31
The Market for Human Kidneys
 Other Inefficiency Costs
Allocation is not necessarily to those who
value the kidneys the most
Price may increase to $40,000, the
equilibrium price, with hospitals getting the
price
©2005 Pearson Education, Inc.
Chapter 9
32
The Market for Kidneys
S’
Price
The loss to suppliers
is seen in areas A & C.
$40,000
S
D
$30,000
If kidneys are zero
cost, consumer gain
would be A minus B.
B
$20,000
A and D measure the
total value of kidneys
when supply is
constrained.
C
A
$10,000
D
0
4,000
©2005 Pearson Education, Inc.
8,000
Chapter 9
12,000
Quantity
33
The Market for Human Kidneys
 Arguments in favor of prohibiting the
sale of organs:
1. Imperfect information about donor’s health
and screening
2. Unfair to allocate according to the ability to
pay

Holding price below equilibrium will create
shortages
 Organs versus artificial substitutes
©2005 Pearson Education, Inc.
Chapter 9
34
Minimum Prices
 Periodically, government policy seeks to
raise prices above market-clearing levels
Minimum wage law
Regulation of airlines
Agricultural policies
 We will investigate this by looking at the
minimum wage legislation
©2005 Pearson Education, Inc.
Chapter 9
35
Minimum Prices
 When price is set above the market
clearing price:
Quantity demanded falls
Suppliers may, however, choose to increase
quantity supplied in face of higher prices
This causes additional producer losses equal
to the total cost of production above quantity
demanded
©2005 Pearson Education, Inc.
Chapter 9
36
Minimum Prices
 Losses in consumer surplus are still the
same
Increased price leading to decreased
quantity equals area A
Those priced out of the market lose area B
 Producer surplus similar
Increases from increased price for units sold
equal to A
Losses from drop in sales equal to C
©2005 Pearson Education, Inc.
Chapter 9
37
Minimum Prices
 What if producers expand production to
Q2 from the increased price?
Since they only sell Q3, there is no revenue
to cover the additional production (Q2-Q3)
Supply curve measures MC of production so
total cost of additional production is area
under the supply curve for the increased
production (Q2-Q3) = area D
Total change in producer surplus = A – C – D
©2005 Pearson Education, Inc.
Chapter 9
38
Minimum Prices
Price
S
If producers produce
Q2, the amount Q2 - Q3
will go unsold.
Pmin
A
D measures total cost
of increased
production not sold.
B
C
P0
The change in producer
surplus will be
A - C - D. Producers
may be worse off.
D
D
Q3
©2005 Pearson Education, Inc.
Q0
Chapter 9
Q2
Quantity
39
Minimum Wages
 Wage is set higher than market clearing
wage
 Decreased quantity of workers
demanded
 Those workers hired receive higher
wages
 Unemployment results, since not
everyone who wants to work at the new
wage can
©2005 Pearson Education, Inc.
Chapter 9
40
The Minimum Wage
Firms are not allowed to
pay less than wmin. This
results in unemployment.
w
S
wmin
A
A is gain to workers
who find jobs at
higher wage.
B
C
w0
The deadweight loss
is given by
triangles B and C.
Unemployment
L1
©2005 Pearson Education, Inc.
L0
Chapter 9
D
L2
L
41
Airline Regulation
 Before 1970, the airline industry was
heavily regulated by the Civil Aeronautics
Board (CAB)
 During 1976-1981, the airline industry in
the U.S. changed dramatically as
deregulation led to major changes
 Some airlines merged or went out of
business as new airlines entered the
industry
©2005 Pearson Education, Inc.
Chapter 9
42
Airline Regulation
 Although prices in the industry fell
considerably (helping consumers), profits
did not.
Regulation caused significant inefficiencies
and artificially high costs
 We can show the effects of this
regulation by looking at the effects on
surplus from the controlled prices
©2005 Pearson Education, Inc.
Chapter 9
43
Effect of Airline Regulation
S
Price
Pmin
Prior to deregulation
price was at Pmin.
Production was Q3
hoping to outsell
competitors.
A
P0
B
C
Area D is the cost
of unsold output.
D
D
Q1 Q3 Q0
©2005 Pearson Education, Inc.
Chapter 9
Q2
After deregulation:
Prices fell to PO. The
change in consumer
surplus is A + B.
