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Introduction to Microeconomics Chapter 7. Economics of Perfect Competition Economic Surplus. Perfect Competition. Some markets (e.g., foreign exchange, many agricultural products) are closer to perfect competition than to other market types.

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introduction to microeconomics chapter 7

Introduction to MicroeconomicsChapter 7

Economics of Perfect Competition

Economic Surplus

perfect competition
Perfect Competition
  • Some markets (e.g., foreign exchange, many agricultural products) are closer to perfect competition than to other market types.
  • When individuals with equal means complete make mutually beneficial transactions in a perfectly competitive market, their self-interested behaviour is harmonized with the common good.
  • Perfect competition serves as a reference for the other more common situation

LO1: How markets can maximize total economic surplus

invisible hand
Invisible Hand

As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other eases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.

Adam Smith (1723 – 1790)

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.

figure 7 1 the demand curve facing a perfectly competitive firm
FIGURE 7.1: The Demand Curve Facing a Perfectly Competitive Firm

S

P0

P0

Di

D

Q0

Panel (a): The market demand and supply curves intersect to determine the market price of the product. Panel (b): The individual firm’s demand curve (Di) is a horizontal line at the market price.

LO1: How markets can maximize total economic surplus

a market in which price is below equilibrium level excess demand
A Market in Which Price Is Below Equilibrium Level – Excess Demand

S

$0.50

D

In this market, milk is currently selling for $1/litre, $0.50 below the equilibrium price of $1.50/litre

consumer surplus
Consumer Surplus
  • Consumer Surplus
    • The difference between what consumers would have been willing to pay and what they actually did pay.
    • Economic surplus gained by the buyers of a product.
    • Measured by the cumulative difference (adding up over all consumers) between their reservation price for each unit of the good, and the price they pay .

LO3: Graphical representation of consumer surplus, producer surplus, and total economic surplus

producer surplus
Producer Surplus
  • Producer Surplus
    • The difference between what producers do get for output and the minimum price they would have been willing to accept.
    • Economic surplus gained by the sellers of a product.
    • Measured by the cumulative difference (adding up over all producers) between the price they receive and their reservation price for each unit of the good.

LO3: Graphical representation of consumer surplus, producer surplus, and total economic surplus

figure 7 5 consumer and producer surplus
FIGURE 7.5: Consumer and Producer Surplus

S

Consumer surplus

Producer surplus

D

LO3: Graphical representation of consumer surplus, producer surplus, and total economic surplus

how excess demand creates an opportunity for a surplus enhancing transaction
: How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction

S

$0.75

1.25

$0.25

D

  • At a market price of $1/litre, the most intensely dissatisfied buyer is willing to pay $2 for an additional litre, which a seller can produce at a cost of only $1. If this buyer pays the seller $1.25 for the extra litre, the buyer gains an economic surplus of $0.75 and the seller gains an economic surplus of $0.25.
figure 7 4 how excess supply creates an opportunity for a surplus enhancing transaction
FIGURE 7.4: How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction

At a market price of

$2/litre, dissatisfied sellers

can produce an additional

litre of milk at a cost of only

$1, which is $1 less than

a buyer would be willing

to pay for it. If the buyer

pays the seller $1.75 for an

extra litre, the buyer gains

an economic surplus of

$0.25 and the seller gains an

economic surplus of $0.75.

S

$0.25

1.75

$0.75

D

Market Equilibrium and Mutually Beneficial Exchange

reservation price
Reservation Price
  • Supplier’s reservation price
    • The lowest price they will accept in return for providing a good or service.
  • Consumer reservation price
    • The highest price a demander will offer in order to obtain a good or service.

