1. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Some Midterm Stats ●Average score: 77 out of 100 ●6 (six) maximum scores ●Problems 3 and 4 were most challenging on average ●See the Answer Key published ●Go to recitation to get your MT1 back ●Average score: 77 out of 100 ●6 (six) maximum scores ●Problems 3 and 4 were most challenging on average ●See the Answer Key published ●Go to recitation to get your MT1 back

2. Last Lecture Clean-up: Tax Policy Analysis

3. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Tax Policy Analysis ●Last time we considered the model of supply and demand ●It can be used to demonstrate the effects of taxation on both consumers and producers ●Today we will consider an example of how to measure the tax burden ●Assume a market for cigarettes ●Last time we considered the model of supply and demand ●It can be used to demonstrate the effects of taxation on both consumers and producers ●Today we will consider an example of how to measure the tax burden ●Assume a market for cigarettes

4. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Tax Policy Analysis ●We assume demand is: P(Q) = 140 – 2Q ●And supply is: P(Q) = 20 + Q ♦We call these inverse demand and inverse supply since usually think of quantity as function of price ●What is the equilibrium? ●What are CS, PS, TS? ●We assume demand is: P(Q) = 140 – 2Q ●And supply is: P(Q) = 20 + Q ♦We call these inverse demand and inverse supply since usually think of quantity as function of price ●What is the equilibrium? ●What are CS, PS, TS?

5. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Tax Policy Analysis ●Eqm: S = D, or 140 – 2Q = 20 + Q ●Solving for Q gives Q = 40, then P = 60 ●CS = (140 – 60) * 40 * ½ = 1600 ●PS = (60 – 20) * 40 * ½ = 800 ●So TS = 1600 + 1600 = 2400 ●Illustration: ●Eqm: S = D, or 140 – 2Q = 20 + Q ●Solving for Q gives Q = 40, then P = 60 ●CS = (140 – 60) * 40 * ½ = 1600 ●PS = (60 – 20) * 40 * ½ = 800 ●So TS = 1600 + 1600 = 2400 ●Illustration:

6. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. FIGURE 1 Supply and Demand for Cigarettes Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 40 Q P 0 20 D S E 140 60

7. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Tax Policy Analysis ●Suppose government wants to introduce a tax that induces people not to smoke ●Usually taxes are levied on producers – easier to collect ●So assume there is a tax of 12 per pack ♦If uncomfortable with such high prices, think of other currency rather than dollars ●Suppose government wants to introduce a tax that induces people not to smoke ●Usually taxes are levied on producers – easier to collect ●So assume there is a tax of 12 per pack ♦If uncomfortable with such high prices, think of other currency rather than dollars

8. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Tax Policy Analysis ●Costs of producers stay the same ●So they translate tax into price one-for-one ♦Had supply P(Q) = 20 + Q ♦Now have P(Q) = (20 + Q) + 12 = 32 + Q ●New eqm: S = D, or 140 – 2Q = 32 + Q ●Solving for Q gives Q = 36, then P = 68 ●What changes in the picture? ●Costs of producers stay the same ●So they translate tax into price one-for-one ♦Had supply P(Q) = 20 + Q ♦Now have P(Q) = (20 + Q) + 12 = 32 + Q ●New eqm: S = D, or 140 – 2Q = 32 + Q ●Solving for Q gives Q = 36, then P = 68 ●What changes in the picture?

9. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. FIGURE 2 Supply and Demand for Cigarettes, After Tax Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 36 40Q P 0 20 68 60 D S S’ E E’ 140 32

10. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Tax Policy Analysis ●We compute new CS and PS: ●CS = ½ * (140 – 68) * 36 = 1296 ●PS = ½ * (68 – 32) * 36 = 648 ●Now CS + PS ≠ TS, also have tax revenue of government ●Where is it on the picture? ●We compute new CS and PS: ●CS = ½ * (140 – 68) * 36 = 1296 ●PS = ½ * (68 – 32) * 36 = 648 ●Now CS + PS ≠ TS, also have tax revenue of government ●Where is it on the picture?

11. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. FIGURE 6 Demand Curve for Milk Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 36 40Q P 0 20 68 60 D S S’ E E’ 140 32 56 Consumer tax burden Producer tax burden

12. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Tax Policy Analysis ●Notice that both consumers and producers pay tax, what are the burdens? ●Total tax collected = 12 * 36 = 432 ♦Consumers pay = (68 – 60) * 36 = 288 ♦Producers pay = (60 – 56) * 36 = 144 ●Had CS = 1296, PS = 648 ●TS now is CS + PS + Tax Revenue = 1296 + 648 + 432 = 2376 ●Notice that both consumers and producers pay tax, what are the burdens? ●Total tax collected = 12 * 36 = 432 ♦Consumers pay = (68 – 60) * 36 = 288 ♦Producers pay = (60 – 56) * 36 = 144 ●Had CS = 1296, PS = 648 ●TS now is CS + PS + Tax Revenue = 1296 + 648 + 432 = 2376

13. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Tax Policy Analysis ●Before had TS = 2400 ●Now have TS = 2376 ●Difference is DWL of taxation ●Can compute it to check ourselves: ♦DWL = (68 – 56 ) * (40 – 36) * ½ = 24 ♦Note that 2400 – 2376 = 24, which confirms our calculations are correct ●Before had TS = 2400 ●Now have TS = 2376 ●Difference is DWL of taxation ●Can compute it to check ourselves: ♦DWL = (68 – 56 ) * (40 – 36) * ½ = 24 ♦Note that 2400 – 2376 = 24, which confirms our calculations are correct

14. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. FIGURE 6 Demand Curve for Milk Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 36 40Q P 0 20 68 60 D S S’ E E’ 140 32 56 Consumer tax burden Producer tax burden Dead Weight Loss

15. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Tax Policy Analysis: Results ●By introducing taxes, government creates inefficiency (positive DWL) ●So for efficient outcomes it is best not to have any taxes at all ♦But this is rarely possible in practice ●Some current research in economics tries to design taxes that minimize inefficiency ♦That’s what our professor got Nobel Prize for! ●By introducing taxes, government creates inefficiency (positive DWL) ●So for efficient outcomes it is best not to have any taxes at all ♦But this is rarely possible in practice ●Some current research in economics tries to design taxes that minimize inefficiency ♦That’s what our professor got Nobel Prize for!

16. The Firm and the Industry Under Perfect Competition

17. ●Perfect Competition Defined ●The Competitive Firm ●The Competitive Industry ●Perfect Competition and Economic Efficiency ●Perfect Competition Defined ●The Competitive Firm ●The Competitive Industry ●Perfect Competition and Economic Efficiency Contents Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

18. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Perfect Competition Defined ●Four Principal Market Types ♦Perfect competition ♦Monopolistic competition ♦Oligopoly ♦Pure monopoly ●Four Principal Market Types ♦Perfect competition ♦Monopolistic competition ♦Oligopoly ♦Pure monopoly

19. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Perfect Competition Defined ●Perfect competition ♦Many small firms and customers ♦Homogeneous product ♦Free entry and exit ♦Well-informed producers and consumers ●Perfect competition ♦Many small firms and customers ♦Homogeneous product ♦Free entry and exit ♦Well-informed producers and consumers

20. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Competitive Firm ●Perfect competition ♦Firm is a price taker. ♦Price is set in the market. ♦Firm is too small to affect the market. ●Perfect competition ♦Firm is a price taker. ♦Price is set in the market. ♦Firm is too small to affect the market.

21. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Competitive Firm ●The Firm’s Demand Curve under Perfect Competition ♦Horizontal ♦Can sell as much as it wants at the market price. ●The Firm’s Demand Curve under Perfect Competition ♦Horizontal ♦Can sell as much as it wants at the market price.

