CH 9 The Analysis of Competitive Markets Summer 2022

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
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 8e. 1 of 28
MARKET EFFICIENCY
Efficiency is the property of a resource allocation of maximizing the total surplus [= consumer surplus (CS) and producer surplus (PS)] received by all members of society.
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.
CS and PS
Consumer and Producer Surplus in the Market
Equilibrium
•Price •A
•D
•Supply
•Consumer
•surplus
•Equilibrium •E
•Price
•Producer
•surplus
•Demand
•B
•C
•0 •Equilibrium •Quantity
•quantity
•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 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.
Review of Consumer and Producer Surplus
Figure 9.1
Consumer and Producer 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.
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.
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 [ maximum price] is ‘illegal’.
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.
Application of Consumer and Producer Surplus
● welfare effects Gains and losses to consumers and
producers.
Change in Consumer and Producer ● deadweight loss Net loss of

Surplus from Price Controls total (consumer plus producer)
surplus.
DEFINE; GRAPH; EXPLANATION, DECISION
Change of Consumer Surplus = A – B Change of Producer surplus = -A - C
Change of Welfare = Change of CS + Change

of PS
= A – B – A –C
=-B-C
= DEAD WEIGHT LOSS= DWL
= NET SUFFERINGs/LOSS OF THE SOCIETY
9.2 THE EFFICIENCY OF A COMPETITIVE MARKET
Figure 9.5
Welfare Loss When Price is Held Above
Market-Clearing Level [ Floor Price]
When price is regulated to be no lower

than P2, only Q3 will be demanded.
Consumers 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
Change of PS = A –C
Welfare Loss (DWL) = - A –B +A –C = -B
–C = DWL
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.
Floor Price: Minimum price buyers need to
pay
Change of CS = -A – B Change of Producer surplus = A -C
Change of welfare = Change of CS +
Change of PS
= -A – B +A- C
= - B –C
= DEAD WEIGHT LOSS [ Net loss of
the society due to government’s
regulation of the price]
PRICE CEILING: MATHEMATICAL
IMPLICATION . SEE. PAGE 326, FIGURE
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?
SUPPLY: QS = 16,000 + 0.4P
DEMAND: QD = 32,000 - 0.4P
D=S
32000 -0.4p = 16000+ 0.4p
P = Taka 20,000
D = 32000 -0.4P = 32000- 0.4*20,000 = 24000
S = 16000+0.4P = 16000+0.4*20000 = 24000.
Draw figure
Now intervention with ceiling price (maximum price) = Taka 15,000
QD = 32000- 0.4P = 32000 -0.4*15000 = 26,000
Qs = 16000+ 0.4P = 16000+ 0.4*15000 = 22000
Shortage = 4000
Find Dead weight loss: see text book, P. 326 for drawing
SUPPLY: QS = 16,000 + 0.4P
DEMAND: QD = 32,000 - 0.4P
How to draw figure?
For demand curve: P = 0; Qd = 32000; Qd = 0
0 = 32000 - 0.4P
P = 80000
How to draw supply curve?
P = 0; Qs = 16000; Qs = 0
Qd = 22000 = 32000 -0.4P

0.4P = 10000
P = 25000
SUPPLY: QS = 16,000 + 0.4P
DEMAND: QD = 32,000 - 0.4P;
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,
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.
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
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
How to calculate DWL
Change of CS = - A - B CHANGE OF PS = A+B+D

Costs of the govt.
= (Q2 – Q1)Ps
Welfare loss = -A-B+ A+B+D – (Q2 –

Q1)Ps
= D – (Q2 –Q1)Ps
PRICE SUPPORT: MATHEMATICAL
EXAMPLE
 1981 Supply of rice: QS = 1800 + 240P
 1981 Demand for rice: QD = 3550 - 266P
 What is the market clearing price [ equilibrium 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.)
1981 SUPPLY OF RICE: QS = 1800 + 240P
1981 DEMAND FOR RICE: QD = 3550 - 266P
HOW TO CALCULATE DWL
Change of CS = - A – B = -2566*(3.7 -3.46) - ½* (2630 -2566)* (3.7 -3.46)
Change of PS = A+B+D = 2566*(3.7 -3.46) + ½* (2688 -2566)* (3.7 -3.46) + ½* (2688 -2566)*
*(3.7 -3.46)
Costs of the govt.

= (Q2 – Q1)Ps = (2688 -2566)* 3.7 =
Welfare loss = -A-B+ A+B+D – (Q2 –Q1)Ps
= D – (Q2 –Q1)Ps
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
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 P s. 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)
COST OF THE GOVERNMENT = -B –C –D
Δ Welfare = -A –B + A –C +B+C+D – B – C -D = -B –C=

DWL
Assume that supply restriction is 16000 units
Change of CS = A –B
Change of PS = -A –C
See. Page 326 D = 16000 = 32000- 0.4P ; P = Taka 40.000
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
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.
DWL = Change of CS + Change of
PS = -A- B-C +A = -B -C
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 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.
[ = -A-B-C-D+A +D = -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.
Tariff:
Import Quota:
-A-B-C-D +A +D
= -B-C = -B –C -D
Find the DWL under Tariff and Import Quota. P.
353, Ex6. [ A = ½(8+6)*(12 -9) = 21
World Market Price = $9, Tariff = $3 Per unit of import
TARIFF VS IMPORT QUOTA: WHICH ONE IS GOOD FOR A HOME
COUNTRY? Ex. 5, Page 353. D = 40- 2P; S =2P/3
TARIFF:
IMPORT QUOTA
Change of CS = -A-B-C-D
Change of PS = A
Govt. revenue (tariff) = C
Welfare Loss
= -A-B-C-D+A +C
= -B –D
Welfare loss = -B- D -C