Quantity
44
Airline Industry Data
©2005 Pearson Education, Inc.
Chapter 9
45
Airline Industry Data
 Airline industry data show:
1. Long-run adjustment as the number of
carriers increased and prices decreased
2. Higher load factors indicating more
efficiency
3. Falling rates
4. Real cost increased slightly (adjusted fuel
cost)
5. Large welfare gain
©2005 Pearson Education, Inc.
Chapter 9
46
Price Supports
 Much of agricultural policy is based on a
system of price supports
Prices set by government above free-market
level and maintained by governmental
purchases of excess supply
 Government can also increase prices
through restricting production, directly or
through incentives to producers
©2005 Pearson Education, Inc.
Chapter 9
47
Price Supports
 What are the impacts on consumers,
producers and the federal budget?
 Consumers
Quantity demanded falls and quantity
supplied increases
Government buys surplus
Consumers must pay higher price for the
good
Loss in consumer surplus equal to A+B
©2005 Pearson Education, Inc.
Chapter 9
48
Price Supports
 Producers
Gain since they are selling more at a higher
price
Producer surplus increases by A+B+D
 Government
Cost of buying the surplus, which is funded
by taxes, so indirect cost on consumers
Cost to government = (Q2-Q1)PS
©2005 Pearson Education, Inc.
Chapter 9
49
Price Supports
 Government may be able to “dump” some of the
goods in the foreign markets
 Hurts domestic producers that government is trying to
help in the first place
 Total welfare effect of policy
CS + PS – Govt. cost = D – (Q2-Q1)PS
 Society is worse off overall
 Less costly to simply give farmers the money
©2005 Pearson Education, Inc.
Chapter 9
50
Price Supports
Price
S
Qg
Ps
A
P0
To maintain a price Ps
the government buys
quantity Qg .
D
B
Net Loss to
society is E + B.
D + Qg
E
D
Q1
©2005 Pearson Education, Inc.
Q0
Q2
Chapter 9
Quantity
51
Production Quotas
 The government can also cause the price
of a good to rise by reducing supply
Limitations of taxi medallions in New York
City
Limitation of required liquor licenses for
restaurants
©2005 Pearson Education, Inc.
Chapter 9
52
Supply Restrictions
S’
Price
S
PS
•Supply restricted to Q1
•Supply shifts to S’ & Q1
A
B
P0
•CS reduced by A + B
•Change in PS = A - C
•Deadweight loss = BC
C
D
Q1
©2005 Pearson Education, Inc.
Q0
Chapter 9
Quantity
53
Supply Restrictions
 Incentive Programs
US agricultural policy uses production
incentives instead of direct quotas
Government gives farmers financial
incentives to restrict supply
 Acreage
limitation programs
Quantity decreases and price increases for
the crop
©2005 Pearson Education, Inc.
Chapter 9
54
Supply Restrictions
 Incentive Program
Gain in PS of A from increased price of
amount sold
Loss of PS of C from decreased production
Government pays farmers not to produce
Total PS = A – C + payments from Govt.
Government must pay enough to keep
producers from producing more at the higher
price
Equals B+C+D
©2005 Pearson Education, Inc.
Chapter 9
55
Supply Restrictions
S’
Price
S
PS
•CS reduced by A + B
D
A
Cost to government
=B+C+D
= additional profit
made if producing
Q0 at PS
B
P0
C
D
Q1
©2005 Pearson Education, Inc.
Q0
Chapter 9
•Change in PS
=A+B+D
Quantity
56
Supply Restrictions
 Which program is more costly?
Both programs have same loss to
consumers
Producers are indifferent between programs
because end up with same amount in both
Typically, acreage limitation programs cost
society less than price supports maintained
by government purchases
However, society is better off if government
would just give farmers cash
©2005 Pearson Education, Inc.
Chapter 9
57
Supporting the Price of Wheat
 From previous example, the supply and
demand for wheat in 1981 was
Supply: QS = 1,800 + 240P
Demand: QD = 3,550 - 266P
Equilibrium price and quantity was $3.46 and
2,630 million bushels
 Government raised the price to $3.70
through government purchases
©2005 Pearson Education, Inc.
Chapter 9
58
Supporting the Price of Wheat
 How much would the government have
had to buy to keep price at $3.70?
