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1 Ch 10: Competitive Markets: Applications Often government intervene in markets, even perfectly competitive markets, for a variety of reasons Equity (instead.

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Presentation on theme: "1 Ch 10: Competitive Markets: Applications Often government intervene in markets, even perfectly competitive markets, for a variety of reasons Equity (instead."— Presentation transcript:

1 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

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

3 3 Chapter 10: Competitive Markets: Applications In this chapter we will cover: 10.1 Maximum Efficiency 10.2 Policy: Excise Tax 10.2.1 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

4 4 In 1776, Adam Smiths 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 5 For any given good: Consumer Surplus is difference between the consumers willingness to pay and the price Producer Surplus is the difference between the price and the producers willingness to provide Total Surplus is the difference between the consumers willingness to pay and the producers willingness to provide

6 6 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 7 Consumer and Producer Surplus Demand Consumer Surplus Q P Q* P* A B C D Q1Q1 Producer Surplus Supply

8 8 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 9 Example: Excise Tax T S+T S Q P Q1Q1 Q* PdPd PsPs Demand P* Q*=Original Q P*=Original P P d =Price Paid by buyers P s =Price received by sellers T(ax)=P d -P s

10 10 Consumer and Producer Surplus D Old Consumer Surplus Q P Q* P* A B C D Q1Q1 Old Producer Surplus S S+T

11 11 Consumer and Producer Surplus D New Consumer Surplus Q P Q* P* A B C D Q1Q1 New Producer Surplus S S+T Government Income Deadweight Loss PdPd PsPs

12 12 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 13 Deadweight loss – reduction in net economic benefit due to inefficient allocation of resources Taxes create inefficiencies!!

14 14 S + tax Sales Tax Imposed on the Sellers Quantity (thousands of CD players per week) Price (dollars per player) 34563456 95 100 105 110 S DADA Tax revenue $10 tax After Tax Market Price Supply is affected

15 15 D-tax Tax applied to buyer: Same Effect as tax on seller Quantity (thousands of CD players per week) Price (dollars per player) 34563456 95 100 105 110 S DADA $10 tax Original Market Price

16 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 17 S + tax The Sales Tax: Who Pays? Demand Relatively Inelastic Quantity (thousands of CD players per week) Price (dollars per player) 34563456 95 100 105 110 S DADA 98 108 $10 tax Consumer Price Rises from 100 to 108

18 18 S + tax The Sales Tax: Who Pays? Demand Relatively More Elastic. Quantity (thousands of CD players per week) Price (dollars per player) 34563456 95 100 105 110 S DADA $10 tax Original Market Price 103 93 Consumer Price Rises from 100 to 103

19 19 The relationship between tax incidence and elasticity is as follows: P d / P s = / where: is the own-price elasticity of supply is the own-price elasticity of demand

20 20 Example: Let = -.5 and = 2. What is the relative incidence of a specific tax on consumers and producers? P d / P s = 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 21 Subsidies work as a negative tax, increasing the sellers price by T (or reducing the buyers 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 22 Subsidies D OLD Consumer Surplus Q P Q1Q1 P* A B C D Q* OLD Producer Surplus S-T S PsPs PdPd

23 23 Subsidies D New Consumer Surplus Q P Q* P* A B C D Q1Q1 S-T S PsPs PdPd

24 24 Subsidies D Q P Q* P* A B C D Q1Q1 New Producer Surplus S-T S PsPs PdPd

25 25 Subsidies D Q P Q* P* A B C D Q1Q1 Government Cost S-T S PsPs PdPd

26 26 Subsidies D Q P Q* P* A B C D Q1Q1 Deadweight Loss S-T S PsPs PdPd Government Cost New Producer Surplus New Consumer Surplus

27 27 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 28 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 29 Price Ceiling Demand Old Consumer Surplus Q P Q* P* A B C D Old Producer Surplus Supply Price Ceiling

30 30 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 31 Price Ceiling: Maximize Consumer Surplus Demand New Consumer Surplus Q P QdQd P* A B C D QsQs New Producer Surplus Supply Price Ceiling Excess Demand QsQs Deadweight Loss

32 32 Price Ceiling: Minimize Consumer Surplus Demand New Consumer Surplus Q P QdQd P* A B C D QsQs New Producer Surplus Supply Price Ceiling Excess Demand QsQs

