Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Chapter 9

The analysis of
competitive markets

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Topics

„ The efficiency of a competitive market

„ Price controls: minimum and maximum prices

„ Price supports and production quotas

„ The impact of a tax or subsidy

„ Import quotas and tariffs

„ Export quotas and tariffs

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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

The efficiency of a competitive market

price Consumer
surplus S

A CS =A

P
PS = B
B NW = A + B

Producer surplus D

0
Q Quantity
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Price controls: Maximum price

P

* Objective: to protect consumer

welfare S
DWL
•* Create shortage
•* Need a non-price distribution A B
mechanism.
P0
•* Host of misconducts C D
•* Total social welfare falls Pmax
∆CS = C-B Shortage D
∆PS = -C-D
Q1 Q0 Q2 Q
∆NW (DWL) = -B-D
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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Effect of price controls when

demand is inelastic

D
P
∆CS = C - B S

A
B

P0 if demand is sufficiently
C D inelastic, triangle B can
Pmax be larger than rectangle
C. In this case,
consumers suffer a net
loss from price controls

Q0 Q
Q1
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Price controls: Minimum price

When price is regulated to
P be no lower than Pmin only
Q2 will be demanded, DWL
are triangles B and D S

Pmin
A B

P0 What is DWL if QS = Q3 ?
D
C

Q2 Q0 Q3 Q

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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Minimum price
If producer produces at Q3, the amount Q3
P
– Q2 will go unsold
S

Pmin Change in producer

surplus will be A - D -
A
P0
B E. Producers welfare
D can be lower.
C DWL = B,D and E
E

D
Q2 Q0 Q3 Q

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The minimum wage

Firms cannot pay wages lower than wmin. or they
w will increase unemployment.
S

wmin
A
w0
B DWL are triangles B and D.
D
C

Unemployment
D
L1 L0 L2 L

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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Price supports and production quotas

„ Much of agricultural policy is based on a

system of price supports.
„ Price set by government above free-market
level and maintained by governmental
purchases of excess supply.

„ This policy can go hand in hand with

restriction of production.
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Price supports
S
P
Qg
To maintain price Ps
government buys
Ps
D quantity Qg = Q2 – Q1
A
B ∆CS = - A – B
P0
∆PS = A + B + D

D + Qg

Q1 Q0 Q2 Q
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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Price supports

P S
Qg

Ps Cost to the government is

D
A rectangle = PS (Q2 - Q1)
B
P0

DWL
D + Qg

Q1 Q0 Q2 Q
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Price supports

„ Is there an efficient way that can

increase farmers incomes equal to A + B
+ D?

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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Production quotas
S’
•Supply is restricted to Q1
•Supply curve shifts to S’ = Q1
P
S

PS
D
A
B
P0 • ∆CS = - A - B
C • ∆ PS = A - C
• DWL = - B - C

Q1 Q0 Q
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Production quotas
•PS is regulated plus financial
incentive
P •Cost to the government = B + C + D
S’

„ ∆PS = A - C + B + C + D S
= A + B + D. PS
A D
B
„ ∆CS = -A -B P0
C
„ ∆G =-B -C-D
D
„ DWL = - B - C
Q1 Q0 Q

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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Production quotas

P S’
„ Question:
„ What policy the S
government can apply PS
in order to cut cost D
A
and support farmers? B
„ Which policy is more P0
C
expensive: subsidy or
acreage limitation?
D

Q1 Q0 Q

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The impact of a tax or subsidy

„ When government levies indirect tax on
producers, who will bear the tax?
„ When government taxes consumers, who will
bear the tax?
„ When government gives subsidy to producers
based on production output, who will benefit?
„ When government gives subsidy to consumers
based on quantity of specific goods consumed,
who will benefit?
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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

The impact of a tax or subsidy

„ Tax burden (or benefit of subsidy) is

shared between consumers and producers.

„ We look at a specific tax called unit tax.

