Chapter 9

1. Chapter 9 Applying the Competitive Model © 2004 Thomson Learning/South-Western

2. Consumer Surplus • Consumer surplus is the extra value individuals receive from consuming a good over what they pay for it. • Alternatively, it is what people would be willing to pay for the right to consume a good at its current price.

3. Consumer Surplus • In Figure 9.1, the equilibrium price and quantity are P* and Q*. • The demand curve, D, shows what people are willing to pay for the good. • The total value of the good to buyers is given by the area below the demand curve from Q = 0 to Q = Q* (AEQ*0).

4. FIGURE 9.1: Competitive Equilibrium and Consumer/Producer Surplus Price A S P* E D B 0 Q* Quantity per period

5. Consumer Surplus • Consumers expenditures for Q* are given by the area P*EQ*0. • Consumers receive a “surplus” (total value less what they pay) equal to the area AEP*, which is shaded gray in Figure 9.1.

6. FIGURE 9.1: Competitive Equilibrium and Consumer/Producer Surplus Price A S P* E D B 0 Q* Quantity per period

7. Producer Surplus • Producer surplus is the extra value producers get for a good in excess of the opportunity costs they incur for producing it. • It can also be defined as what all producers would pay for the right to sell a good at its current market price.

8. Producer Surplus • At the equilibrium shown in Figure 9.1, producers receive total revenue equal to the area P*EQ*0. • If producers sold one unit at a time at the lowest possible price, producers would have been willing to produce Q* for the payment of BEQ*0.

9. Producer Surplus • Thus, producer surplus the the area P*EB shaded in green in Figure 9.1.

10. FIGURE 9.1: Competitive Equilibrium and Consumer/Producer Surplus Price A S P* E D B 0 Q* Quantity per period

11. Short-Run Producer Surplus • The positive slope of the short-run supply curve, S, in Figure 9.1 results from the diminishing returns to variable inputs that are encountered as output is increased. • For production up to Q*, price exceeds marginal cost, so total short-run profits equal the area P*EB less fixed costs

12. Short-Run Producer Surplus • Producer surplus, the area P*EB, reflects the sum of total short-run profits and short-run fixed costs. • Short-run producer surplus is the part of total profits that is in excess of the profits firms would have if they chose to produce nothing at all. • As such, it is similar to consumer surplus.

13. Long-Run Producer Surplus • Since long-run economic profits are zero and there are no fixed costs in the long-run, producer surplus is much different in the long run. • The positive slope of the long-run supply curve reflects increasing input costs as output is expanded.

14. Long-Run Producer Surplus • Consider the area P*EB in Figure 9.1 as long-run producer surplus. • It measures all of the increased payments relative to the situation in which the industry produces no output. • The inputs would have received lower prices if this industry had not produced output.

15. Ricardian Rent • Ricardian rent is the long-run profits earned by owners of low-cost firms. • It may be capitalized into the prices of these firms’ inputs. • Assume there are many parcels of land on which tomatoes might be grown. • These farms range from very fertile land (low cost) to poor, dry land (high cost).

16. Ricardian Rent • At low prices, only the most fertile land is used. • As output increases, higher-cost plots of land are brought into production because higher prices make this land profitable. • The long-run supply curve is positively sloped because of the increasing costs associated with using less fertile land.

17. Ricardian Rent • The market equilibrium price and quantity, P*, Q*, are shown in Figure 9.2 (d). • Low-cost farms, Figure 9.2 (a) and medium-cost farms, Figure 9.2 (b), earn long-run economic profits. • Marginal farms, Figure 9.2 (c) earn zero economic profits

18. FIGURE 9.2 (d): The Market Price S P* E D B Q per Q* period

19. FIGURE 9.2 (a): Low-Cost Farm Price MC AC P* q* q per period

20. FIGURE 9.2 (b): Medium-Cost Farm MC Price AC P* q per period q*

21. FIGURE 9.2 (c): Marginal Farm Price MC AC P* q* q per period

22. FIGURE 9.2: Ricardian Rent Price Price MC AC MC AC P* P* q* q per q* q per period period (a) Low-Cost Farm (b) Medium-Cost Farm Price Price MC AC S P* P* E D B q* q per Q* Q per period period (c) Marginal Farm (d) The Market

23. Ricardian Rent • Profits earned by the intramarginal farms can persist in the long run because they reflect the returns to a scarce resource, low-cost land. • Entry can not erode these profits because of the scarcity of the low-cost land. • The sum of these long run profits (P*EB) is the producer surplus ( Ricardian rent).

