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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

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MARKET EFFICIENCY

Efficiency is the property of a resource allocation of


maximizing the total surplus received by all members of
society.
Chapter 9: The Analysis of Competitive Markets

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.

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Consumer and Producer Surplus in the Market
Equilibrium
•Price •A

•D
•Supply
Chapter 9: The Analysis of Competitive Markets

•Consumer
•surplus

•Equilibrium •E
•price
•Producer
•surplus

•Demand
•B

•C

•0 •Equilibrium •Quantity
•quantity
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•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
Chapter 9: The Analysis of Competitive Markets

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.

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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
Chapter 9: The Analysis of Competitive Markets

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.

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Efficiency in the market equilibrium

•Economic efficiency: Maximization of


aggregate consumer and producer
Chapter 9: The Analysis of Competitive Markets

surplus.
•Market failure Situation in which an
unregulated competitive market is
inefficient because prices fail to provide
proper signals to consumers and
producers.

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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’.
Chapter 9: The Analysis of Competitive Markets

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.

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9.1 EVALUATING THE GAINS AND LOSSES
FROM GOVERNMENT POLICIES—
CONSUMER AND PRODUCER SURPLUS
Application of Consumer and Producer Surplus
● welfare effects Gains and losses to consumers and
producers.
Chapter 9: The Analysis of Competitive Markets

Change in Consumer and Producer ● deadweight loss Net loss of total


Surplus from Price Controls (consumer plus producer) surplus.
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

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.
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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
Chapter 9: The Analysis of Competitive Markets

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.
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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,
Chapter 9: The Analysis of Competitive Markets

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.

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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
Chapter 9: The Analysis of Competitive Markets

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

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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
Chapter 9: The Analysis of Competitive Markets

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)
ΔWelfare = −A − B + A + B + D − B − C − D = −B − C

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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
Chapter 9: The Analysis of Competitive Markets

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.

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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
Chapter 9: The Analysis of Competitive Markets

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.

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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 .
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
Chapter 9: The Analysis of Competitive Markets

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.

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A Tax on Buyers
A tax on
buyers shifts Effects of a $1.50 per
the D curve unit tax on buyers
down by the P
amount of the S1
PB = $11.00
tax. Tax
$10.00
The price PS = $9.50
buyers pay
rises, the D1
price sellers D2
receive falls, Q
equilibrium Q 430 500
falls.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
The Incidence of a Tax:
How the burden of a tax is shared among market
participants
P
As a result of S1
PB = $11.00
the tax, Tax
buyers pay $10.00
$1.00 more, PS = $9.50
and sellers
receive D1
$0.50 less. D2
Q
430 500

SUPPLY, DEMAND, AND GOVERNMENT POLICIES


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

SUPPLY, DEMAND, AND GOVERNMENT POLICIES


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
S1
matters is PB = $11.00
Tax
this: $10.00
A tax drives PS = $9.50
a wedge
between the D1
price buyers
pay and the Q
price sellers 430 500
receive.
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
9.6 THE IMPACT OF A TAX OR SUBSIDY
The Effects of a Subsidy
● subsidy Payment reducing the buyer’s price below the
seller’s price; i.e., a negative tax.
Conditions needed for the market to clear with a subsidy:
QD = QD(Pb) (9.2a)
Chapter 9: The Analysis of Competitive Markets

QS = QS(Ps) (9.2b)
QD = QS (9.3c)
Ps − P b = s (9.4d)
Figure 9.19
Subsidy
A subsidy can be thought of
as a negative tax. Like a tax,
the benefit of a subsidy is
split between buyers and
sellers, depending on the
relative elasticities of supply
and demand.

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The Effects of a Tax
With no tax, •P
eq’m price is PE
and quantity is QE .
•Size of tax = $T
Govt imposes a
Chapter 9: The Analysis of Competitive Markets

tax of $T per unit. •P •S


B
The price buyers •P
pay is PB , E
•P •D
the price sellers S
receive is PS ,
and quantity is QT .
The tax generates •Q
•Q •Q
revenue equal to T E
$T x Q T .
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The Effects of a Tax
Without a tax, •P

CS = A + B + C
PS = D + E + F •A
Chapter 9: The Analysis of Competitive Markets

Tax revenue = 0 •S
•B •C
Total surplus •P
= CS + PS E •D •E
=A+B+C •D
•F
+D+E+F

•Q
•Q •Q
T E

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The Effects of a Tax
With the tax, •P
CS = A
PS = F
•A
Chapter 9: The Analysis of Competitive Markets

Tax revenue •P •S
=B+D B •B •C
Total surplus •D •E
=A+B •P •D
+D+F S •F
The tax causes
total surplus to
•Q
fall by C + E •Q •Q
T E

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The Effects of a Tax
•P
C + E is called the
deadweight loss
(DWL) of the tax, •A
Chapter 9: The Analysis of Competitive Markets

•P •S
the fall in total
B •B •C
surplus that
results from a •D •E
market distortion, •P •D
such as a tax. S •F

•Q
•Q •Q
T E

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Revenue and the Size of the Tax
•Tax
revenue
The Laffer curve
shows the relationship •The Laffer
between curve
Chapter 9: The Analysis of Competitive Markets

the size of the tax and


tax revenue.
The Laffer curves shown here and in the
book are symmetric, and their peak
occurs in the middle. This need not be
the case, and probably is not the case.
However, we just don’t know where the
peak is – it could be at a tax rate of 20%
or a tax rate of 200% - and surely varies
across goods.
President Reagan, and supply-side •Tax
economics, that you may go through.
size

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