Chapter 9

The Analysis of Competitive Markets

Overview
1) Production
(Chapter 6) Theory of the firm
2) The cost of production
(Chapter 7)

3) Profit maximization and competitive supply From individual firm behavior to

(Chapter 8) market supply

4) The analysis of competitive markets Efficiency of competitive markets

(Chapter 9) and government intervention

5) Market power: Monopoly and Monopsony

(Chapter 10)
6) Pricing with market power
(Chapter 11)
7) Markets with asymmetric information Market failure
(Chapter 17)
8) Externalities and public goods
(Chapter 18)

Microeconomics 2
Overview

Production functions (CH6)

Cost functions (CH7)

Profit maximisation in
(perfectly) competitive markets (CH8)

Supply functions (CH8)

Efficiency of (perfectly) competitive markets (CH9)

Microeconomics 3
Recapitulation
Perfect competition
 Assumptions
 market atomism  price takers
 homogeneous products / substitutes
(e.g. commodities)
 free entry and exit
 perfect information

 Profit maximization
P = MR = AR
so that MR = MC  P = MC

Microeconomics 5
Profit maximization in the short run

Microeconomics 6
Choosing output in the long run

Microeconomics 7
Profit maximization

 How are prices determined in perfectly

competitive markets?
S=D
 How do firms decide how much to produce?
 in the short run:
P = MC
 in the long run:
∏=0
(in other words, when price equals minimal average cost)

Microeconomics 8
Topic introduction

Microeconomics 9
Common Agricultural Policy (CAP) of the European Union

Source: Matthews A. et al. (2017). Trade impacts of agricultural support in the EU. IATRC commissioned paper 19.
Source: Elijah A. et al. (2017). Australia, the European Union and the New Trade Agenda. ANU press.

Microeconomics 10
Protectionism

Source: https://www.intellinews.com/eu-announces-fourth-wave-of-russian-sanctions-238153/?source=russia

Microeconomics 11
Problem statement and
learning goals
Problem statement

When is welfare maximized and how do

government interventions affect welfare?

Microeconomics 13
Learning goals
 After this chapter you can

 determine which consequences government interventions

have on market outcomes

 can calculate the effect of government interventions on a

country’s welfare

 can motivate when government interventions are needed

Microeconomics 14
Economic efficiency
Economic efficiency
 Perfectly competitive markets (without government
intervention) are economically efficient
 Welfare is maximized

 Welfare = consumer surplus + producer surplus

W = CS + PS

 But when is this not true?

 Market failures
 Market power
 Asymmetric information
 Externalities

Microeconomics 16
Climate change and the cost of carbon

 The costs of greenhouse gas emissions are not internalized in

the market price
Source: https://www.colorado.edu/ecenter/energyclimate-justice/general-energy-climate-info/climate-change
Source: https://climate.nasa.gov/effects
Source: https://public.wmo.int/en/media/news/climate-change-impacts-highlight-need-action-cop24

Microeconomics 17
 Let us reflect on “profit maximization”

Source: https://de.freepik.com/vektoren/menschen

Microeconomics 18
Putting profit maximization into perspective
 Sustainability
 “Sustainable development is development that meets the
needs of the present without compromising the ability of
future generations to meet their own needs.”
 WCED (1987) “Our Common Future”

Source: https://sustain.wisconsin.edu/sustainability/triple-bottom-line/
Source: Stockholm Resilience Centre (2016), Contributions to Agenda 2030 – How Stockholm Resilience Centre (SRC) contributed to the 2016 Swedish Agenda 2030 HLPF report,  
https://www.stockholmresilience.org/SDG2016

Microeconomics 19
Putting profit maximization into perspective
 Legal embeddedness and ethics

Source: https://www.aa.com.tr/en/africa/one-fifth-of-african-children-are-laborers/1873615
Source: https://www.spiegel.de/international/tomorrow/child-labor-in-bolivia-is-legally-permissable-a-1130131.html
Source: https://globalmarch.org/combating-child-labor-in-global-supply-chains/

Microeconomics 20
How can we measure the effect of government
interventions?
Government interventions

 Price floors and price ceilings

(or minimum and maximum prices)

 Price supports and production quota

 Import quota and tariffs

 Taxes and subsidies

Microeconomics 22
Deadweight loss
 Remember: Perfectly competitive markets (without
government intervention) are economically
efficient, i.e. welfare is maximized

 In these markets policy measures cause an

efficiency cost or welfare loss
(“deadweight loss”)

Microeconomics 23
Consumer and producer surplus

Consumer
surplus

P
Producer
surplus

Q Q

Microeconomics 24
How can we measure welfare?

