MICROECONOMICS: Theory & Applications By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 11 th Edition, Copyright 2012 PowerPoint prepared by Della L. Sue, Marist College Chapter 10: Using the Competitive Model

Copyright 2012John Wiley & Sons, Inc. 2 Learning Objectives Show how changes in market conditions or government policies affect the welfare of consumers, producers, and market participants as a whole. Analyze the effects of an excise tax on a specific good on the welfare of consumers, producers, and market participants as a whole. Detail how regulation of the U.S. airline industry affected fares, airline company profits, and service quality. (continued)

Copyright 2012John Wiley & Sons, Inc. 3 Learning Objectives (continued ) Explain how the entry restrictions imposed by most major U.S. cities on taxis affects fares and the profits earned by licensed taxi owners. Understand the effects of international trade on consumer and producer surplus and why a net gain results to a country from either imports or exports. Explore how government-specified maximum quantities, or quotas, on sugar imports affect consumers, domestic producers, and the net welfare of the United States as well as other countries that produce sugar.

Copyright 2012John Wiley & Sons, Inc. 4 The Evaluation of Gains and Losses Consumer surplus – a measure of the net gain to a consumer or group of consumers from purchasing a good arising from cost being below the maximum that consumers are willing to pay Producer surplus – gains to producers from the sale of output to consumers, arising from price exceeding the minimum necessary to compensate the seller.

Producer Surplus Who gets the producer surplus? Suppliers of inputs to the industry if the supply curve is upward-sloping Owners of inputs with horizontal supply curves to the industry receive no producer surplus. There is no aggregate producer surplus for a constant-cost competitive industry in long-run equilibrium. Copyright 2012John Wiley & Sons, Inc. 5

Copyright 2012John Wiley & Sons, Inc. 6 Figure Producer Surplus

Copyright 2012John Wiley & Sons, Inc. 7 Consumer Surplus, Producer Surplus, and Efficient Output Total surplus – 2 approaches: the sum of producer and consumer surplus the sum of total surplus associated with each unit of output, added over all units of output Efficiency in output – the condition in which output is expanded to the point where marginal benefit equals marginal cost

Copyright 2012John Wiley & Sons, Inc. 8 Figure Competition Maximizes Total Surplus

Copyright 2012John Wiley & Sons, Inc. 9 The Deadweight Loss of a Price Ceiling Deadweight loss – also called welfare cost, a measure of the aggregate loss in well- being of participants in a market resulting from an inefficient output level Comparison of changes in consumer surplus and producer surplus indicate who gains and who loses

Copyright 2012John Wiley & Sons, Inc. 10 Figure A Price Ceiling Reduces Total Surplus

Copyright 2012John Wiley & Sons, Inc. 11 Excise Taxation Excise tax – a tax levied on a specific good Per unit tax: does not depend on the market price Ad valorem tax: an excise tax that is levied as a certain percentage of the market price

Copyright 2012John Wiley & Sons, Inc. 12 Figure Effects of a Per-Unit Excise Tax

Copyright 2012John Wiley & Sons, Inc. 13 The Consequences of an Excise Tax Short-Run Effects Firms reduce output. Market price rises. Long-Run Effects Even when the tax is levied on and collected from firms, consumers bear a cost as a result of the higher price. After the long-run adjustment to the tax, firms make zero economic profits.

Copyright 2012John Wiley & Sons, Inc. 14 Figure How Elasticities Affect the Tax Burden

Copyright 2012John Wiley & Sons, Inc. 15 Who Bears the Burden of the Tax? When an excise tax is imposed on a good, elasticity determines how much output falls and how much the price to consumers rises. For a given demand curve and tax per unit, the more inelastic the supply curve: the smaller is the tax burden on consumers the larger is the tax burden on producers the smaller is the output reduction For a given supply curve and tax per unit, the more inelastic the demand curve: the greater is the tax burden on consumers the smaller is the tax burden on producers the smaller is the reduction in output

Copyright 2012John Wiley & Sons, Inc. 16 When the Consumer Bears the Entire Burden of the Tax Situations of extreme elasticity: If the demand is perfectly inelastic, the demand curve is vertical. If the supply curve is perfectly elastic, the supply curve is horizontal, which is the constant-cost case. In both cases, the price to consumers rises by the amount of the tax.

