# MICROECONOMIC THEORY ```Chapter 11
APPLIED COMPETITIVE
ANALYSIS
1
Economic Efficiency and
Welfare Analysis
• The area between the demand and the
supply curve represents the sum of
consumer and producer surplus
– measures the total additional value
obtained by market participants by being
able to make market transactions
• This area is maximized at the
competitive market equilibrium
2
Economic Efficiency and
Welfare Analysis
Price
S
Consumer surplus is the
area above price and below
demand
P*
Producer surplus is the
area below price and
above supply
D
Quantity
Q*
3
Economic Efficiency and
Welfare Analysis
Price
S
At output Q1, total surplus
will be smaller
At outputs between Q1 and
Q*, demanders would value
it would cost suppliers to
produce
P*
D
Quantity
Q1
Q*
4
Economic Efficiency and
Welfare Analysis
• Mathematically, we wish to maximize
consumer surplus + producer surplus =
Q
Q
0
0
[U (Q )  PQ]  [PQ   P (Q )dQ]  U (Q )   P (Q )dQ
• In long-run equilibria along the long-run
supply curve, P(Q) = AC = MC
5
Economic Efficiency and
Welfare Analysis
• Maximizing total surplus with respect to
Q yields
U’(Q) = P(Q) = AC = MC
– maximization occurs where the marginal
value of Q to the representative consumer
is equal to market price
• the market equilibrium
6
Welfare Loss Computations
• Use of consumer and producer surplus
notions makes possible the explicit
calculation of welfare losses caused by
restrictions on voluntary transactions
– in the case of linear demand and supply
curves, the calculation is simple because
the areas of loss are often triangular
7
Welfare Loss Computations
• Suppose that the demand is given by
QD = 10 - P
and supply is given by
QS = P - 2
• Market equilibrium occurs where P* = 6
and Q* = 4
8
Welfare Loss Computations
• Restriction of output to Q0 = 3 would
create a gap between what demanders
are willing to pay (PD) and what
suppliers require (PS)
PD = 10 - 3 = 7
PS = 2 + 3 = 5
9
Welfare Loss Computations
The welfare loss from restricting output
to 3 is the area of a triangle
Price
S
7
The loss = (0.5)(2)(1) = 1
6
5
D
3
4
Quantity
10
Welfare Loss Computations
• The welfare loss will be shared by
producers and consumers
• In general, it will depend on the price
elasticity of demand and the price
elasticity of supply to determine who
bears the larger portion of the loss
– the side of the market with the smallest
price elasticity (in absolute value)
11
Price Controls and Shortages
• Sometimes governments may seek to
control prices at below equilibrium
levels
– this will lead to a shortage
• We can look at the changes in producer
and consumer surplus from this policy
to analyze its impact on welfare
12
Price Controls and Shortages
Price
Initially, the market is
in long-run equilibrium
at P1, Q1
SS
LS
P1
Demand increases to D’
D’
D
Q1
Quantity
13
Price Controls and Shortages
Price
SS
In the short run, price
rises to P2
P2
LS
P3
Firms would begin to
enter the industry
P1
D’
The price would end
up at P3
D
Q1
Quantity
14
Price Controls and Shortages
Price
Suppose that the
government imposes
a price ceiling at P1
SS
LS
P3
P1
D’
There will be a
shortage equal to
Q2 - Q1
D
Q1
Q2
Quantity
15
Price Controls and Shortages
Price
because they can
purchase the good for
a lower price
SS
LS
P3
P1
D’
This gain in consumer
rectangle
D
Q1
Q2
Quantity
16
Price Controls and Shortages
Price
The gain to consumers
is also a loss to
producers who now
SS
LS
P3
P1
D’
D
Q1
Q2
therefore represents a
pure transfer from
producers to consumers
No welfare loss there
Quantity
17
Price Controls and Shortages
Price
SS
LS
P3
P1
D’
represents the value
consumer surplus
that would have
been attained
without the price
control
D
Q1
Q2
Quantity
18
Price Controls and Shortages
Price
SS
LS
P3
P1
D’
represents the value
producer surplus
that would have
been attained
without the price
control
D
Q1
Q2
Quantity
19
Price Controls and Shortages
Price
SS
LS
P3
represents the total
value of mutually
beneficial transactions
that are prevented by
the government
P1
D’
D
Q1
Q2
This is a measure of
the pure welfare
costs of this policy
Quantity
20
Disequilibrium Behavior
• Assuming that observed market
outcomes are generated by
Q(P1) = min [QD(P1),QS(P1)],
suppliers will be content with the
outcome but demanders will not
• This could lead to a black market
21
Tax Incidence
• To discuss the effects of a per-unit tax
(t), we need to make a distinction
between the price paid by buyers (PD)
and the price received by sellers (PS)
PD - PS = t
• In terms of small price changes, we
wish to examine
dPD - dPS = dt
22
Tax Incidence
• Maintenance of equilibrium in the
market requires
dQD = dQS
or
DPdPD = SPdPS
• Substituting, we get
DPdPD = SPdPS = SP(dPD - dt)
23
Tax Incidence
• We can now solve for the effect of the
tax on PD:
eS
dPD
SP


dt
SP  DP eS  eD
• Similarly,
dPS
DP
eD


dt
SP  DP eS  eD
24
Tax Incidence
• Because eD  0 and eS  0, dPD /dt  0
and dPS /dt  0
• If demand is perfectly inelastic (eD = 0),
the per-unit tax is completely paid by
demanders
• If demand is perfectly elastic (eD = ), the
per-unit tax is completely paid by
suppliers
25
Tax Incidence
• In general, the actor with the less elastic
responses (in absolute value) will
experience most of the price change
caused by the tax
dPS / dt
eD


