the analysis of competitive markets lecture outline · 4cs = a b producer surplus: 4ps = a + b + d...

Microeconomics

Claudia Vogel

EUV

Winter Term 2009/2010

Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 1 / 28

The Analysis of Competitive Markets

Lecture Outline

Part II Producers, Consumers, and Competitive Markets

9 The Analysis of Competitive MarketsEvaluating the Gains and Losses from Government Policies - Consumer andProducer SurplusThe E�ciency of a Competitive MarketMinimum PricesPrice Supports and Production QuotasImport Quotas and Tari�sThe Impact of a Tax or SubsidySummary


The Analysis of Competitive MarketsEvaluating the Gains and Losses from Government Policies -

Consumer and Producer Surplus

Review of Consumer and Producer Surplus

Consumer surplus, which measures the to-tal bene�t to all consumers, is the yellow-shaded area between the demand curveand the market price.

Producer surplus measures the total prof-its of producers, plus rents to factor in-puts. It is the green-shaded area betweenthe supply curve and the market price.Together, consumer and producer surplusmeasure the welfare bene�t of a compet-itive market.




Application of Consumer and Producer Surplus

welfare e�ects: Gains and losses to consumers and producers.

deadweight loss: Net loss of total (consumer plus producer) surplus.




Example: Price Controls and Natural Gas Shortage

Supply: QS = 15.90+ 0.72PG + 0.05PO

Demand: QD = 0.02− 0.18PG + 0.69PO


The Analysis of Competitive Markets The E�ciency of a Competitive Market

The E�ciency of a Competitive Market

economic e�ciency: Maximization of aggregate consumer and producersurplus.

market failure: Situation in which an unregulated competitive market isine�cient because prices fail to provide proper signals to consumers andproducers.

There are two important instance in which market failure can occur:1 Externalities2 Lack of information

externality: Action taken by either a producer or a consumer which a�ectsother producers or consumers but is not accounted for by the market price.



Welfare Loss

When price is regulated to be no lowerthan P2 only Q3 will be demanded.

If Q3is produced, the deadweight loss isgiven by B and C.

At price P2, producers would like to pro-duce more than Q3. If they do, the dead-weight loss will be even larger.



Example: The Market for Human Kidneys

Supply: QS = 16000+ 0.4P Demand: QD = 32000− 0.4P


The Analysis of Competitive Markets Minimum Prices

Minimum Prices

price minimum minimum wage


The Analysis of Competitive Markets Minimum Prices

Example: Airline Regulation


The Analysis of Competitive Markets Price Supports and Production Quotas

Price Supports

price support: Price set by government above free-market level andmaintained by governmental purchases of excess supply.

To maintain a price PS above the market-clearing price P0, the government buys aquantity Qg .

Consumer Surplus:

4CS = −A− BProducer Surplus:

4PS = A+ B + DCost to government:

Cgovt = PS (Q2 − Q1)

Total change in welfare: 4CS +4CS − Cgovt = D − PS (Q2 − Q1)



Production Quotas

To maintain a price PS above the market-clearing price P0, the government can re-strict supply to Q1, either by imposingproduction quotas or by giving producersa �nancial incentive to reduce output.

Consumer Surplus:

4CS = −A− BProducer Surplus:

4PS = A−C+Payments for not produc-ing

Total change in welfare: −A− B + A+ B + D − B − C − D = −B − C



Example: Supporting the Price of Wheat 1/2

1981 Supply:QS = 1800+ 240P 1981 Demand: QD = 3550− 266P

To increase the price to $3.70, the govern-

ment must buy a quantity of wheat Qg .

1981 Total demand:

QDT = 3550− 266P + Qg

Demand of government:

Qg = 506P − 1750 = 506 · 3.70− 1750Qg = 122 million bushels

Loss to consumers:

A+ B = $624 mioCost to government:

3.70 · 122 = $451.4 mio

Total cost of the program: $624+ $451.4 = $1075.4 mio

Gain to producers: A+ B + C = $638 mio



Example: Supporting the Price of Wheat 2/2

1985 Supply:QS = 1800+ 240P 1985 Demand: QD = 2580− 194P

To increase the price to $3.20, the gov-ernment bought 466 mio bushels and alsoimposed a production quota of 2425 miobushels.