LO3: Graphical representation of consumer surplus, producer surplus, and total economic surplus

case study welfare reform
Case study – welfare reform
  • Before welfare reform, a social assistance recipient (SAR) who earned any income (even a paper route) would have their welfare payments reduced by the amount of the increased income?
  • What would you do?
  • The 100% tax discouraged work
  • Now, SARs get to keep a portion of wage earned (until they make too much to qualify)
if i were on welfare what wage do i need to start working
If I were on welfare, what wage do I need to start working?
  • SARs receive a basic benefit, rental housing allowance, transportation allowance, medical (pharmaceuticals)…
  • What is their reservation wage – what wage do they need to go off welfare.
  • This experiment used recipients of the National Child Benefit (98% women at the time)
  • Some received social assistance; others worked (usually at minimum wage)
  • Use discrete choice model
    • Randomly assign SAR to several groups
    • Ask each group – would you be prepared to take a job (40 hr/week) at “$w/hour”
slide15

The average reservation wage ($/hour) needed to entice these respondents to come off social assistance was $4 more than the minimum wage prevalent.

The rational person on social assistance would not give it up if he/she could not get a job that paid at least what was in the table.

This called the welfare trap

example 7 2 how much do buyers and sellers benefit from their participation in the market for milk
Example 7.2: How much do buyers and sellers benefit from their participation in the market for milk?

S

Market for milk: an equilibrium price of $2/litre and an equilibrium quantity

of 4000 litres/day

D

LO4:Calculation of consumer surplus, producer surplus, and total economic surplus

figure 7 6 total economic surplus in the market for milk
FIGURE 7.6: Total Economic Surplus in the Market for Milk

Consumer surplus

2000/Day

S

The total economic surplus from this milk market is the sum of consumer and

producer surplus, or $6000/day

4000/Day

Producer surplus

D

LO4:Calculation of consumer surplus, producer surplus, and total economic surplus

social surplus
Social Surplus

Total economic (social) surplus

  • The sum of all the individual economic surpluses gained by buyers and sellers participating in the market.
  • In a market economy, the goal of economic policy should be to maximize the social surplus
  • Other goals?
changing market outcomes
Changing Market Outcomes
  • Price Ceiling
    • Law or regulation that prevents sellers from charging more than a specified price.
    • Price ceiling prevents some transactions – which would have generated an economic surplus.
  • Applications?
    • Scalping Jets Tickets
    • Rent Control

LO5: How price controls affect total economic surplus

figure 7 7 economic surplus in an unregulated market for home heating oil
FIGURE 7.7: Economic Surplus in an Unregulated Market for Home Heating Oil

Consumer surplus

S

  • For the supply and demand curves shown, the equilibrium price of oil is $14/bbl, and the equilibrium quantity is 3000 bbl/day. Consumer surplus is $9000/day.

Producer surplus

D

LO5: How price controls affect total economic surplus

figure 7 8 the economic surplus lost by price controls
FIGURE 7.8: The Economic Surplus Lost by Price Controls

Consumer surplus

Lost economic surplus

20

S

18

  • By limiting output in the oil market to 1000 bbl/day, price controls cause a loss in economic surplus of $8000/day.

16

Price ($/bbl)

14

12

Price ceiling

10

Producer surplus

D

8

0

1

2

3

4

5

Quantity (1000’s of bbl/day)

LO5: How price controls affect total economic surplus

does it matter how we share the economic surplus
Does it matter how we share the economic surplus
  • Occupy movement
  • Voluntary price controls in times of emergency (war, natural disasters….)
  • Price controls to reduce income inequality
    • Rent control
    • Minimum wage

LO6: Why Distribution is Important

slide23

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price elasticity and the size of total economic surplus
Price Elasticity and the Size of Total Economic Surplus
  • Size of economic surplus depends on the price elasticity of supply and demand – surplus is larger when:
    • Demand is inelastic.
    • Supply is inelastic.
  • For the same demand curve, when supply is more inelastic, price ceilings:
    • Have a smaller impact on the total level of output.
    • Cause a smaller reduction in total economic surplus.
    • Have a larger redistributive effect.
  • Example: compare the impact of rent controls in 2 cities
    • where housing differs in elasticity of supply.