Trapezium = A
= ½(8+6)*(12- 9)
= 21
B = ½*2*(12 -9) =3
C = (16-8)*( 12-9) =24
D = ½*(22-16)* (12-9) =9
7. Suppose the government wants to limit imports of a certain good. Is it preferable to use
an import quota or a tariff? Why?
Changes in domestic consumer and producer surpluses are the same under import quotas and
tariffs. There will be a loss in (domestic) total surplus in either case. However, with a tariff, the
government can collect revenue equal to the tariff times the quantity of imports and these revenues
can be redistributed in the domestic economy to offset the domestic deadweight loss by, for
example, reducing taxes. Thus, there is less of a loss to the domestic society as a whole. With the
import quota, foreign producers can capture the difference between the domestic and world price
times the quantity of imports. Therefore, with an import quota, there is a loss to the domestic
society as a whole. If the national government is trying to increase welfare, it should use a 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 ,Govt. Revenue, and DWL;
 Change of CS = -100 (=1*100) -12.5 [ = -
1*100 – ½*25*1 = -112.5]
 Change of PS
 = -100*0.5 – 1/2*0.50*25 [ = -0.5*100-
1/2*25*0.5]
 GOVT. REVENUE = Taka1.5*100 = Taka
150
INCIDENCE OF INDIRECT TAX [ P.347=
FOR SUBSIDY
Ps – Pb = Subsidy = s
[ here Pb is price buyers pay, Ps = Price supplier receive]
Pass through fraction

If Ed/Es is very less, buyers get most of the befit of subsidy
If Ed/Es is very large, suppliers get most of the befit of subsidy
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
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.
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: Ps =1 + Q
 And Demand equation to: Pb = 9 -Q .
Without Tax d = s
9 –P = -1 + P
-2P = -10 ; P = Taka 5, Qd = 9 –P = 4; Qs = -1+P = 4
With Tax:
Pb – Ps = TAX = 2
9 – Q – 1 –Q= 2; -2Q = - 6 ; Q = 3 ; Pb = 9 -Q = 9- 3 = Taka 6;
Ps =1 + Q = 1+3 = 4
Govt. revenue = 3*Taka 2 = Taka 6
EXERCISE 2.
IF TAKA 1 SUBSIDY IS GIVEN
Ps – Pb = Subsidy = 1
Q- 4 – 10+Q = 1
2q -14 = 1
2Q = 15; Q = 7.5
Pb = 10 –Q = 10 -7.5 = Taka 2.5
Ps = Q- 4 = 7.5 – 4 = Taka 3.5
Pb –Ps = t [ for tax]

10 –Q – Q+ 4 = 1
-2Q = -13 ; Q = 6.5; Pb = 10-Q = Taka 3.5;
Ps = Q -4 = 6.5 – 4 = Taka 2.5
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 buyers
PS = $9.50
pay rises, the
price sellers
receive falls, D1
equilibrium Q D2
falls. Q
430 500
SUPPLY, DEMAND, AND GOVERNMENT POLICIES

The Incidence of a Tax:
How the burden of a tax is shared among market
participants
As a result of the P
tax, S1
buyers pay PB = $11.00
$1.00 more, and
Tax
sellers receive $10.00
$0.50 less. PS = $9.50
Change of CS, Change of
PS, Govt. revenue, DWL
D1
D2
Q
430 500

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
PS = $9.50
The price buyers
pay rises, the
price sellers D1
receive falls,
equilibrium Q Q
falls. 430 500

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 matters
is this: S1
PB = $11.00
A tax drives Tax
a wedge $10.00
between the PS = $9.50
price buyers
pay and the
price sellers D1
receive.
Q
430 500
EFFECTS OF SUBSIDY
SUBSIDY

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CHAPTER 9 OUTLINE

9.1 Evaluating the Gains and Losses from

9.2 The Efficiency of a Competitive Market

Consumer and Producer Surplus

Consumer A would pay $10

Producer surplus measures

•Economic efficiency: Maximization of

Price ceiling or price control: Government sets a price

higher than the ceiling price [ maximum price] is ‘illegal’.

Government intervention through Price ceiling is inefficient

Change in Consumer and Producer ● deadweight loss Net loss of

Change of Welfare = Change of CS + Change

When price is regulated to be no lower

rectangle A and those consumers who

At price P2, producers would like to

Qd = 22000 = 32000 -0.4P

The Minimum Wage

Although the market-

firms are not allowed to

price support: Price set by

Total change in welfare: ΔCS + ΔPS − Cost to Govt. = D − (Q2 − Q1)Ps

Change of CS = - A - B CHANGE OF PS = A+B+D

Welfare loss = -A-B+ A+B+D – (Q2 –

 What is the market clearing price [ equilibrium price]?

 Assume now that government wants to support a price of

Costs of the govt.

Welfare loss = -A-B+ A+B+D – (Q2 –Q1)Ps

government can restrict supply to

Δ Welfare = -A –B + A –C +B+C+D – B – C -D = -B –C=

Import Tariff or Quota That Eliminates

Import Tariff or Quota (General Case)

When imports are reduced, the

Welfare loss = -B- D -C

an import quota or a tariff? Why?

Pass through fraction

Pb is the price (including the

price that sellers receive, less

Pb –Ps = t [ for tax]

SUPPLY, DEMAND, AND GOVERNMENT POLICIES

SUPPLY, DEMAND, AND GOVERNMENT POLICIES

SUPPLY, DEMAND, AND GOVERNMENT POLICIES

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