Ch 10: Competitive Markets: Applications

Often government intervene in markets,

even perfectly competitive markets, for a
variety of reasons

Equity (instead of efficiency)

Fixing Market Failures
Achieving Policy Goals
Politics

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 Sidenote: Partial Equilibrium Analysis
•In this chapter we’ll use
partial equilibrium analysis
 we’ll assume government intervention only
affects 1 market
•We will also assume no externalities exist – no
extra results will arise from these programs

2
 Chapter 10: Competitive Markets:
Applications
In this chapter we will cover:
10.1 Maximum Efficiency
10.2 Policy: Excise Tax
10.2.1 Tax Incidence
10.3 Policy: Subsidy
10.4 Policy: Price Ceiling
10.5 Policy: Price Floor
10.6 Policy: Production Quotas
10.7 Agricultural Support
10.8 Policy: Import Quotas and Tariffs
3
In 1776, Adam Smith’s An Inquiry into the Nature
and Causes of the Wealth of Nations
mentioned an “Invisible Hand” that guided
competitive markets to maximize efficiency.

Although no “Invisible Hand” actually exists,

perfectly competitive markets do maximize
producer and consumer surplus:
4
For any given good:

Consumer Surplus is difference between the

consumer’s willingness to pay and the price

Producer Surplus is the difference between the

price and the producer’s willingness to provide

Total Surplus is the difference between the

consumer’s willingness to pay and the
producer’s willingness to provide 5
For example:

Jacob is willing to pay $20 for essay editting, and

Beth is willing to edit essays for $10. The PC
market price for editting is $14.

Consumer Surplus =$20-$14= $6

Producer Surplus =$14-$10= $4
Total Surplus =$20-$10= $10

6
Consumer and Producer Surplus
P

A Consumer Surplus Supply

C
P* B

D
Producer Surplus Demand

Q1 Q* Q
7
Definition: An excise tax is an amount paid
by either the consumer or the producer per
unit of the good at the point of sale.

(The difference between the amount paid by

the demanders and the amount received by
the suppliers is the tax T.)

8
Example: Excise Tax
S+T
Q*=Original Q
P
S P*=Original P
Pd=Price Paid
T
by buyers
Pd Ps=Price
P* received by
Ps sellers
T(ax)=Pd-Ps
Demand
Q1 Q* Q

9
Consumer and Producer Surplus
P
Old S+T
A Consumer Surplus
S

C
P* B

D
Old Producer Surplus D

Q1 Q* Q
10
Consumer and Producer Surplus
P
New S+T
A Consumer Surplus
Government Income
S
Pd
C
P* B
Deadweight
Ps Loss
D
New Producer Surplus D

Q1 Q* Q
11
Originally, efficiency was maximized.

After the tax was imposed, portions of consumer

and producer surplus was transferred to the
government
-this transfer is still efficient
-WHO gets the surplus is irrelevant

After the tax, a small triangle of producer and

consumer surplus is lost – this triangle is the
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deadweight loss
Deadweight loss – reduction in net economic
benefit due to inefficient allocation of
resources

Taxes create inefficiencies!!

13
a) Calculate original equilibrium in the market
for oranges expressed as:
Qs=2P Qd=21-P
Qs=Qd Q*=2P*
2P=21-P Q*=2(7)
3P=21 Q*=14
P*=7

14
 b) Calculate Consumer and Producer
Surplus. Show Graphically.
P
CS = (1/2)bh
21 CS = (1/2)(14)(21-7)
Supply
CS = 98
Consumer PS = (1/2)bh
Surplus
7 Producer PS = (1/2)(14)(7)
PS = 49
Surplus
Demand

Q
14 15
c) If a $3 excise tax is imposed, calculate new
equilibrium.