QDTotal = QD + Qg = 3,550 - 266P + Qg
QS = QDT
 1,800
+ 240P = 3,550 - 266P + Qg
 Qg = 506P - 1,750
 At a price of $3.70, government would buy
 Qg = (506)(3.70) - 175 = 122 million bushels
©2005 Pearson Education, Inc.
Chapter 9
59
The Wheat Market in 1981
Price
•AB consumer loss
•ABC producer gain
S
Qg
PS = $3.70
A
P0 = $3.46
B
By buying 122
million bushels,
the government
increased the
market-clearing
price.
C
D
1,800
©2005 Pearson Education, Inc.
2,566 2,630 2,688
Chapter 9
D + Qg
Quantity
60
Supporting the Price of Wheat
 We can quantify the effects on CS
The change in consumer surplus = (-A -B)
A=
(3.70 - 3.46)(2,566) = $616 million
 B = (1/2)(3.70 - 3.46)(2,630 - 2,566) = $8 million
CS = -$624 million
©2005 Pearson Education, Inc.
Chapter 9
61
Supporting the Price of Wheat
 Cost to the government:
$3.70 x 122 million bushels = $451.4 million
Total cost of program = $624 + 451 = $1,075
million
 Gain to producers
 A + B + C = $638 million
Government also paid 30 cents/bushel =
$806 million
©2005 Pearson Education, Inc.
Chapter 9
62
Supporting the Price of Wheat
 In 1985, the situation became worse
Export demand fell and the market clearing
price of wheat fell to $1.80/bushel
Equilibrium quantity was 2231
The actual price, however, was $3.20
To keep price at $3.20, the government had
to purchase excess wheat
Government also imposed a production
quota of about 2425 million bushels
©2005 Pearson Education, Inc.
Chapter 9
63
Supporting the Price of Wheat
 1985 Government Purchase:
 2,425 = 2,580 - 194P + Qg
Qg = -155 + 194P
P = $3.20 -- the support price
Qg = -155 + 194($3.20) = 466 million bushels
©2005 Pearson Education, Inc.
Chapter 9
64
The Wheat Market in 1985
Price
S
’
S
Qg
To increase the
price to $3.20, the
government bought
466 million bushels
and imposed
a production quota
of 2,425 bushels.
PS = $3.20
P0 = $1.80
D
1,800 1,959
©2005 Pearson Education, Inc.
2,232 2,425
Chapter 9
D + Qg
Quantity
65
Supporting the Price of Wheat
 1985 Government Cost:
Purchase of Wheat = $3.20 x 466 = $1,491
million
80 cent subsidy = .80 x 2,425 = $1,940
million
Total government program cost = $3.5 billion
©2005 Pearson Education, Inc.
Chapter 9
66
Supporting the Price of Wheat
 In 1996, Congress passed the Freedom
to Farm law
Goal was to reduce the role of government
and make agriculture more market-oriented
Eliminated production quotas, gradually
reduced government purchases and
subsidies through 2003
©2005 Pearson Education, Inc.
Chapter 9
67
Supporting the Price of Wheat
 In 2002, Congress and President Bush
reversed the effects of the 1996 bill by
reinstating subsidies for most crops
Calls for “fixed direct payments”
New bill would cost taxpayers almost $1.1
billion in annual payments to wheat
producers alone
2002 farm bill expected to cost taxpayers
$190 billion over 10 years
 Estimated
©2005 Pearson Education, Inc.
$83 billion over existing programs
Chapter 9
68
Import Quotas and Tariffs
 Many countries use import quotas and
tariffs to keep the domestic price of a
product above world levels
Import quotas: Limit on the quantity of a
good that can be imported
Tariff: Tax on an imported good
 This allows domestic producers to enjoy
higher profits
 Cost to consumers is high
©2005 Pearson Education, Inc.
Chapter 9
69
Import Quotas and Tariffs
 With lower world price, domestic
consumers have incentive to purchase
from abroad
Domestic price falls to world price and
imports equal difference between quantity
supplied and quantity demanded
 Domestic industry might convince
government to protect industry by
eliminating imports
Quota of zero or high tariff
©2005 Pearson Education, Inc.
Chapter 9
70
Import Tariff to Eliminate
Imports
Price
In a free market, the
domestic price equals the
world price PW.
