Literature: Pindyck and Rubinfeld, Chapter 9 Varian, …...Literature: Pindyck and Rubinfeld, Chapter 9 Varian, Chapter 16 | 20.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public

| 20.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 9 Slide 1 |

9. The Analysis of Competitive Markets

Literature: Pindyck and Rubinfeld, Chapter 9

Varian, Chapter 16


Chapter Outline

• Evaluating the Gains and Losses from Governmental Policies – Consumer and Producer Surplus

• The Efficiency of Competitive Markets

• Minimum Prices

• Price Supports and Production Quotas

• Import Quotas and Tariffs

• The Impact of a Tax or Subsidy


Evaluating the Gains and Losses from Governmental Policies – Consumer and Producer Surplus

• Review of consumer and producer surplus

– Consumer Surplus: Difference between what a consumer is willing to pay for a good and the amount actually paid.

– Producer Surplus: The difference between the market price of a good and the marginal cost of production, aggregated over all units produced by a firm.


Consumer and Producer Surplus

Producer Surplus

Between 0 and Q0, producers enjoy a net gain from producing the product: Producer Surplus.

Consumer Surplus

Quantity 0

Price

S

D

5

Q0

Consumer C

10

7

Consumer B Consumer A

Between 0 and Q0,consumers A and B enjoy a net gain (since they are willing to pay more) from purchasing the product: Consumer Surplus.


Application of Consumer and Producer Surplus

• Together, consumer and producer surplus measure the welfare benefit of a competitive market.

• Welfare effects:

– Gains and losses to consumers and producers.

• Deadweight loss:

− Net loss of total (consumer plus producer) surplus.



The loss to producers is the sum of rectangle A and triangle C. Triangles B and C together measure the deadweight loss from price controls.

B

A C

The gain to consumers is the difference between rectangle A and triangle B.

Deadweight Loss

Quantity

Price

S

D

P0

Q0

Pmax

Q1 Q2

The price of a good has been regulated to be not higher than Pmax, which is below the market-clearing price P0.



• Remark: Effect of price control when demand is inelastic

• If demand is sufficiently inelastic, consumers can suffer a net loss of consumer surplus.


Effect of Price Controls when Demand is Inelastic

B

A Pmax

C

Q1

If demand is sufficiently inelastic, triangle B can be larger than rectangle A. In this case, consumers suffer a net loss from price controls.

S

D

Quantity

Price

P0

Q2


The Efficiency of a Competitive Market

• When does an inefficient allocation of resources or a market failure occur in competitive markets?

1) Externalities Action taken by either a producer or a consumer

which affects other producers or consumers but is not accounted for by the market price (e.g., pollution).

2) Lack of Information

Lack of information about the quality or nature of a product, thus inhibiting utility-maximizing purchasing decisions.


The Efficiency of a Competitive Market

• To increase efficiency, government intervention may then be desired in such markets.

• Government intervention without market failures could create an inefficiency or welfare loss.


Welfare Loss when Price is held below Market-Clearing Level

P1

Q1

A

B

C

When the price is regulated to be not higher than P1, the dead weight loss is given by triangles B and C.

Quantity

Price

S

D

P0

Q0


Welfare Loss when Price is held above Market-Clearing Level

P2

Q3

A B

C

Q2

When price is regulated to be not lower than P2, only Q3 will be demanded. The deadweight loss is given by triangles B and C.

Quantity

Price

S

D

P0

Q0


Minimum Prices

• Government policy sometimes seeks to raise prices above market-clearing levels, rather than lower them.

• We will investigate this by looking at price supports and the minimum wage.


Minimum Prices

B A

The change in producer surplus will be A - C - D. In this case, producers as a group may be worse off.

C

D

Quantity

Price

S

D

P0

Q0

Pmin

Q3 Q2

If producers indeed produce Q2, the amount Q2 - Q3 will go unsold.