Old: Qs=2P Qs=Qd Q*=21-P*

P=Qs/2 2P-6=21-P Q*=21-9
P=Qs/2+3 3P=27 Q*=12
New: Qs=2P-6 Pd=9
Ps = Pd-T
Ps = 9-3
Ps = 6 16
 d) Calculate new Consumer and Producer Surplus,
government revenue, and deadweight loss. Show
graphically
P CS = (1/2)bh
CS = (1/2)(12)(21-9)
21 CS = 72
S+T
CS PS = (1/2)bh
9
PS = (1/2)(12)(6)
S PS = 36
G DWL
D
6
PS
Q 17
12 14
 d) Calculate new Consumer and Producer Surplus,
government revenue, and deadweight loss. Show
graphically
P G = TQ
G = 3(12)
21 G = 36
S+T
CS DWL = (1/2)bh
9
DWL =
S (1/2)(14-12)(9-6)
G DWL DWL = 3
D
6
PS
Q 18
13 14
Notice that:

DWL = Old Surplus - New Surplus

DWL = CSPC+PSPC – [CSTax+PSTax+GTax]
DWL = 98 + 49 – [ 72 + 36 + 36 ]
DWL = 3

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Sales Tax Imposed on the Sellers
Effect is shown based
on supply curve S + tax

1100 S
$100 tax
1050
Price

Tax After Tax

revenue Market Price
1000

950
DA

3 4 5 6
20
Quantity (Big Screen TV’s per week)
Tax applied to buyer: Same Outcome

1100 S
D-tax
1050
Price

$100 tax
1000 Original Market Price

950
DA
3 4 5 6
21
Quantity (Big screen TV’s per week)
Summary:
• Taxes discourage/decrease market activity
• Tax incidence measures the effect of a tax
on buyers’ and sellers’ prices

•Tax burden falls most heavily on the

side of the market that is least elastic
in its response to a price change:

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The Sales Tax: Who Pays?
Demand Relatively Inelastic
S + tax

110 S
Price of Internet

108 $10 tax

105 Consumer
Price Rises
100 from $100
98 to $108
95
DA
3 4 5 6
23
Quantity (internet customers in 1000’s)
The Sales Tax: Who Pays? Demand
Relatively More Elastic.
S + tax
Consumer
110 S Price Rises
DA $10 tax from $100
Price of hiking shoes

105 to $103
103
100 Original Market Price

95
93

3 4 5 6
Quantity (daily shoe sales) 24
 The relationship between tax incidence and
elasticity is as follows:

Pd/Ps = /

where:  is the own-price elasticity of supply

 is the own-price elasticity of demand

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Example: Let  = -.5 and  = 2. What is the
relative incidence of a specific tax on consumers
and producers?

Pd/Ps = 2/-.5 = -4 OR Pd = -4Ps

interpretation: “consumers/demanders pay four

times as much as producers/suppliers. Hence, an
excise tax of $1 results in an increase in
consumer price of $.80 and a decrease in price
received by producers of $.20"
Next: Subsidies are negative taxes…
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•Subsidies work as a negative tax, increasing the
seller’s price by T (or reducing the buyer’s price
by T; outcomes are the same)
•Subsidies will:
•Encourage overproduction
•Increase Consumer Surplus
•Increase Producer Surplus
•Be a government cost
•Government Cost is always greater than the
gain in consumer and producer surplus 27
Subsidies
P
OLD S
A Consumer Surplus
Ps S-T
P*
B C
Pd

D
OLD Producer Surplus D

Q* Q1 Q
28
Subsidies
P
New S
A Consumer Surplus
Ps S-T
P*
B C
Pd

D
D

Q1 Q* Q
29
Subsidies
P S
A
Ps S-T
P*
B C
Pd

D
New Producer Surplus D

Q1 Q* Q
30
Subsidies
P S
A
Ps S-T
P*
B C
Pd Government Cost

D
D

Q1 Q* Q
31
Subsidies
P S
A
Ps S-T
P*
B C
Pd Deadweight Loss
(yellow triangle)
D
D

Q1 Q* Q
32
Definition: A price ceiling is a legal
maximum on the price per unit that a
producer can receive. If the price
ceiling is below the pre-control
competitive equilibrium price, then the
ceiling is called binding.

33
A price ceiling always has the following effects:
• Excess demand will exist
• The market will underproduce
• Producer surplus will decrease
• Some producer surplus is transferred to the
consumer
• Consumer surplus may increase or decrease
• There will be a deadweight loss

34
 Price Ceiling
P
Old
A Supply
Consumer Surplus

C
P* B
Price Ceiling

D
Old Demand
Producer Surplus
Q* Q
35
The impact of a price ceiling depends on
which consumer receive the available good.
We will examine the 2 extreme cases:

•Consumers with greatest willingness to pay

receive good (maximize consumer surplus)

•Consumers with least willingness to pay

receive good (minimize consumer surplus)
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Price Ceiling: Maximize Consumer Surplus
P
New
A Supply
Consumer Surplus
Deadweight Loss
C
P* B
Price Ceiling