General methodology
to calculate welfare change

Before After Change (Δ)

Consumer
surplus
Producer
surplus
Government
(income or expenses)

Welfare

Why do we need to take into account

income/expenses at government?
Microeconomics 25
Price ceiling (maximum price)
Price ceiling (maximum price)
 Why do governments impose maximum prices?
 A maximum price or price ceiling is imposed to protect
consumers
 A maximum price only makes sense when it is
below the competitive equilibrium price

 A sales ban boils down to a price ceiling or

maximum price of 0 EUR

Examples:
 UN’s Convention on the Rights of the Child
 Belgian law on the removal and transplantation of
organs (see also example 9.2 p. 333-335)

Microeconomics 27
Welfare effect of a price ceiling (maximum price)

Price

∆ CS = +A-B

B
∆ PS = -A-C
P0
A C
∆ W = -B-C
Pmax  welfare loss
(DWL)
EXCESS DEMAND
D

Qs Q0 Qd
Quantity

Microeconomics 28
Welfare effect of a sales ban (~ maximum price)

Price S’

∆ CS= +A-B

∆PS: -A-C
B
∆W = -B-C

C
Here, a maximum
A price of 0 EUR is
justified for ethical
D reasons

0 Quantity

Microeconomics 29
Consequences of price ceilings and/or sales bans
 When a maximum price is imposed
 it results in a deadweight loss
 there is excess demand
 causing very long waiting lists
 and potentially black markets (cf. illegal trade of drugs)
(compare pmax with the willingness to pay)

Microeconomics 30
Welfare effect of a price ceiling (maximum price)

D
Price

P0 Are price ceilings always

A C
advantageous for consumers?
Pmax

Q1 Q2 Quantity

Microeconomics 31
Welfare effect of a price ceiling (maximum price)

D
Price

P0 Inelastic demand (cf. gasoline)

A C
|B| > |A|
Pmax
 net loss of CS

Q1 Q2 Quantity

Microeconomics 32
Price floor (minimum price)
Welfare effect price floor (minimum price)
Why do governments impose minimum prices?
P

Pmin

P0

Q0 Q
Qd Qs
A minimum price is imposed to protect producers and only makes sense
when it is above competitive equilibrium price.
Microeconomics 34
Welfare effect price floor (minimum price)
Suppose producers limit their production to Qd

Pmin

A B ∆ CS = -A-B

P0
∆ PS = +A-C
C
∆ W = -B-C
 DWL

Qd=Qs Q0 Q

Microeconomics 35
Welfare effect price floor (minimum price)
Suppose producers do not limit production to Qd

Pmin

A B ∆ CS = -A-B

P0
∆ PS = +A-C-D
C
∆ W = -B-C-D
 DWL
D
EXCESS SUPPLY V

Q0 Q
Qd Qs

Microeconomics 36
Welfare effect price floor on labour markets

wmin
A
B
w0 ∆ EMPLOYERS = -A-B
C
∆ EMPLOYEES = +A-C

∆ W = -B-C

UNEMPLOYMENT
D
Ld L0 Ls L

Microeconomics 37
Price supports and production quota
Price support
In order to guarantee higher prices (Ps) (e.g. for farmers)
government buys excess production (Qg)
(which will be financed by taxpayers)
P S ∆ CS = -A-B
Qg
∆ PS = +A+B+D

