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Microeconomics: An Integrated Approach David Besanko and Ronald Braeutigam Chapter 10: Competitive Markets: Applications Prepared by Katharine Rockett.

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Presentation on theme: "Microeconomics: An Integrated Approach David Besanko and Ronald Braeutigam Chapter 10: Competitive Markets: Applications Prepared by Katharine Rockett."— Presentation transcript:

1 Microeconomics: An Integrated Approach David Besanko and Ronald Braeutigam Chapter 10: Competitive Markets: Applications Prepared by Katharine Rockett © 2002 John Wiley & Sons, Inc.

2 1. Motivation: Agricultural Price Supports 2. Deadweight Loss: "A Perfectly Competitive Market Without Intervention Maximizes Total Surplus" 3. Government Intervention: Who wins and who loses? 4. Examples of Various Government Policies Excise Taxes Price Ceilings Production Quotas Import Tariffs 5. Conclusions

3 At the Perfectly Competitive Equilibrium, (Q*,P*), Total Surplus is maximized. Consumer's Surplus at (Q*,P*): ABC Producer's Surplus at (Q*,P*) : DBC Total Surplus at (Q*,P*): ADC

4 Example: Surplus Maximization in Competitive Equilibrium Demand Supply Q P Q* P* A B C D Q1Q1 PdPd PsPs

5 Example: Surplus Maximization in Competitive Equilibrium Demand Supply Q P Q* P* A B C D PsPs PdPd Q2Q2

6 Definition: A deadweight loss is a reduction in net economic benefits resulting from an inefficient allocation of resources. (Shaded area in diagrams)

7 Definition: Economic Efficiency means that the total surplus is maximized. The perfectly competitive equilibrium attains economic efficiency. "Every consumer who is willing to pay more than the opportunity cost of the resources needed to produce extra output is able to buy; every consumer who is not willing to pay the opportunity cost of the extra output does not buy." "All gains from trade (between buyers and suppliers) are exhausted at the efficient point."

8 Government Intervention: Who Wins and Who Loses? Effect on Effect on Effect on Effect on (domestic) (domestic) (domestic) (domestic) Is a (domestic) Intervention Quantity Consumer Producer Government Deadweight Type: Traded Surplus Surplus Budget Loss created?

9 Definition: An excise tax (or a specific 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)

10 Example: Excise Tax T S S Q P Q1Q1 Q* PdPd PsPs Demand P*

11 Definition: The amount by which the price paid by buyers, P D, rises over the non-tax equilibrium price, P*, is the incidence of the tax on consumers; the amount by which the price received by sellers, P S, falls below P* is called the incidence of the tax on producers.

12 Example: Incidence of a Tax in Two Cases D D Q Q P P S S T S T P s = P* P d =P*+T P d = P* P s = P*-T

13 "Back of the envelope" method to calculate the incidence of a specific tax P d / P s = / where: is the own-price elasticity of supply is the own-price elasticity of demand

14 Why?…consider a small tax applied to an economy at point (Q*,P*)… =( Q/Q*)/( P d /P*)… Q/Q*= P d /P* =( Q/Q*)/( P s /P*)… Q/Q*= P s /P* but for market to clear, Q/Q* must be the same for demand and supply, hence P d /P* = P s /P*

15 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 $.8 and a decrease in price received by producers of $.2" Note: Subsidies are negative taxes…

16 Example: Subsidies S D Q P Q*Q2Q2 PsPs PdPd

17 Example: Subsidies S S D Q P Q*Q2Q2 PsPs PdPd T

18 Example: Subsidies S S D Q P Q*Q2Q2 PsPs PdPd T

19 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.

20 Example: Price Ceilings S D Q P

21 S D Q P P MAX

22 Example: Price Ceilings S D Q P Q*QdQd QsQs P MAX Excess Demand

23 Definition: A price floor is a minimum price that consumers can legally pay for a good. Price floors sometimes are referred to as price supports. If the price floor is above the pre-control competitive equilibrium price, it is said to be binding.

24 Example: Price Floor S D Q P

25 S D Q P Q*QsQs QdQd

26 Example: Price Floor S D Q P Q*QsQs QdQd P MIN Excess Supply

27 Definition: A production quota is a limit on either the number of producers in the market or on the amount that each producer can sell. The quota usually has a goal of placing a limit on the total quantity that producers can supply to the market.

28 Example: Production Quota Original Supply Demand Q P Q* Q MAX

29 Example: Production Quota Original Supply Demand Q P Q* Q MAX P*

30 Example: Production Quota Original Supply Demand Q P Q* Q MAX Supply with quota P*

31 Definition: Tariffs are taxes levied by a government on goods imported into the government's own country. Tariffs sometimes are called duties. Definition: An import quota is a limit on the total number of units of a good that can be imported into the country.

32 When will importation occur of a good? Domestic Supply Domestic Demand A C D Q P Example: Importation of a Good

33 When will importation occur of a good? Example: Importation of a Good Domestic Supply Domestic Demand Q1Q1 Q4Q4 A BC D Q P P*

34 When will importation occur of a good? Example: Importation of a Good Domestic Supply Domestic Demand Foreign Supply PWPW Q1Q1 Q4Q4 A BC D Q P P*

35 Example: Import Tariff Now, add an import tariff… Domestic Supply Domestic Demand Q P

36 Example: Import Tariff Now, add an import tariff… Domestic Supply Domestic Demand Q1Q1 Q4Q4 Q2Q2 Q3Q3 Q P

37 Example: Import Tariff Now, add an import tariff… Domestic Supply Domestic Demand PWPW Q1Q1 Q4Q4 T Q2Q2 Q3Q3 P W +T Q P

38 Example: Import Tariff Now, add an import tariff… Domestic Supply Domestic Demand PWPW Q1Q1 Q4Q4 T Q2Q2 Q3Q3 P W +T Q P A B CD

39 Comparing a tariff to a quota… Let quota limit imports to Q 3 -Q 2 …the equilibrium price would be the same as for the tariff…and the (world) deadweight loss would be the same as well. Is there a difference? The quota generates no government revenue. Hence, while the total supply and total price for the domestic market remains the same under the two policies, domestic deadweight loss is larger under the quota.

40 1. An "invisible hand" guides the competitive market to the efficient level of production and consumption. 2. We obtained conclusion (1) for a single market only and under the assumption that price fully reflects all costs and benefits to the market and that there is perfect information. We will relax these assumptions in subsequent chapters. 3. The government policies we examined here all resulted in a deadweight loss compared to the perfectly competitive equilibrium.

41 4. Conclusion (3) is sensitive to the underlying market structure. We will examine non-competitive market structures in subsequent chapters. 5. Even though all policies resulted in a reduction in total surplus, each had a "constituency" in the form of consumers, producers or the government (effect on budget). If total surplus maximization is not the goal of policy-makers, each policy can be argued for on economic grounds.


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