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Chapter 9

The Analysis of

CompetitiveMarkets

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Chapter 9 Slide 2

Topics to be Discussed

Evaluating the Gains and Losses fromGovernment Policies--Consumer and

Producer Surplus The Efficiency of a Competitive Market

Minimum Prices

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Chapter 9 Slide 3

Topics to be Discussed

Price Supports and Production Quotas

Import Quotas and Tariffs

The Impact of a Tax or Subsidy

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Chapter 9 Slide 4

Evaluating the Gains and Losses fromGovernment Policies--Consumer and Producer Surplus

Review

Consumer surplusis the total benefit or

value that consumers receive beyond whatthey pay for the good.

Producer surplusis the total benefit orrevenue that producers receive beyond

what it cost to produce a good.

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ProducerSurplusBetween 0 and Q0producers receive

a net gain fromselling each product--

producer surplus.

ConsumerSurplus

Consumer and Producer Surplus

Quantity0

Price

S

D

5

Q0

Consumer C

10

7

Consumer BConsumer A

Between 0 and Q0consumers A and B

receive a net gain frombuying the product--consumer surplus

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Chapter 9 Slide 6

To determine the welfare effectof agovernmental policy we can measure

the gain or loss in consumer andproducer surplus.

Welfare Effects

Gains and losses caused by governmentintervention in the market.

Evaluating the Gains and Losses fromGovernment Policies--Consumer and Producer Surplus

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The loss to producers isthe sum of rectangle

A and triangle C. TriangleB and Ctogether measure

the deadweight loss.

B

A C

The gain to consumers isthe difference betweenthe rectangle A and the

triangle B.

Deadweight Loss

Change in Consumer andProducer Surplus from Price Controls

Quantity

Price

S

D

P0

Q0

Pmax

Q1 Q2

Suppose the governmentimposes a price ceiling Pmaxwhich is below the

market-clearing price P0.

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Observations:

The total loss is equal to area B + C.

The total change in surplus =

(A - B) + (-A - C) = -B - C

The deadweight lossis the inefficiency of

the price controls or the loss of theproducer surplus exceeds the gain fromconsumer surplus.


8/10/2019 chap9-ev


Observation

Consumers can experience a net loss in

consumer surplus when the demand issufficiently inelastic


8/10/2019 chap9-ev


B

APmax

C

Q1

If demand is sufficiently

inelastic, triangle Bcanbe larger than rectangleA and the consumer

suffers a net loss fromprice controls.

ExampleOil price controls

and gasoline shortagesin 1979

S

D

Effect of Price ControlsWhen Demand Is Inelastic

Quantity

Price

P0

Q2

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Price Controls andNatural Gas Shortages

1975 Price controls created a shortageof natural gas.

What was the deadweight loss?

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Chapter 9 Slide 12

Supply: QS= 14 + 2PG+ 0.25PO

Quantity supplied in trillion cubic feet (Tcf)

Demand: QD= -5PG+ 3.75PO

Quantity demanded (Tcf)

PG = price of natural gas in $/mcf andPO= price of oil in $/b.


Data for 1975

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Chapter 9 Slide 13

PO= $8/b

Equilibrium PG= $2/mcf andQ = 20 Tcf

Price ceiling set at $1

This information can be seengraphically:


Data for 1975

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Chapter 9 Slide 14

B

A

2.40

C

The gain to consumers isrectangle A minus triangle

B, and the loss toproducers is rectangle

A plus triangle C.

SD

2.00

Quantity (Tcf)0

Price($/mcf)

5 10 15 20 25 3018

(Pmax

)1.00


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Chapter 9 Slide 15

Measuring the Impact of Price Controls 1 Tcf = 1 billion mcf

If QD= 18, then P = $2.40

[18 = -5PG+ 3.75(8)]

A = (18 billion mcf) x ($1/mcf) = $18 billion

B =(1/2) x (2 b. mcf) x ($0.40/mcf) = $0.4 billion C= (1/2) x (2 b. mcf) x ($1/mcf) = $1 billion


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Chapter 9 Slide 16

Measuring the Impact of Price Controls

1975

Change in consumer surplus =A - B= 18 - 0.04 = $17.6 billion

Change in producer surplus

= -A - C = -18-1 = -$19.0 billion


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Chapter 9 Slide 17

Measuring the Impact of Price Controls

1975 dollars, deadweight loss

= -B - C = -0.4 - 1 = -$1.4 billion In 2000 dollars, the deadweight loss is

more than $4 billion per year.


