chapter 9 the analysis of competitive markets. ©2005 pearson education, inc. chapter 92 consumer...
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Chapter 9
The Analysis of Competitive Markets
Chapter 9 2©2005 Pearson Education, Inc.
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
Chapter 9 3©2005 Pearson Education, Inc.
Consumer and Producer Surplus
Between 0 and Q0 producers receive
a net gain from selling each product--
producer surplus.
ConsumerSurplus
Quantity
Price
S
D
Q0
5
9
Between 0 and Q0
consumer A receives a net gain from buying
the product-- consumer surplus.
ProducerSurplus
3
QD QS
Chapter 9 4©2005 Pearson Education, Inc.
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
Chapter 9 5©2005 Pearson Education, Inc.
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
Chapter 9 6©2005 Pearson Education, Inc.
Consumer and Producer Surplus
Producers sell less at a lower priceSome producers are no longer in the
marketBoth of these producer groups lose and
producer surplus decreasesThe economy as a whole is worse off
since surplus that used to belong to producers or consumers is simply gone
Chapter 9 7©2005 Pearson Education, Inc.
The loss to producers is the sum of
rectangle A and triangle C
B
A C
Consumers that can buy the good gain A
Price Control and Surplus Changes
Quantity
Price
S
D
P0
Q0
Pmax
Q1 Q2
Consumers that cannot buy, lose B
Triangles B and C are losses to society – dead weight loss
Chapter 9 8©2005 Pearson Education, Inc.
Price Controls and Welfare Effects
The total loss is equal to area B + CThe 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
Chapter 9 9©2005 Pearson Education, Inc.
B
APmax
C
Q1
With inelastic demand, triangle B can be larger
than rectangle A and consumers suffer net
losses from price controls.
S
D
Price Controls With Inelastic Demand
Quantity
Price
P0
Q2
Chapter 9 10©2005 Pearson Education, Inc.
The Efficiency ofa 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
Chapter 9 11©2005 Pearson Education, Inc.
The Efficiency ofa 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
Chapter 9 12©2005 Pearson Education, Inc.
Types of Market Failures
1. Externalities Costs or benefits that are not reflected in market
supply and demand (e.g. pollution) Costs or benefits are experienced by a third party
not involved in transaction
2. Lack of Information Imperfect information prevents consumers from
making utility-maximizing decisions
Government intervention may be desirable in these cases
Chapter 9 13©2005 Pearson Education, Inc.
BA
C
Price Control and Surplus Changes
Quantity
Price
S
D
P0
Q0
Pmin
Q1 Q2
When price is regulated to be no lower than Pmin, the
deadweight loss given by triangles B and C
results.
Chapter 9 14©2005 Pearson Education, Inc.
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
Chapter 9 15©2005 Pearson Education, Inc.
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
Chapter 9 16©2005 Pearson Education, Inc.
The Market for Human Kidneys
Suppliers: Those who supply them are not paid the
market price, estimated at $20,000Loss 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 ‘producer’ loss of A + C = $200 million
Chapter 9 17©2005 Pearson Education, Inc.
The Market for Human Kidneys
Recipients: Since they do not have to pay for the kidney,
they gain rectangle A ($160 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
Chapter 9 18©2005 Pearson Education, Inc.
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
Chapter 9 19©2005 Pearson Education, Inc.
D
A and D measure the total value of
kidneys when supply is constrained.
A
C
The loss to suppliersis seen in areas A & C.
The Market for Kidneys
Quantity
Price
4,0000
$10,000
$30,000
$40,000
8,000
S’
B
If kidneys are zero cost, consumer gain would be A minus B.
S
D
12,000
$20,000
Chapter 9 20©2005 Pearson Education, Inc.
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
Chapter 9 21©2005 Pearson Education, Inc.
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
Chapter 9 22©2005 Pearson Education, Inc.
BA
The change in producersurplus will be
A - C - D. Producersmay be worse off.
C
D
Minimum Prices
Quantity
Price
S
D
P0
Q0Q3 Q2
Pmin
If producers produce Q2, the amount Q2 - Q3
will go unsold.
D measures total cost of increased
production not sold.
Chapter 9 23©2005 Pearson Education, Inc.
B
The deadweight lossis given by
triangles B and C.
C
A
L1 L2
Unemployment
wmin
Firms are not allowed topay less than wmin. This
results in unemployment.
S
D
w0
L0
The Minimum Wage
L
w
A is gain to workers who find jobs at
higher wage.
Chapter 9 24©2005 Pearson Education, Inc.
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
Chapter 9 25©2005 Pearson Education, Inc.
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
Chapter 9 26©2005 Pearson Education, Inc.
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
Chapter 9 27©2005 Pearson Education, Inc.
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 overallLess costly to simply give farmers the money
Chapter 9 28©2005 Pearson Education, Inc.
B
DA
To maintain a price Ps
the government buys quantity Qg .
D + Qg
Qg
Price Supports
Quantity
PriceS
D
P0
Q0
Ps
Q2Q1
E
Net Loss to society is E + B.