33 33 Price Ceiling: Minimize Consumer Surplus Demand Q P QdQd P* A B QsQs Supply Price Ceiling Excess Demand QsQs Deadweight Loss=A-B

34 34 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 35 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 36 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 37 Price Floor Demand Old Consumer Surplus Q (L) P (W) Q* P* A B C D Old Producer Surplus Supply Price Floor (min. wage)

38 38 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 39 Price Floor: Maximize Producer Surplus Demand New Consumer Surplus Q (L) P (W) P* A B C D QsQs New Producer Surplus Supply Price Floor Ie: Min. Wage Excess Supply QdQd Deadweight Loss

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

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

42 42 The attempt of a union to increase wages has two effects: 1)Some workers receive a higher wage 2)Some workers lose their jobs Note that there is a difference between negotiating a higher wage (a unions publicized goal) and ensuring wages keep up with inflation (often a unions achieved goal)

43 43 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 44 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 45 Production Quota Demand Old Consumer Surplus Q P Q* P* A B C D Old Producer Surplus Supply Production Quota P1P1

46 46 Production Quota: Maximize Producer Surplus Demand New Consumer Surplus Q (L) P (W) P* A B C D QsQs New Producer Surplus Supply Production Quota QdQd Deadweight Loss P1P1

47 47 Quota: Minimize Producer Surplus Demand New Consumer Surplus Q P =Q d P* A B C D QdQd New Producer Surplus Supply Quota QsQs P1P1

48 48 Quota: Minimize Producer Surplus Demand Q P =Q d P* Y X QdQd SupplyQuota QsQs Deadweight Loss=Y-X P1P1

49 49 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 50 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 51 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 52 Acreage Limitation Demand Old Consumer Surplus Q P P* A B C D Old Producer Surplus Supply Production Limit P1P1

53 53 Acreage Limitation Demand New Consumer Surplus Q P P* A B C D New Producer Surplus Supply Production Limit P1P1

54 54 Acreage Limitation Demand New Consumer Surplus Q P P* A B C D New Producer Surplus Supply Production Limit Government Cost P1P1

55 55 Acreage Limitation Demand New Consumer Surplus Q P P* A B C D New Producer Surplus Supply Production Limit Government Cost Deadweight Loss P1P1

56 56 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 57 Gov. Purchase Programs Demand Old Consumer Surplus Q P P* A B C D Old Producer Surplus Supply Demand + Gov. Purchases Q*Q1Q1 Q 1 +G P1P1

58 58 Gov. Purchase Programs Demand New Consumer Surplus Q P P* A B C D New Producer Surplus Supply Demand + Gov. Purchases Q*Q1Q1 Q 1 +G Note: Change In Consumer And Producer Surplus is Equal to Acre Limitation P1P1

59 59 Gov. Purchase Programs Demand New Consumer Surplus Q P P* A B C D Supply Demand + Gov. Purchases Q*Q1Q1 Q 1 +G Note: Gov. Costs are Greater Gov. Cost P1P1

60 60 Gov. Purchase Programs Demand New Consumer Surplus Q P P* A B C D Supply Demand + Gov. Purchases Q*Q1Q1 Q 1 +G Note: Deadweight Loss is Greater Deadweight Loss P1P1

61 61 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 62 Often foreign countries can produce a good cheaper than domestic industries P w { "@context": "http://schema.org", "@type": "ImageObject", "contentUrl": "http://images.slideplayer.com/5/1583573/slides/slide_62.jpg", "name": "62 Often foreign countries can produce a good cheaper than domestic industries P w

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

64 64 Trade Prohibition (Zero Imports) Demand New Consumer Surplus Q P P* New Domestic Producer Surplus Supply Q Dom PWPW Deadweight Loss

65 65 Import Quota Demand New Consumer Surplus Q P P* New Domestic Producer Surplus Supply PWPW Deadweight Loss PqPq Q Dom Q Dom +Quota

66 66 Import Tarrif (t) Demand New Consumer Surplus Q P P* New Domestic Producer Surplus Supply PWPW Deadweight Loss P W +t Q Dom Q Dom +Quota Government Revenue

67 67 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 68 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 69 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


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