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Chapter 9 Slide 18

The Efficiency ofa Competitive Market

When do competitive markets generatean inefficient allocation of resources ormarket failure?

1) Externalities

Costs or benefits that do not show up as

part of the market price (e.g. pollution)

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Chapter 9 Slide 19


When do competitive markets generatean inefficient allocation of resources ormarket failure?

2) Lack of Information

Imperfect information preventsconsumers from making utility-maximizing decisions.

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Chapter 9 Slide 20

Government intervention in thesemarkets can increase efficiency.

Government intervention without amarket failure creates inefficiency ordeadweight loss.


W lf L Wh P i

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Chapter 9 Slide 21

P1

Q1

A

B

C

When price isregulated to be nohigher than P1, the

deadweight loss given bytriangles B and C results.

Welfare Loss When PriceIs Held Below Market-Clearing Level

Quantity

Price

S

D

P0

Q0

W lf L Wh P i

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Chapter 9 Slide 22

P2

Q3

A B

C

Q2

What would the deadweightloss be if QS= Q2?

When price isregulated to be no

lower than P2only Q3will be demanded. The

deadweight loss is givenby triangles B and C

Welfare Loss When PriceIs Held Above Market-Clearing Level

Quantity

Price

S

D

P0

Q0

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Chapter 9 Slide 23

The Market for Human Kidneys

The 1984 National OrganTransplantation Act prohibits the sale oforgans for transplantation.

Analyzing the Impact of the Act

Supply: QS= 8,000 + 0.2P

If P= $20,000, Q = 12,000

Demand: QD= 16,000 - 0.2P

Th M k t f Kid d Eff t

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Chapter 9 Slide 24

D

Rectangles A and D

measure the total valueof kidneys when

supply is constrained.A

C

The loss to suppliers

is given by rectangle Aand triangle C.

The Market for Kidneys, and Effectsof the 1984 Organ Transplantation Act

Quantity

Price

8,0004,0000

$10,000

$30,000

$40,000

SThe 1984 act effectivelymakes the price zero.

BIf consumers received

kidneys at no cost, theirgain would be given by

rectangle A less triangle B.

S

D

12,000

$20,000

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Chapter 9 Slide 25

The act limits the quantity supplied(donations) to 8,000.

Loss to supplier surplus:

A + C =

(8,000)($20,000) + (1/2)(4,000)($20,000) =$200/m.


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Chapter 9 Slide 26

Gain to recipients:

A - B =

(8,000)($20,000) - (1/2)(4,000)($20,000) =$120/m.

Deadweight loss:

B + C or

$200 million - $120 million = $80 million


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Chapter 9 Slide 27

Other Inefficiency Cost

1) Allocation is not necessarily to those

who value the kidneys the most.

2) Price may increase to $40,000, the

equilibrium price, with hospitalsgetting the price.


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Chapter 9 Slide 28

Arguments in favor of prohibiting thesale of organs:

1) Imperfect information about donorshealth and screening


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Chapter 9 Slide 29

Arguments in favor of prohibiting thesale of organs:

2) Unfair to allocate according to theability to pay

Holding price below equilibrium will

create shortagesOrgans versus artificial substitutes


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Chapter 9 Slide 30

Minimum Prices

Periodically government policy seeks toraise prices above market-clearinglevels.

We will investigate this by looking at aprice floor and the minimum wage.

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Chapter 9 Slide 31

BA

The change in producer

surplus will beA - C - D. Producers

may be worse off.

C

D

Price Minimum

Quantity

Price

S

D

P0

Q0

Pmin

Q3 Q2

If producers produceQ2, the amount Q2 - Q3

will go unsold.

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Chapter 9 Slide 32

B The deadweight lossis given by

triangles B and C.C

A

wmin

L 1 L 2

Unemployment

Firms are not allowed topay less than wmin. This

results in unemployment.

S

D

w0

L 0

The Minimum Wage

L

w

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Chapter 9 Slide 33

Airline Regulation

During 1976-1981 the airline industry inthe U.S. changed dramatically.

Deregulation lead to major changes inthe industry.

Some airlines merged or went out ofbusiness as new airlines entered theindustry.

Effect of Airline Regulation

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Chapter 9 Slide 34

B

A

C After deregulation:Prices fell to PO. Thechange in consumer

surplus is A + B.

Q3

D

Area Dis the costof unsold output.

Effect of Airline Regulationby the Civil Aeronautics Board

Quantity

Price S

D

P0

Q0Q1

Pmin

Q2

Prior to deregulationprice was at PminandQD= Q1 and Qs= Q2.