Ps ∆ G = -(Qs-Qd)Ps
D = -B-D-E
A
B
P0 ∆ W = -B-E

D + Qg
E
D

Qd Q0 Qs Q

Microeconomics 39
Production quota
In order to guarantee higher prices (Ps) (e.g. for farmers)
government limits production to S’

P S’ : production quotum

PS

A
B ∆ CS = -A-B
P0
C
∆ PS = +A-C

∆ W = -B-C

Qd=Qs Q0 Q

Microeconomics 40
Production quotum with compensation
In order to guarantee higher prices (Ps) (e.g. for farmers)
government limits production to S’
but financially compensates farmers for incurred losses
P S’ production quotum

S
PS
∆ CS = -A-B
D
A
B ∆ G = -B-C-D
P0
C ∆ PS = +A-C+compensation
= +A-C+B+C+D
= +A+B+D

∆ W = -B-C
D

Qd=Qs Q0 Q

Microeconomics 41
Price support versus production quota
 Change in consumer surplus is identical (= -A-B)
 Change in producer surplus is identical as well (=+A+B+D)
 Cost for the government
 Price support : -(Q2-Q1)PS
 Production quotum : -B-C-D
 Most often production quota are cheaper
 BUT society would be even better off if governments would
just provide direct payments to farmers (decoupling
support from production)
 For consumers nothing changes (price stays the competitive P0)
 Government directly pays A+B+D to producers

Microeconomics 42
Import quotas and tariffs
Quotum of zero
Free market: world market price PW = domestic price
P
Quotum of zero import  excess demand 
price increases to P0
S

P0
A ∆ CS = -A-B-C
B C
PW
∆ PS = +A

D ∆ W = -B-C
IMPORT

QS Q0 QD Q

Microeconomics 44
Import quotum (but no zero import)
Instead of prohibiting imports, it will be limited
(to QD’-QS’)

S
P As a consequence of the import
quotum:
• domestic P increases from Pw to P*
• domestic production increases
• domestic QD decreases
P* • import decreases
A D ∆ CS = -A-B-C-D
B C
Pw
∆ PS = +A
IMPORT

∆ W = -B-C-D
IMPORT D

QS Q’S Q’D QD Q

Remark: thanks to the import quotum foreign supplier gain surface D

Microeconomics 45
Import tariff

S
P As a consequence of the import tariff:
• domestic P increases from Pw to P*
• domestic production increases
• domestic QD decreases
• import decreases
P*
A D ∆ CS = -A-B-C-D
B C
Pw
∆ PS = +A
IMPORT

∆ G = +D

IMPORT D
∆ W = -B-C

QS Q’S Q’D QD Q

Remark: an import tariff is better for domestic welfare than an import quotum
(compare their deadweight loss) Microeconomics 46
Import tariff – exam question

S
P

P*

Pw
IMPORT

IMPORT D

QS Q’S Q’D QD Q
True or false
 For the true/false questions a “gambling correction” applies, that is,
for each incorrect answer one point is subtracted. Each correct
answer gives one point and blank answers give zero points.

True False  
 
An import tariff is worse for domestic welfare
 
than an import quota.
A B  
 
  An import tariff increases domestic welfare.
A B  

Microeconomics 48
Taxes and subsidies
Impact specific tax

P
S’ = S + t
S

consumer price PB ∆ CS = -A-B

A
B
P0 ∆ PS = -C-D
C
D
producer price PS ∆ G = +A+D

∆ W = -B-C

Q1 Q0 Q

Microeconomics 50
Impact specific subsidy

Prijs

PS ∆ CS = +A+B
C D
P0 E ∆ PS = +C+D
A
Pb B
∆ G = -A-B-C-D-E

∆ W = -E
D

Q0 Q1 Hoeveelheid

Microeconomics 51
When is government intervention needed?

Microeconomics 52
When is government intervention needed?
 In the presence of market failures
 market power (CH10 & 11)
 externalities (CH18)
 asymmetric information (CH17)

 Market failures cause efficiency costs in non

regulated competitive markets
 despite the ‘free’ market, the sum of consumer and
producer surplus is not maximized
 price fails in its signalling function

 Government has to intervene to correct for

market failure!

Microeconomics 53