LO7: Price Elasticity and Total Economic Surplus

rent controls winnipeg vancouver
Rent Controls – Winnipeg, Vancouver
  • Winnipeg
    • where new apartments can be constructed either by making buildings taller or by extending new construction further out on the plain.
  • Vancouver
    • mountains or the sea confine growth, except up..

LO7: Price Elasticity and Total Economic Surplus

figure 7 9 economic surplus in two unregulated housing markets
FIGURE 7.9: Economic Surplus in Two Unregulated Housing Markets

1,600,000/

month

1,600,000/

month

Consumer surplus

Consumer surplus

S

CS = ½(4000)(800)

S

Supply is less elastic

400,000/

month

700,000/

month

Producer

surplus

Producer

surplus

PS = ½(4000)(200)

PS = ½(3000+4000)(200)

D

D

LO7: Price Elasticity and Total Economic Surplus

slide28

Inelastic Supply or Demand:

    • Price controls have minor impact.
    • Implication:
      • Small changes in total surplus.
      • Large changes in shares of surplus.
  • Elastic Supply and Demand
    • the surplus lost due to price controls is greater.

LO7: Price Elasticity and Total Economic Surplus

rent control rents capped at 100 per month in both cities
Rent Control: Rents capped at $100 per month in both cities

D

D

Redistributed surplus

Redistributed surplus

Consumer surplus

Consumer surplus

S

Loss of total

economic

surplus

S

Loss of total

economic

surplus

Producer

surplus

Rent control

Producer

surplus

Loss of total economic surplus

= ½ (2000)(500) = 500 000

Redistributed surplus

= (2000)(100) = 200 000

Loss of total economic surplus

= ½ (500)(200) = 500 00

Redistributed surplus

= (3500)(100) = 350 000

LO7: Price Elasticity and Total Economic Surplus

removing rent control winnipeg
Removing Rent Control - Winnipeg
    • Supply rises from 2000 to 4000/month.
    • Total economic surplus up by $500 000/month.
    • Better off
      • Renters who choose to rent the 2000 new apartments
      • Landlords who choose to make them available will be better off.
  • Worse off
      • Renters who paid $100/month for each of 2000 apartments will be worse off by ($100)(2000) =$200 000 /month (rectangle in black) transferred to the landlord.

LO7: Price Elasticity and Total Economic Surplus

slide31

Removing Rent Control – Vancouver

    • Supply rises by 500/month.
    • Total economic surplus up by $50 000/month.
    • Better off
      • Renters who choose to rent the 500 new apartments
      • Landlords who choose to make them available will be better off.
  • Worse off
      • Renters who paid $100/month for each of 500 apartments will be worse off by ($100)(3500) =$350 000 /month (rectangle in black) transferred to the landlord.

LO7: Price Elasticity and Total Economic Surplus

congestion pricing
Congestion Pricing
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price floors
Price Floors
  • Law or regulation that prevents buyers from paying less than a specified amount
    • Keeps prices high.
    • Reduces total economic surplus.
    • Guarantees those suppliers a minimum price for their product.
    • It requires the regulator to take care of the ensuing market surplus.

LO5: How price controls affect total economic surplus

lost surplus from price supports for wheat
Lost Surplus from Price Supports for Wheat

S

Lost economic surplus

D

tonnes/month )

  • A price support of $40/million tonnes results in 4 tonnes of wheat/month being produced, of which the government buys half and the public buys half. Lost economic surplus from the program is equal to $10 million/month.
minimum wage
Minimum Wage

S

Lost economic surplus

D

New workers at the higher wage

Existing workers laid-off at the higher wage

LO5: How price controls affect total economic surplus

measuring the effects of minimum wage
Measuring the effects of Minimum Wage
  • Campoleti/Gunderson (U of T) showed that a 10% increase in min wage reduces employment by 3 – 5%
  • Famous experiment
    • New Jersey/Pennsylvania have similar economic structure along their border
    • In 1992 NY raised its min wage from $4.25 to $5.05, while PA left its min wage at $4.25
    • Card/Kreuger noted that teen employment increased. They argue that increased min wage increases worker commitment, reduces turnover and raises productivity
  • Debate.
    • Critics say the experiment was flawed – employers cut staff before changes