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Airline Industry Data

Number of carriers 33 72 86 60 86 96

Passenger load factor(%) 54 59 61 62 67 69

Passenger-mile rate(constant 1995 dollars) .218 .210 .166 .150 .129 .126

Real cost index (1995=100) 101 122 111 107 100 99

Real cost index corrected

for fuel cost increases 94 98 98 100 100 98

1975 1980 1985 1990 1995 1996

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Chapter 9 Slide 36


Airline industry data show:

1) Long-run adjustment as the number

of carriers increased and pricesdecreased

2) Higher load factors indicating moreefficiency

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Chapter 9 Slide 37


Airline industry data show:

3) Falling rates

4) Real cost increased slightly(adjusted fuel cost)

5) Large welfare gain

Price Supports and

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Chapter 9 Slide 38

Price Supports andProduction Quotas

Much of agricultural policy is based on asystem of price supports.

This is support price is set above theequilibrium price and the government buysthe surplus.

This is often combined with incentivesto reduce or restrict production

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Chapter 9 Slide 39

B

DA

To maintain a price Psthe government buys

quantity Qg . The change in

consumer surplus = -A - B,and the change in producer

surplus is A + B + D

D + Qg

Qg

Price Supports

Quantity

Price

S

D

P0

Q0

Ps

Q2Q1

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Chapter 9 Slide 40

D + Qg

Qg

BA

Price Supports

Quantity

Price

S

D

P0

Q0

Ps

Q2Q1

The cost to thegovernment is the

speckled rectanglePs(Q2-Q1)

D

TotalWelfare

Loss

Total welfare loss

D-(Q2-Q1)ps

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Chapter 9 Slide 41

Price Supports

Question:

Is there a more efficient way to increasefarmers income byA + B + D?

Price Supports and

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Chapter 9 Slide 42

Production Quotas

The government can also cause the price of

a good to rise by reducing supply.


Price Supports and

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Chapter 9 Slide 43

What is the impact of:

1) Controlling entry into the taxicab

market?

2) Controlling the number of liquor

licenses?


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Chapter 9 Slide 44

B

A

CS reduced by A + BChange in PS = A - CDeadweight loss = BC

C

D

Supply Restrictions

Quantity

Price

D

P0

Q0

S

PS

S

Q1

Supply restricted to Q1Supply shifts to S @ Q1

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Chapter 9 Slide 45

B

A

C

D

Supply Restrictions

Quantity

Price

D

P0

Q0

S

PS

S

Q1

Psis maintained withand incentive

Cost to government = B + C + D

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Chapter 9 Slide 46

Supply Restrictions

BA

Quantity

Price

D

P0

Q0

PS

S

S

D

C

=A - C + B +C + D = A + B + D.

The change inconsumer andproducer surplus isthe same as withprice supports.

= -A - B +A + B + D - B - C -

D = -B - C.

PS

welfare

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Chapter 9 Slide 47

Supply Restrictions

Questions:

How could thegovernment reduce

the cost and stillsubsidize the farmer?

Which is more costly:supports or acreage

limitations?

BA

Quantity

Price

D

P0

Q0

PS

S

S

D

C

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Chapter 9 Slide 48

Supporting the Price of Wheat

1981

Supply: Qs= 1,800 + 240P

Demand: QD= 3,550 - 266P Equilibrium price and quantity was $3.46

and 2,630 million bushels

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Chapter 9 Slide 49


1981

Price support was set at $3.70

QD + QG= QDT = 3,440 -266P+ QG

QS = QD

1,800 + 240P= 3,550 - 266P + QG

QG = 506P -1,750

QG= (506)(3.70) -175=122 millionbushels

Th Wh t M k t i 1981

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Chapter 9 Slide 50

D + Qg

By buying 122million bushels

the governmentincreased themarket-clearing

price.

P0 = $3.70

2,566 2,688

A B C

Qg

AB consumer lossABC producer gain

S

D

P0 = $3.46

2,6301,800

The Wheat Market in 1981

Quantity

Price

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Chapter 9 Slide 51


1981

The change in consumer surplus = (-A -B)

A =(3.70 - 3.46)(2,566) = $616 millionB= (1/2)(3.70-3.46)(2,630-2,566) = $8

million

Change in consumer surplus: -$624million.

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Chapter 9 Slide 52


1981

Cost to the government:

$3.70 x 122 million bushels = $452 million Total cost = $624 + 452 = $1,076 million

Total gain =A + B + C =$638 million

Government also paid 30 cents/bushel =$806 million

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Chapter 9 Slide 53


In 1985, export demand fell and themarket clearing price of wheat fell to$1.80/bushel.

