Ch 10: Competitive Markets: Applications

1. Ch 10: Competitive Markets: Applications • Often government intervene in markets, even perfectly competitive markets, for a variety of reasons • Equity (instead of efficiency) • Fixing Market Failures • Achieving Policy Goals • Politics

2. Sidenote: Partial Equilibrium Analysis • In this chapter we’ll use partial equilibrium analysis • we’ll assume government intervention only affects 1 market • We will also assume no externalities exist – no extra results will arise from these programs

3. Chapter 10: Competitive Markets: Applications In this chapter we will cover: 10.1 Maximum Efficiency 10.2 Policy: Excise Tax 10.2.1 Tax Incidence 10.3 Policy: Subsidy 10.4 Policy: Price Ceiling 10.5 Policy: Price Floor 10.6 Policy: Production Quotas 10.7 Agricultural Support 10.8 Policy: Import Quotas and Tariffs

4. The Invisible Hand In 1776, Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations mentioned an “Invisible Hand” that guided competitive markets to maximize efficiency. Although no “Invisible Hand” actually exists, perfectly competitive markets do maximize producer and consumer surplus:

5. 10.1 Maximizing Efficiency For any given good: Consumer Surplus is difference between the consumer’s willingness to pay and the price Producer Surplus is the difference between the price and the producer’s willingness to provide Total Surplus is the difference between the consumer’s willingness to pay and the producer’s willingness to provide

6. Maximizing Efficiency For example: Jacob is willing to pay $20 for essay editting, and Beth is willing to edit essays for $10. The PC market price for editting is $14. Consumer Surplus =$20-$14= $6 Producer Surplus =$14-$10= $4 Total Surplus =$20-$10= $10

7. Consumer and Producer Surplus P Consumer Surplus Supply A C B P* D Producer Surplus Demand Q Q1 Q*

8. 10.2 Policy: Excise Tax Definition: An excise tax is an amount paid by either the consumer or the producer per unit of the good at the point of sale. (The difference between the amount paid by the demanders and the amount received by the suppliers is the tax T.)

9. Example: Excise Tax Q*=Original Q P*=Original P Pd=Price Paid by buyers Ps=Price received by sellers T(ax)=Pd-Ps S+T P S T Pd P* Ps Demand Q Q1 Q*

10. Consumer and Producer Surplus P Old Consumer Surplus S+T A S C B P* D Old Producer Surplus D Q Q1 Q*

11. Consumer and Producer Surplus P New Consumer Surplus S+T A Government Income S Pd C B P* Deadweight Loss Ps D New Producer Surplus D Q Q1 Q*

12. Deadweight Loss? Originally, efficiency was maximized. After the tax was imposed, portions of consumer and producer surplus was transferred to the government -this transfer is still efficient -WHO gets the surplus is irrelevant After the tax, a small triangle of producer and consumer surplus is lost – this triangle is the deadweight loss

13. Deadweight Loss? Deadweight loss – reduction in net economic benefit due to inefficient allocation of resources Taxes create inefficiencies!!

14. Excise Tax Example a) Calculate original equilibrium in the market for oranges expressed as: Qs=2P Qd=21-P Qs=Qd 2P=21-P 3P=21 P*=7 Q*=2P* Q*=2(7) Q*=14

15. b) Calculate Consumer and Producer Surplus. Show Graphically. P CS = (1/2)bh CS = (1/2)(14)(21-7) CS = 98 21 Supply PS = (1/2)bh PS = (1/2)(14)(7) PS = 49 Consumer Surplus 7 Producer Surplus Demand Q 14

16. Excise Tax Example c) If a $3 excise tax is imposed, calculate new equilibrium. Qs=Qd 2P-6=21-P 3P=27 Pd=9 Q*=21-P* Q*=21-9 Q*=12 Old: Qs=2P P=Qs/2 P=Qs/2+3 New: Qs=2P-6 Ps = Pd-T Ps = 9-3 Ps = 6

17. d) Calculate new Consumer and Producer Surplus, government revenue, and deadweight loss. Show graphically CS = (1/2)bh CS = (1/2)(12)(21-9) CS = 72 P 21 S+T PS = (1/2)bh PS = (1/2)(12)(6) PS = 36 CS 9 S G DWL D 6 PS Q 12 14

18. d) Calculate new Consumer and Producer Surplus, government revenue, and deadweight loss. Show graphically G = TQ G = 3(12) G = 36 P 21 S+T DWL = (1/2)bh DWL = (1/2)(14-12)(9-6) DWL = 3 CS 9 S G DWL D 6 PS Q 13 14

19. Excise Tax Example Notice that: DWL = Old Surplus - New Surplus DWL = CSPC+PSPC – [CSTax+PSTax+GTax] DWL = 98 + 49 – [ 72 + 36 + 36 ] DWL = 3

20. Sales Tax Imposed on the Sellers S + tax $100 tax After Tax Market Price Tax revenue Effect is shown based on supply curve S 1100 1050 Price 1000 950 DA 3 4 5 6 Quantity (Big Screen TV’s per week)

21. Tax applied to buyer: Same Outcome D-tax Original Market Price $100 tax S 1100 1050 Price 1000 950 DA 3 4 5 6 Quantity (Big screen TV’s per week)

22. Summary: • Taxes discourage/decrease market activity • Tax incidence measures the effect of a tax on buyers’ and sellers’ prices • Tax burden falls most heavily on the side of the market that is least elastic in its response to a price change:

23. The Sales Tax: Who Pays? Demand Relatively Inelastic S + tax S 110 $10 tax 108 Consumer Price Rises from $100 to $108 105 Price of Internet 100 98 95 DA 3 4 5 6 Quantity (internet customers in 1000’s)

