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Chapter 9
The Analysis of Competitive
Markets
Q: Rent Control
 Chuncheon City decided to control
rent around KNU campus for
students.
 Are KNU students going to be better
off?
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Consumer and Producer
Surplus
1. Consumer surplus is the total benefit or
value that consumers receive beyond
what they pay for the good.
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Consumer and Producer
Surplus
2. Producer surplus is the total benefit or
revenue that producers receive beyond
what it cost to produce a good.
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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
QS
Q0
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Between 0 and Q0
producers receive
a net gain from
selling each product-producer surplus.
Quantity
5
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
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Price Control and Surplus
Changes
Price
S
B
P0
A
C
Pmax
D
Q1
Q0
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Q2
Quantity
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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
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Price Controls With Inelastic
Demand
D
Price
S
B
P0
Pmax
With inelastic demand,
triangle B can be larger
than rectangle A and
consumers suffer net
losses from price controls.
C
A
Q1
Q2
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Quantity
9
The Efficiency of
a Competitive Market
 In the evaluation of markets, we often talk
about whether it reaches economic
efficiency
 Policies such as price controls that cause
dead weight losses in society are said to
impose an efficiency cost on the
economy
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The Efficiency of
a Competitive Market
 If efficiency is the goal, then you can
argue leaving markets alone is the
answer
 However, sometimes market failures
occur
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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
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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?
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Price Control and Surplus
Changes
Price
S
Pmin
A
B
P0
C
D
Q1
Q0
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Q2
Quantity
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The Efficiency of a Competitive
Market
 Deadweight loss triangles, B and C, give
a good estimate of 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
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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
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The Minimum Wage
w
S
wmin
A
B
C
w0
Unemployment
L1
L0
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D
L2
L
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Price Supports
 Much of agricultural policy is based on a
system of price supports.
 Government can also increase prices
through restricting production, directly or
through incentives to producers
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Price Supports
 What are the impacts on consumers,
producers and the federal budget?
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Price Supports
 Government may be able to “dump”
some of the goods in the foreign markets
 Total welfare effect of policy
CS + PS – Govt. cost = D – (Q2-Q1)PS
 Society is worse off over all
 Less costly to simply give farmers the
money
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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
Q0
Q2
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Quantity
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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
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Supply Restrictions
S’
Price
S
PS
A
B
P0
C
D
Q1
Q0
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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
 Costs to consumers is high
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Import Tariff To Eliminate
Imports
Price
S
P0
A
B
C
PW
Imports
D
QS
Q0
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QD
Quantity
25
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?
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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.
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The Effects of a Specific Tax
 For simplicity we will consider a specific
tax on a good
 For our example, consider a specific tax
of $t per widget sold
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Incidence of a Specific Tax
Price
S
Pb price
buyers pay
Tax =
$1.00
A
B
P0
PS price
producers
get
C
D
D
Q1
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Q0
Quantity
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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
 If supply is relatively inelastic, the burden
of tax will fall mostly on sellers
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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