S f

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Chapter 9 Slide 54


1985 Supply: QS = 1,800 + 240P

1986 Demand: QD= 2580 - 194P

QS = QDat $1.80 and 2,232 million bushels

PS= $3.20

To maintain $3.20/bushel a productionquota of 2,425 bushels was imposed

S i h P i f Wh

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Chapter 9 Slide 55


1985

Government Purchase:

2,425 = 2,580 - 194P + QGQG= -155 + 194P

P= $3.20 -- the support price

QG = -155 + 194($3.20) = 466 millionbushels

Th Wh t M k t i 1985

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Chapter 9 Slide 56

The Wheat Market in 1985

Quantity

Price

1,800

S

D

P0 = $1.80

2,232

To increase theprice to $3.20, the

government bought466 million bushels

and imposeda production quotaof 2,425 bushels.

D + QS

S

P0 = $3.20

1,959 2,425

QS

S ti th P i f Wh t

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Chapter 9 Slide 57


1985

Government Purchase:

Government cost = $3.20 x 466 =$1,491million

80 cent subsidy = .80 x 2,425 = $1,940million

Total cost = $3.5 billion

S ti th P i f Wh t

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Chapter 9 Slide 58


Question:

What is the change in consumer andproducer surplus?

S ti th P i f Wh t

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Chapter 9 Slide 59


1996 Freedom to Farm

Reduces price supports and quotas until2003 when they go back into effect underthe 1996 law.

S ti th P i f Wh t

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Chapter 9 Slide 60


1998 Wheat Market

P = $2.65

QD= 3244 - 283P

QS = 1944 + 207P

Q = 2493

Government subsidy of .66/bushel or $1.6billion

I t Q t d T iff

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Chapter 9 Slide 61

Import Quotas and Tariffs

Many countries use import quotas andtariffs to keep the domestic price of aproduct above world levels

Import Tariff or Quota

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Chapter 9 Slide 62

QS QD

PW

Imports

AB C

By eliminating imports,

the price is increased toPO. The gain is area A.The

loss to consumers A + B + C,so the deadweight loss

is B + C.

pThat Eliminates Imports

Quantity

Price

How high woulda tariff have

to be to get thesame result?

D

P0

Q0

S

In a free market, thedomestic price equals the

world price PW.

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Chapter 9 Slide 64

(general case)

If a tariff is used thegovernment gains D, sothe net domestic productloss is B + C.

If a quota is used instead,rectangle Dbecomes partof the profits of foreignproducers, and the netdomestic loss is B + C + D.

DCB

QS QDQS QD

A

P*

Pw

Quantity

D

SPrice


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Chapter 9 Slide 65

Question:

Would the U.S. bebetter off or worse offwith a quota instead of

a tariff? (e.g. Japaneseimport restrictions inthe 1980s)

(general case)

DCB

QS QDQS QD

A

P*

Pw

Quantity

D

SPrice

The Sugar Quota

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Chapter 9 Slide 66

The Sugar Quota

The world price of sugar has been aslow as 4 cents per pound, while in theU.S. the price has been 20-25 cents per

pound.

The Sugar Quota

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Chapter 9 Slide 67

The Sugar Quota

The Impact of a Restricted Market(1997)

U.S. production = 15.6 billion pounds

U.S. consumption = 21.1 billion pounds

U.S. price = 22 cents/pound

World price = 11 cents/pound

The Sugar Quota

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Chapter 9 Slide 68

The Sugar Quota

The Impact of a Restricted Market

U.S. ES= 1.54

U.S. ED= -0.3 U.S. supply: QS= -7.83+ 1.07P

U.S. demand: QD= 27.45 - 0.29P

P = .23 and Q= 13.7 billion pounds

Sugar Quota in 1997

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C

D

B

QS = 4.0 QS = 15.6 Qd = 21.1

Qd = 24.2

A

The cost of the quotasto consumers was

A + B + C + D, or $2.4b.The gain to producers

was area A, or $1b.

Sugar Quota in 1997

Quantity

(billions of pounds)

Price(cents/lb.)

SUS DUS

5 10 15 20 250

4

8

11

16

20

PW = 11

PUS = 21.9

30

Sugar Quota in 1997

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C

D

B

QS = 4.0 QS = 15.6 Qd = 21.1

Qd = 24.2

A

Sugar Quota in 1997

Quantity

(billions of pounds)

Price(cents/lb.)

