Competitive Markets: Applications

1. Efficiency of Perfect Competition

2. Government Intervention
3. Examples of Various Government Policies
 Excise Taxes
 Price Ceilings
 Production Quotas

2
 A perfectly competitive market allocates
resources efficiently
 Alternatively, at a perfectly competitive
equilibrium, (Q*,P*), total surplus is
maximized.
 It assumes there is no outside intervention

3
 Example: Maximisation of Surplus
in Competitive Equilibrium
P

A Supply

B C
P*

D
Demand

Q* Q
4
 Example: Maximisation of Surplus
in Competitive Equilibrium
P

A Supply

: Consumer Surplus: ABC

B C
P*

D
Demand

Q* Q
5
 Example: Maximisation of Surplus
in Competitive Equilibrium
P

A Supply

: Consumer Surplus: ABC

B C
P* : Producer Surplus: BCD

D
Demand

Q* Q
6
 Example: Maximisation of Surplus
in Competitive Equilibrium
P

A Supply

: Consumer Surplus: ABC

B C
P* : Producer Surplus: BCD

+ : Total Surplus
D
Demand

Q* Q
7
Definition: Economic Efficiency means that the
total surplus is maximized.

Definition: A deadweight loss is a reduction in net

economic benefits resulting from an inefficient
allocation of resources.

 Deadweight losses occur when there is

government intervention
8
 Example: Deadweight Loss
P

A Supply

B C
P*

D
Demand

Q* Q
9
 Example: Deadweight Loss
P

A Supply

B C
P*

D
Demand

Q1 Q* Q
10
 Example: Deadweight Loss
P

A Supply

Pd

B C
P*

D
Demand

Q1 Q* Q
11
 Example: Deadweight Loss
P

A Supply

Pd

B C
P*

Ps

D
Demand

Q1 Q* Q
12
 Example: Deadweight Loss
P

A Supply

Pd

C : Deadweight Loss
B
P*

Ps

D
Demand

Q1 Q* Q
13
 There are several instruments that the
government can use to modify the equilibrium
in a perfectly competitive market
 Deadweight losses occur when there is
government intervention

14
 Examples of Government Intervention:
1. Excise taxes
2. Subsidies to producers
3. Price floors
4. Price ceilings
5. Production quotas
6. Import tariffs and quotas
7. Government Purchase programs
8. Acreage Limitation program
15
Definition: An excise tax (or a specific tax) is an
amount paid per unit of the good at the point
of sale.

 It is paid by either the consumer or the

producer.

 If consumers pay price PD and producers

receive PS, then the tax is given by T = PD – PS.
16
 Example: Excise Tax

P
S

P*

Demand
Q* Q

17
 Example: Excise Tax

P S’ = S + T
S

P*

Demand
Q* Q

18
 Example: Excise Tax

P S’ = S + T
S

P*

Demand
Q1 Q* Q

19
 Example: Excise Tax

P S’ = S + T
S

Pd
P*

Demand
Q1 Q* Q

20
 Example: Excise Tax

P S’ = S + T
S

Pd
P*
Ps

Demand
Q1 Q* Q

21
 Example: Excise Tax

P S’ = S + T
S
: Consumer Surplus
T

Pd
P*
Ps

Demand
Q1 Q* Q

22
 Example: Excise Tax

P S’ = S + T
S
: Consumer Surplus
T
: Producer Surplus

Pd
P*
Ps

Demand
Q1 Q* Q

23
 Example: Excise Tax

P S’ = S + T
S
: Consumer Surplus
T
: Producer Surplus

Pd : Tax Revenue
P*
Ps

Demand
Q1 Q* Q

24
 Example: Excise Tax

P S’ = S + T
S
: Consumer Surplus
T
: Producer Surplus

Pd : Tax Revenue
P*
: Deadweight Loss
Ps

Demand
Q1 Q* Q

25
Definition:
 The amount by which the price paid by
consumers, PD, rises over the non-tax
equilibrium price, P*, is the incidence of the
tax on consumers.
 The amount by which the price received by
sellers, PS, falls below P* is called the incidence
of the tax on producers.

26
Definition: A price ceiling is a minimum price that
consumers can legally pay for a good.

 If the price floor is above the pre-control

competitive equilibrium price, then it said to be
binding.

