CHAPTER-8: THE ANALYSIS OF

COMPETITIVE MARKETS

Course instructor:
Dr. Tamgid Ahmed Chowdhury
CHAPTER OBJECTIVES
 We will:
- Evaluate the Gains and Losses from Government
Policies—Consumer and Producer Surplus
- Discuss the Efficiency of a Competitive Market
- Analyze Minimum Pricing policies
- Analyze Price Supports and Production Quotas
- Discuss Import Quotas and Tariffs
- Analyze the Impacts of a Tax or Subsidy
CONSUMER SURPLUS
 It is the difference
between what
consumer is willing to
pay and what he/she is
actually paying
 In this diagram,
consumer A is ready to
pay 10 taka but
actually paying 5 taka
(market price) thus has
a surplus of (10-5) = 5
taka.
 For consumer B, the
amount is 2 taka. But
for consumer-C, there is
no surplus.
PRODUCER SURPLUS

 It’s the difference

between the market
price and the
production cost of a
specific quantity.
 In other words it’s the
area between supply
curve and the price
line.
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.
 The price of a good has been
regulated to be no higher
than Pmax, which is below
the market-clearing price
P0. And this action creates
dead weighted loss
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 DWL.
 Example: Rent control,
rationing the price of gas
or electricity etc.
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.
PRICE SUPPORT BY THE GOVERNMENT
 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.
 Change in welfare =
ΔCS + ΔPS − Cost to
Govt.
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.)
IMPORT QUOTAS AND TARIFFS

 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.
MATHEMATICAL EXAMPLE ON TARIFF
 U.S. supply: QS = -7.48
+ 0.84P
 U.S. demand: QD =
26.7 - 0.23P
 Price was initially 12
cents/pound.
Government has
imposed a tariff of 15
cents/pound. Show the
change in consumer
surplus, producer
surplus, government
revenue gain and DWL
according to new 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 and DWL.
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 .
 THE IMPACT OF A TAX OR SUBSIDY

Impact of a Tax Depends on Elasticities of Supply and Demand

If demand is very inelastic relative to If demand is very elastic relative to

supply, the burden of the tax falls supply, it falls mostly on sellers.
mostly on buyers.
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