22. FIGURE 1: Demand Curve for a Firm under Perfect Competition Copyright © 2006 South-Western/Thomson Learning. All rights reserved. S S Industry supply curve Industry demand curve (b) Total Sales in Chicago in Thousands of Truckloads per Year D D 4003002001000 Jasmine’s demand curve Price per Bushel in Chicago (a) Truckloads of Corn Sold by Farmer Jasmine per Year $3 ECBA 43210

23. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Competitive Firm ●Short-Run Equilibrium for the Perfectly Competitive Firm ♦Marginal revenue = price ♦Profit-maximizing level of output we derived before: MR = MC ●Short-Run Equilibrium for the Perfectly Competitive Firm ♦Marginal revenue = price ♦Profit-maximizing level of output we derived before: MR = MC

24. TABLE 1: Revenues, Costs, and Profits of a Competitive Firm Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

25. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Short-Run Equilibrium The Competitive Firm ●D = MR = AR = P at all levels of output ♦Since P is constant, AR = TR / Q = = P * Q / Q = P ♦MR = TR(Q+1) – TR(Q) = P (Q+1) – P Q = P ●D = MR = AR = P = MC at the equilibrium level of output ●D = MR = AR = P at all levels of output ♦Since P is constant, AR = TR / Q = = P * Q / Q = P ♦MR = TR(Q+1) – TR(Q) = P (Q+1) – P Q = P ●D = MR = AR = P = MC at the equilibrium level of output

26. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Short-Run Equilibrium Computing Profit: An Equivalent Approach ●For single firm, D = AR = MR = P ●Recall that ATC(Q) = TC(Q) / Q ●Also recall that Profit = TR − TC ♦Since TC(Q) = ATC(Q) * Q ♦And since TR = P * Q ●Can write Profit = (P – ATC) * Q ●Will use this one a lot ●For single firm, D = AR = MR = P ●Recall that ATC(Q) = TC(Q) / Q ●Also recall that Profit = TR − TC ♦Since TC(Q) = ATC(Q) * Q ♦And since TR = P * Q ●Can write Profit = (P – ATC) * Q ●Will use this one a lot

27. FIGURE 2: Short-Run Equilibrium of the Perfectly Competitive Firm Copyright © 2006 South-Western/Thomson Learning. All rights reserved. ACMC 1.50 2.25 Revenue and Cost per Bushel Bushels of Corn per Year $3.00 50,0000 D = MR = AR B A

28. ●The MC = P condition does not show if the firm is making a profit or incurring a loss. ●Compare price (average revenue) with average cost to calculate profit or loss per unit. ●The profit-maximizing output may lead to a loss, but if so it is the minimum possible loss. ●The MC = P condition does not show if the firm is making a profit or incurring a loss. ●Compare price (average revenue) with average cost to calculate profit or loss per unit. ●The profit-maximizing output may lead to a loss, but if so it is the minimum possible loss. Short-Run Profit: Graphic Representation Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

29. FIGURE 3: S-R Equilibrium of Competitive Firm w/Lower Price Copyright © 2006 South-Western/Thomson Learning. All rights reserved. MC 1.50 $2.25 Revenue and Cost per Bushel Bushels of Corn per Year 30,0000 D = MR =P AC A B

30. ●Rule 1: The firm will make a profit if total revenue (TR) > total cost (TC) ●Should not plan to shut down in either the short run or the long run. ●Rule 1: The firm will make a profit if total revenue (TR) > total cost (TC) ●Should not plan to shut down in either the short run or the long run. Shutdown and Break-Even Analysis Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

31. ●Rule 2: Even if TR TVC. ●If TR > TVC, the firm can at least pay some of its fixed costs. ●The firm should close in the long run if TR < TC. ●Rule 2: Even if TR TVC. ●If TR > TVC, the firm can at least pay some of its fixed costs. ●The firm should close in the long run if TR < TC. Shutdown and Breakeven Analysis Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

32. TABLE 2: The Shutdown Decision Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

33. ●The competitive firm will produce nothing unless price lies above the minimum point on the AVC curve. Shutdown and Breakeven Analysis Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

34. FIGURE 4: Shutdown Analysis Copyright © 2006 South-Western/Thomson Learning. All rights reserved. 0 Quantity Supplied Price P 1 P 1 P 2 P 2 P 3 P 3 AVC AC MC B A

35. ●Horizontal  individual supply curves  market supply curve ●Since assume firms are identical – just replicate the individual supplies as many times as there are firms in the industry ●Horizontal  individual supply curves  market supply curve ●Since assume firms are identical – just replicate the individual supplies as many times as there are firms in the industry The Competitive Firm’s Short-run Supply Curve Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

