1. Ch 10: Competitive Markets: Applications
Often government intervene in markets, even perfectly competitive markets, for a variety of reasons
Equity (instead of efficiency)
Fixing Market Failures
Achieving Policy Goals
Politics 6

2. Sidenote: Partial Equilibrium Analysis
In this chapter we’ll use
partial equilibrium analysis
we’ll assume government intervention only affects 1 market
We will also assume no externalities exist – no extra results will arise from these programs 6

3. Chapter 10: Competitive Markets: Applications
In this chapter we will cover:
10.1 Maximum Efficiency
10.2 Policy: Excise Tax
Tax Incidence
10.3 Policy: Subsidy
10.4 Policy: Price Ceiling
10.5 Policy: Price Floor
10.6 Policy: Production Quotas
10.7 Agricultural Support
10.8 Policy: Import Quotas and Tariffs 6

4. The Invisible Hand
In 1776, Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations mentioned an “Invisible Hand” that guided competitive markets to maximize efficiency.
Although no “Invisible Hand” actually exists, perfectly competitive markets do work to maximize producer and consumer surplus

5. 10.1 Maximizing Efficiency
For any given good:
Consumer Surplus is difference between the consumer’s willingness to pay and the price
Producer Surplus is the difference between the price and the producer’s willingness to provide
Total Surplus is the difference between the consumer’s willingness to pay and the producer’s willingness to provide

6. Maximizing Efficiency
For example:
Jacob is willing to pay $20 for the assignment answers, and Beth is willing to sell her answers for $10. The PC market price for answers is $14.
Consumer Surplus =$20-$14= $6
Producer Surplus =$14-$10= $4
Total Surplus =$20-$10= $10

7. Consumer and Producer Surplus
Consumer Surplus
Supply A B C P* D
Producer Surplus
Demand Q Q1 Q*

8. 10.2 Policy: Excise Tax
Definition: An excise tax is an amount paid by either the consumer or the producer per unit of the good at the point of sale.
(The amount paid by the demanders exceeds the total amount received by the sellers by amount T)

9. Example: Excise Tax Q*=Original Q P*=Original P
Pd=Price Paid by buyers
Ps=Price received by sellers
T(ax)=Pd-Ps
S+T P S T Pd P* Ps
Demand Q Q1 Q*

10. Consumer and Producer Surplus
Old
Consumer Surplus
S+T A S B C P* D
Old Producer Surplus D Q Q1 Q*

11. Consumer and Producer Surplus
New
Consumer Surplus
S+T A
Government Income S Pd B C P*
Deadweight
Loss Ps D
New Producer Surplus D Q Q1 Q*

12. Deadweight Loss? Originally, efficiency was maximized.
After the tax was imposed, portions of consumer and producer surplus was transferred to the government
-this transfer is still efficient
-WHO gets the surplus is irrelevant
After the tax, production decreases, and a small triangle of producer and consumer surplus is lost – this triangle is the deadweight loss

13. Taxes create inefficiencies!!
Deadweight Loss?
Deadweight loss – reduction in net economic benefit due to inefficient allocation of resources
Taxes create inefficiencies!!

14. Sales Tax Imposed on the Sellers
Supply is affected
S + tax S
110
$10 tax
105
Tax
revenue
After Tax
Market Price
Price (dollars per player)
100 95 DA
Quantity (thousands of CD players per week)

15. Tax applied to buyer: Same Effect as tax on seller
110
D-tax
105
Price (dollars per player)
$10 tax
100
Original Market Price 95 DA
Quantity (thousands of CD players per week)

16. Summary:
Taxes discourage market activity
Tax incidence measures the effect of a tax on buyers’ and sellers’ prices
Tax burden falls most heavily on the side of the market that is least elastic in its response to a price change:

17. The Sales Tax: Who Pays? Demand Relatively Inelastic
110
$10 tax
108
Consumer Price Rises from 100 to 108
105
Price (dollars per player)
100 98 95 DA
Quantity (thousands of CD players per week)

18. The Sales Tax: Who Pays? Demand Relatively More Elastic.
Consumer Price Rises from 100 to 103 S
110 DA
$10 tax
105
103
Price (dollars per player)
100
Original Market Price 95 93
Quantity (thousands of CD players per week)

19. The relationship between tax incidence and elasticity is as follows:
Pd/Ps = /
where:  is the own-price elasticity of supply
 is the own-price elasticity of demand

20. Example: Let  = -.5 and  = 2. What is the relative incidence of a specific tax on consumers and producers?
Pd/Ps = 2/-.5 = -4
interpretation: "consumers pay four times as much as the decrease in price producers receive. Hence, an excise tax of $1 results in an increase in consumer price of $.80 and a decrease in price received by producers of $.20"
Note: Subsidies are negative taxes…

21. 10.3 Subsidies
Subsidies work as a negative tax, increasing the seller’s price by T (or reducing the buyer’s price by T, to the same effect)
Subsidies will:
Encourage overproduction
Increase Consumer Surplus
Increase Producer Surplus
Be a government cost
The cost to the government is always greater than gained consumer and producer surplus

22. Subsidies OLD Consumer Surplus OLD Producer Surplus P S A Ps S-T P* BPd D
OLD Producer Surplus D Q Q* Q1

23. Subsidies P
New
Consumer Surplus S A Ps
S-T P* B C Pd D D Q Q1 Q*

24. Subsidies P S A Ps
S-T P* B C Pd D
New Producer Surplus D Q Q1 Q*

25. Subsidies P S A Ps
S-T P* B C
Government Cost Pd D D Q Q1 Q*

26. Subsidies New Consumer Surplus Government Cost Deadweight LossPs
S-T P* B C
Deadweight Loss Pd D
New Producer Surplus D Q Q1 Q*

27. 10.4 Policy: Price Ceilings
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.