D New
Excess
Qs Demand Producer Surplus
Demand
Qs Qd Q
37
Price Ceiling: Minimize Consumer Surplus
P

A Supply

New
C Consumer Surplus
P* B
Price Ceiling
Qs
D New
Excess Producer Surplus
Demand Demand
Qs Qd Q
38
Price Ceiling: Minimize Consumer Surplus
P
Supply

A Deadweight Loss=A-B
P*
B Price Ceiling
Qs

Excess
Demand Demand
Qs Qd Q
39
•It is generally assumed that the consumers
with the greatest willingness to pay receive
the good, but this does not always occur

•Price ceilings are only effective if resale

(black market) is prevented

•Price ceilings can also cause a reliance on

imports to meet excess demand
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Definition: A price floor is a legal
minimum on the price per unit that a
producer can receive. (ie: minimum
wage) If the price floor is above the
pre-control competitive equilibrium
price, then the floor is called binding.

41
A price floor always has the following effects:
• Excess supply will exist
• The market will underconsume
• Consumer surplus will decrease
• Some consumer surplus is transferred to the
producer
• Producer surplus may increase or decrease
• There will be a deadweight loss

42
 Price Floor
P (W)
Old
A Supply
Consumer Surplus
Price Floor
C (min. wage)
P* B

D
Old Demand
Producer Surplus
Q* Q (L)
43
The impact of a price floor depends on which
producer will sell the good (which worker
works). We will examine the 2 extreme
cases:

•Producers with greatest efficiency supply

good (maximize producer surplus)

•Producers with least efficiency supply good

(minimize producer surplus)
44
 Price Floor: Maximize Producer Surplus
P (W)
New
A Supply
Consumer Surplus
Price Floor
Ie: Min. Wage
C
P* B
Deadweight Loss

D New
Excess
Qd Supply Producer Surplus
Demand
Q (L)
Qs
45
 Price Floor: Minimize Producer Surplus
P
New
Supply
A Consumer Surplus
Price Floor
Ie: Min. Wage
C
P* B

Qs=Qd
D New
Excess
Supply
Producer Surplus
Demand
Qd Q
46
 Price Floor: Minimize Producer Surplus
P
Supply

Price Floor
Ie: Min. Wage
X
P*
Y Deadweight Loss=Y-X
Qs=Qd

Excess
Supply Demand
Qd Q
47
• The attempt of a union to increase wages has
two effects:

1)Some workers receive a higher wage

2)Some workers lose their jobs
• Note that there is a difference between
negotiating a higher wage (a union’s publicized
goal) and ensuring wages keep up with
inflation (often a union’s achieved goal)
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• In place of a price floor, the government can
instead impose a PRODUCTION QUOTA

• Production Quotas restrict the quantity

supplied of any good
• Ie: Taxi Cabs
• Ie: Bear hunting permits

49
Production Quotas have IDENTICAL effects to
price floors:

• There will be excess supply (some will want to

supply but be prevented)
• Quantity purchased will decrease
• Consumer surplus will decrease
• Some consumer surplus will transfer to
producers
• Producer surplus may increase or decrease
• There will be a deadweight loss 50
 Production Quota
Production Quota
P
Old
A Consumer Surplus Supply

P1
C
P* B

D
Old Demand
Producer Surplus
Q* Q
51
Production Quotas effect on producer surplus
depends on which producers are allowed to
produce (IDENTICAL TO price floors):

• Producers with lowest willingness to produce

(lowest costs – most efficient) – producer
surplus is maximized
• Producers with highest (valid) willingness to
produce (highest costs – most inefficient) –
producer surplus is minimized
52
Production Quota: Maximize Producer Surplus
P (W) Production Quota
New
A Consumer Surplus Supply

P1
C
P* B
Deadweight Loss

D New
Qd Producer Surplus
Demand
Qs Q (L)
53
 Production Quota: Minimize Producer
P Quota Surplus
New
A Consumer Surplus Supply

P1
C
P* B

Qs =Qd
D New
Producer Surplus
Demand
Qd Q
54
 Production Quota: Minimize Producer
P Surplus
Quota Supply

P1
X
P*
Y Deadweight Loss=Y-X
Qs =Qd

Demand
Qd Q
55
•Agriculture is one area often receiving
government support

•Often it is argued that farming is no longer a

viable profession at market-clearing wages

•The government can raise the price of

agricultural outputs through 2 policies:
•Acre Limitation Programs
•Government Purchase Programs 56
Since demand is downward sloping, prices can be
raised by reducing output.

