The Analysis of Competitive Markets Study Unit 9 The Analysis of Competitive Markets

Outcomes Use consumer and producer surplus to evaluate government policies Determine the efficiency of a competitive market. Describe the effects of the implementation of minimum prices Describe the effects of price support and production quotas Describe the effects of import quotas and tariffs Describe the effects of a tax or subsidy

Evaluating the gains and losses from government policies – consumer and producer surplus

Application of consumer and producer surplus We evaluate welfare effects of government intervention. I.e. gains and losses to consumers and producers Look at price controls: Ceiling price: Government makes it illegal to charge more than a set max price. Increasing demand and decreasing production = creates a shortage/excess demand

Graph explained Change in consumer surplus Some worse off others due to policy Worse off: Rationed out of market due to ↓ production and sales Q0-Q1. Loose their surplus (green). Better off: Can buy goods @ Pmax rather than P0. Enjoy an increase in consumer surplus (blue).

Graph explained Change in producer surplus: Some producers will stay in the market others will leave, price control Remain in market: Produce Q1 will receive lower price. Lose producer surplus (blue). Total production also lost (purple)

Graph explained Deadweight loss: Net loss of total surplus (consumer and producer surplus) Total loss = Green + Purple

Application of consumer and producer surplus

Effect of price controls when demand is inelastic

The efficiency of a competitive market Evaluate market outcome = Do we achieve economic efficiency? Max aggregate of consumer and producer surplus Market failure: A situation in which an unregulated competitive market is inefficient because prices fail to provide proper signals to consumers and producers

The efficiency of a competitive market Why market failure occurs: Externalities: Action taken by producer/consumer which affects other producers/consumers but is not accounted for in market price Lack of information: Lack info on quality or nature of product Can’t make max utility decisions

Welfare loss

Minimum price Government seeks to raise priced above market-clearing levels. One way is to raise price as a direct regulation – illegal to charge a lower price.

Minimum price

Price supports Definition: Price set by government above free-market level and maintained by governmental purchases of excess supply

Price supports

Price supports Consumers: At Ps, quantity demanded fall to Q1 Quantity supplied rises to Q2 Avoid inventories piling up, government must buy Qg = Q2-Q1 Loss in consumer surplus = A Others no longer buy, loss = B Customers lose ∆CS = -A-B

Price Supports Producers: Government: Producers gain hence price SUPPORT Selling larger quantities Q2 at higher price Ps Producer surplus: ∆PS = A+B+D Government: Cost to government to pay (Q2-Q1)Ps Cost will lower if dump goods elsewhere – sell abroad This will hurt domestic production Change in welfare: ∆CS + ∆PS - (Q2-Q1)Ps = D - (Q2-Q1)Ps

Production quotas Government can cause price of a good to rise by reducing supply. Setting a quota on how much firm can produce.

Production quotas

Incentive programs Output reduced by incentives rather that quotas. Getting firms to agree to reduce.

Import Tariff or Quota Import quota: Limit on the quantity of a good that can be imported. Tariff: Tax on an imported good. Without quota/tariff: Country will import at a world price below domestic price

Import quotas and tariffs

General case

Impact of a tax Burden of a tax or benefit of a subsidy falls partly on the consumer and partly the producer. Government collects in 2 ways: Producer pay tax over to SARS. The buyer will pay the tax.

Specific tax Definition: Tax of a certain amount per money Per unit sold In contrast to ad volarem tax or proportional tax.

Incidence of a tax

Specific tax Market clearing requires 4 conditions to be satisfied after tax is in place: Qsold and Pbuyer must be lie on the demand curve Qsold and Pseller must lie on the supply curve Qdemanded = Qsupplied Price buyer pay and Price seller receive = Tax (t)

Tax depend on elasticities Tax shared evenly in previous graph Not always the case. Demand relatively inelastic and supply relatively elastic = Burden of tax mostly on buyers. General: A tax falls mostly on the buyer if Ed/Es is small and mostly on the seller if Ed/Es is large

Tax depend on elasticities

Effects of a subsidy Definition: Payment reducing buyer’s price Below the seller’s price A negative tax The benefit of a subsidy accrues mostly on the buyer if Ed/Es is small and mostly on the seller if Ed/Es is large.

Subsidy