Applying the Competitive Model Perloff Chapter 9

Consumer Welfare Measure how much consumers are affected by shocks which affect the equilibrium. Marginal Willingness to Pay The maximum amount a consumer will pay for an extra unit. The monetary difference between what a consumer is willing to pay and what the good actually costs.

Consumer Surplus p , $ per magazine a 5 b 4 CS = $ 2 CS = $ 1 c 3 Price = $ 3 2 E = $ 3 E = $ 3 E = $ 3 Demand 1 2 3 1 1 2 3 4 5 q , Magazines per week

Consumer Surplus with Continuous Demand , $ per trading card Consumer surplus, CS p 1 Expenditure, E Demand Marginal willingness to pay for the last unit of output q q , Trading cards per year 1

Aggregate consumer surplus and the effect of a price change , ¢ per stem 57.8 Influenced by: Position of the demand curve (revenue) Elasticity of demand A = $149.64 million b C = $0.9 million 32 B = $23.2 million a 30 Demand 1.16 1.25 Q , Billion rose stems per year

Producer Welfare Difference between the amount that a good sells for and the minimum they have to be paid to produce (avoidable cost). VC: costs that change as output changes. MC: change in cost when output changes by one unit. VCn=MC1+MC2+ … +MCn

Producer Surplus p , $ per unit Supply 4 p PS = $ 3 PS = $ 2 PS = $ 1 MC = $1 MC = $ 2 MC = $ 3 MC = $ 4 1 2 3 4 1 2 3 4 q , Units per week

Producer Surplus in the Market , Price per unit Market supply curve Market price p * Producer surplus, PS Variable cost, VC Q * Q , Units per year

Producer surplus and profit Producer surplus is revenue minus variable costs. In the long run: all costs are variable profit is zero producer surplus is zero Long run supply curve is horizontal In an increasing cost industry fixed factors earn a return equal to their opportunity cost, rent. Producer surplus is rent in the long run.

Competition maximises welfare How should we measure societies welfare? W = CS + PS Weights both producers and consumers equally If output is either more or less than the competitive equilibrium, welfare is reduced.

The effect of reducing output on welfare , $ per unit A Supply e 2 p e 2 1 B C MC = p 1 1 E Demand D MC 2 F Q Q Q , Units per year 2 1

Explanation At competitive equilibrium P = MC Consumers are prepared to pay (value) the last unit produced at exactly what it costs to produce. P > MC consumers increase in satisfaction outweighs producers reduction as output expands. P < MC consumers reduction in satisfaction folowing a reduction in output is less than producers increase.

Effect of a restriction on the number of taxis p , $ per ride p , $ per ride AC 2 AC 1 M C S 2 A p p E 2 e 2 2 2 p B C S 1 p p 1 e 1 1 E 1 D q q n q Q = n q Q = n q 1 2 2 1 2 2 2 1 1 1 Unrestricted market gives a horizontal LRS curve, a shift in demand is met by more taxi firms entering the market. Restrict number of firms to n2, these firms can be persuaded to supply more rides by shifting up the MC curve. Aggregating this together gives S2 as the industry supply curve. Note rent causes AC1 to go to AC2. q , Rides per month Q , Rides per month

Accounting for the effects of a tax Prices to consumers and producers change. PS and CS change. Government raises tax revenues which is spent to raise peoples welfare. W = PS + CS +T

Effects of a tax p , ¢ per stem Supply A e 32 e B C 30 t = 11 E Demand 21 F 1.16 1.25 Q , Billion rose stems per year

Effects of a price floor , $ per bushel Supply A p = 5.00 Price support D B C e p = 4.59 1 Demand E F G 3.60 MC Q = = = d 1.9 Q 1 2.1 Q s 2.2 Q g = 0.3 Q , Billion bushels of soybeans per year

Trade Policies (imports) Allow free trade (domestic price is the world price). Ban all imports. Set a non-zero import quota. Set a tariff on imported goods.

Free trade versus an import ban , 1988 dollars S a = S 2 Demand per barrel A e 29.04 2 B C e 1 14.70 S 1 , World price D 8.2 9.0 10.2 11.8 13.1 Imports = 4.9 Q , Million barrels of oil per day

Tariff or quota versus import ban , 1988 dollars S a = S 2 per barrel A e 29.04 2 e 3 19.70 S 3 t = 5.00 B D C E e 1 14.70 S 1 , World price F G H Demand 8.2 9.0 11.8 13.1 Imports = 2.8 Q , Million barrels of oil per day With a quota, the internal price must be at a level sufficient to ensure that the domestic supply plus the quota is enough to meet demand. If there is a shortfall the market price will be competed upwards.