28. Policy: Price Ceilings
A price ceiling always has the following effects:
Excess demand will exist
The market will underproduce
Producer surplus will decrease
Some producer surplus is transferred to the consumer
Consumer surplus may increase or decrease
There will be a deadweight loss

29. Price Ceiling Old Consumer Surplus Old Producer Surplus P Supply A C B
Demand Q Q*

30. Policy: Price Ceiling
The impact of a price ceiling depends on which consumer receive the available good. We will examine the 2 extreme cases:
Consumers with greatest willingness to pay receive good (maximize consumer surplus)
Consumers with least willingness to pay receive good (minimize consumer surplus)

31. Price Ceiling: Maximize Consumer Surplus
New
Consumer Surplus
Supply A
Deadweight Loss B C P*
Price Ceiling
New
Producer Surplus D
Excess
Demand Qs
Demand Q Qs Qd

32. Price Ceiling: Minimize Consumer Surplus
Supply A
New
Consumer Surplus B C P*
Price Ceiling Qs
New
Producer Surplus D
Excess
Demand
Demand Q Qs Qd

33. Price Ceiling: Minimize Consumer Surplus
Supply
Deadweight Loss=A-B A P* B
Price Ceiling Qs
Excess
Demand
Demand Q Qs Qd

34. Policy: Price Ceiling
It is generally assumed that the consumers with the greatest willingness to pay receive the good, but this does not always occur
Price ceilings are only effective if resale (black market) is prevented
Price ceilings can also cause a reliance on imports to meet excess demand

35. 10.5 Policy: Price Floor
Definition: A price floor is a legal minimum on the price per unit that a producer can receive. (ie: minimum wage) If the price floor is above the pre-control competitive equilibrium price, then the floor is called binding.

36. Policy: Price Floor A price floor always has the following effects:
Excess supply will exist
The market will underconsume
Consumer surplus will decrease
Some consumer surplus is transferred to the producer
Producer surplus may increase or decrease
There will be a deadweight loss

37. Price Floor Old Consumer Surplus Old Producer Surplus P (W) Supply A
(min. wage) B C P* D
Old
Producer Surplus
Demand
Q (L) Q*

38. Policy: Price Floor
The impact of a price floor depends on which producer will sell the good (which worker works). We will examine the 2 extreme cases:
Producers with greatest efficiency supply good (maximize producer surplus)
Producers with least efficiency supply good (minimize producer surplus)

39. Price Floor: Maximize Producer Surplus
P (W)
New
Consumer Surplus
Supply A
Price Floor
Ie: Min. Wage B C P*
Deadweight Loss
New
Producer Surplus D
Excess
Supply Qd
Demand
Q (L) Qs

40. Price Floor: Minimize Producer Surplus
New
Consumer Surplus
Supply A
Price Floor
Ie: Min. Wage B C P* Qs
=Qd
New
Producer Surplus D
Excess
Supply
Demand Q Qd

41. Price Floor: Minimize Producer Surplus
Supply
Price Floor
Ie: Min. Wage X P* Y
Deadweight Loss=Y-X Qs
=Qd
Excess
Supply
Demand Q Qd

42. Some workers receive a higher wage Some workers lose their jobs
Labour Price Floor
The attempt of a union to increase wages has two effects:
Some workers receive a higher wage
Some workers lose their jobs
Note that there is a difference between negotiating a higher wage (a union’s publicized goal) and ensuring wages keep up with inflation (often a union’s achieved goal)

43. 10.6 Production Quotas
In place of a price floor, the government can instead impose a PRODUCTION QUOTA
Production Quotas restrict the quantity supplied of any good
Ie: Taxi Cabs
Ie: Bear hunting permits

44. Production Quotas
Production Quotas have similar effects to price floors:
There will be excess supply (some will want to supply but be prevented)
Quantity purchased will decrease
Consumer surplus will decrease
Some consumer surplus will transfer to producers
Producer surplus may increase or decrease
There will be a deadweight loss

45. Production Quota Old Consumer Surplus Old Producer Surplus
Supply A P1 B C P* D
Old
Producer Surplus
Demand Q Q*

46. Production Quota: Maximize Producer Surplus
P (W)
New
Consumer Surplus
Supply A P1 B C P*
Deadweight Loss
New
Producer Surplus D Qd
Demand
Q (L) Qs