Minimum Wage

B The deadweight loss is given by triangles B and C. C

A wmin

L1 L2 Unemployment

Although the market-clearing wage is w0, firms are not allowed to pay less than wmin. This results in unemployment of an amount L2 − L1.

S

D

w0

L0 L

w


Price Supports and Production Quotas

• US Agricultural policies deal largely with price supports. In the EU this was common practice until 1992.

• Price support: price set by the government above free-market level and maintained by governmental purchases of excess supply.

• This is often associated with incentives to reduce or limit production.


Price Supports

B D

A

To maintain a price Ps above the market-clearing price P0, the government buys a quantity Qg. The loss to consumers is A + B and the gain to producers is A + B + D.

D + Qg

Qg

Quantity

Price S

D

P0

Q0

Ps

Q2 Q1


Price Supports

D + Qg

Qg

B A

Quantity

Price S

D

P0

Q0

Ps

Q2 Q1

The cost to government is the rectangle Ps(Q2 - Q1)

D

Deadweight Loss

Dead weight loss D-(Q2-Q1)ps

Vorführender

Präsentationsnotizen

Rechteck noch bepunkten.


Price Supports and Production Quotas

• Production Quotas – The government can also increase the price of a good by

reducing supply. (Milk-quota in the EU (until 2015))

• What effects do the following measures have?

1) Control entry into the taxicab medallions.

2) Control the number of liquor licenses.


Supply Restrictions, Part I

B A

•CS is reduced by triangle A + B. •Change in PS (gain A but lose C) = A – C. •Deadweight loss = B + C .

C

D

Quantity

Price

D

P0

Q0

S

PS

S’

Q1

•Restrict supply to Q1. •Supply curve becomes the vertical line S’ at Q1.


Supply Restrictions

B A

C

D

Quantity

Price

D

P0

Q0

S

PS

S’

Q1

• To maintain Ps we can make use of production quotas and/or financial incentives (set-aside payments). •Cost to government = B + C + D.


Supply Restrictions

B A

Quantity

Price

D

P0

Q0

PS

S

S’

D

C

• = A - C + Payments for not producing A - C + B + C + D = A + B + D.

• The change in consumer and producer surplus is equal to the change resulting from price support.

• = - A - B + A + B + D - B - C - D = - B - C.

• Alternatively you could simply give the producers A+B+D. This would be more efficient, since

PS∆

Welfare∆

Welfare=0∆


Import Quotas and Tariffs

• Many countries use import quotas and tariffs to keep the domestic price of a product above the global level.

• Import quota: limit on the quantity of a good that can be imported.

• Tariff: tax on an imported good.

• Estimates of the EU average bound MFN tariff on agricultural imports range between 18% and 28%. This is much higher than the EU's protection of manufactured goods, which averages around 3%. It is also higher than the protection to agriculture in the United States or Canada, albeit lower than in Japan.


Import Tariff or Quota that Eliminates Imports

QS QD

PW

Imports

A B C

When imports are eliminated, the price increases to PO. The gain to producers is trapezoid A. The loss to consumers is A + B + C; so, the deadweight loss is B + C.

Quantity

Price

What tariff could be imposed here to have the same result? D

P0

Q0

S

In a free market, the domestic price equals the world price PW .


Import Tariff or Quota (general case)

D C B

QS QD Q’S Q’D

A P*

Pw

Quantity

Price

D

S • An increase in price can be achieved by a quota or a tariff.

• Trapezoid A is, again, the gain to domestic producers.

• The loss to consumers is A + B + C + D.

T


Import Tariff or Quota (generall case)

• If a tariff is used, the government gains D, the revenue from the tariff. The net domestic loss is B + C.

• If a quota is used instead, rectangle D becomes part of the profits of foreign producers, and the net domestic loss is B + C + D.

D C B

QS QD Q’S Q’D

A P*

Pw

Quantity

D

S Price

T


The Impact of a Tax or Subsidy

• The tax burden (or subsidy) is either passed on (partly) to the consumers or to the producers.

• Consider a specific tax, i.e., a tax on each unit sold.