36. FIGURE 5: Derivation of the Industry Supply Curve Copyright © 2006 South-Western/Thomson Learning. All rights reserved. S S (b) 5045 Quantity Supplied in Millions of Bushels Price per Bushel s s (a) 2.25 $3.00 5045 Quantity Supplied in Thousands of Bushels e c E C 2.25 $3.00 Price per Bushel

37. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Competitive Industry ●The Competitive Industry’s Short-Run Supply Curve ♦A competitive industry has a stable equilibrium at the output where supply equals demand. ♦The competitive industry (unlike the competitive firm) faces a downward sloping demand curve. ●The Competitive Industry’s Short-Run Supply Curve ♦A competitive industry has a stable equilibrium at the output where supply equals demand. ♦The competitive industry (unlike the competitive firm) faces a downward sloping demand curve.

38. FIGURE 6: Supply-Demand Eqm. of a Competitive Industry Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Quantity of Corn in Millions of Bushels Price per Bushel $3.75 3.00 2.25 0724550 S S D D C A E

39. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Competitive Industry ●Industry Equilibrium in the Short Run ♦Economic costs include opportunity costs, so zero economic profit means that firms are earning the normal, economy-wide rate of profit. ♦Freedom of entry and exit guarantee this result in the long run under perfect competition. ●Industry Equilibrium in the Short Run ♦Economic costs include opportunity costs, so zero economic profit means that firms are earning the normal, economy-wide rate of profit. ♦Freedom of entry and exit guarantee this result in the long run under perfect competition.

40. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Competitive Industry ●Industry and Firm Equilibrium in the Long Run ♦In the long run, firms enter or exit the industry in response to profits or losses. ♦This shifts the supply curve and the price until profits are zero. ♦In long-run, competitive equilibrium, P = MC = AC. ●Industry and Firm Equilibrium in the Long Run ♦In the long run, firms enter or exit the industry in response to profits or losses. ♦This shifts the supply curve and the price until profits are zero. ♦In long-run, competitive equilibrium, P = MC = AC.

41. FIGURE 7: A Shift in the Industry Supply Curve Copyright © 2006 South-Western/Thomson Learning. All rights reserved. (1,600 firms) S 1 S 1 8072 2.25 Quantity of Corn in Millions of Bushels Price per Bushel $3.00 50 (1,000 firms) S 0 S 0 F D D A E

42. FIGURE 8: The Competitive Firm and the Competitive Industry Copyright © 2006 South-Western/Thomson Learning. All rights reserved. S 1 (1,600 firms) S 1 D 1 Industry (b) D D S 0 (1,000 firms) S 0 72 Quantity of Corn in Millions of Bushels 50 A E Price per Bushel (a) 45 Quantity of Corn in Thousands of Bushels 4050 D 0 AC Firm MC 2.25 $3.00 Price per Bushel $3.00 e a b

43. FIGURE 9: L-R Equilibrium of the Competitive Firm and Industry Copyright © 2006 South-Western/Thomson Learning. All rights reserved. D D Price per Bushel $1.87 (b) 83 Quantity of Corn in Millions of Bushels AC IndustryFirm MC Price per Bushel $1.87 (a) 40 (2,075 firms) S 2 S 2 D 2 Quantity of Corn in Thousands of Bushels m M

44. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Perfect Competition and Economic Efficiency ●In the long run, competitive firms are driven to produce at the minimum point of their average cost curves. ●In this case, output is produced at the lowest possible cost to society. ●In the long run, competitive firms are driven to produce at the minimum point of their average cost curves. ●In this case, output is produced at the lowest possible cost to society.

45. TABLE 3: Avg. Cost for the Firm and Total Cost for the Industry Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

46. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Which is Better to Cut Pollution: Carrot or Stick? ●The analysis of perfect competition can be used to show that, if firms are offered a subsidy to reduce their polluting emissions, the industry is likely to increase its emissions, because of free entry. ?

47. FIGURE 11: Taxes vs. Subsidies as Incentives to Cut Pollution Copyright © 2006 South-Western/Thomson Learning. All rights reserved. D D X X Q a Q e Output Q b 0 Price, Average Cost S S T T E B A