Chapter 9 29©2005 Pearson Education, Inc.
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
Chapter 9 30©2005 Pearson Education, Inc.
BA
•CS reduced by A + B•Change in PS = A - C•Deadweight loss = BC
C
Supply Restrictions
Quantity
Price
D
P0
Q0
S
S’
PS
Q1
•Supply restricted to Q1
•Supply shifts to S’ & Q1
Chapter 9 31©2005 Pearson Education, Inc.
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
Chapter 9 32©2005 Pearson Education, Inc.
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
Chapter 9 33©2005 Pearson Education, Inc.
QS QD
PW
AB C
Quota of zero pushes domestic price to P0 and
imports go to zero.
Import Tariff to Eliminate Imports
Quantity
Price
Q0
D
P0
S
In a free market, the domestic price equals the
world price PW.
Imports
Loss to consumers is A+B+C.
Gain to producers is A.Dead weight loss: B +C.
Chapter 9 34©2005 Pearson Education, Inc.
Import Tariff (General Case)
The increase in price can be achieved by a tariff
QS increases and QD decreases
Area A is the gain to domestic producers
The loss to consumers is A + B + C + D
DWL = B + C Government Revenue is D
= tariff * imports
DCB
QS QDQ’S Q’D
AP*
Pw
Q
P
D
S
Chapter 9 35©2005 Pearson Education, Inc.
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 ANet domestic loss is
B + C + D
DCB
QS QDQ’S Q’D
AP*
Pw
Q
P
D
S
Chapter 9 36©2005 Pearson Education, Inc.
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
Chapter 9 37©2005 Pearson Education, Inc.
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
Chapter 9 38©2005 Pearson Education, Inc.
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 This situation led 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
Chapter 9 39©2005 Pearson Education, Inc.
Sugar Quota in 1997
C
D
B
AThe cost of the quotas
to consumers was A + B + C + D = $2.4b.
The gain to producers was area A = $1b.
SUS DUSPrice(cents/lb.)
4
8
11
16
20
PW = 8.3 before quota
PUS = 21.5 after quota
Quantity(billions of pounds)24.21.4 17.4 20.4
Chapter 9 40©2005 Pearson Education, Inc.
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?
Chapter 9 41©2005 Pearson Education, Inc.
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
Chapter 9 42©2005 Pearson Education, Inc.
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
Chapter 9 43©2005 Pearson Education, Inc.
•Buyers lose A + B
Incidence of a Specific Tax
D
S
B
D
A
C
Quantity
Price
P0
Q0Q1
PS price producers get
Pb price buyers pay
Tax = $1.00 •Government gains A
+ D in tax revenue.
•Sellers lose D + C
•The deadweightloss is B + C.
Chapter 9 44©2005 Pearson Education, Inc.
Effect of an OutputTax on Industry Output
Price($ per
unit ofoutput)
Output
DD
P1
SS1
Q1
P2
Q2
SS2 = S1 + t
t
Tax shifts S1 to S2 andoutput falls to Q2. Price
increases to P2.
Chapter 9 45©2005 Pearson Education, Inc.
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
Chapter 9 46©2005 Pearson Education, Inc.
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
Chapter 9 47©2005 Pearson Education, Inc.
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
Impact of Elasticities on Tax Burdens
Quantity Quantity
Price Price
S
D S
D
Q0
P0 P0
Q0Q1
Pb
PS
t
Q1
Pb
PS
t
Burden on Buyer Burden on Seller
Chapter 9 49©2005 Pearson Education, Inc.
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
Chapter 9 50©2005 Pearson Education, Inc.
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 taxThe seller’s price exceeds the buyer’s
priceQuantity increases
Chapter 9 51©2005 Pearson Education, Inc.
D
S
Effects of a Subsidy
Quantity
Price
P0
Q0 Q1
PS
Pb
Like a tax, the benefitof a subsidy is split
between buyers and sellers, depending
upon the elasticities ofsupply and demand.
Subsidy
Chapter 9 52©2005 Pearson Education, Inc.
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 ED /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
Chapter 9 53©2005 Pearson Education, Inc.
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
Chapter 9 54©2005 Pearson Education, Inc.
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 = 0.4QS = 60 + 40P
QS = QD at $1 and 100 billion gallons per year (bg/yr)
Chapter 9 55©2005 Pearson Education, Inc.
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
Chapter 9 56©2005 Pearson Education, Inc.
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 28 cents per gallon
less Both producers and consumers were
opposed to the tax Government revenue would be significant at
$44.5 billion per year
Chapter 9 57©2005 Pearson Education, Inc.
CD
A
The Impact of a 50 Cent Gasoline Tax
Quantity (billiongallons per year)
Price($ pergallon)
50 150100
P0 = 1.00
Pb = 1.22
PS = .72
89
11
The buyer pays 22 cents of the tax, and
the producer pays 28 cents.
SD
60
$0.50 Tax
Consumer Loss = A + B
Producer Loss = C + D
Government revenue = A + D = 0.50(89) = $44.5 billion.
B
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