CH 9 The Analysis of Competitive Markets

CHAPTER 9 OUTLINE
9.1 Evaluating the Gains and Losses from

Government Policies—Consumer and
Producer Surplus
Chapter 9: The Analysis of Competitive Markets
9.2 The Efficiency of a Competitive Market

9.3 Minimum Prices
9.4 Price Supports and Production Quotas
9.5 Import Quotas and Tariffs
9.6 The Impact of a Tax or Subsidy
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 8e. 1 of 28
MARKET EFFICIENCY
Efficiency is the property of a resource allocation of maximizing the total surplus [= consumer surplus and producer surplus] received by all members of society.
In addition to market efficiency, a social planner might also care about equity – the fairness of the distribution of well-being among the various buyers and sellers.
Consumer and Producer Surplus in the Market
Equilibrium
•Price •A
•D
•Supply
•Consumer
•surplus
•Equilibrium •E
•price
•Producer
•surplus
•Demand
•B
•C
•0 •Equilibrium •Quantity
•quantity
•Copyright©2003 Southwestern/Thomson Learning
9.1 EVALUATING THE GAINS AND LOSSES
FROM GOVERNMENT POLICIES—
CONSUMER AND PRODUCER SURPLUS
Review of Consumer and Producer Surplus
Figure 9.1
Consumer and Producer Surplus
Consumer A would pay $10

for a good whose market
price is $5 and therefore
enjoys a benefit of $5.
Consumer B enjoys a benefit
of $2,
and Consumer C, who
values the good at exactly
the market price, enjoys no
benefit.
Consumer surplus, which
measures the total benefit to
all consumers, is the yellow-
shaded area between the
demand curve and the
market price.
Review of Consumer and Producer Surplus
Figure 9.1
Consumer and Producer Surplus
(continued)
Producer surplus measures

the total profits of producers,
plus rents to factor inputs.
It is the benefit that lower-
cost producers enjoy by
selling at the market price,
shown by the green-shaded
area between the supply
curve and the market price.
Together, consumer and
producer surplus measure
the welfare benefit of a
competitive market.
Efficiency in the market equilibrium
•Economic efficiency: Maximization of

aggregate consumer and producer
surplus.
•Market failure Situation in which an
unregulated competitive market is
inefficient because prices fail to provide
proper signals to consumers and
producers.
Evaluating the impacts of government
intervention
Price ceiling or price control: Government sets a price

which is lower than the equilibrium price. Charging a price
higher than the ceiling price is ‘illegal’.
Government intervention through Price ceiling is inefficient

because it creates Dead Weight Loss (DWL).
Example: Rent control, rationing the price of gas or
electricity etc.
Application of Consumer and Producer Surplus
● welfare effects Gains and losses to consumers and
producers.
Change in Consumer and Producer ● deadweight loss Net loss of

Surplus from Price Controls total (consumer plus producer)
The price of a good has been surplus.
regulated to be no higher than Pmax,
which is below the market-clearing
price P0 and this action creates dead
weighted loss
The gain to consumers is the

difference between rectangle A and
triangle B.
The loss to producers is the sum of
rectangle A and triangle C.
Triangles B and C together measure
the deadweight loss from price
controls.
9.2 THE EFFICIENCY OF A COMPETITIVE MARKET
Figure 9.5
Welfare Loss When Price is Held
Above Market-Clearing Level
When price is regulated to be no

lower than P2, only Q3 will be
demanded. Consumers who
bought the goods paid a high
price and suffers a loss given by

the rectangle A and those
consumers who dropped out of
the market because of the higher
price is given by triangle B.
Therefore
Change of CS = -A-B
If Q3 is produced, producers
receive a higher price
represented by A and lost sales
is the area C. the deadweight
loss is given by triangles B and
C.
At price P2, producers would like

to produce more than Q3. If they
do, the deadweight loss will be
even larger.
PRICE CEILING: MATHEMATICAL
IMPLICATION
Supply and demand equations for government housing are
given below.
Supply: QS = 16,000 + 0.4P
Demand: QD = 32,000 - 0.4P
Now assume that, government has set a price ceiling of
15000 Taka by considering the social need of the
product/service. What will be the impacts of this
intervention. Do you support this type of intervention by
government? Why or why not?
PRICE FLOOR OR MINIMUM
PRICE
 A price minimum is a
regulation that makes
it illegal to trade at a
price lower than a
specified level.
 If the price minimum <
the equilibrium price,
no effect
 If the price minimum >
the equilibrium price,
powerful effects
Example is minimum
wage rule.
9.3 MINIMUM PRICES
The Minimum Wage
Although the market-

