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Market Intervention under Competitive Market Conditions.

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Presentation on theme: "Market Intervention under Competitive Market Conditions."— Presentation transcript:

1 Market Intervention under Competitive Market Conditions

2 Overview Efficiency of a competitive market Implications of:- 1.Price controls 2.Supply restrictions 3.Import tariff/quota 4.Tax/subsidy

3 Producer Surplus Between 0 and Q 0 producers receive a net gain from selling each product-- producer surplus. Consumer Surplus Digression on Consumer and Producer Surplus Quantity 0 Price S D 5 Q0Q0 Consumer C 10 7 Consumer BConsumer A Between 0 and Q 0 consumers A and B receive a net gain from buying the product-- consumer surplus To determine the welfare effect of a government policy we can measure the gain or loss in consumer and producer surplus.

4 The loss to producers is A+C. Hence, deadweight loss =A+C-A+B=B+C B A C The gain to consumers is A-B. Deadweight Loss Change in Consumer and Producer Surplus from Price Controls Quantity Price S D P0P0 Q0Q0 P max Q1Q1 Q2Q2 Suppose the government imposes a price ceiling P max which is below the market-clearing price P 0.

5 B A P max C Q1Q1 If demand is sufficiently inelastic, triangle B can be larger than rectangle A and the consumer suffers a net loss from price controls. Example Oil price controls and gasoline shortages in 1979 S D Effect of Price Controls When Demand Is Inelastic Quantity Price P0P0 Q2Q2

6 Situations when government intervention can increase efficiency When competitive markets generate an inefficient allocation of resources or market failure? 1)Externalities Costs or benefits that do not show up as part of the market price (e.g. pollution) 2)Lack of Information Imperfect information prevents consumers from making utility- maximizing decisions. Government intervention without a market failure, however, creates inefficiency or deadweight loss.

7 P2P2 Q3Q3 A B C Q2Q2 What would the deadweight loss be if producers cant cut down output at Q S = Q 2 ? Then loss will include D as well. Hence, PS = A-C-D can be negative When only minimum price is held at P 2 only Q 3 will be demanded. The deadweight loss = (-A-B) + (A-C) = -(B+C). With minimum wage, a similar situation arises. Welfare Loss When Price Is Held Above Market-Clearing Level Quantity Price S D P0P0 Q0Q0 D

8 D + Q g QgQg B A Price support with govt. purchase vs. direct income support Quantity Price S D P0P0 Q0Q0 PsPs Q2Q2 Q1Q1 The cost to the government is the speckled rectangle P s (Q 2 -Q 1 ) D C CS=-A-B; PS =A+B+D Total welfare loss= CS + PS – Govt. Cost = D-(Q 2 -Q 1 )p s Govt. purchase With direct income support of A+B+D, total loss is limited to 0+(A+B+D) –(A+B+D) = 0, i.e., free-market is undisturbed With acreage restriction CS=-A-B; PS =A- C+(B+C+D)=A+B+D; govt. cost=-(B+C+D). Hence, total loss = -(B+C)

9 B A CS reduced by A + B Change in PS = A - C Deadweight loss = B+C C Supply Restrictions: Production Quota Quantity Price D P0P0 Q0Q0 S PSPS S Q1Q1 Supply restricted to Q 1 Supply shifts to Q 1

10 QSQS QDQD PWPW Imports A BC By eliminating imports, the price is increased to P O. The producer gain is area A. The loss to consumers = A + B + C, so the deadweight loss is B + C. Import Tariff or Quota That Eliminates Imports Quantity Price How high would a tariff have to be to get the same result? D P0P0 Q0Q0 S In a free market, the domestic price equals the world price P W.

11 Question: – Would the U.S. be better off or worse off with a quota instead of a tariff? (e.g. Japanese import restrictions in the 1980s) Import Tariff or Quota (general case) D CB QSQS QDQD QSQS QDQD A P* PwPw Quantity D S Price

12 Import Tariff or Quota (general case) If a tariff is used the government gains D, so the net domestic product loss is 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. D CB QSQS QDQD QSQS QDQD A P* PwPw Quantity D S Price

13 Example: The Sugar Quota The world price of sugar has been as low as 4 cents per pound, while in the U.S. the price has been cents per pound.

14 C D B Q S = 4.0Q S = 15.6Q d = 21.1 Q d = 24.2 A The cost of the quotas to consumers was A + B + C + D, or $2.4b. The gain to producers was area A, or $1b. Sugar Quota in 1997 Quantity (billions of pounds) Price (cents/lb.) S US D US P W = 11 P US =

15 C D B Q S = 4.0Q S = 15.6Q d = 21.1 Q d = 24.2 A Sugar Quota in 1997 Quantity (billions of pounds) Price (cents/lb.) S US D US P W = 11 P US = Rectangle D was the gain to foreign producers who obtained quota allotments, or $600 million. Triangles B and C represent the deadweight loss of $800 million.

16 The Impact of a Tax or Subsidy The burden of a tax (or the benefit of a subsidy) falls partly on the consumer and partly on the producer. We will consider a specific tax which is a tax of a certain amount of money per unit sold.

17 D S B D A Buyers lose A + B, and sellers lose D + C, and the government earns A + D in revenue. The deadweight loss is B + C. C Incidence of a SpecificTax Quantity Price P0P0 Q0Q0 Q1Q1 PSPS PbPb t P b is the price (including the tax) paid by buyers. P S is the price sellers receive, net of the tax. The burden of the tax is split evenly.

18 Impact of a Tax Depends on Elasticities of Supply and Demand Quantity Price S D S D Q0Q0 P0P0 P0P0 Q0Q0 Q1Q1 PbPb PSPS t Q1Q1 PbPb PSPS t Burden on Buyer Burden on Seller

19 The Effects of a Subsidy A subsidy can be analyzed in much the same way as a tax. It can be treated as a negative tax. The sellers price exceeds the buyers price.

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