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Notes for Chapter 9: The Analysis of Competitive Markets
Pindyck and Rubinfeld - Microeconomics
1. Evaluating the Gains and Losses from Government Policies
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.
2. Review of Consumer and producer surplus
 Consumer surplus is the consumers’ maximum willingness to pay minus the
total expenditures on the good. This is used to evaluate the consumers’
welfare.
 Producer surplus is the sum over all the units produced of difference between
market price of the good and marginal cost of production. Producer surplus is
used to evaluate the producers’ welfare. Producer surplus is the benefit that
lower-cost producers enjoy by selling at the market price.
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Consumer Surplus for an individual consumer
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
p, $ per
trading card
Consumer
surplus, CS
p1
Expenditure, E
Demand
Marginal willingness to
pay for the last unit of output
q
q , Trading cards per year
3
Fall in Consumer Surplus from 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
4
Some real world data:
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Producer Surplus:
(a) A Firm’s Producer Surplus
p, $ per unit
Supply
4
p
PS1 = $3 PS 2 = $2 PS 3 = $1
3
2
1
MC1 = $1 MC2 = $2 MC3 = $3 MC4 = $4
0
1
2
3
4
q, Units per week
6
(b) A Market’s Producer Surplus
p, Price per unit
Market supply curve
Market price
p*
Producer
PS
Variable cost, VC
Q*
Q, Units per year
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Change in Producer Surplus due to a price change:
p, ¢ per stem
E = $4.05 million
30
Supply
a
D = $104.4 million
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b
F
0
1.16
1.25
Q, Billion rose stems per year
Producer Surplus
Original Price
P=$0.30
D+E+F
New Lower Price
P=$0.21
F
Change in PS
(in $ millions)
– D – E = $108.45
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We can show the consumer surplus and producer surplus on a demand-supply
diagram.
Price
S
Consumer
surplus
PEQ
Producer
surplus
D
QEQ
Output
Welfare or Total Surplus = CS + PS
Welfare is maximized at the competitive market equilibrium P and Q. (This, of
course, assumes that there are no market failures or externalities.)
On the next page, you will see two graphs, one with lower than equilibrium output,
and one with higher than equilibrium output. At each of these (non-equilibrium Qs),
total surplus (CS+PS) is less than that achieved at the competitive market
equilibrium QEQ .
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Why Reducing Output from the Competitive Level Lowers Welfare:
p, $ per unit
Supply
A
p
MC
e2
2
1 = p1
B
D
C
E
e1
Demand
MC 2
F
Q2
Q 1 Q, Units per year
Why Increasing Output from the Competitive Level Lowers Welfare:
p , $ per unit
+F
Supply
MC 2
A
e
1
MC 1 = p 1
p2
C
B
DE
e2
Demand
F
G
H
Q1
Q2
Q, Units per year
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3. Welfare effects of price ceiling
With consumer and producer surplus, we can evaluate the welfare effects of a price
ceiling. Welfare effects are the gains and losses caused by government intervention
in the market.
Here, we want to evaluate the welfare effects of price ceiling.
Suppose that the following diagram shows the initial situation before the imposition
of price ceiling.
Price
B
S
Consumer
surplus
PEQ
C
Producer
surplus
Pceiling
D
A
QEQ
Output
As can be seen, the sum of consumer surplus and producer surplus is the area of the
triangle ABC. Here, we will show the welfare effects by going over some exercise
questions.
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Price
B
S
Consumer
surplus
PEQ
C
Producer
surplus
Pceiling
D
A
QEQ
Output
Exercise 1
Q1: Suppose that government imposes a ceiling price (Pceiling in the diagram). 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.]
Q2: What is the consumer surplus under this price ceiling policy? Show graphically.
Q3: What is the producer surplus under this price ceiling policy?
Q4: What is the sum of producer surplus and consumer surplus under the price
ceiling policy? Show graphically.
Q5: What is the change in the sum of consumer surplus and producer surplus
compared to the market equilibrium??
From the exercise, we can see that the price ceiling is likely to reduce the sum of the
consumer and producer surplus. The reduction is referred to as “deadweight loss”.
 Deadweight loss  The reduction in the sum of the consumer surplus and
producer surplus.
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Effects of price ceiling:
A
Supply
B
p1
D
p2
F
C
e1
E
e2
p, Price ceiling
Demand
Qs = Q2
Q1
Qd
Q, Pounds per year
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.
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4. Price Floors or Minimum Prices
The government mandates a price floor or a minimum price, such that it is illegal
for the price to be below the Pmin. (The price is permitted, however, to be higher
than the minimum price/price floor.)
wage
S
E
A
Minimum
wage
B
C
D
D
Qd
Qs
Quantity of
Labor
Workers would like to supply Qs, however, firms only want to hire Qd at the
minimum wage. Therefore, the difference Qs - Qd is “unemployment”.