clearing wage is w0,
firms are not allowed to

pay less than wmin.
This results in
unemployment of an
amount L2 − L1
and a deadweight loss
given by triangles B
and C.
9.4 PRICE SUPPORTS AND PRODUCTION QUOTAS
Price Supports
● price support Price set by government above free market level and
maintained by governmental purchases of excess supply.
Prince Supports
price support: Price set by

government above free market
level and maintained by
governmental purchases of
excess supply.
To maintain a price Ps above the
market-clearing price P0, the
government buys a quantity Qg.
The gain to producers is A + B +
D. The loss to consumers is A +
B.
The cost to the government is the
speckled rectangle, the area of
which is Ps(Q2 − Q1).
Total change in welfare: ΔCS + ΔPS − Cost to Govt. = D − (Q2 − Q1)Ps
PRICE SUPPORT: MATHEMATICAL
EXAMPLE
 1981 Supply of rice: QS = 1800 + 240P
 1981 Demand for rice: QD = 3550 - 266P
 What is the market clearing price?
 Assume now that government wants to support a price of

$3.70/kg and thus buys the additional amount from the market.
Find the change in consumer surplus, cost to the government
and gain of the producer.
 (Hint: To set the price at $3.70, government must buy Qg=
506P – 1750.)
9.4 PRICE SUPPORTS AND PRODUCTION QUOTAS
Price Quotas
Figure 9.11
Supply Restrictions
To maintain a price Ps above the
market-clearing price P0, the
government can restrict supply to

Q1, either by imposing production
quotas (as with taxicab medallions)
or by giving producers a financial
incentive to reduce output (as with
acreage limitations in agriculture).
For an incentive to work, it must be
at least as large as B + C + D, which
would be the additional profit earned
by planting, given the higher price
Ps. The cost to the government is
therefore at least B + C + D.
ΔCS = −A − B
ΔPS = A − C + Payments for not producing (or at least B + C + D)
COST OF THE GOVERNMENT = -B –C –D
ΔWelfare = -A –B + A –C +B+C+D – B – C -D = -B -C
9.5 IMPORT QUOTAS AND TARIFFS
● import quota Limit on the quantity of a good that can be
imported.
● tariff Tax on an imported good.
Figure 9.14
Import Tariff or Quota That Eliminates

Imports
In a free market, the domestic

price equals the world price Pw.
A total Qd is consumed, of which
Qs is supplied domestically and
the rest imported.
When imports are eliminated,
the price is increased to P0.
The gain to producers is
trapezoid A.
The loss to consumers is A + B
+ C, so the deadweight loss is B
+ C.
9.5 IMPORT QUOTAS AND TARIFFS
Figure 9.15
Import Tariff or Quota (General Case)
When imports are reduced, the

domestic price is increased from Pw
to P*.
This can be achieved by a quota, or
by a tariff T = P* − Pw.
Trapezoid A is again the gain to
domestic producers.
The loss to consumers is A + B + C
+ D.
If a tariff is used, the government
gains D, the revenue from the tariff.
The net domestic loss is B + C.
If a quota is used instead, rectangle
D becomes part of the profits of
foreign producers, and the net
domestic loss is B + C + D.
Find the DWL under Tariff and Import Quota.
World Market Price = $9, Tariff = $3 Per unit of import

TARIFF VS IMPORT QUOTA: WHICH ONE IS GOOD
FOR A HOME COUNTRY?
TARIFF:
Change of CS = -A-B-C-D
Change of PS = A
Govt. revenue (tariff) = C
IMPORT QUOTA
Welfare loss = -B- D -C
Welfare Loss
= -A-B-C-D+A +C
= -B -D
7. Suppose the government wants to limit imports of a certain good. Is it preferable to use
an import quota or a tariff? Why?
Changes in domestic consumer and producer surpluses are the same under import quotas and
tariffs. There will be a loss in (domestic) total surplus in either case. However, with a tariff, the
government can collect revenue equal to the tariff times the quantity of imports and these revenues
can be redistributed in the domestic economy to offset the domestic deadweight loss by, for
example, reducing taxes. Thus, there is less of a loss to the domestic society as a whole. With the
import quota, foreign producers can capture the difference between the domestic and world price
times the quantity of imports. Therefore, with an import quota, there is a loss to the domestic
society as a whole. If the national government is trying to increase welfare, it should use a tariff.
IMPACT OF TAX
 Who really pays these
taxes?
 Income tax (Direct tax) -
deducted from your pay,
 GST (Indirect tax) - added
to the price of most things
you buy
Direct tax reduces the buying
power of the individuals and
thus shifts the demand curve
to the left.
INCIDENCE OF INDIRECT
TAX
 Figure shows the effects of this tax.
 With no tax: Equil. price = $3.00 a
packet
 With tax on sellers of $1.50 a packet
 Indirect tax amount equals the
vertical distance between two supply
curves
 The market price paid by buyers
rises to $4.00 a packet and the
quantity bought decreases.
 The price received by the sellers
falls to $2.50 a packet.
 Let’s see the change in consumer
and producer surplus ,Govt.
Revenue, and DWL;
9.6 THE IMPACT OF A TAX OR SUBSIDY
● specific tax Tax of a certain amount of money per unit sold.
Figure 9.17
Incidence of a Tax
Pb is the price (including the

