Applying the Competitive Model

Perloff Chapter 9

Consumer Welfare

• Measure how much consumers are affected by shocks which affect the equilibrium.

• Marginal Willingness to Pay– The maximum amount a consumer will pay for

an extra unit.

• The monetary difference between what a consumer is willing to pay and what the good actually costs.

Consumer Surplus5

4

3

2

1

543210

CS2 = $1CS1 = $2

E1 = $3 E2 = $3 E3 = $3

Price = $3

a

b

c

q, Magazines per week

p, $ per magazine

Demand

Consumer Surplus with Continuous Demand

p1

p, $ pertrading card

q1 q, Trading cards per year

DemandExpenditure, E

Consumersurplus, CS

Marginal willingness topay for the last unit of output

Aggregate consumer surplus and the effect of a price change

¢ per stem

Q, Billion rose stems per year

57.8

3230

1.160 1.25

b

a

A = $149.64 million

B = $23.2 million

C = $0.9 million

Demand

Influenced by:• Position of the demand curve (revenue)• Elasticity of demand

Producer Welfare

• Difference between the amount that a good sells for and the minimum they have to be paid to produce (avoidable cost).

• VC: costs that change as output changes.

• MC: change in cost when output changes by one unit.

• VCn=MC1+MC2+ … +MCn

Producer Surplus4

3

2

1

43210

PS 2 = $2 PS 3 = $1PS1 = $3

MC2 = $2 MC3 = $3 MC4 = $4MC1 = $1

p

Supply

q, Units per week

p, $ per unit

Producer Surplus in the Market

p*

p, Price per unit

Q*

Market supply curve

Q, Units per year

Market price

Variable cost, VC

Producer surplus, PS

Producer surplus and profit

• Producer surplus is revenue minus variable costs.• In the long run:

– all costs are variable– profit is zero– producer surplus is zero– Long run supply curve is horizontal

• In an increasing cost industry fixed factors earn a return equal to their opportunity cost, rent.– Producer surplus is rent in the long run.

Competition maximises welfare

• How should we measure societies welfare?– W = CS + PS– Weights both producers and consumers equally

• If output is either more or less than the competitive equilibrium, welfare is reduced.

The effect of reducing output on welfare

p, $ per unit

Q, Units per year

Supply

Demand

p 2

MC 1 = p1

Q 2 Q1

e1

MC 2

e 2

CE

B

D

A

F

Explanation

• At competitive equilibrium P = MC• Consumers are prepared to pay (value) the last

unit produced at exactly what it costs to produce.• P > MC consumers increase in satisfaction

outweighs producers reduction as output expands.• P < MC consumers reduction in satisfaction

folowing a reduction in output is less than producers increase.

Effect of a restriction on the number of taxis

p, $ per ride

q 2q1

q, Rides per month

E1

D

S1

S2

E 2

B

A

C

AC 2

AC 1 MC

e 2

e1

p 2

p1

p 2

p1

p, $ per ride

n2q 1 Q2 = n2q 2 Q1 = n1 1

Q, Rides per month

q

Accounting for the effects of a tax

• Prices to consumers and producers change. PS and CS change.

• Government raises tax revenues which is spent to raise peoples welfare.

• W = PS + CS +T

Effects of a tax p, ¢ per stem

Q, Billion rose stems per year

21

0

= 11

1.16 1.25

e1e2

D

Supply

Demand

C

E

BA

F

3230

Effects of a price floorp, $ per bushel

Qd = 1.9 Q1 = 2.1

G

D

Qs = 2.20

Q, Billion bushels of soybeans per yearQg

= 0.3

p1 = 4.59

3.60

Supply

Demand

Price support

e

F

B

MC

A

C

E

p = 5.00

Trade Policies (imports)

• Allow free trade (domestic price is the world price).

• Ban all imports.

• Set a non-zero import quota.

• Set a tariff on imported goods.

Free trade versus an import banp, 1988 dollars

per barrel

9.0 10.28.2 11.8 13.1

Q, Million barrels of oil per day

Imports = 4.9

14.70

0

29.04

S a = S2

S1, World price

e 2

e1

D

B

A

C

Demand

Tariff or quota versus import banp, 1988 dollars

per barrel

9.08.2 11.8 13.1

Q, Million barrels of oil per day

Imports = 2.8

0

14.70

19.70

29.04

Sa =S2

S3

Demand

S1, World price

e2

e3

e1 = 5.00

FG H

B

A

C ED