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Effects of unit tax

P

* Output falls S

* Demand price
PD1
increases A
B
P0
* Supply price falls C t D

∆CS = - A – B PS1

∆PS = -C – D
D
∆G = A + C
Q
Q1 Q0
DWL = -B -D
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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Effect of tax depends on elasticities

of supply and demand
P D P S
Tax burden falls on
PD1 buyers

S
t PD1
P0 P0
PS1
t
D

PS1 Tax burden falls

on sellers

Q1 Q0 Q Q1 Q0 Q
12.10.2005 Ñaëng Vaên Thanh 19

Subsidy
Like tax, benefits of subsidy are shared
between sellers and buyers depending on
elasticities of supply and demand.
* Output increases P S
* Demand price falls
PS1
* Supply price A B
P0 s
increases C
E
D
∆CS = C + D PD1

∆PS = A + B
D
∆G = -A -B - C -D -E
Q
DWL = -E Q0 Q1
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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Benefits of free-import policy

P
S
* Domestic price falls
* Quantity demanded
increases P0
A
* Quantity supplied B C
PW
falls
∆CS = A + B + C D
∆PS = - A QIM
Q
QS Q0 QD
∆NW = B + C
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Import quotas and tariffs

„ Objective:
„ Protect domestic industries

„ Economic tools to promote or restrict

production and consumption

„ Create revenue

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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Import tariffs
P S

„ Area A is benefit to
domestic producers.
PW (1+ t)
A D
„ Consumer lost areas PW
B C

A + B + C + D.
D
Q
QS QS1 QD1 QD

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Import quotas

„ If the government P S S+quota

imposes a tariff, it will
gain D, thus net
domestic loss is B + C.
Pq
„ If a quota is used, A D
B C
rectangle D becomes PW
part of the profits of
importers, and net
domestic loss is B + C D
Q
QS QS1 QD1 QD

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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Import quotas vs. tariffs

„ Similarity:
„ Main objective: to protect domestic producers.
„ Both have effects that:
„ increase domestic price.
„ increase domestic quantity supplied.
„ reduce domestic quantity demanded.
„ reduce imports.

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Import quotas vs. tariffs

„ Differences:
Quota Tax
Volume and foreign Know Not know
exchange for import

Beneficiary beside Quota holders Government budget

producers

Increase in Domestic Domestic prices increases, Domestic prices

demand local producers benefit unchanged, local
producers not benefit
Change in world Unchanged Domestic prices Changed Domestic prices
price

Domestic monopoly Monopolistic power No monopolistic power

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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Benefits of free-export policy

QEX S
* Domestic price
increases PW
C
A B
* Quantity demanded P0
falls
* Quantity supplied
increases
D
∆CS = -A - B
∆PS = + A+B + C Q
QD Q0 QS
=+C
∆NW12.10.2005 Ñaëng Vaên Thanh 27

Export tax
P
(S)

PW (DT)
c e
a b d
∆CS = + a + b (DT) with tax
„
PW(1 -t)
„ ∆PS = - a - b - c - d - e
„ ∆G = d
„ DWL = - c - e
(D)

QD0 QD1 Q S1 Q S0 Q

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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Export quotas

P
(S)

PW (DT)
c e
a d
b
Pq

„ ∆CS = + a + b
(D) +quota
„ ∆PS = -a - b - c - d - e
„ Quota holders = d (D)
„ DWL = - c - e
QD0 QD1 Q S1 Q S0 Q

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Export quotas vs. Export tax

„ Similarity:
Both have impact to:
„ reduce domestic price.
„ reduce domestic quantity supplied.
„ increase domestic quantity
demanded.
„ reduce volume of exports.

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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Import quotas vs. tariffs

„ Differences: Quota Tax

Volume and foreign Know exactly Not sure
exchange for export

Beneficiary beside Quota holders Government budget

consumer

Increase in Domestic Domestic prices increases, Domestic prices

demand local producers benefit unchanged, local
producers not benefit
Change in world Unchanged Domestic prices Changed Domestic prices
price

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Summary
„ Simple demand and supply models can be
used to analyze different government
policies.

„ In each case, consumer and producer

surplus are used to evaluate losses and
gains to consumers and producers.

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Fulbright Economics Teaching Program, 2005-2006 Microeconomics - Lecture 10

Summary
„ When government imposes a tax or
subsidy, price usually does not rise or fall
by the full amount of the tax or subsidy.
„ Government intervention generally leads
to a deadweight loss (DWL).
„ Government intervention in a competitive
market is not always bad.

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End of chapter 9
The analysis of
competitive markets

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