tax) paid by buyers. Ps is the
price that sellers receive, less

the tax.
Here the burden of the tax is
split evenly between buyers
and sellers.
Buyers lose A + B.
Sellers lose D + C.
The government earns A + D
in revenue.
The deadweight loss is B + C.
INEFFICIENCY CREATED BY INDIRECT
TAX
 Tax revenue takes part of the total surplus.
 The decreased quantity creates a deadweight loss
MATHEMATICAL EXAMPLE ON
INDIRECT TAX
 Demand equation is Q = 9 –P
 Supply equation is Q = -1 + P
 Government has imposed an indirect tax of 2 Taka on the
product. Find the new equilibrium, change in consumer
and producer surplus and amount of government revenue
and DWL.
 First convert the Supply equation to: P =1 + Q
 And Demand equation to: P = 9 -Q .
EXERCISE 2.
A Tax on Buyers
AA taxtax on on
buyers
buyers shifts
shifts Effects of a $1.50 per
the
the DD curve
curve unit tax on buyers
down P
down byby the
the
amount
amount of
of the
the S1
PB = $11.00
tax.
tax. Tax
$10.00
The
The price
price buyers
buyers PS = $9.50
pay
pay rises,
rises, thethe
price
price sellers
sellers
receive falls, D1
receive falls,
equilibrium
equilibrium Q Q D2
falls.
falls. Q
430 500
SUPPLY, DEMAND, AND GOVERNMENT POLICIES

The Incidence of a Tax:
How the burden of a tax is shared among market
participants
P
As
As aa result
result of
of S1
the tax, PB = $11.00
the tax, Tax
buyers
buyers pay pay $10.00
$1.00
$1.00 more,
more, and
and PS = $9.50
sellers
sellers receive
receive
$0.50
$0.50 less.
less.
D1
D2
Q
430 500

A Tax on Sellers
AA tax tax on on
Effects of a $1.50 per
sellers
sellers shifts
shifts unit tax on sellers
the P
the SS curve
curve upup S2
by
by the
the amount
amount S1
of PB = $11.00
of the
the tax.
tax. Tax
$10.00
PS = $9.50
The
The price
price buyers
buyers
pay
pay rises,
rises, thethe
price sellers D1
price sellers
receive
receive falls,
falls,
equilibrium
equilibrium Q Q Q
falls. 430 500
falls.

The Outcome Is the Same in Both Cases!
The effects on P and Q, and the tax incidence are the
same whether the tax is imposed on buyers or sellers!
P
What matters
is this: S1
PB = $11.00
A tax drives Tax
a wedge $10.00
between the PS = $9.50
price buyers
pay and the
price sellers D1
receive.
Q
430 500
EFFECTS OF SUBSIDY
 Price = $40 a tonne and
the Quantity produced =
40 million tonnes a year.
 With a subsidy of $20 a
tonne: Marginal cost
minus subsidy falls by
$20 a tonne and the curve
S – subsidy is the new
supply curve.
 Market Price falls to $30 a
tonne

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CHAPTER 9 OUTLINE

9.1 Evaluating the Gains and Losses from

9.2 The Efficiency of a Competitive Market

Consumer and Producer Surplus

Consumer A would pay $10

Producer surplus measures

•Economic efficiency: Maximization of

Price ceiling or price control: Government sets a price

higher than the ceiling price is ‘illegal’.

Government intervention through Price ceiling is inefficient

Change in Consumer and Producer ● deadweight loss Net loss of

The gain to consumers is the

When price is regulated to be no

price and suffers a loss given by

At price P2, producers would like

The Minimum Wage

Although the market-

firms are not allowed to

price support: Price set by

Total change in welfare: ΔCS + ΔPS − Cost to Govt. = D − (Q2 − Q1)Ps

 What is the market clearing price?

 Assume now that government wants to support a price of

government can restrict supply to

Import Tariff or Quota That Eliminates

In a free market, the domestic

Import Tariff or Quota (General Case)

When imports are reduced, the

World Market Price = $9, Tariff = $3 Per unit of import

an import quota or a tariff? Why?

Pb is the price (including the

price that sellers receive, less

SUPPLY, DEMAND, AND GOVERNMENT POLICIES

SUPPLY, DEMAND, AND GOVERNMENT POLICIES

SUPPLY, DEMAND, AND GOVERNMENT POLICIES

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