S
Quota of zero pushes
domestic price to P0 and
imports go to zero.
P0
A
B
Loss to consumers is
A+B+C.
Gain to producers is A.
Dead weight loss: B +C.
C
PW
Imports
D
QS
©2005 Pearson Education, Inc.
Q0
Chapter 9
QD
Quantity
71
Import Tariff (General Case)
 The increase in price can
P
be achieved by a tariff
 QS increases and QD
decreases
 Area A is the gain to
P*
domestic producers
 The loss to consumers is
Pw
A+B+C+D
 DWL = B + C
 Government Revenue is D
= tariff * imports
S
A
B
Chapter 9
C
D
QS
©2005 Pearson Education, Inc.
D
Q’S
Q’D
Q
QD
72
Import Quota (General Case)
 If a quota is used,
rectangle D becomes
part of the profits to
foreign producers
 Consumers lose
A+B+C+D
 Producers gain A
 Net domestic loss is
B+C+D
S
P
P*
A
B
Pw
Chapter 9
C
D
QS
©2005 Pearson Education, Inc.
D
Q’S
Q’D
Q
QD
73
The Sugar Quota Example
 The world price of sugar has been as low as 4
cents per pound, while in the U.S. the price has
been 20-25 cents per pound
 Sugar quotas have protected the sugar industry
but driven up prices
 Domestic producers have been better off and so
have some foreign producers that have quota
rights
 Consumers are worse off
©2005 Pearson Education, Inc.
Chapter 9
74
The Sugar Quota Example
 The Impact of a Sugar Quota in 2001
 US
production = 17.4 billion pounds
 US consumption = 20.4 billion pounds
 US price = 21.5 cents/pound
 World price = 8.3 cents/pound
 Price elasticity of US supply = 1.5
 Price elasticity of US demand = –0.3
©2005 Pearson Education, Inc.
Chapter 9
75
Impact of Sugar Quota
 The data can be used to fit the US supply
and demand curves
QS = -8.70 + 1.21P
QD = 26.53 - 0.29P
World price was 24.2 million pounds, leading
to little domestic supply and most domestic
consumption coming from large imports
Government restricted imports to 3 billion
pounds raising price to 21.5 cents/pound
©2005 Pearson Education, Inc.
Chapter 9
76
Sugar Quota in 1997
DUS
SUS
Price
(cents/lb.)
PUS = 21.5 after quota
20
A
16
D
C
B
11
The cost of the quotas
to consumers was
A + B + C + D = $2.4b.
The gain to producers
was area A = $1b.
PW = 8.3 before quota
8
4
1.4
©2005 Pearson Education, Inc.
17.4
Chapter 9
20.4 24.2
Quantity
(billions of pounds)
77
The Impact of a Tax or Subsidy
 The government wants to impose a $1.00
tax on movies. It can do it two ways:
Make the producers pay $1.00 for each
movie ticket they sell
Make consumers pay $1.00 when they buy
each movie
 In which option are consumers paying
more?
©2005 Pearson Education, Inc.
Chapter 9
78
The Impact of a Tax or Subsidy
 The burden of a tax (or the benefit of a
subsidy) falls partly on the consumer and
partly on the producer
 How the burden is split between the
parties depends on the relative
elasticities of demand and supply
©2005 Pearson Education, Inc.
Chapter 9
79
The Effects of a Specific Tax
 For simplicity we will consider a specific
tax on a good
Tax of a particular amount per unit sold
Federal and state taxes on gas and
cigarettes
 For our example, consider a specific tax
of $t per widget sold
©2005 Pearson Education, Inc.
Chapter 9
80
Incidence of a Specific Tax
Price
S
Pb price
buyers pay
Tax =
$1.00
•Buyers lose A + B
A
B
P0
PS price
producers
get
•Sellers lose D + C
•Government gains A
+ D in tax revenue.
C
D
•The deadweight
loss is B + C.
D
Q1
©2005 Pearson Education, Inc.
Chapter 9
Q0
Quantity
81
Incidence of a Specific Tax
 Four conditions that must be satisfied
after the tax is in place:
1. Quantity sold and buyer’s price, Pb, must be
on the demand curve

Buyers only concerned with what they must
pay
2. Quantity sold and seller’s price, PS, must be
on the supply curve

Sellers only concerned with what they receive
©2005 Pearson Education, Inc.
