Chapter 9 Chapter 9 Properties and Applications Of The Competitive Market Chapter Outline • • • • • Consumer Welfare Producer Welfare How Competition Maximizes Welfare Policies that shift Supply Curve Policies that create a wedge between Supply and Demand • Comparing both types of Policies: Trade Evaluating the Gains and Losses from Government Policies • Welfare tools are helpful in predicting the impact of government policies and other events that alter a competitive equilibrium. • When we evaluate the gains and losses from government policies, such as price ceilings, price floors, import tariffs, minimum wages etc., consumer surplus and producer surplus are the standard tools for the analyses. Consumer Surplus • Consumer welfare from a good is the benefit a consumer gets from consuming that good minus what the consumer paid to buy the good. • Rephrasing the above, consumer surplus is the consumers’ maximum willingness to pay minus the total expenditures on the good. • The demand curve reflects a consumer’s marginal willingness to pay: – the maximum amount a consumer will spend for an extra unit. – the marginal value the consumer places on the last unit of output. Consumer Surplus • An individual’s consumer surplus is the area under the demand curve and above the market price up to the quantity the consumer buys. Consumer Surplus for an individual consumer (a) David ’s Consumer Surplus p, $ per magazine 5 a b 4 CS1 = $2 CS2 = $1 c 3 Price = $3 2 E 1 = $3 E2 = $3 E 3 = $3 Demand 1 0 1 2 3 4 5 q, Magazines per week Consumer Surplus for the market (b) Steven’s Consumer Surplus p, $ per trading card Consumer surplus, CS p1 Expenditure, E Demand Marginal willingness to pay for the last unit of output q1 q, Trading cards per year Fall in Consumer Surplus as Price Rises p, ¢ per stem 57.8 A = $149.64 million b 32 30 B = $23.2 million C = $0.9 million a Demand 0 1.16 1.25 Q, Billion rose stems per year SOME REAL WORLD DATA Effect of a 10% Increase in Price on Consumer Surplus (Revenue and Consumer Surplus in Billions of 1999 Dollars) p, $ per unit Relatively inelastic demand (at e 1) p2 In general, as the price increases, consumer surplus falls more: 1. the greater the initial revenues spent on the good and 2. the less elastic the demand curve B A C e3 D e2 e p1 1 Relatively elastic demand (at e 1) Q3 Q2 Q 1 Q, Units per week Producer Surplus • PS: The difference between the amount for which a good sells and the minimum amount necessary for the seller to be willing to produce the good • Producer surplus is used to evaluate the producers’ welfare. It is the benefit that lower-cost producers enjoy by selling at the market price. Producer Surplus • It is the sum over all the units produced of difference between market price of the good and marginal cost of production A Firm’s Producer Surplus ’ p, $ per unit Supply 4 p PS1 = $3 PS 2 = $2 PS 3 = $1 3 Actual benefits above costs that producers receive 2 1 MC1 = $1 MC2 = $2 MC3 = $3 MC4 = $4 0 1 2 3 4 q, Units per week A Market’s Producer Surplus p, Price per unit The total producer surplus is the area above the supply curve and below the market price up to the quantity actually produced. Market supply curve Market price p* Producer surplus, PS Variable cost, VC Q* Q, Units per year Change in Producer Surplus due to a price change p, ¢ per stem E = $4.05 million 30 Supply a D = $104.4 million 21 b F 0 1.16 1.25 Q, Billion rose stems per year Producer Surplus Original Price P=$0.30 New Lower Price P=$0.21 Change in PS (in $ millions) D+E+F F – D – E = $108.45 Consumer Surplus and Producer Surplus on a Demand-Supply diagram S Price Welfare is maximized at the competitive market equilibrium P and Q. (This, of course, assumes that there are no market failures or externalities.) Consumer surplus PEQ Producer surplus D QEQ Welfare or Total Surplus = CS + PS Output Deadweight Loss • deadweight loss (DWL) - the net reduction in welfare from a loss of surplus by one group that is not offset by a gain to another group from an action that alters a market equilibrium. Why Reducing Output from the Competitive Level Lowers Welfare p, $ per unit Supply A p MC 1 e2 2 = p1 B D C E e1 Demand MC 2 F Q2 Q 1 Q , Units per year The deadweight loss results because consumers value extra output by more than the marginal cost of producing