Chapter 9

The Analysis of Competitive

Markets
 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
©2005 Pearson Education, Inc. Chapter 9 2
 Consumer and Producer
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

©2005 Pearson Education, Inc. Chapter 9 3

 Consumer and Producer
Surplus

2. Producer surplus is the total benefit or

revenue that producers receive beyond
what it cost 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
©2005 Pearson Education, Inc. Chapter 9 4
 Consumer and 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

©2005 Pearson Education, Inc. Chapter 9 5

 Consumer and Producer
Surplus
Price
9 Consumer
Surplus
S

Between 0 and Q0
consumer A receives
a net gain from buying
the product--
5 consumer surplus
Producer
Surplus
3 Between 0 and Q0
producers receive
a net gain from
selling each product--
D producer surplus.

QD QS Q0 Quantity
©2005 Pearson Education, Inc. Chapter 9 6
 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.

©2005 Pearson Education, Inc. Chapter 9 7

 Price Control and Surplus
Changes
Price
Consumers that can Consumers that
buy the good gain A cannot buy, lose B
S

The loss to producers

is the sum of
B rectangle A and
triangle C.
P0
A C Triangles B and C are
losses to society –
Pmax dead weight loss

Q1 Q0 Q2
©2005 Pearson Education, Inc. 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 has greater effects in political decisions

©2005 Pearson Education, Inc. Chapter 9 9

 Price Controls With Inelastic
Demand
D
Price

P0 With inelastic demand,

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

Quantity
Q1 Q2
©2005 Pearson Education, Inc. Chapter 9 10
 Price Control and Surplus
Changes
Price

Pmin
When price is
A B regulated to be no
lower than Pmin, the
P0 deadweight loss given
C by triangles B and C
results.

Q0 Quantity
Q1 Q2
©2005 Pearson Education, Inc. Chapter 9 11
 The Efficiency of a Competitive
Market

 Deadweight loss triangles, B and C, give

a good estimate of efficiency cost of
policies that force price above or below
market clearing price.

 Measuring effects of government price

controls on the economy can be
estimated by measuring these two
triangles
©2005 Pearson Education, Inc. Chapter 9 12
 The Market for Human Kidneys
 Many countries have laws prohibiting the
sale of organs for transplantation. E.g.
India, Malaysia, and the United States
 What has been the impact such laws?
 We can measure this using the supply
and demand for kidneys. Consider the
following example.
Supply: QS = 8,000 + 0.2P
Demand: QD = 16,000 - 0.2P
©2005 Pearson Education, Inc. Chapter 9 13
 The Market for Human Kidneys

 Since sale of organs is not allowed, the

amount available depends on the amount
donated
Supply of donated kidneys is limited to 8000

 The welfare effect of this supply

constraint can be analyzed using
consumer and producer surplus in the
kidney market

©2005 Pearson Education, Inc. Chapter 9 14

 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 in the current market
 Loss of surplus equal to area C = $40 million

Total consumer loss of A + C = $200 million

©2005 Pearson Education, Inc. Chapter 9 15

 The Market for Human Kidneys

 Recipients:
Since they do not have to pay for the kidney,
they gain rectangle A ($140 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

©2005 Pearson Education, Inc. Chapter 9 16
 The Market for Human Kidneys

 Other Inefficiency Cost

Allocation is not necessarily to those who
value the kidney’s the most.

Price may increase to $40,000, the

equilibrium price, with hospitals getting the
price.

©2005 Pearson Education, Inc. Chapter 9 17

 The Market for Kidneys
Price S’
The loss to suppliers
Is areas A & C. S
$40,000

$30,000 D If kidneys are zero

cost, consumer gain
B would be A minus B.

$20,000 A and D measure

the total value of
C kidneys when supply
is constrained.
$10,000 A
D

0 4,000 8,000 12,000 Quantity

©2005 Pearson Education, Inc. Chapter 9 18

 The Market for Human Kidneys

 Arguments in favor of prohibiting the

sale of organs:
1. Imperfect information about donor’s health
and screening
2. Unfair to allocate according to the ability to
pay
 Holding price below equilibrium will create
shortages
 Organs versus artificial substitutes
©2005 Pearson Education, Inc. Chapter 9 19
 Minimum Prices
Price

S If producers produce
Q2, the amount Q2 - Q3
will go unsold.
Pmin
A D measures total cost
B of increased
P0 C production not sold

The change in producer

D surplus will be
A - C - D. Producers
may be worse off.

D
Q3 Q0 Q2 Quantity

©2005 Pearson Education, Inc. Chapter 9 20

 The Minimum Wage
w Firms are not allowed to
pay less than wmin. This
results in unemployment.
S

wmin A is gain to workers

A who find jobs at
B higher wage
w0
C

The deadweight loss

is given by
triangles B and C.

Unemployment
D
L1 L0 L2 L

©2005 Pearson Education, Inc. Chapter 9 21

 Supply Restrictions
Price S’

PS

A •Supply restricted to Q1
B •Supply shifts to S’ @ Q1
P0
C •CS reduced by A + B
•Change in PS = A - C
•Deadweight loss = BC

Q1 Q0 Quantity
©2005 Pearson Education, Inc. Chapter 9 22
 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
 Costs to consumers is high
©2005 Pearson Education, Inc. Chapter 9 23
 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
©2005 Pearson Education, Inc. Chapter 9 24
 Import Tariff To Eliminate
Imports
Price In a free market, the
domestic price equals the
world price PW.
S

Quota of zero pushes

domestic price to P0 and
imports go to zero.
P0
Loss to consumers is
A A+B+C.
B C
Gain to producers is A.
PW Dead weight loss: B +C.

Imports
D

QS Q0 QD Quantity
©2005 Pearson Education, Inc. Chapter 9 25
 Import Tariff (general case)
 The increase in price can
S
be achieved by a tariff. P
 QS increases and QD
decreases
 Area A is the gain to
P*
domestic producers. A D
 The loss to consumers is Pw
B C
A + B + C + D.
 DWL = B + C
 Government Revenue is D D
= tariff * imports
QS Q’S Q’D QD Q

©2005 Pearson Education, Inc. Chapter 9 26

 Import Quota (general case)
 If a quota is used, S
P
rectangle D becomes
part of the profits to
foreign producers
 Consumers lose P*
A D
A+B+C+D B C
Pw
 Producers gain A
 Net domestic loss is
B + C + D. D

QS Q’S Q’D QD Q

©2005 Pearson Education, Inc. Chapter 9 27

 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?

©2005 Pearson Education, Inc. Chapter 9 28

 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.

©2005 Pearson Education, Inc. Chapter 9 29

 Incidence of a Specific Tax
Price

S
Pb price •Buyers lose A + B
buyers pay
A •Sellers lose D + C
Tax = B
$1.00 P0 •Government gains A
C
D + D in tax revenue.
PS price
producers •The deadweight
get loss is B + C.

Q1 Q0 Quantity
©2005 Pearson Education, Inc. Chapter 9 30
 Impact of Elasticities on Tax Burdens
Burden on Buyer Burden on Seller
Price D Price S

Pb

S
t Pb
P0 P0
PS
t
D
PS

Q1 Q 0 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 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
©2005 Pearson Education, Inc. Chapter 9 32
 Effects of a Subsidy
Price

Like a tax, the benefit

PS of a subsidy is split
between buyers and
Subsidy P0 sellers, depending
upon the elasticities of
Pb supply and demand.

Q0 Q1 Quantity
©2005 Pearson Education, Inc. Chapter 9 33