The Analysis of

Competitive Markets

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

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

Consumer 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

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

Consumer and Producer Surplus

Price

Consumer
Surplus

S
Between 0 and Q0
consumer A receives
a net gain from buying
the product-consumer surplus.

5
Producer
Surplus

3
D
QD

QS

Q0

Between 0 and Q0
producers receive
a net gain from
selling each product-producer surplus.

Quantity

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

Which is the price that maximizes

the total surplus?

Consumer and Producer

Surplus
When government institutes a price
ceiling, the price of a good cant 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

Price Control and Surplus Changes

Price

S
Pmin
A

When price is
regulated to be no
lower than Pmin, the
deadweight loss given
by triangles B and C
results.

P0

D
Q1

Q0

Q2

Quantity

Price Control and Surplus Changes

Price
Consumers that
cannot buy, lose B

Consumers that can

buy the good gain A

S
The loss to producers
is the sum of
rectangle A and
triangle C

B
P0

Triangles B and C are

losses to society
dead weight loss

Pmax
D
Q1

Q0

Q2
Quantity

Price Controls With Inelastic Demand

D

Price

S
B

P0
Pmax

With inelastic demand,

triangle B can be larger
than rectangle A and
consumers suffer net
losses from price controls.

Q1

Q2

Quantity

Price Controls and Natural Gas Shortages

From example in 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

Price Controls and Natural Gas Shortages

Price
($/mcf)

S
The gain to consumers is
rectangle A minus triangle
B, and the loss to
producers is rectangle A
plus triangle C.

2.40
B

2.00

C
A

(Pmax)1.00

10

15 18 20

25

30 Quantity (Tcf)

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

The Efficiency of a 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

The Efficiency of a 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

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 utilitymaximizing decisions

Government intervention may be desirable in these cases

The Efficiency of a Competitive Market

Other than market failures, unregulated

competitive markets lead to economic
efficiency

Some Final Examples and

Remarks

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

The Minimum Wage

Firms are not allowed to
pay less than wmin. This
results in unemployment.

S
wmin
A

A is gain to workers
who find jobs at
higher wage.

B
C

w0

The deadweight loss

is given by
triangles B and C.
Unemployment

L1

L0

D
L2

The Wheat Market in 1981

Price

AB consumer loss
ABC producer gain

Qg
PS = $3.70

P0 = $3.46

By buying 122
million bushels,
the government
increased the
market-clearing
price.

D
1,800

2,566 2,630 2,688

D + Qg

Quantity

The Wheat Market in 1985

Price

Qg

To increase the
price to $3.20, the
government bought
466 million bushels
and imposed
a production quota
of 2,425 bushels.

PS = $3.20

P0 = $1.80

D
1,800 1,959

2,232 2,425

D + Qg
Quantity

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

Incidence of a Specific Tax

Price

S
Pb price
buyers pay
Tax =
$1.00

Buyers lose A + B

P0
PS price
producers
get

Sellers lose D + C
Government gains A
+ D in tax revenue.

The deadweight
loss is B + C.

D
Q1

Q0

Quantity

Impact of Elasticities on Tax Burdens

Burden on Buyer

Burden on Seller

Price

Price

Pb

t
P0
PS

Pb
P0

t
D
PS

Q1 Q0

Quantity

Q1 Q0

Quantity

The Effects of a Tax or Subsidy

A subsidy can be analyzed in much the
same way as a tax
Payment reducing the buyers price below
the sellers price

It can be treated as a negative tax

The sellers price exceeds the buyers
price
Quantity increases

Effects of a Subsidy
Price

S
Like a tax, the benefit
of a subsidy is split
between buyers and
sellers, depending
upon the elasticities of
supply and demand.

PS
Subsidy

P0
Pb

D
Q0

Q1

Quantity