27
 Example: Price Floors

P*

D
Q
Q*

28
 Example: Price Floors

PMIN

P*

D
Q
Q*

29
 Example: Price Floors

PMIN

P*

D
Q
Qd Q*

30
 Example: Price Floors

PMIN

P*

D
Q
Qd Q* Qs

31
 Example: Price Floors

PMIN

P*
Qs – Qd : Excess Supply

D
Q
Qd Q* Qs

32
 Example: Price Floors

S
: Consumer Surplus

PMIN

P*

D
Q
Qd Q* Qs

33
 Example: Price Floors

S
: Consumer Surplus

PMIN : Producer Surplus

P*

D
Q
Qd Q* Qs

34
 Example: Price Floors

S
: Consumer Surplus

PMIN : Producer Surplus

P* : Deadweight Loss

D
Q
Qd Q* Qs

35
Definition: A production quota is a limit either on
the number of producers in the market or on
the amount that each producer can sell.

 The goal of a quota is to place a limit on the

total quantity that producers can supply to the
market.

36
 Example: Production Quota

Original Supply

Demand
Q* Q

37
 Example: Production Quota

Original Supply

Demand
Q
QMAX Q*

38
 Example: Production Quota

Supply with quota

P

Original Supply

Demand
Q
QMAX Q*

39
 Example: Production Quota

Supply with quota

P

Original Supply

: Consumer Surplus

: Producer Surplus

: Deadweight Loss

Demand
Q
QMAX Q*

40
Government Intervention: Who Wins and Who Loses?
Effect on Effect on Effect on Effect on
(domestic) (domestic) (domestic) (domestic) Is a (domestic)
Intervention Quantity Consumer Producer Government Deadweight
Type: Traded Surplus Surplus Budget Loss created?

Excise Tax Falls Falls Falls Positive Yes

Subsidies to Rises Rises Rises Negative Yes

Producers

Maximum Price Falls; Rise or Falls Zero Yes

Ceilings for Excess Fall
Producers Demand
Minimum Price Falls; Falls Rise or Zero Yes
Floors for Excess Fall
Producers Supply
Production Falls; Falls Rise or Zero Yes
Quotas Excess Fall
Supply
Import Tariffs Falls Falls Rises Positive Yes

Import Quotas Falls Falls Rises Zero Yes

41
1. An "invisible hand" guides the competitive
market to the efficient level of production and
consumption.

2. The government policies examined here all

resulted in a deadweight loss compared to the
perfectly competitive equilibrium.

42
3. Efficiency is obtained under the assumption
that price fully reflects all costs and benefits to
the market and that there is perfect information.

4. Government intervention may be efficient under

imperfectly competitive markets.

43
Additional Slides

44
Definition: A subsidy is an amount paid by the
government per unit of the good to the sellers.

 If consumers pay price PD, then the

government pays an amount T per unit on top
of that price, so producers receive PS = PD + T.

45
 Example: Subsidies

P*

D
Q* Q

46
 Example: Subsidies

S
S’ = S – T
T

P*

D
Q* Q

47
 Example: Subsidies

S
S’ = S – T
T

P*

D
Q* Q2 Q

48
 Example: Subsidies

S
S’ = S – T
T

P*
Pd

D
Q* Q2 Q

49
 Example: Subsidies

S
S’ = S – T
T
Ps
P*
Pd

D
Q* Q2 Q

50
 Example: Subsidies

S
S’ = S – T
T
Ps : Consumer Surplus
P*
Pd

D
Q* Q2 Q

51
 Example: Subsidies

S
S’ = S – T
T
Ps
P* : Producer Surplus
Pd

D
Q* Q2 Q

52
 Example: Subsidies

S
S’ = S – T
T
Ps
P* : Government Expenditure
Pd

D
Q* Q2 Q

53
 Example: Subsidies

S
S’ = S – T
T
Ps
P* : Deadweight Loss
Pd

D
Q* Q2 Q

54
Definition: A price ceiling is a legal maximum on
the price per unit that a producer can receive.

 If the price ceiling is below the pre-control

competitive equilibrium price, then the ceiling
is called binding.

55
 Example: Price Ceilings

P*

D
Q
Q*

56
 Example: Price Ceilings

P*
PMAX

D
Q
Q*

57
 Example: Price Ceilings

P*
PMAX

D
Q
Q* Qd

58
 Example: Price Ceilings

P*
PMAX

D
Q
Qs Q* Qd

59
 Example: Price Ceilings

Qd – Qs : Excess Demand
P*
PMAX

D
Q
Qs Q* Qd

60
 Example: Price Ceilings

: Producer Surplus

P*
PMAX

D
Q
Qs Q* Qd

61
 Example: Price Ceilings

S
: Consumer Surplus

: Producer Surplus

P*
PMAX

D
Q
Qs Q* Qd

62
 Example: Price Ceilings

S
: Consumer Surplus

: Producer Surplus

P*
: Deadweight Loss
PMAX

D
Q
Qs Q* Qd

63