it. Why Increasing Output from the Competitive Level Lowers Welfare p, $ per unit Supply MC 2 A e 1 MC 1 = p 1 p2 C B DE e2 the cost of producing this extra output exceeds the value consumers place on it. Demand F G H Q1 Q2 Q, Units per year Why Increasing/Decreasing Output from the Competitive Level Lowers Welfare • The reason that competition maximizes welfare is that price equals marginal cost at the competitive equilibrium. • Consumers value the last unit of output by exactly the amount that it costs to produce it • market failure - inefficient production or consumption, often because a price exceeds marginal cost • All government actions affect a competitive equilibrium in one of two ways. 1. by shifting the supply curve (barriers to entry) 2. by creating create a wedge between SUPPLY and DEMAND so that they are not equal, as they were in the original competitive equilibrium. 1. 2. 3. 4. taxes, price ceilings, price floors, and tariffs Policies that shift the Supply Curve • The two most common types of government policies that shift the supply curve are: – limits on the number of firms in a market and – quotas or other limits on the amount of output that firms may produce. Policies that shift the Supply Curve • Governments, other organizations, and social pressures limit the number of firms in at least three ways: – explicitly in some markets, such as the one for taxi service. – barring some members of society from owning firms or performing certain jobs or services. – by raising the cost of entry. Restricting the Number of Firms • A limit on the number of firms causes a shift of the supply curve to the left, which raises the equilibrium price and reduces the equilibrium quantity. – Consumers are harmed since they don’t buy as much as they would at lower prices. – Firms that are in the market when the limits are first imposed benefit from higher profits. Restricting the Number of Firms: Example • Regulation of taxicabs. – Countries throughout the world regulate taxicabs. • To operate a cab in these cities legally, you must possess a city-issued permit, which may be a piece of paper or a medallion. Effect of a Restriction on the Number of Cabs Welfare Effects of a Sales Tax/Subsidy • A new sales tax: – causes the price consumers pay to rise • resulting in a loss of consumer surplus – a fall in the price firms receive • resulting in a drop in producer surplus • However, the new tax provides the government with new tax revenue Welfare Effects of a Sales Tax/Subsidy • Assuming that the government does something useful with the tax revenue, we should include tax revenue in our definition of welfare: W = CS + PS + T. • As a result, the change in welfare is ΔW = ΔCS + ΔPS + ΔT. Welfare Effects of a Sales Tax • The government wants to impose a $1.00 tax on movies. It can do it two ways: – Make the producers pay $1.00 for each movie ticket they sell – Make consumers pay $1.00 when they buy each movie • In which option are consumers paying more? • The burden of a tax (or the benefit of a subsidy) falls partly on the consumer and partly on the producer • How the burden is split between the parties depends on the relative elasticities of demand and supply Welfare Effects of a Sales Tax • For simplicity we will consider a specific tax on a good • Specific tax: A tax of a certain amount of money per unit sold. This tax can be levied on either producers or consumers. If this is levied on producers, they have to pay the tax to the government for each unit they sell. If the tax is levied on consumers, they have to pay the tax the government for each unit they purchase. • Suppose that government imposes a tax of t-cents per unit on widgets; The government must receive t-cents for every widget sold. • First, notice that this means that price the buyer pays must exceed the net price the seller receives by t-cents Welfare Effects of a Sales Tax • We want to know the effects of the specific tax on the market quantity, prices, consumer surplus and producer surplus. • Suppose for simplicity that this tax is levied on producers so that for each unit sold, the producers should pay t-cents to the government Welfare Effects of a Sales Tax A S1 C t Pb 1. The market quantity after the imposition of tax. To figure out the market quantity, first, shift the supply curve vertically by tcents to S1. Then, the market quantity after the imposition of tax is determined by where new supply curve S1 and the demand curve D0 intersect. Therefore,Q1 will be the new market quantity. We shift the supply curve upward by t-cents because the producers have to pay t-cents for each unit sold and this increase marginal cost. S0 . P0 Ps D0 Q1 Q0 Before the tax is imposed, equilibrium market price and quantity are Q0 and P0 2. The price that consumers pay This is given by Pb in the graph. 