SUS DUS

5 10 15 20 250

4

8

11

16

20

PW = 11

PUS = 21.9

30

Rectangle Dwas thegain to foreign producers

who obtained quotaallotments, or $600 million.

Triangles B and Crepresentthe deadweight loss of

$800 million.


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Chapter 9 Slide 71


The burden of a tax (or the benefit of asubsidy) falls partly on the consumerand partly on the producer.

We will consider a specific taxwhich isa tax of a certain amount of moneyper

unit sold.

Incidence of a SpecificTax

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Chapter 9 Slide 72

D

S

B

D

ABuyers lose A + B, andsellers lose D + C, and

the government earns A + Din revenue. The deadweight

loss is B + C.

C

Incidence of a SpecificTax

Quantity

Price

P0

Q0Q1

PS

Pb

t

Pbis the price (including

the tax) paid by buyers.PSis the price sellers receive,

net of the tax. The burdenof the tax is split evenly.

Incidence of a Specific Tax

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Chapter 9 Slide 73


Four conditions that must be satisfiedafter the tax is in place:

1) Quantity sold and Pbmust be on thedemand line: QD= QD(Pb)

2) Quantity sold and PSmust be on thesupply line: QS= QS(PS)


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Chapter 9 Slide 74


Four conditions that must be satisfiedafter the tax is in place:

3) QD=QS

4) Pb - PS = tax

Impact of a Tax DependsEl ti iti f S l d D d

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on Elasticities of Supply and Demand

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


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Chapter 9 Slide 76

Pass-through fraction

ES/(ES - Ed)

For example, when demand is perfectlyinelastic (Ed= 0), the pass-through fractionis 1, and all the tax is borne by theconsumer.


The Effects of a Tax or Subsidy

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Chapter 9 Slide 77

The Effects of a Tax or Subsidy

A subsidy can be analyzed in much thesame way as a tax.

It can be treated as a negative tax.

The sellers price exceeds the buyers

price.

Subsidy

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Chapter 9 Slide 78

D

S

Subsidy

Quantity

Price

P0

Q0 Q1

PS

Pb

s

Like a tax, the benefitof a subsidy is split

between buyers andsellers, depending

upon the elasticities ofsupply and demand.

Subsidy

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Chapter 9 Slide 79

Subsidy

With a subsidy (s), the selling price Pbisbelow the subsidized price PSso that:

s = PS - Pb

Subsidy

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Chapter 9 Slide 80

Subsidy

The benefit of the subsidy dependsupon Ed/ES.

If the ratio is small, most of the benefit

accrues to the consumer. If the ratio is large, the producer benefits

most.

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A Tax on Gasoline

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Chapter 9 Slide 82

A Tax on Gasoline

With a 50 cent tax

QD=150 - 50Pb= 60 + 40PS = QS

150 - 50(PS+ .50) = 60 + 40PS PS = .72

Pb= .5 + PS

Pb= $1.22

A Tax on Gasoline

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Chapter 9 Slide 83

A Tax on Gasoline

With a 50 cent tax

Q =150 -(50)(1.22) = 89 bg/yr

Q falls by 11%

Impact of a 50 Cent Gasoline Tax

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Chapter 9 Slide 84

D

A

Lost ConsumerSurplus

Lost ProducerSurplus

PS= .72

Pb= 1.22


Quantity (billiongallons per year)

Price($ pergallon)

0 50 150

.50

100

P0= 1.00

1.50

89

t = 0.50

11

The annual revenuefrom the tax is .50(89)

or $44.5 billion. The buyerpays 22 cents of the tax, andthe producer pays 28 cents.

SD

60


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Chapter 9 Slide 85

D

A

Lost ConsumerSurplus

Lost ProducerSurplus

PS= .72

Pb= 1.22


Price($ pergallon)

0 50 150

.50

100

P0= 1.00

1.50

89

t = 0.50

11

SD

60

Deadweight loss = $2.75 billion/yr

Quantity (billiongallons per year)

Summary

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Chapter 9 Slide 86

Summary

Simple models of supply and demandcan be used to analyze a wide variety ofgovernment policies.

In each case, consumer and producersurplus are used to evaluate the gains

and losses to consumers andproducers.

Summary

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Chapter 9 Slide 87

Summary

When government imposes a tax orsubsidy, price usually does not rise orfall by the full amount of the tax or

subsidy.

Government intervention generally

leads to a deadweight loss.

Summary

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Chapter 9 Slide 88

Summary

Government intervention in acompetitive market is not always a badthing.

8/10/2019 chap9-ev

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