Incidence of a Tax

D

S

B

D

A Buyers lose A + B, sellers lose D + C, and the government earns A + D in revenue. The deadweight loss is B + C.

C

Quantity

Price

P0

Q0 Q1

PS

Pb

t

Pb is the price (including the tax) paid by buyers. PS is the price that sellers receive, less the tax. Here, in this example, the burden of the tax is split evenly between buyers and selle


Incidence of a Tax

• After the tax has been levied, four conditions must be satisfied:

1) The quantity sold and the buyer’s price, Pb, must be on the demand curve: QD = QD(Pb).

2) The quantity sold and the seller’s price, PS, must be on the supply curve: QS = QS(PS).

3) QD = QS.

4) Pb - PS = tax.


Impact of a Tax depends on Elasticities of Supply and Demand

Quantity Quantity

Price

S

D S

D

Q0

P0 P0

Q0 Q1

Pb

PS

t

Q1

Pb

PS

t

Tax burden falls mostly on buyers.

Tax burden falls mostly on sellers.


The Effects of a Subsidy or a Tax

Subsidy: Payment reducing the buyer’s price below the seller’s price, i.e., a negative tax.

• A subsidy can be thought of as a negative tax.

• The price of the seller is greater than the price of the buyer.


Subsidy

D

S

Quantity

Price

P0

Q0 Q1

PS

Pb

s

A subsidy can be thought of as a negative tax. Like a tax, the benefit of a subsidy is split between buyers and sellers, depending on the relative elasticities of supply and demand.


Subsidy

• In the case of a subsidy (s), the selling price Pb is below the subsidized price PS, such that

s = PS – Pb.

• The advantage from having a subsidy depends on the ratio of the demand and supply elasticities.

– If the ratio is low, more benefits flow to buyers. – If the ratio is large, more benefits flow to sellers.


A Tax on Gasoline

• Measuring the effect of a €0.50 tax on gasoline. – Intermediate-run elasticity (EP ) of demand = -0.5;

QD = 150 - 50P.

– EP of supply = 0.4; QS = 60 + 40P.

– QS = QD for €1 and 100 billion liters per year.


A Tax on Gasoline

• For a tax of €0.50: – QD = 150 - 50Pb = 60 + 40PS = QS

– 150 - 50(PS+ 0.50) = 60 + 40PS

– PS = 0.72

– Pb = 0.5 + PS

– Pb = 1.22


A Tax on Gasoline

• For a tax of €0.50: – Q = 150 - (50)(1.22) = 89 billions Liter/year

– Q decreases by 11%.


Impact of a 50-Cent Gasoline Tax

D

A

Lost Consumer Surplus

Lost Producer Surplus PS = 0.72

Pb = 1.22

Quantity (billion liters per year)

Price (€ per liter)

0 50 150

0.50

100

P0 = 1.00

1.50

89

t = 0.50

11

Annual revenue from the tax is 0.50(89) or 44.5 billion Euro. The buyer pays a tax amounting to 22 cents, and the producer pays a tax amounting to 28 cents.

S D

60


Impact of a 50 Cent Gasoline Tax

D

A

Lost Consumer Surplus

Lost Producer Surplus PS = 0.72

Pb = 1.22

Price (€ per liter)

0 50 150

0.50

100

P0 = 1.00

1.50

89

t = 0.50

11

S D

60

Deadweight loss = 2.75 billion €/yr

Quantity (billion liters per year)


Summary

• Simple models of supply and demand can be used to analyze a wide variety of government policies.

• In each case, consumer and producer surpluses are used to evaluate the gains and losses to producers and consumers.

• When the government imposes a tax or subsidy, price usually does not rise or fall by the full amount of the tax or subsidy.

• Government intervention generally leads to a dead-weight loss.

• Government intervention in a competitive market is not always bad.

Documents

Literature: Pindyck and Rubinfeld, Chapter 9 Varian, …...Literature: Pindyck and Rubinfeld, Chapter 9 Varian, Chapter 16 | 20.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public