Rational expectations – people make decisions in anticipation change, prior to the change actually occurring

equilibrium and social optimum
Equilibrium and Social Optimum
  • Equilibrium no incentive for anyone to change their behavior:
  • All opportunities for private gain have been exhausted.
  • Market equilibrium does not necessarily allocation of resources is socially optimal
  • Market equilibrium = social optimum

Only when all prices reflect all the costs and benefits of a transaction (good’s production/exchange)

LO8: Difference between maximum economic surplus and a social optimum

taxation the effect of a tax
Taxation: The Effect of a Tax

S + tax

With no tax, 3 million

kilograms of potatoes

are sold each month at a

price of $3/kg.

S

Lost Surplus

3.50

With a tax of $1/kg collected from sellers, consumers end up paying $3.50/kg (including

tax), while sellers receive

only $2.50/kg (net of tax).

2.50

D

2.5

Equilibrium quantity falls from 3 million kilograms/

month to 2.5 million.

LO9: Effect of Tax

the effect of a tax on sellers of a good with infinite price elasticity of supply
The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of Supply

S + $100

$10 100

Price ($/car)

S

$10 000

D

1.9

2.0

Quantity (millions of cars/month)

LO9: Effect of Tax

figure 7 14 the effect of a 1 kg tax on potatoes
FIGURE 7.14: The Effect of a $1/kg Tax on Potatoes

S + tax

6

S

5

4

3.50

Price ($/kg)

3

2.50

2

1

D

0

1

2

3

4

5

2.5

Quantity (millions of kg/month)

$1/kg tax on potatoes would cause an upward shift in the supply curve by $1. Total surplus would shrink to the area of the pale blue triangle, $6.25 million/month.

x

taxes elasticity and economic surplus
Taxes, Elasticity, and Economic Surplus
  • Deadweight loss is minimized when supply or demand are relatively inelastic.

LO9: Effect of Tax

figure 7 16 elasticity of demand and the deadweight loss from a tax
FIGURE 7.16: Elasticity of Demand and the Deadweight Loss from a Tax

Deadweight loss

Deadweight loss

S + T

S + T

2.60

S

S

2.40

2.00

2.00

1.60

1.40

D1

D2

19

24

21

24

  • At the equilibrium price and quantity, price elasticity of demand is smaller for the good shown in panel (b) than for the good shown in panel (a). The area of the deadweight loss triangle in panel (b) ($1.50/day) is smaller than the area of the deadweight loss triangle in panel (a) ($2.50/day).

LO9: Effect of Tax

figure 7 17 elasticity of supply and the deadweight loss from a tax
FIGURE 7.17:Elasticity of Supply and the Deadweight Loss from a Tax
  • At the equilibrium price and quantity, price elasticity of supply is smaller for the good shown in panel (b) than for the good shown in panel (a). The area of the deadweight loss triangle in panel (b) ($4.50/day) is smaller than the area of the deadweight loss triangle in panel (a) ($7.50/day).

LO9: Effect of Tax

taxes external costs and economic surplus
Taxes, External Costs, and Economic Surplus
  • Taxes reduce the equilibrium quantity produced and consumed.
    • To a degree which depends on supply and demand elasticity for that commodity.
  • Therefore, taxing activities that people tend to pursue to excess (e.g., activities that cause pollution) can have a “double dividend”.

LO9: Effect of Tax

chapter summary
Chapter Summary
  • In a perfectly competitive market when the supply and demand curves for a product capture all the relevant costs and benefits of producing and consuming that product, then market equilibrium for that product will be efficient.
  • For an individual buyer, the economic surplus from a transaction is the difference between the most the buyer would have been willing to pay and the amount actually paid.
  • For an individual seller, the economic surplus from a transaction is the difference between the price received and the lowest amount at which the seller would have been willing to make the sale.
  • Total economic surplus in a market is the sum of all producer and consumer surplus in that market.

Chapter Summary

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