Microeconomics: Lecture 11

The Analysis of Competitive Markets

Roadmap
Now we have model of supply and demand and measures of CS and PS to evaluate

Gains and Losses from Government Policies

Minimum price Maximum price Supply restriction Tax, subsidy

The Efficiency of a Competitive Market

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 and Producer Surplus

1.
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

Consumer and Producer Surplus

2.
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

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

Example: When government institutes a price ceiling, the price of a good cant go above that price

Price Control and Surplus Changes

Price
Consumers that can buy the good gain A Consumers that cannot buy, lose B

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

B P0 Pmax D Q1 Q0 Q2
Quantity

Triangles B and C are losses to society dead weight loss

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

Price Controls With Inelastic Demand

D
Price

P0 Pmax

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

Q1

Q2

Quantity

The Efficiency of a Competitive Market

In the evaluation of markets, we often talk about whether it reaches economic efficiency, max CS+PS
Policies such as price controls that cause deadweight losses in society are said to impose an efficiency cost on the economy However, sometimes market failures occur

Prices fail to provide proper signals to consumers

and producers

Leads to inefficient unregulated competitive market

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

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

Minimum Wages
w

Supply Restrictions

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

Supply Restrictions
Price

S PS
A
B Supply restricted to Q1 Supply shifts to S & Q1 CS reduced by A + B Change in PS = A - C Deadweight loss = BC

P0

D Q1 Q0
Quantity

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?

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

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

Incidence of a Specific Tax

Price

S
Pb price buyers pay Tax = $1.00 Buyers lose A + B

P0
PS price producers get

B C

Sellers lose D + C Government gains A + D in tax revenue. The deadweight loss is B + C.

Q1

Q0

Quantity

Incidence of a Specific Tax

Four conditions that must be satisfied after the tax is in place:

1. Quantity sold and buyers price, Pb, must be on the demand curve

Buyers only concerned with what they must pay

2. Quantity sold and sellers price, PS, must be on the supply curve

Sellers only concerned with what they receive

Incidence of a Specific Tax

Four conditions that must be satisfied after the tax is in place (cont.):
3. QD = QS 4. Difference between what consumers pay and what sellers 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

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

Impact of Elasticities on Tax Burdens

Burden on Buyer
Price Pb

Burden on Seller
Price

t
P0 PS

S
Pb P0

t
D
PS

Q1 Q0

Quantity

Q1 Q0

Quantity

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

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

P0 Pb

D Q0 Q1
Quantity

Effects of a Subsidy

The benefit of the subsidy accrues mostly to buyers if ED /ES is small
The benefit of the subsidy accrues mostly to sellers if ED /ES is large As with a tax, using supply and demand curves, and the size of the subsidy, one can solve for resulting prices and quantities

A Tax on Gasoline

We can measure the effects of a tax by looking at an example of a gasoline tax

The goal of a large gasoline tax is to:

Raise government revenue Reduce oil consumption and reduce U.S.

dependence on oil imports

We will consider a gas tax in the market during mid1990s

A Tax on Gasoline

Measuring the Impact of a $1.00 Gasoline Tax

Intermediate-run EP of demand = -0.5 QD = 150 25P EP of supply = 0.4 QS = 60 + 20P

A Tax on Gasoline

With a $1.00 tax:

A Tax on Gasoline

With a $1.00 tax: Q falls by 11% Price to consumers increases by 44 cents per gallon Producers receive about 56 cents per gallon less Both producers and consumers were opposed to the tax Government revenue would be significant at $89 billion per year

The Impact of a $1.00 Gasoline Tax

50

150

Quantity (billion gallons per year)

Summary

Use demand/supply to evaluate

intervention

Price controls Supply restrictions Taxes Subsidies

Required Reading

Pindyck and Rubinfeld (8th edition),

Chapter 9, P&R, pp. 317-339, 345-351.