The Deadweight Loss of Excise Taxation Any deviation from the competitive level of output is inefficient and results in a decrease in consumer surplus and producer surplus (total loss) Tax revenue: gain to the government Excess burden –deadweight loss produced by a tax total loss = tax revenue + excess burden Copyright 2012John Wiley & Sons, Inc. 17

Figure The Deadweight Loss of Excise Taxation Copyright 2012John Wiley & Sons, Inc. 18

Copyright 2012John Wiley & Sons, Inc. 19 Figure The Deadweight Loss of Rent Control

Copyright 2012John Wiley & Sons, Inc. 20 Airline Regulation and Deregulation : period of regulation in the airline industry by the Civil Aeronautics Board (CAB) Factors that were regulated: Fares Routes between 2 cities Entry of new firms into the industry Support for deregulation: Fares were set above the market equilibrium fare. Accounting profits for the airline industry were below the national average for all industries over the 20 years prior to deregulation in 1978.

What Happened to the Profits? [in the airline industry] Profitable routes covered the loss from unprofitable routes that airlines were required to operate. Airline employee unions bargained for higher wages when fares were above competitive levels. Nonprice competition increased costs. Copyright 2012John Wiley & Sons, Inc. 21

Copyright 2012John Wiley & Sons, Inc. 22 Figure Airline Profitability Under CAB Regulation

Copyright 2012John Wiley & Sons, Inc. 23 The Airline Industry After Deregulation Since the domestic airline industry was deregulated, several changes have occurred: The cost of air travel to consumers has fallen. A major restructuring of the industry has taken place. New entrants into the industry have been able to operate at lower costs than the established carriers. Air service to small communities has increased but fares have also gone up.

Copyright 2012John Wiley & Sons, Inc. 24 The Contestability of Airline Markets Contestable markets – markets in which competition is so perfect that the market price is independent of the number of firms currently serving a market, because the mere possibility of entry suffices to discipline the actions of incumbent suppliers.

Copyright 2012John Wiley & Sons, Inc. 25 Results of Airline Deregulation Concerns after deregulation: Greater congestion at airports Issues of airline safety Possible solutions: Re-regulation Expand airport capacity Implement peak-load pricing

City Taxicab Markets Medallion – a city-issued taxi license; fixed supply Value of medallion: determined by expected profitability of operating a taxi Results include higher fares and lower output than under unregulated conditions Alternative regulation: maximum fares (price ceiling) Illegal markets in transportation services develop Copyright 2012John Wiley & Sons, Inc. 26

Figure 10.9 – Licensing Taxicabs Copyright 2012John Wiley & Sons, Inc. 27

Copyright 2012John Wiley & Sons, Inc. 28 Figure Consumer and Producer Surplus, and the Net Gains from Trade [International Trade]

Copyright 2012John Wiley & Sons, Inc. 29 Figure The Gains from Free Trade [International Trade]

Copyright 2012John Wiley & Sons, Inc. 30 The Link Between Imports and Exports Both nations are better off from trading. When nations trade, one country’s imports are the other country’s exports. When the U.S. imports goods from the rest of the world, the dollars used to pay international suppliers for those goods come back to the U.S. economy in the form of international demand for U.S. exports. Currency is a medium of exchange between imports and exports - Free trade neither creates or destroys currency.

Copyright 2012John Wiley & Sons, Inc. 31 Government Intervention in Markets: Quantity Controls Quotas – government-imposed maximum quantities of goods Application: sugar import quota in the United States Effect of quotas: Deadweight loss occurs Markets of related products are affected Price differentials between countries arise in the regulated market

Copyright 2012John Wiley & Sons, Inc. 32 Figure The Sugar Import Quota

Copyright 2012John Wiley & Sons, Inc. 33 Copyright © 2012 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein.