Performance and Strategy in Competitive Markets Chapter 8

Competitive Market Efficiency Why is it Called Perfect Competition? Competitive markets balance supply and demand. Competitive markets maximize social welfare Deadweight Loss Problem Deadweight losses occur when market imperfections reduce transaction volume. Any benefit enjoyed by consumers or producers that is not transferred but lost due to market imperfections is a deadweight loss.

Consumer Surplus the difference between the maximum price a consumer is will to pay for something & its market price is called consumer surplus one of the key elements in cost-benefit analysis

D=MB Q market price Q* Consumer Surplus Marys consumer surplus

D=MB Q market price amountpaid Q* total consumer surplus Consumer Surplus

Producer Surplus the increase in the economic well-being of producers who are able to sell the product at a market price higher than the lowest price that would have drawn out their supply. The difference between total revenues and total costs

Q P D=MB PcPcPcPc QcQcQcQc S = MC consumersurplus producersurplus efficientoutputefficientoutput outcomes with pure competition outcomes with pure competition

A restriction in market supply

Market Failure Situation when competitive market outcomes fail to efficiently allocate economic resources. Failure by market structure Failure can occur in markets with few participants. Failure by incentive Externalities create incentive problems due to differences between private and social costs or benefits. A negative externality is an unpaid cost. A positive externality is an unrewarded benefit.

Role for Government How Government Influences Competitive Markets Tax policy or regulation is efficient if expected benefits exceed expected costs. Fairness must be carefully weighed. Broad Social Considerations Consumer sovereignty is an important benefit of competitive markets. Public policy can control unfairly gained market power. Tax and regulatory policy limit concentration of economic and political power.

© 2009, 2006 South-Western, a part of Cengage Learning Subsidy and Tax Policy Subsidy Policy Subsidies can be indirect, like government highway spending that benefits the trucking industry. Subsidies can be direct, as in agricultural programs. Deadweight Loss From Taxes Taxes reduce economic activity and cause deadweight losses. Pollution taxes explicitly recognize the public's right to a clean environment.

How Taxes on Buyers (and Sellers) Affect Market Outcomes Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden.

How Taxes on Buyers Affect Market Outcomes Elasticity and tax incidence Tax incidence is the manner in which the burden of a tax is shared among participants in a market.

How Taxes on Buyers Affect Market Outcomes Elasticity and Tax Incidence Tax incidence is the study of who bears the burden of a tax. Taxes result in a change in market equilibrium. Buyers pay more and sellers receive less, regardless of whom the tax is levied on.

A Tax on Buyers Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Equilibrium without tax Tax ($0.50) Price buyers pay D1D1 D2D2 Supply,S1S1 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). $ Equilibrium with tax A Tax on Buyers

2.80 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Equilibrium with tax Equilibrium without tax Tax ($0.50) Price buyers pay S1S1 S2S2 Demand,D1D1 A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50) $ A Tax on Sellers

Elasticity and Tax Incidence What was the impact of tax? Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden.

Figure 8 A Payroll Tax Quantity of Labor 0 Wage Labor demand Labor supply Tax wedge Wage workers receive Wage firms pay Wage without tax

Elasticity and Tax Incidence In what proportions is the burden of the tax divided? How do the effects of taxes on sellers compare to those levied on buyers? The answers to these questions depend on the elasticity of demand and the elasticity of supply.

Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (a) Elastic Supply, Inelastic Demand the incidence of the tax falls more heavily on consumers When supply is more elastic than demand... Price without tax than on producers. How the Burden of a Tax Is Divided

Quantity 0 Price Demand Supply Tax Price sellers receive Price buyers pay (b) Inelastic Supply, Elastic Demand than on consumers. 1. When demand is more elastic than supply... Price without tax the incidence of the tax falls more heavily on producers...

Elasticity and Tax Incidence So, how is the burden of the tax divided? The burden of a tax falls more heavily on the side of the market that is less elastic.

Summary: Tax Incidence and Burden Tax Incidence and Burden Tax incidence is the point of tax collection. Tax burden is borne by party who ultimately pays the tax. Role of Elasticity Who pays the economic burden of a tax or operating control depends on the elasticities of supply and demand. The burden of a tax falls more heavily on the side of the market that is less elastic. Elasticity affects the deadweight loss of taxation. Deadweight loss is small when supply (or demand) is inelastic. Deadweight loss is large when supply (or demand) is elastic.

CONTROLS ON PRICES Price Ceiling A legal maximum on the price at which a good can be sold. Price Floor A legal minimum on the price at which a good can be sold.

How Price Ceilings Affect Market Outcomes Two outcomes are possible when the government imposes a price ceiling: The price ceiling is not binding if set above the equilibrium price. The price ceiling is binding if set below the equilibrium price, leading to a shortage.

A Market with a Price Ceiling (a) A Price Ceiling That Is Not Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium quantity $4 Price ceiling Equilibrium price Demand Supply The market clears at $3 and the price ceiling is ineffective.

A Market with a Price Ceiling (b) A Price Ceiling That Is Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply 2Price ceiling Shortage 75 Quantity supplied 125 Quantity demanded Equilibrium price $3

How Price Ceilings Affect Market Outcomes Effects of Price Ceilings A binding price ceiling creates Shortages because Q D > Q S. Example: Gasoline shortage of the 1970s Nonprice rationing Examples: Long lines, discrimination by sellers

CASE STUDY: Lines at the Gas Pump Economists blame government regulations that limited the price oil companies could charge for gasoline. In 1973, OPEC raised the price of crude oil in world markets. Crude oil is the major input in gasoline, so the higher oil prices reduced the supply of gasoline. What was responsible for the long gas lines?

The Market for Gasoline with a Price Ceiling (a) The Price Ceiling on Gasoline Is Not Binding Quantity of Gasoline 0 Price of Gasoline 1. Initially, the price ceiling is not binding... Price ceiling Demand Supply,S1S1 P1P1 Q1Q1

The Market for Gasoline with a Price Ceiling (b) The Price Ceiling on Gasoline Is Binding Quantity of Gasoline 0 Price of Gasoline Demand S1S1 S2S2 Price ceiling QSQS resulting in a shortage the price ceiling becomes binding but when supply falls... P2P2 QDQD P1P1 Q1Q1

CASE STUDY: Rent Control in the Short Run and Long Run Rent controls are ceilings placed on the rents that landlords may charge their tenants. The goal of rent control policy is to help the poor by making housing more affordable. One economist called rent control the best way to destroy a city, other than bombing.

Rent Control in the Short Run and in the Long Run (a) Rent Control in the Short Run (supply and demand are inelastic) Quantity of Apartments 0 Supply Controlled rent Rental Price of Apartment Demand Shortage

Rent Control in the Short Run and in the Long Run (b) Rent Control in the Long Run (supply and demand are elastic) 0 Rental Price of Apartment Quantity of Apartments Demand Supply Controlled rent Shortage

How Price Floors Affect Market Outcomes When the government imposes a price floor, two outcomes are possible. The price floor is not binding if set below the equilibrium price. The price floor is binding if set above the equilibrium price, leading to a surplus.

A Market with a Price Floor (a) A Price Floor That Is Not Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium quantity 2 Price floor Equilibrium price Demand Supply $3 100 The government says that ice- cream cones must sell for at least $2; this legislation is ineffective at the current market price.

A Market with a Price Floor (b) A Price Floor That Is Binding Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply $4 Price floor 80 Quantity demanded 120 Quantity supplied Equilibrium price Surplus 3

How Price Floors Affect Market Outcomes A binding price floor causes... a surplus because Q S > Q D. nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria. Examples: The minimum wage, agricultural price supports

CASE STUDY: The Minimum Wage An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay.

How the Minimum Wage Affects the Labor Market Quantity of Labor Wage 0 Labor demand Labor Supply Equilibrium employment Equilibrium wage

How the Minimum Wage Affects the Labor Market Quantity of Labor Wage 0 Labor Supply Labor surplus (unemployment) Labor demand Minimum wage Quantity demanded Quantity supplied