24. The Sales Tax: Who Pays? Demand Relatively More Elastic. Original Market Price S + tax Consumer Price Rises from $100 to $103 S 110 $10 tax DA 105 103 Price of hiking shoes 100 95 93 3 4 5 6 Quantity (daily shoe sales)

25. 10.2.1 Tax Incidence The relationship between tax incidence and elasticity is as follows: Pd/Ps = / where:  is the own-price elasticity of supply  is the own-price elasticity of demand

26. Example: Let  = -.5 and  = 2. What is the relative incidence of a specific tax on consumers and producers? Pd/Ps = 2/-.5 = -4 OR Pd = -4Ps interpretation: “consumers/demanders pay four times as much as producers/suppliers. Hence, an excise tax of $1 results in an increase in consumer price of $.80 and a decrease in price received by producers of $.20" Next: Subsidies are negative taxes…

27. 10.3 Subsidies • Subsidies work as a negative tax, increasing the seller’s price by T (or reducing the buyer’s price by T; outcomes are the same) • Subsidies will: • Encourage overproduction • Increase Consumer Surplus • Increase Producer Surplus • Be a government cost • Government Cost is always greater than the gain in consumer and producer surplus

28. Subsidies P OLD Consumer Surplus S A Ps S-T P* C B Pd D OLD Producer Surplus D Q Q* Q1

29. Subsidies P New Consumer Surplus S A Ps S-T P* C B Pd D D Q Q1 Q*

30. Subsidies P S A Ps S-T P* C B Pd D New Producer Surplus D Q Q1 Q*

31. Subsidies P S A Ps S-T P* C B Government Cost Pd D D Q Q1 Q*

32. Subsidies P S A Ps S-T P* C B Deadweight Loss (yellow triangle) Pd D D Q Q1 Q*

33. 10.4 Policy: Price Ceilings Definition: A price ceiling is a legal maximum on the price per unit that a producer can receive. If the price ceiling is below the pre-control competitive equilibrium price, then the ceiling is called binding.

34. Policy: Price Ceilings A price ceiling always has the following effects: • Excess demand will exist • The market will underproduce • Producer surplus will decrease • Some producer surplus is transferred to the consumer • Consumer surplus may increase or decrease • There will be a deadweight loss

35. Price Ceiling P Old Consumer Surplus Supply A C B P* Price Ceiling D Old Producer Surplus Demand Q Q*

36. Policy: Price Ceiling The impact of a price ceiling depends on which consumer receive the available good. We will examine the 2 extreme cases: • Consumers with greatest willingness to pay receive good (maximize consumer surplus) • Consumers with least willingness to pay receive good (minimize consumer surplus)

37. Price Ceiling: Maximize Consumer Surplus P New Consumer Surplus Supply A Deadweight Loss C B P* Price Ceiling New Producer Surplus D Excess Demand Qs Demand Q Qs Qd

38. Price Ceiling: Minimize Consumer Surplus P Supply A New Consumer Surplus C B P* Price Ceiling Qs New Producer Surplus D Excess Demand Demand Q Qs Qd

39. Price Ceiling: Minimize Consumer Surplus P Supply Deadweight Loss=A-B A P* B Price Ceiling Qs Excess Demand Demand Q Qs Qd

40. Policy: Price Ceiling • It is generally assumed that the consumers with the greatest willingness to pay receive the good, but this does not always occur • Price ceilings are only effective if resale (black market) is prevented • Price ceilings can also cause a reliance on imports to meet excess demand

41. 10.5 Policy: Price Floor Definition: A price floor is a legal minimum on the price per unit that a producer can receive. (ie: minimum wage) If the price floor is above the pre-control competitive equilibrium price, then the floor is called binding.

42. Policy: Price Floor A price floor always has the following effects: • Excess supply will exist • The market will underconsume • Consumer surplus will decrease • Some consumer surplus is transferred to the producer • Producer surplus may increase or decrease • There will be a deadweight loss

43. Price Floor P (W) Old Consumer Surplus Supply A Price Floor (min. wage) C B P* D Old Producer Surplus Demand Q (L) Q*

44. Policy: Price Floor The impact of a price floor depends on which producer will sell the good (which worker works). We will examine the 2 extreme cases: • Producers with greatest efficiency supply good (maximize producer surplus) • Producers with least efficiency supply good (minimize producer surplus)

45. Price Floor: Maximize Producer Surplus P (W) New Consumer Surplus Supply A Price Floor Ie: Min. Wage C B P* Deadweight Loss New Producer Surplus D Excess Supply Qd Demand Q (L) Qs

46. Price Floor: Minimize Producer Surplus P New Consumer Surplus Supply A Price Floor Ie: Min. Wage C B P* =Qd Qs New Producer Surplus D Excess Supply Demand Q Qd

47. Price Floor: Minimize Producer Surplus P Supply Price Floor Ie: Min. Wage X P* Y Deadweight Loss=Y-X Qs =Qd Excess Supply Demand Q Qd

48. Labour Price Floor • The attempt of a union to increase wages has two effects: • Some workers receive a higher wage • Some workers lose their jobs • Note that there is a difference between negotiating a higher wage (a union’s publicized goal) and ensuring wages keep up with inflation (often a union’s achieved goal)

49. 10.6 Production Quotas • In place of a price floor, the government can instead impose a PRODUCTION QUOTA • Production Quotas restrict the quantity supplied of any good • Ie: Taxi Cabs • Ie: Bear hunting permits

50. Production Quotas Production Quotas have IDENTICAL effects to price floors: • There will be excess supply (some will want to supply but be prevented) • Quantity purchased will decrease • Consumer surplus will decrease • Some consumer surplus will transfer to producers • Producer surplus may increase or decrease • There will be a deadweight loss