Chapter 9
82
Incidence of a Specific Tax
 Four conditions that must be satisfied
after the tax is in place (cont.):
3. QD = QS
4. Difference between what consumers pay
and what buyers receive is the tax
 If we know the demand and supply
curves as well as the tax, we can solve
for PB, PS, QD and QS
©2005 Pearson Education, Inc.
Chapter 9
83
Incidence of a Specific Tax
 In the previous example, the tax was
shared almost equally by consumers and
producers
 If demand is relatively inelastic, however,
burden of tax will fall mostly on buyers
Cigarettes
 If supply is relatively inelastic, the burden
of tax will fall mostly on sellers
©2005 Pearson Education, Inc.
Chapter 9
84
Impact of Elasticities on Tax Burdens
Burden on Buyer
Burden on Seller
D
Price
Price
S
Pb
S
t
Pb
P0
P0
PS
t
D
PS
Q1 Q0
Quantity
Q1 Q 0
Quantity
The Impact of a Tax or Subsidy
 We can calculate the percentage of a tax
borne by consumers using pass-through
fraction
ES/(ES - Ed)
Tells fraction of tax “passed through” to
consumers through higher prices
For example, when demand is perfectly
inelastic (Ed = 0), the pass-through fraction is
1 – consumers bear 100% of tax
©2005 Pearson Education, Inc.
Chapter 9
86
The Effects of a Tax or Subsidy
 A subsidy can be analyzed in much the
same way as a tax
Payment reducing the buyer’s price below
the seller’s price
 It can be treated as a negative tax
 The seller’s price exceeds the buyer’s
price
 Quantity increases
©2005 Pearson Education, Inc.
Chapter 9
87
Effects of a Subsidy
Price
S
Like a tax, the benefit
of a subsidy is split
between buyers and
sellers, depending
upon the elasticities of
supply and demand.
PS
Subsidy
P0
Pb
D
Q0
©2005 Pearson Education, Inc.
Chapter 9
Q1
Quantity
88
Effects of a Subsidy
 The benefit of the subsidy accrues mostly
to buyers if ED /ES is small
 The benefit of the subsidy accrues mostly
to sellers if ES /ES is large
 As with a tax, using supply and demand
curves, and the size of the subsidy, one
can solve for resulting prices and
quantities
©2005 Pearson Education, Inc.
Chapter 9
89
A Tax on Gasoline
 We can measure the effects of a tax by
looking at an example of a gasoline tax
 The goal of a large gasoline tax is to:
Raise government revenue
Reduce oil consumption and reduce US
dependence on oil imports
 We will consider a gas tax in the market
during mid-1990’s
©2005 Pearson Education, Inc.
Chapter 9
90
A Tax on Gasoline
 Measuring the Impact of a 50 Cent
Gasoline Tax
Intermediate-run EP of demand = -0.5
 QD
= 150 - 50P
EP of supply = 0.4
 QS
= 60 + 40P
QS = QD at $1 and 100 billion gallons per
year (bg/yr)
©2005 Pearson Education, Inc.
Chapter 9
91
A Tax on Gasoline
 With a 50 cent tax:
QD = QS
150 - 50Pb = 60 + 40PS
150 - 50(PS+ 0.50) = 60 + 40PS
PS = .72
Pb = PS + 0.50 = $1.22
QD = QS = 89 bg/yr
©2005 Pearson Education, Inc.
Chapter 9
92
A Tax on Gasoline
 With a 50 cent tax:
Q
falls by 11%
 Price to consumers increases by 22 cents
per gallon
 Producers receive about 20 cents per gallon
less
 Both producers and consumers were
opposed to the tax
 Government revenue would be significant at
$44.5 billion per year
©2005 Pearson Education, Inc.
Chapter 9
93
The Impact of a 50 Cent
Gasoline Tax
D
Price
($ per
gallon)
S
Consumer Loss = A + B
B
Producer Loss = C + D
Pb = 1.22
A
$0.50
Tax
P0 = 1.00
C
D
PS = .72
The buyer pays 22 cents of
the tax, and
the producer pays 28 cents.
Government revenue = A + D
= 0.50(89) = $44.5 billion.
11
50 60
©2005 Pearson Education, Inc.
89 100
Chapter 9
150
Quantity (billion
gallons per year)
94