47. Quota: Minimize Producer Surplus
New
Consumer Surplus
Supply A P1 B C P* Qs
=Qd
New
Producer Surplus D
Demand Q Qd

48. Quota: Minimize Producer Surplus
Supply P1 X P* Y
Deadweight Loss=Y-X Qs
=Qd
Demand Q Qd

49. Production Quotas
Production Quotas effect on producer surplus depends on which producers are allowed to produce:
Producers with lowest willingness to produce (lowest costs – most efficient) – producer surplus is maximized
Producers with highest (valid) willingness to produce (highest costs – most inefficient) – producer surplus is minimized

50. 10.7 Agricultural Support
Agriculture is one area often receiving government support
Often it is argued that farming is no longer a viable profession at market-clearing wages
The government works to raise the price of agricultural outputs through 2 policies:
Acre Limitation Programs
Government Purchase Programs

51. Policy: Acreage Limitation
Since demand is downward sloping, prices can be raised by reducing output.
However, supply and demand will force quantity up and price down.
In order to keep quantity down and price up, the government can pay farmers to reduce production:

52. Acreage Limitation Old Consumer Surplus Old Producer Surplus P SupplyB C P* D
Old
Producer Surplus
Demand Q
Production Limit

53. Acreage Limitation New Consumer Surplus New Producer Surplus P SupplyB C P* D
New
Producer Surplus
Demand Q
Production Limit

54. Acreage Limitation New Consumer Surplus Government Cost New
Supply A P1
Government
Cost B C P* D
New
Producer Surplus
Demand Q
Production Limit

55. Acreage Limitation New Consumer Surplus Government Cost Deadweight
Supply A P1
Government
Cost B C P*
Deadweight
Loss D
New
Producer Surplus
Demand Q
Production Limit

56. Policy: Purchase Programs
Critics may criticize acreage limitation programs as being wasteful – if the land is there, why not use it?
Alternately, the government can purchase agricultural output in order to benefit farmers:

57. Gov. Purchase Programs Old Consumer Surplus Old Producer Surplus P
Supply A P1 B C P*
Demand + Gov.
Purchases D
Old
Producer Surplus
Demand Q Q1 Q*
Q1+G

58. Gov. Purchase Programs New Consumer Surplus Note: Change In Consumer
And Producer
Surplus is
Equal to Acre
Limitation P
Supply A P1 B C P*
Demand + Gov.
Purchases D
New
Producer Surplus
Demand Q Q1 Q*
Q1+G

59. Gov. Purchase Programs New Consumer Surplus Note: Gov. Costs are
Greater P
Supply A P1 B C P*
Gov.
Cost
Demand + Gov.
Purchases D
Demand Q Q1 Q*
Q1+G

60. Gov. Purchase Programs New Consumer Surplus Note: Deadweight Loss is
Greater P
Supply A P1 B C P*
Demand + Gov.
Purchases D
Deadweight
Loss
Demand Q Q1 Q*
Q1+G

61. Agricultural Supports
As seen previously, government purchase programs have greater deadweight loss than acreage limitation programs.
But acreage limitation programs also have deadweight loss.
The most efficient program is to simply give the farmers money. (No deadweight loss)
Often however, politics overrules economics.

62. 10.8 Import Quotas and Tariffs
Often foreign countries can produce a good cheaper than domestic industries
Pw<P*
In order to protect domestic industries, governments often impose import quotas or tariffs
These policies cause deadweight loss

63. Free Trade Old Consumer Surplus
At world prices, only a small amount of domestic industry can survive P
Supply P* PW
Old Domestic
Producer Surplus
Demand Q
QDom

64. Trade Prohibition (Zero Imports)
New
Consumer Surplus P
Supply
Deadweight
Loss P* PW
New Domestic
Producer Surplus
Demand Q
QDom

65. Import Quota New Consumer Surplus Deadweight Loss New Domestic
Supply
Deadweight
Loss P* Pq PW
New Domestic
Producer Surplus
Demand Q
QDom
QDom+Quota

66. Import Tarrif (t) New Consumer Surplus Deadweight Loss Government
Supply
Government
Revenue P*
PW+t PW
New Domestic
Producer Surplus
Demand Q
QDom
QDom+Quota

67. Import Quotas and Tariffs
The greater the import quota, the smaller the benefit to domestic industries and the smaller the deadweight loss
Import tariffs are better for the domestic economy as government revenue decreases deadweight loss
This increased government revenue is equal to foreign producer surplus under a quota; worldwide surplus is simply transferred

68. Government Intervention
Under normal perfectly competitive conditions, any government intervention will cause DEADWEIGHT LOSS
The most efficient manner of government intervention is lump sum payments to the segment of society is desires to aid
This however, is politically undesirable – Why should one segment of society get something for free?

69. Benefit > Deadweight Loss
Chapter 10 Summary
Under Perfect Competition, efficiency is maximized
All government intervention in Perfect Competition cause deadweight loss
Lump-sum cash transfers have the least distortion, but are unpopular
Whenever government intervenes, it must be asked if
Benefit > Deadweight Loss