However, supply and demand will force quantity

up and price down.

In order to keep quantity down and price up, the

government can pay farmers to reduce
production:
57
 Acreage Limitation
P
Old
A Consumer Surplus Supply

P1
C
P* B

D
Old Demand
Producer Surplus
Q
Production Limit
58
 Acreage Limitation
P
New
A Consumer Surplus Supply

P1
C
P* B

D
New Demand
Producer Surplus
Q
Production Limit
59
 Acreage Limitation
P
New
A Consumer Surplus Supply

P1

P* B
C Government
Cost

D
New Demand
Producer Surplus
Q
Production Limit
60
 Acreage Limitation
P
New
A Consumer Surplus Supply

P1

P* B
C Government
Cost
Deadweight
D Loss
New Demand
Producer Surplus
Q
Production Limit
61
Critics may criticize acreage limitation programs
as being wasteful – if the land is there, why
not use it?

Alternately, the government can purchase

agricultural output to keep prices high:

62
 Gov. Purchase Programs
Old
P Consumer Surplus
A Supply

P1
C
P* B

D Demand + Gov.
Old Demand
Purchases
Producer Surplus
Q
Q
1
Q* Q +G
1
63
 Gov. Purchase Programs
New
P Consumer Surplus Note: Change
Supply In Consumer
A
And Producer
P1 Surplus is
C Equal to Acre
P* B
Limitation

D Demand + Gov.
New Demand
Purchases
Producer Surplus
Q
Q
1
Q* Q +G
1
64
 Gov. Purchase Programs
New
P Consumer Surplus Note: Gov.
Supply Costs are
A
Greater
P1
C
P* B

Gov.
D Demand + Gov.
Cost Purchases
Demand

Q
Q
1
Q* Q +G
1
65
 Gov. Purchase Programs
New
P Consumer Surplus Note:
Supply Deadweight
A
Loss is
P1 Greater
C
P* B

D Demand + Gov.
Deadweight Purchases
Demand
Loss
Q
Q
1
Q* Q +G1
66
As seen previously, government purchase
programs have greater deadweight loss than
acreage limitation programs.
But acreage limitation programs also have
deadweight loss.
The most efficient program is to simply give the
farmers money. (No deadweight loss)

Often however, politics overrules economics.

67
•Often foreign countries can produce a good
cheaper than domestic industries
Pw<P*

•In order to protect domestic industries,

governments often impose import quotas or
tariffs

•These policies cause deadweight loss

68
 Free Trade
Old
P Consumer Surplus At world prices,
only a small
Supply
amount of
domestic
industry can
P* survive

PW
Old Domestic Demand
Producer Surplus
Q
QDom
69
 Trade Prohibition (Zero Imports)
New
P
Consumer Surplus
Supply

Deadweight
P*
Loss
PW
New Domestic Demand
Producer Surplus
Q
QDom
70
 Import Quota
New
P
Consumer Surplus
Supply

Deadweight
P*
Pq
Loss
PW
New Domestic Demand
Producer Surplus
Q
QDom QDom+Quota 71
 Import Tarrif (t)
New
P
Consumer Surplus
Deadweight Supply
Loss
Government
P* Revenue
PW+t
PW
New Domestic Demand
Producer Surplus
Q
QDom QDom+Quota 72
•The greater the import quota, the smaller the
benefit to domestic industries and the smaller the
deadweight loss

•Import tariffs are better for the domestic

economy as government revenue decreases
deadweight loss
•This increased government revenue is
equal to foreign producer surplus under a
quota; worldwide surplus is simply 73
transferred
•Under normal perfectly competitive conditions,
any government intervention will cause
DEADWEIGHT LOSS

•The most efficient manner of government

intervention is lump sum payments to the
segment of society is desires to aid

•This however, is politically undesirable – Why

should one segment of society get something74for
free?
 Chapter 10 Summary
Under Perfect Competition, efficiency is
maximized
All government intervention in Perfect
Competition cause deadweight loss
Lump-sum cash transfers have the least
distortion, but are unpopular
Whenever government intervenes, it must
be asked if

Benefit > Deadweight Loss

75