Chapter 9

1. Chapter 9 The Analysis of Competitive Markets

2. Topics to be Discussed • Evaluating the Gains and Losses from Government Policies • The Efficiency of a Competitive Market • Minimum Prices • Price Supports and Production Quotas • Import Quotas and Tariffs • The Impact of a Tax or Subsidy Chapter 9

3. 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

4. Consumer and Producer Surplus • Consumer surplus is the total benefit or value that consumers receive beyond what they pay for the good • Assume market price for a good is $5 • Some consumers would be willing to pay more than $5 for the good • If you were willing to pay $9 for the good and pay $5, you gain $4 in consumer surplus Chapter 9

5. Consumer and Producer Surplus • The demand curve shows the willingness to pay for all consumers in the market • Consumer surplus can be measured by the area between the demand curve and the market price • Consumer surplus measures the total net benefit to consumers Chapter 9

6. Consumer and Producer Surplus • Producer surplus is the total benefit or revenue that producers receive beyond what it costs to produce a good • Some producers produce for less than market price and would still produce at a lower price • A producer might be willing to accept $3 for the good but get $5 market price • Producer gains a surplus of $2 Chapter 9

7. Consumer and Producer Surplus • The supply curve shows the amount that a producer is willing to take for a certain amount of a good • Producer surplus can be measured by the area between the supply curve and the market price • Producer surplus measures the total net benefit to producers Chapter 9

8. S 9 Consumer Surplus 5 Producer Surplus 3 D Consumer and Producer Surplus Price Between 0 and Q0 consumer A receives a net gain from buying the product-- consumer surplus. Between 0 and Q0 producers receive a net gain from selling each product-- producer surplus. Q0 QS QD Quantity Chapter 9

9. 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

10. Consumer and Producer Surplus • When government institutes a price ceiling, the price of a good can’t go above that price • With a binding price ceiling, producers and consumers are affected • How much they are affected can be determined by measuring changes in consumer and producer surplus Chapter 9

11. 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

12. Consumer and Producer Surplus • Producers sell less at a lower price • Some producers are no longer in the market • Both of these producer groups lose and producer surplus decreases • The economy as a whole is worse off since surplus that used to belong to producers or consumers is simply gone Chapter 9

13. S B P0 A C Pmax D Q1 Q0 Q2 Price Control and Surplus Changes Price Consumers that cannot buy, lose B Consumers that can buy the good gain A The loss to producers is the sum of rectangle A and triangle C Triangles B and C are losses to society – dead weight loss Chapter 9 Quantity

14. Price Controls and Welfare Effects • The total loss is equal to area B + C • The 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

15. D S P0 C Pmax Q1 Q2 Price Controls With Inelastic Demand Price B With inelastic demand, triangle B can be larger than rectangle A and consumers suffer net losses from price controls. A Quantity Chapter 9

16. Price Controls and Natural Gas Shortages • From example in Chapter 2, 1975 Price controls created a shortage of natural gas • What was the effect of those controls? • Decreases in surplus and overall loss for society • We can measure these welfare effects from the demand and supply of natural gas Chapter 9

17. Price Controls and Natural Gas Shortages • QS = 14 + 2PG + 0.25PO • Quantity supplied in trillion cubic feet (Tcf) • QD = -5PG + 3.75PO • Quantity demanded (Tcf) • PG = price of natural gas in $/mcf • PO = price of oil in $/b Chapter 9

18. Price Controls and Natural Gas Shortages • Using PO = $8/b and gives equilibrium values for natural gas • PG = $2/mcf and QG = 20 Tcf • Price ceiling was set at $1/mcf • Showing this graphically, we can see and measure the effects on producer and consumer surplus Chapter 9

19. Price ($/mcf) D S 2.40 2.00 C (Pmax)1.00 Quantity (Tcf) 0 5 10 15 18 20 25 30 Price Controls and Natural Gas Shortages The gain to consumers is rectangle A minus triangle B, and the loss to producers is rectangle A plus triangle C. B A Chapter 9

20. Price Controls and Natural Gas Shortages • Measuring the Impact of Price Controls • 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 Chapter 9

21. Price Controls and Natural Gas Shortages • Measuring the Impact of Price Controls in 1975 • Change in consumer surplus • = A - B = 18 - 0.4 = $17.6 billion Gain • Change in producer surplus • = A + C = 18 + 1 = $19.0 billion Loss • Dead Weight Loss • = B + C = 0.4 + 1 = $1.4 billion Loss Chapter 9

22. 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

23. 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

24. Types of Market Failures • Externalities • Costs or benefits that do not show up as part of the market price (e.g. pollution) • Costs or benefits are external to the market • Lack of Information • Imperfect information prevents consumers from making utility-maximizing decisions • Government intervention may be desirable in these cases Chapter 9