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 (aka deadweight loss)
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General price floor (for commodities)
P
S
Price Floor
E
A
B
F2
C
D
F1
D
Qd
Qs
Q
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
Where – F1 – F2 represents the costs of production of unsold output.
Change in welfare with price floor (compared to equilibrium)= – B – C – F1 – F2
= deadweight loss
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Price Supports
The government sets a minimum price, and buys all of the excess supply. This is a
common agricultural policy.
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
Q1= 2.1 Qs = 2.2
Q g= 0.3
Q, Billion bushels of soybeans per year
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Production Quotas
Government reduces supply by setting a quota on production. Government might
restrict the quantity that each firm produces, or reduce the number of firms able
to produce.
For example, in the U.S. cities may only issue a limited number of licenses to
operate taxicabs.
P
S
PQuota
E
A
B
C
D
D
Quota
At the quota, price is driven up to Pquota.
At the market equilibrium, CS = A+B+E
PS = C+D
Welfare = A+B+C+D+E
With the quota, CS = E
PS = A+D
Welfare = A+D+E
Change in welfare (due to the quota) = – B – C
= deadweight loss
Q
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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.
P
S
P target
E
A
F
B
D
C
D
Q target
Qhigh
Q
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,
Welfare = A+B+C+D+E
PS = C+D, and
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
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Price Support + Production Quota
Q , Quota
Supply
A
p = 5.00
B
C
e
p 1 = 4.59
E
Demand
F
G1
0
Price support
D2
D1
Qd=1.9
G2
Q 1= 2.1 Q 2= 2.2
Q g= 0.3
Q*g =0.2
Q, Billion bushels of soybeans per year
G1
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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.
Price
S
P0
Pw
D
Qs
Q0
Qd
Quantity
P0 is the price that would prevail if there were no imports. Q0 is the
corresponding market equilibrium output if there were no imports.
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.
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 (QdQs).
[Exercise] In the figure, graphically show the consumer surplus and producer surplus
when the country imports the good.
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5. The effects of import quotas and import tariffs.
Import Quotas: Import quotas restrict the quantity of the good to be imported.
[Exercise]
As an exercise, we will consider the special case of zero import quotas. That is,
forbidding any importation of the good.
The 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.
Price
S
Pw
D
Qs
Qd
Quantity
[Exercise] In the diagram above, to eliminate the import, how big should the tariff
be?
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.
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a 2
Demand S = S
p, 1988 dollars
per barrel
A
e2
29.04
B
14.70
0
C
e1
D
8.2 9.0
10.2
11.8
S 1, World price
13.1
Imports = 4.9
Q , Million barrels of oil per day
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6. 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*.
Price
S
Tariff “t”
P*
Pw
D
Output
We will see the effects of the import tariff by going over some exercise questions.
[Exercise]
Q1. What is the quantity demanded and supplied before the import tariff is imposed?
Q2. What is the producer surplus and consumer surplus before the import tariff is
imposed.
Q3. What is the quantity demanded and supplied after the import tariff is imported?
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?
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p , 1988 dollars
per barrel
Sa = S 2
A
29.04
e2
A
e3
S3
19.70
 = 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
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Welfare Cost of Trade Barriers for the U.S. (millions of 1999 dollars)
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7. Effect of tax and subsidy
Effects of a specific tax
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.
Here, we will see the effects of a specific tax. 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.
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Here, 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
S1
S0
t
Pb
P0
Ps
D0
Q1 Q0
Before the tax is imposed, equilibrium market price and quantity are Q0 and P0.
(i)
The market quantity after the imposition of tax.
 To figure out the market quantity, first, shift the supply curve vertically
by t-cents 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.
(ii)
The price that the consumers pay
 This is given by Pb in the graph.
(iii)
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.
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(iv)
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).
(v)
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 in
this case, the burden of tax is split between consumers and producers (or sellers).
[Exercise]
What is net welfare effect of this tax?
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We considered the case where the specific tax is levied on producers in the previous
page.
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.
S0
Pb
P0
Ps
t
D0
D1
Q1
Q0
Before the tax is imposed, the market equilibrium quantity is Q0.
(i)
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 t-cents. (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.
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(ii)
Price that the producer receives.
This is given by the intersection between D1 and S0
(iii)
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.
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.
S0
Pb
t
Find the output quantity
where the distance between
S0 and D0 is t-cents.
P0
Ps
D0
Q1
Price that consumers pay
Price that producers receive
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Supply
p, ¢ per stem
A
B
32
30
 = 11
D
e2
C
e1
E
Demand
21
F
0
1.16
1.25
Q, Billion rose stems per year