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

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

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 6

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

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

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

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

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)

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*

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

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*

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

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

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 3 4 5 6 Quantity (thousands of CD players per week)

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 3 4 5 6 Quantity (thousands of CD players per week)

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:

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 3 4 5 6 Quantity (thousands of CD players per week)

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 3 4 5 6 Quantity (thousands of CD players per week)

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

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…

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

Subsidies OLD Consumer Surplus OLD Producer Surplus P S A Ps S-T P* B Pd D OLD Producer Surplus D Q Q* Q1

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

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

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

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

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.

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

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

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)

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

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

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

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

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.

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

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*

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)

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

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

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

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)

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

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

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

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

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

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

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

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

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:

Acreage Limitation Old Consumer Surplus Old Producer Surplus P Supply B C P* D Old Producer Surplus Demand Q Production Limit

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

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

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

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:

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

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

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

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

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.

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

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

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

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

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

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

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?

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