3. The net price that producers receive. This is given by Ps. This is because, even if the producers receive Pb from consumers, they have to pay t-cents per unit sold. Welfare Effects of a Sales Tax 4. Burden of tax for producers. This is given by (P0 Ps). Producers are burdened by the tax in the sense that they are receiving a lower net price (Ps) compared to the initial market equilibrium price (P0). 5. Burden of tax for consumers. This is given by (Pb P0). Consumers are burdened by the tax in the sense that they have to pay higher price (Pb) compared to the initial market equilibrium price P0. Important: From (iv) and (v), notice that, even if the tax is levied on producers as in this case, the burden of tax is split between consumers and producers (or sellers). • [Exercise] What is the net welfare effect of this tax? Welfare Effects of a Sales Tax • Next we consider the case where specific tax is levied on consumers. • We will see that regardless of whether it is levied on producers and consumers, the results will be the same: that is, the price that consumers pay, and price that producers receive, market quantity and welfare effects are the same. • Suppose for this tax is levied on consumers so that for each unit purchased, the consumers should pay t-cents to the government. Welfare Effects of a Sales Tax Before the tax is imposed, the market equilibrium quantity is Q0. S0 Pb P0 1. The market quantity after the tax is imposed. We can figure this out, first by shifting the demand curve down by t-cents. We shift the demand curve downward since for every unit purchased, the consumers have to pay tcents. (You may think of this as the tax reducing the marginal utility b/c demand curve is basically the marginal utility curve). Then, the market quantity is given by the intersection between the new demand curve D1 and S0. 2. Price that the producer receives. This is given by the intersection between D1 and S0 Ps t D1 Q1 Q0 D0 3. Net Price that the consumer pays. This is given by Pb because, even if the producer offers the price Ps, the consumers have to pay tax of t-cents to government. Welfare Effects of a Sales Tax • Notice that regardless of whether the specific tax is levied on producers or consumers, the price for consumers, price for producers and the market quantity will be the same. • We can simply find those by finding the market quantity where the distance between demand and supply curves is exactly t-cents. Then the price for consumers and producers are given in the graph below. Welfare Effects of a Sales Tax S0 Price Pb P0 Find the output quantity where the distance between S0 and D0 is tcents t PS D0 Q1 Price that consumers pay Price that producers receive Quantity Welfare Effects of a Specific Tax on Roses Supply p, ¢ per stem A B 32 30 t = 11 D e2 C e1 E Demand 21 F 0 1.16 1.25 Q, Billion rose stems per year Impact of Elasticities on Tax Burdens Price Burden on Buyer Price Burden on Seller D S Pb S t Pb P0 P0 PS t D PS Q1 Q 0 Quantity Q1 Q0 Quantity Welfare Effects of a Sales Tax • We can calculate the percentage of a tax borne by consumers using pass-through fraction – ES/(ES - Ed) – Tells fraction of tax “passed through” to consumers through higher prices – For example, when demand is perfectly inelastic (Ed = 0), the pass-through fraction is 1 – consumers bear 100% of tax Welfare Effects of a Subsidy • A subsidy can be analyzed in much the same way as a tax – Payment reducing the buyer’s price below the seller’s price • It can be treated as a negative tax • The seller’s price exceeds the buyer’s price • Quantity increases Welfare Effects of a Subsidy • Suppose that the government gives rose producers a specific subsidy of s = 11¢ per stem. What is the effect of the subsidy on the equilibrium prices and quantity, consumer surplus, producer