2425 = 2580− 194P + QgDemand of government:

Qg = 194P − 155 = 194 · $3.20− 155Qg = 466 million bushels

Cost to government:

$3.20 · 466 = $1419.2 mio


The Analysis of Competitive Markets Import Quotas and Tari�s

Elimination of Imports

import quota: Limit on the quantity of a good that can be imported

tari�: Tax on imported good.

In a free market, the domestic price equalsthe world price PW .

A total Qd is consumed, of which Qsis supplied domestically and the rest im-ported.

When imports are eliminated, the price isincreased toP0.



Import Tari� or Quota (General Case)

When imports are reduced, the domesticprice is increased from PW to P

∗.This can be achieved by a quota, or by atari� T = P∗ − PW .

If a tari� is used, the government gainsD, the revenue from the tari�. The netdomestic loss is B+C.

If a quota is used instead, D becomes partof the pro�ts of foreign producers, and thenet domestic loss is B+C+D.



Example: The Sugar Quota in 2005

U.S. demand: QD = 26.7− 0.23P U.S. supply: QS = −7.48+ 0.84P


The Analysis of Competitive Markets The Impact of a Tax or Subsidy

The Impact of a Tax or Subsidy

speci�c tax: Tax of a certain amount of money per unit sold.

Market clearing requires four conditions tobe satis�ed after a tax is in place:

QD = QD (Pb)

QS = QS (Ps)

QD = QS

Pb − Ps = t



Tax and Elasticities of Demand and Supply

If demand is very inelastic relative tosupply, the burden of the tax falls mostlyon buyers.

If demand is very elastic relativeto supply, it falls mostly on sellers.



The E�ects of a Subsidy

subsidy: Payment reducing the buyers's price below the seller's price; i.e. anegative tax.

Conditions needed for the market to clearwith a subsidy:

QD = QD (Pb)

QS = QS (Ps)

QD = QS

Pb − Ps = s



Example: The Tax on Gasoline 1/2

E�ect of a $1-per gallon tax:

QD = 150− 25Pb (Demand billion gallons per year)QS = 60+ 20Ps (Supply billion gallons per year)QD = QS (Supply must equal demand)Pb − Ps = 1.00 (Government must receive $1.00/gallon)

150− 25Pb = 60+ 20PsPb = Ps + 1.00

150− 25 (Ps + 1) = 60+ 20Ps20Ps + 25Ps = 150− 25− 60

Ps = 1.44Q = 150− 25 · 2.44 = 89



Example: The Tax on Gasoline 2/2

Gasoline demand: QD = 150− 25Pb Gasoline supply: QS = 60+ 20Ps

Annual revenue from the tax:tQ = 1.00 · 89 = 89

Deadweight loss:(1

2

)($1.00/gallon)(11 billion gallons/year = $5.5 billion per year


The Analysis of Competitive Markets Summary

Summary

Simple models of supply and demand can be used to analyze a wide varietyof government policies such as price controls, minimum prices, price supportprograms, production quotas or incentive programs to limit output, importtari�s and quotas, and taxes and subsidies.

When government imposes a tax or subsidy, price usually does not rise or fallby the full amount of the tax or subsidy. Also, the incidence of a tax orsubsidy is usually split between producers and consumers. The fraction thateach group ends up paying or receiving depends on the relative elasticities ofsupply and demand.

Government intervention generally leads to a deadweight loss. Thisdeadweight loss is a form of economic ine�ciency that must be taken intoaccount when policies are designed and implemented.

Government intervention in a competitive market is not always bad.Government - and the society it represents - might have objectives other thaneconomic e�ciency. And there are situations in which governmentintervention can improve economic e�ciency. Examples are externalities andcases of market failure.


