Chapter 9

1. Chapter 9 The Analysis of Competitive Markets

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. Types of Market Failures • Externalities • Costs or benefits that are not reflected in market supply and demand (e.g. pollution) • Costs or benefits are experienced by a third party not involved in transaction • Lack of Information • Imperfect information prevents consumers from making utility-maximizing decisions • Government intervention may be desirable in these cases Chapter 9

13. 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

14. 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

15. 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

16. 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 ‘producer’ loss of A + C = $200 million Chapter 9

17. The Market for Human Kidneys • Recipients: • Since they do not have to pay for the kidney, they gain rectangle A ($160 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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 Chapter 9

25. 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

26. 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

27. 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

28. S Qg Ps D P0 D + Qg E D Q1 Q0 Q2 Price Supports Price To maintain a price Ps the government buys quantity Qg . A B Net Loss to society is E + B. Quantity Chapter 9

29. Production Quotas • The government can also cause the price of a good to rise by reducing supply • Limitations of taxi medallions in New York City • Limitation of required liquor licenses for restaurants Chapter 9

30. S’ S PS P0 C D Q1 Q0 Supply Restrictions Price A B • Supply restricted to Q1 • Supply shifts to S’ & Q1 • CS reduced by A + B • Change in PS = A - C • Deadweight loss = BC Quantity Chapter 9

31. Import Quotas and Tariffs • Many countries use import quotas and tariffs to keep the domestic price of a product above world levels • Import quotas: Limit on the quantity of a good that can be imported • Tariff: Tax on an imported good • This allows domestic producers to enjoy higher profits • Cost to consumers is high Chapter 9

32. Import Quotas and Tariffs • With lower world price, domestic consumers have incentive to purchase from abroad • Domestic price falls to world price and imports equal difference between quantity supplied and quantity demanded • Domestic industry might convince government to protect industry by eliminating imports • Quota of zero or high tariff Chapter 9

33. S P0 A B C PW Imports D QS Q0 QD Import Tariff to Eliminate Imports Price In a free market, the domestic price equals the world price PW. Quota of zero pushes domestic price to P0 and imports go to zero. Loss to consumers is A+B+C. Gain to producers is A. Dead weight loss: B +C. Quantity Chapter 9

34. The increase in price can be achieved by a tariff QS increases and QD decreases Area A is the gain to domestic producers The loss to consumers is A + B + C + D DWL = B + C Government Revenue is D = tariff * imports S P P* B D C A Pw D Q QS Q’S Q’D QD Import Tariff (General Case) Chapter 9

35. If a quota is used, rectangle D becomes part of the profits to foreign producers Consumers lose A+B+C+D Producers gain A Net domestic loss is B + C + D S P P* B D C A Pw D Q QS Q’S Q’D QD Import Quota (General Case) Chapter 9

36. The Sugar Quota Example • The world price of sugar has been as low as 4 cents per pound, while in the U.S. the price has been 20-25 cents per pound • Sugar quotas have protected the sugar industry but driven up prices • Domestic producers have been better off and so have some foreign producers that have quota rights • Consumers are worse off Chapter 9

37. The Sugar Quota Example • The Impact of a Sugar Quota in 2001 • US production = 17.4 billion pounds • US consumption = 20.4 billion pounds • US price = 21.5 cents/pound • World price = 8.3 cents/pound • Price elasticity of US supply = 1.5 • Price elasticity of US demand = –0.3 Chapter 9

38. Impact of Sugar Quota • The data can be used to fit the US supply and demand curves • QS = -8.70 + 1.21P • QD = 26.53 - 0.29P • This situation led to little domestic supply and most domestic consumption coming from large imports • Government restricted imports to 3 billion pounds raising price to 21.5 cents/pound Chapter 9

39. DUS SUS Price (cents/lb.) PUS = 21.5 after quota 20 A 16 11 PW = 8.3 before quota 8 4 Quantity (billions of pounds) 1.4 17.4 20.4 24.2 Sugar Quota in 1997 B C D The cost of the quotas to consumers was A + B + C + D = $2.4b. The gain to producers was area A = $1b. Chapter 9

40. The Impact of a Tax or Subsidy • The government wants to impose a $1.00 tax on movies. It can do it two ways: • Make the producers pay $1.00 for each movie ticket they sell • Make consumers pay $1.00 when they buy each movie • In which option are consumers paying more? Chapter 9

41. The Impact of a Tax or Subsidy • The burden of a tax (or the benefit of a subsidy) falls partly on the consumer and partly on the producer • How the burden is split between the parties depends on the relative elasticities of demand and supply Chapter 9

42. The Effects of a Specific Tax • For simplicity we will consider a specific tax on a good • Tax of a particular amount per unit sold • Federal and state taxes on gas and cigarettes • For our example, consider a specific tax of $t per widget sold Chapter 9

43. S Pbprice buyers pay Tax = $1.00 P0 C PS price producers get D Q1 Q0 Incidence of a Specific Tax Price • Buyers lose A + B B A • Sellers lose D + C • Government gains A + D in tax revenue. D • The deadweight • loss is B + C. Quantity Chapter 9

44. S2 = S1 + t S1 t P2 Tax shifts S1to S2and output falls to Q2. Price increases to P2. P1 D Q2 Q1 Effect of an OutputTax on Industry Output Price ($ per unit of output) Output Chapter 9

45. Incidence of a Specific Tax • Four conditions that must be satisfied after the tax is in place: • Quantity sold and buyer’s price, Pb, must be on the demand curve • Buyers only concerned with what they must pay • Quantity sold and seller’s price, PS, must be on the supply curve • Sellers only concerned with what they receive Chapter 9

46. Incidence of a Specific Tax • Four conditions that must be satisfied after the tax is in place (cont.): • QD = QS • Difference between what consumers pay and what buyers receive is the tax • If we know the demand and supply curves as well as the tax, we can solve for PB, PS, QD and QS Chapter 9

47. Incidence of a Specific Tax • In the previous example, the tax was shared almost equally by consumers and producers • If demand is relatively inelastic, however, burden of tax will fall mostly on buyers • Cigarettes • If supply is relatively inelastic, the burden of tax will fall mostly on sellers Chapter 9

48. D S Pb S t Pb P0 P0 PS t D PS Q1 Q0 Q1 Q0 Impact of Elasticities on Tax Burdens Burden on Buyer Burden on Seller Price Price Quantity Quantity

49. The Impact of a Tax or Subsidy • We can calculate the percentage of a tax borne by consumers using pass-through fraction • ES/(ES - Ed) • Tells fraction of tax “passed through” to consumers through higher prices • For example, when demand is perfectly inelastic (Ed = 0), the pass-through fraction is 1 – consumers bear 100% of tax Chapter 9

50. The Effects of a Tax or Subsidy • A subsidy can be analyzed in much the same way as a tax • Payment reducing the buyer’s price below the seller’s price • It can be treated as a negative tax • The seller’s price exceeds the buyer’s price • Quantity increases Chapter 9