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 .

INDIRECT TAX AND ELASTICITY OF THE
GOODS

If demand is very inelastic If demand is very elastic

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