Exerxises 8

Problem 1

1 What is meant by deadweight loss? Why does a price ceiling usually result ina deadweight loss?

2 How can a price ceiling make consumers better o�? Under what conditionsmight it make them worse o�?

3 Suppose the government regulates the price of a good to be no lower thansome minimum level. Can such a minimum price make producers as a wholeworse o�?

4 Suppose the government wants to increase farmer's incomes. Why do pricesupports or acreage-limitation programs cost society more than simply givingfarmers money?

5 Suppose the government wants to limit imports of a certain good. Is itpreferable to use an import quota or a tari�? Why?


Exerxises 8

Problem 2

Suppose the market for widgets can be described by the following equations:

Demand: QD = 10− P Supply: QS = P − 4

where P is the price in dollars per unit and Q is the quantity in thousands of units.

1 What is the equilibrium price and quantity?

2 Suppose the government imposes a tax of $1 per unit to reduce widgetconsumption and raise government revenues. What will the new quantity be?What price will the buyer pay? What amount per unit will the seller receive?

3 Suppose the government has a change of heart about the importance ofwidgets to the happiness of the American public. The tax is removed and asubsidy of $1 per unit granted to widget producers. What will the equilibriumquantity be? What price will the buyer pay? What amount per unit(including the subsidy) will the seller receive? What will be the total cost tothe government?


Exerxises 8

Problem 3

In Problem 6 in Exercise 1 we examined a vegetable �ber traded in a competitive world marketand imported into the United States at a world price of $9 per unit. U.S. domestic supply anddemand for various price levels are shown below.

U.S. Supply U.S. Demand

Price (Million Lbs.) (Million Lbs.)

3 2 34

6 4 28

9 6 22

12 8 16

15 10 10

18 12 4

As calculated in Exercise 1 the demand curve

is given by QD = 40 − 2P, and the supplycurve is given by QS =

2

3P.

1 Con�rm that if there were no restrictions on trade, the United States would import 16million pounds.

2 If the United States imposes a tari� of $3 per pound, what will be the U.S. price and levelof imports? How much revenue will the government earn from the tari�? How large is thedeadweight loss?

3 If the United States has no tari� but imposes an import quota of 8 million pounds, whatwill be the U.S. domestic price? What is the cost of this quota for U.S. consumers of the�ber? What is the gain for U.S. producers?


Exerxises 8

Problem 4

The United States currently imports all of its co�ee. The annual demand forco�ee by U.S. consumers is given by the demand curve Q = 250− 10P, where Qis the quantity (in millions of pounds) and P is the market price per pound ofco�ee. World producers can harvest and ship co�ee to the U.S. distributors at aconstant cost of $8 per pound. U.S. distributors can in turndistribute for aconstant $2 per pound. The U.S. co�ee market is competitive. Congress isconsidering a tari� on co�ee imports of $2 per pound.

1 If there is no tari�, how much do consumers pay for a pound of co�ee? Whatis the quantity demanded?

2 If the tari� is imposed, how much will consumers pay for a pound of co�ee?What is the quantity demanded?

3 Calculate the lost consumer surplus.

4 Calculate the tax revenue collected by the government.

5 Does the tari� result in a net gain or a net loss to society as a whole?


Exerxises 8

Problem 5

In 2007, Americans smoked 19.2 billion packs of cigarettes. They paid an averageretail price of $4.50 per pack.

1 Given that the elasticity of supply is 0.5 and the elasticity of demand is -0.4,derive linear demand and supply curves for cigarettes.

2 Cigarettes are subject to a federal tax, which was about 40 cents per pack in2007. What does this tax do to the market-clearing price and quantity?

3 How much of the federal tax will consumers pay? What part will producerspay?


The Analysis of Competitive MarketsEvaluating the Gains and Losses from Government Policies - Consumer and Producer SurplusThe Efficiency of a Competitive MarketMinimum PricesPrice Supports and Production QuotasImport Quotas and TariffsThe Impact of a Tax or SubsidySummary

Exerxises 8

the analysis of competitive markets lecture outline · 4cs = a b producer surplus: 4ps = a + b + d...

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