dPD / dt
eS
26
Tax Incidence
Price
S
A per-unit tax creates a
wedge between the price
the price that sellers
PD
P*
t
PS
D
Q**
Q*
Quantity
27
Tax Incidence
Price
S
PD
P*
But some of this loss goes
to the government in the
form of tax revenue
PS
D
Q**
Q*
Quantity
28
Tax Incidence
Price
S
Sellers also incur a welfare
loss equal to the shaded area
PD
But some of this loss goes
to the government in the
form of tax revenue
P*
PS
D
Q**
Q*
Quantity
29
Tax Incidence
Price
S
PD
Therefore, this is the deadweight loss from the tax
P*
PS
D
Q**
Q*
Quantity
30
Elasticity
• All nonlump-sum taxes involve
– the size of the losses will depend on the
elasticities of supply and demand
• A linear approximation to the deadweight
loss accompanying a small tax, dt, is
given by
DW = -0.5(dt)(dQ)
31
Elasticity
• From the definition of elasticity, we know
that
dQ = eDdPD  Q0/P0
• This implies that
dQ = eD [eS /(eS - eD)] dt Q0/P0
• Substituting, we get
2
 dt 
DW  0.5  [eD eS /( eS  eD )]P0Q0
 P0 
32
Elasticity
• Deadweight losses are zero if either eD
or eS are zero
– the tax does not alter the quantity of the
• Deadweight losses are smaller in
situations where eD or eS are small
33
Transactions Costs
• Transactions costs can also create a
wedge between the price the buyer pays
and the price the seller receives
– real estate agent fees
– broker fees for the sale of stocks
• If the transactions costs are on a per-unit
basis, these costs will be shared by the
– depends on the specific elasticities involved
34
Price
S
P*
In the absence of
the domestic
equilibrium price
would be P* and
the domestic
equilibrium quantity
would be Q*
D
Q*
Quantity
35
Price
S
If the world price (PW)
is less than the domestic
price, the price will fall
to PW
Quantity demanded will
rise to Q1 and quantity
supplied will fall to Q2
P*
PW
D
Q2
Q*
Q1
imports
Imports = Q1 - Q2
Quantity
36
Price
S
Consumer surplus rises
Producer surplus falls
There is an unambiguous
welfare gain
P*
PW
D
Q1
Q*
Q2
Quantity
37
Effects of a Tariff
Price
S
Suppose that the government
creates a tariff that raises
the price to PR
Quantity demanded falls
to Q3 and quantity supplied
rises to Q4
PR
PW
Imports are now Q3 - Q4
D
Q2 Q4 Q3 Q1
imports
Quantity
38
Effects of a Tariff
Price
Consumer surplus falls
S
Producer surplus rises
The government gets
tariff revenue
PR
PW
These two triangles
D
Q2 Q4 Q3 Q1
Quantity
39
Quantitative Estimates of
• Estimates of the sizes of the welfare
loss triangle can be calculated
• Because PR = (1+t)PW, the proportional
change in quantity demanded is
Q3  Q1 PR  PW

 eD  teD
Q1
PW
40
Price
Quantitative Estimates of
S
The areas of these two
triangles are
DW1  0.5(PR  PW )(Q1  Q3 )
DW1  0.5t 2eDPW Q1
PR
PW
DW2  0.5(PR  PW )(Q4  Q2 )
D
Q2 Q4 Q3 Q1
DW2  0.5t 2eS PW Q2
Quantity
41
• A quota that limits imports to Q3 - Q4
would have effects that are similar to
those for the tariff
– same decline in consumer surplus
– same increase in producer surplus
• One big difference is that the quota
does not give the government any tariff
revenue
– the deadweight loss will be larger
42
• If the market demand curve is
QD = 200P-1.2
and the market supply curve is
QS = 1.3P,
the domestic long-run equilibrium will
occur where P* = 9.87 and Q* = 12.8
43
• If the world price was PW = 9, QD would
be 14.3 and QS would be 11.7
– imports will be 2.6
• If the government placed a tariff of 0.5
on each unit sold, the world price will be
PW = 9.5
– imports will fall to 1.0
44
• The welfare effect of the tariff can be
calculated
DW1 = 0.5(0.5)(14.3 - 13.4) = 0.225
DW2 = 0.5(0.5)(12.4 - 11.7) = 0.175
• Thus, total deadweight loss from the
tariff is 0.225 + 0.175 = 0.4
45
Important Points to Note:
• The concepts of consumer and producer
surplus provide useful ways of analyzing
the effects of economic changes on the
welfare of market participants
– changes in consumer surplus represent
changes in the overall utility consumers
receive from consuming a particular good
– changes in long-run producer surplus
represent changes in the returns product
46
Important Points to Note:
• Price controls involve both transfers
between producers and consumers and
losses of transactions that could benefit
both consumers and producers
47
Important Points to Note:
• Tax incidence analysis concerns the
determination of which economic actor
ultimately bears the burden of a tax
– this incidence will fall mainly on the actors
who exhibit inelastic responses to price
changes
– taxes also involve deadweight losses that
constitute an excess burden in addition to
the burden imposed by the actual tax
revenues collected
48
Important Points to Note:
• Transaction costs can sometimes be
modeled as taxes
– both taxes and transaction costs may affect
the attributes of transactions depending on
the basis on which the costs are incurred
49
Important Points to Note:
• Trade restrictions such as tariffs or
quotas create transfers between
consumers and producers and