surplus, government expenditures, welfare, and deadweight loss? Effects of a Subsidy Price D is the deadweight loss from subsidy S Like a tax, the benefit of a subsidy is split between buyers and sellers, depending upon the elasticities of supply and demand. PS Subsidy P0 D Pb D Q0 Q1 Quantity 44 Chapter 9 Price Floors or minimum wages wage S E A D Minimum wage B C D Qd Qs Quantity of Labor In the labor market, workers are suppliers, and firms are consumers. At the market equilibrium, CS = A+B+E PS = C+D Welfare = A+B+C+D+E With the minimum wage, CS = E PS = A+D Welfare = A+D+E Change in welfare due to minimum wage = – B – C =deadweight loss Workers would like to supply Qs, however, firms only want to hire Qd at the minimum wage. Therefore, the difference Qs - Qd is “unemployment”. General price floor (for commodities, like agricultural) At the price floor (artificially high price), quantity demanded is Qd, but producers (by setting p = MC) decide to produce Qs. There is excess supply. At the market equilibrium, CS = A+B+E PS = C+D Welfare =A+B+C+D+E With the price floor, CS = E PS = A + D – F1 – F2 Welfare = A + D + E – F1 – F2 PMIN Q0 Where – F1 – F2 represents the costs of production of unsold output. Change in welfare with price floor (compared to equilibrium)= – B – C – F1 – F2 = DWL Effect of Price Supports in Soybeans p, $ per bushel Supply A p = 5.00 Price support D B C E F e p1 = 4.59 Demand G 3.60 0 MC Qd = 1.9 Q 1= 2.1 Qs = 2.2 Q g = 0.3 Q, Billion bushels of soybeans per year PRICE SUPPORT The government sets a minimum price, and buys all of the excess supply. This is big expenditure for the government!!! Alternative Subsidy Program • What are the effects in the soybean market of a $5-per-bushel price support using a deficiency payment on the equilibrium price and quantity, consumer surplus, producer surplus, and deadweight loss? Here, the government pays the price difference= $5 $4.39 Incentive Programs • Incentive Programs – Government may try to encourage a reduction in quantity (by making a payment) to producers in order to raise price to a target price – For example, government gives farmers financial incentives to restrict supply • Acreage limitation programs – Quantity decreases and price increases for the crop Incentive Programs S’ Price S E Ptarget •CS reduced by A + B F A Cost to government = B+C+F = additional profit made if producing Qhigh at Ptarget B P0 C D D Qtarget Q0 •Change in PS =A+B+F Qhigh Quantity Incentive Programs At the target price, producers will be tempted to produce Qhigh. Therefore, the government payment to producers must give them PS + payment (when they produce Q target) equivalent to PS they would have received from producing Qhigh. Minimum payment needed for producers to supply Q target rather than Qhigh is B+C+F. As before, at the market equilibrium, CS = A+B+E, PS = C+D, and Welfare = A+B+C+D+E With the incentive program, CS = E PS = A+D + B+C+F Change in welfare = Change in CS + Change in PS – Cost to Government = – C – B Welfare Effects of a Price Ceiling • price ceiling - the highest price that a firm can legally charge. • If the government sets the ceiling below the precontrol competitive price, – consumers demand more than the precontrol equilibrium quantity and – firms supply less than that quantity • Producer surplus must fall because firms receive a lower price and sell fewer units. Welfare Effects of a Price Ceiling • We will show the welfare effects by going over some exercise questions. – Suppose that government imposes a ceiling price. What is the quantity supplied in the market? A price ceiling is a government policy such that the government makes it illegal for producers to charge more than the ceiling price. The price ceiling is the maximum price allowed. [Producers are allowed, however to charge less than the ceiling price.] – What is the consumer surplus under this price ceiling policy? Show graphically. – What is the producer surplus under this price ceiling policy? – What is the sum of producer surplus and consumer surplus under the price ceiling policy? Show graphically? – What is the change in the sum of consumer surplus and producer surplus compared to the market equilibrium?? Welfare Effects of a Price Ceiling p, $ per pound Price Ceiling is likely to reduce the sum of the consumer