25. The Efficiency of a Competitive Market • Other than market failures, unregulated competitive markets lead to economic efficiency • What if the market is constrained to a price higher than the economically efficient equilibrium price? Chapter 9

26. S Pmin B P0 A C D Q0 Q1 Q2 Price Control and Surplus Changes Price When price is regulated to be no lower than Pmin, the deadweight loss given by triangles B and C results. Quantity Chapter 9

27. The Efficiency of a Competitive Market • Deadweight loss triangles B and C give a good estimate of the efficiency cost of policies that force price above or below market clearing price • Measuring effects of government price controls on the economy can be estimated by measuring these two triangles Chapter 9

28. 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

29. 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

30. The Market for Human Kidneys • Suppliers: • Those who supply them are not paid the market price, estimated at $20,000 • Loss 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 consumer loss of A + C = $200 million Chapter 9

31. The Market for Human Kidneys • Recipients: • Since they do not have to pay for the kidney, they gain rectangle A ($140 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

32. 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

33. S’ S $20,000 C D 8,000 12,000 The Market for Kidneys Price The loss to suppliers is seen in areas A & C. $40,000 D B $30,000 If kidneys are zero cost, consumer gain would be A minus B. A and D measure the total value of kidneys when supply is constrained. A $10,000 Quantity 0 4,000 Chapter 9

34. The Market for Human Kidneys • Arguments in favor of prohibiting the sale of organs: • Imperfect information about donor’s health and screening • Unfair to allocate according to the ability to pay • Holding price below equilibrium will create shortages • Organs versus artificial substitutes Chapter 9

35. 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

36. Minimum Prices • When price is set above the market clearing price: • Quantity demanded falls • Suppliers may, however, choose to increase quantity supplied in face of higher prices • This causes additional producer losses equal to the total cost of production above quantity demanded Chapter 9

37. Minimum Prices • Losses in consumer surplus are still the same • Increased price leading to decreased quantity equals area A • Those priced out of the market lose area B • Producer surplus similar • Increases from increased price for units sold equal to A • Losses from drop in sales equal to C Chapter 9

38. Minimum Prices • What if producers expand production to Q2 from the increased price? • Since they only sell Q3, there is no revenue to cover the additional production (Q2-Q3) • Supply curve measures MC of production so total cost of additional production is area under the supply curve for the increased production (Q2-Q3) = area D • Total change in producer surplus = A – C – D Chapter 9

39. S Pmin P0 C D D Q3 Q0 Q2 Minimum Prices Price If producers produce Q2, the amount Q2 - Q3 will go unsold. B A D measures total cost of increased production not sold. The change in producer surplus will be A - C - D. Producers may be worse off. Quantity Chapter 9

40. Minimum Wages • Wage is set higher than market clearing wage • Decreased quantity of workers demanded • Those workers hired receive higher wages • Unemployment results, since not everyone who wants to work at the new wage can Chapter 9

41. S wmin w0 C Unemployment D L1 L0 L2 The Minimum Wage Firms are not allowed to pay less than wmin. This results in unemployment. w A is gain to workers who find jobs at higher wage. A B The deadweight loss is given by triangles B and C. L Chapter 9

42. Airline Regulation • Before 1970, the airline industry was heavily regulated by the Civil Aeronautics Board (CAB) • During 1976-1981, the airline industry in the U.S. changed dramatically as deregulation led to major changes • Some airlines merged or went out of business as new airlines entered the industry Chapter 9

43. Airline Regulation • Although prices in the industry fell considerably (helping consumers), profits did not. • Regulation caused significant inefficiencies and artificially high costs • We can show the effects of this regulation by looking at the effects on surplus from the controlled prices Chapter 9

44. S Pmin P0 C D D Q3 Q0 Q1 Q2 Effect of Airline Regulation Price Prior to deregulation price was at Pmin. Production was Q3 hoping to outsell competitors. B A Area D is the cost of unsold output. After deregulation: Prices fell to PO. The change in consumer surplus is A + B. Quantity Chapter 9

45. Airline Industry Data Chapter 9

46. Airline Industry Data • Airline industry data show: • Long-run adjustment as the number of carriers increased and prices decreased • Higher load factors indicating more efficiency • Falling rates • Real cost increased slightly (adjusted fuel cost) • Large welfare gain Chapter 9

47. 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 • Government can also increase prices through restricting production, directly or through incentives to producers Chapter 9

48. 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

49. 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

50. 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 overall • Less costly to simply give farmers the money Chapter 9