surplus and producer surplus A Supply B p1 D p2 F C e1 E e2 p, Price ceiling Demand Qs = Q2 Q1 Qd Q, Pounds per year Welfare Effects of a Price Ceiling We can interpret D as welfare gain due to the decreased price, and C as the welfare loss due to the decreased consumption. If D is greater than C, then consumer surplus increases due to the price ceiling. But if D is smaller than C, then consumer surplus falls due to the price ceiling. A price ceiling always decreases producer surplus Comparing Both Types of Policies: Imports • The government of the (potentially) importing country can use one of four import policies: – Allow free trade. – Ban all imports. – Set a positive quota. – Set a tariff. • a tax on only imported goods Comparing Both Types of Policies: Imports • If there is no restriction on imports, a country will import a good when the world price is below the (domestic) market price that would prevail if there were no imports. • P0 is the price that would prevail if there were no imports. Q0 is the corresponding market equilibrium output if there were no imports. (see the graph on the next slide) • Suppose that the world price for this good is Pw, which is lower than P0. Then if the country imports the good, the producers in the country will have to sell their product at the world price Pw, not P0. This is because, if domestic producers sold their products higher than Pw, they would lose all their customers (assuming that world supply is unlimited and products are identical). This forces domestic producers to sell at the world price Pw. Comparing Both Types of Policies: Imports S Price P0 PW As can be seen, when the country imports the goods, the price of the good will be Pw, and therefore, quantity supplied will be Qs, and quantity demanded will be Qd. Qs is the amount which is domestically supplied. However, the quantity demanded (Qd) exceeds quantity supplied domestically (Qs). Therefore, the country will import the difference (QdQs). D Qs Q0 Qd Quantity [Exercise] In the figure, graphically show the consumer surplus and producer surplus when the country imports the good. Comparing Both Types of Policies: Imports Price In the diagram, to eliminate the import, how big should the tariff be? Pw Qs Qd Quantity Notice that if government impose import tariff that is big enough to eliminate the imports, the revenue from the tariff would be zero since there is no imports. Comparing Both Types of Policies: Imports • Import Quotas: Import quotas restrict the quantity of the good to be imported. • As an exercise, we will consider the special case of zero import quotas. That is, forbidding any importation of the good. • The next diagram shows the demand and supply diagram when the country imports the good. What would happen to the consumer and producer surplus if the government eliminates all imports? Imports could be reduced to zero either by setting a quota = zero or by imposing a sufficiently high import tariff. Loss from Eliminating Free Trade 9-62 Free Trade Versus a Tariff • There are two common types of tariffs: – specific tariffs — τ dollars per unit and – ad valorem tariffs — α percent of the sales price. • Tariffs are just taxes. – If the only goods sold were imported, the effect of a tariff in the importing country is the same as we showed for a sales tax. Import tariff. More general case • Suppose that the government imposes an import tariff, amount of which is equal to T in the diagram below. Then price of the good in the market will be P*. • We will see the effects of the import tariff by going over some exercise questions. Import Tariff: Exercise Q1. What is the quantity demanded and supplied before the import tariff is imposed? Price Q2. What is the producer surplus and consumer surplus before the import tariff is imposed. S Tariff “t” Q3. What is the quantity demanded and supplied after the import tariff is imported? P* Pw D Output Q4. What is the producer surplus and consumer surplus after the import tariff is imposed? Q5. What is the tax revenue from this import tariff? Q6. What is the net welfare effect of this tariff? Effect of a Tariff (or Quota) p, 1988 dollars per barrel Sa = S 2 A 29.04 e2 e3 S3 19.70 t = 5.00 B 14.70 F D C e1 E G S1, World price H Demand 0 8.2 9.0 11.8 13.1 Imports = 2.8 Q, Million barrels of oil per day