24. Economic Efficiency • The competitive equilibrium is efficient in that it produces the largest surplus equal to the sum of producer and consumer surplus. • In Figure 9.1, an output level of Q1 results in a loss of surplus equal to the area FEG. • Consumers would be willing to pay P1 for a good that producers are willing to produce for P2, so mutually beneficial transactions exit.

25. FIGURE 9.1: Competitive Equilibrium and Consumer/Producer Surplus Price A S F P1 P* E P2 G D B 0 Q1 Q* Quantity per period

26. APPLICATION 9.1: Does Buying Things on the Internet Improve Welfare? • Transaction costs associated with conducting business on the internet have been reduced due to • Technical innovations • significant network externalities. • Prior to this, transaction costs exceed the difference between consumers’ willingness to pay and producers costs.

27. APPLICATION 9.1: Does Buying Things on the Internet Improve Welfare? • Prior to the decline in internet costs, transaction costs exceeded P2 - P1 in Figure 1, so no transactions occurred. • Assuming transaction costs fell to zero, trading would start and a competitive equilibrium would occur at P*, Q*.

28. FIGURE 1: Reduced Transaction Costs Promote Internet Commerce Price P 2 S P* P 1 D Quantity Q*

29. APPLICATION 9.1: Does Buying Things on the Internet Improve Welfare? • Some early evidence • Electronic retailing directly to consumers totaled about $20 billion in 2001. • Business to business sales represented another $50 to $75 billion. • Most sales are in travel-related goods, on-line financial services, and some narrow categories of consumer goods such as books.

30. APPLICATION 9.1: Does Buying Things on the Internet Improve Welfare? • Retailers as Infomediaries • The role for retailing “middlemen” on the internet is to provide information to the consumer. • Internet automobile sellers provide comparative information about the features of cars and point to dealers with the best price. • Internet airline services search for the lowest price or most convenient departure.

31. A Numerical Example • The market equilibrium is P* = $6 and Q* = 4. • The equilibrium is shown as point E in Figure 9.3. • At point E consumers are spending $24 ($6·4).

32. A Numerical Example • At point E in Figure 9.3, consumer surplus is $8 (= ½·$4·4). • Producers also gain a producer surplus of $8 at point E. • Total consumer and producer surplus is $16. • If price stays at $6 but output falls to 3, total surplus falls to $15.

33. FIGURE 9.3: Efficiency in Tape Sales 10 Price S 6 E D 2 1 2 3 4 5 Tapes per period

34. A Numerical Example • For any output level, total surplus is the area between the demand and supply curves out to that level of output. • Once output is specified, the price affects the distribution of the surplus between producers and consumers, but does not affect the total amount of the surplus.

35. A Numerical Example • If output > 4 tapes per period with P = $6, total surplus is less than $16. • At Q = 5, consumer surplus falls to $7.50. • $8 for four tapes less $.50 because the fifth tapes sells for more than people want to pay for the fifth tape. • Producer surplus also equals $7.50 reflecting the loss of $.50 on the production of the fifth tape. • Total surplus is $15 for Q = 5 tapes per week.

36. Price Controls and Shortages • In Figure 9.4 the market initially is in equilibrium at P1, Q1 (point E). • Then demand increases from D to D’. • This would cause price to rise to P2 encouraging entry in the short-run. • Eventually entry would bring the price down to P3 and the market would be in long-run equilibrium.

37. FIGURE 9.4: Price Controls and Shortages Price SS LS P 1 E D Q Quantity 1 per period

38. FIGURE 9.4: Price Controls and Shortages SS Price LS P 2 P 3 E’ P 1 E D’ D Q Q Q Quantity 1 2 3 per period

39. Price Controls and Shortages • Suppose the government imposed a price control at the below equilibrium price of P1 when demand increased. • Firms would only supply Q1 and no entry would take place. • Since customers would demand Q4 at this price, there would be a shortage of Q4 - Q1.

40. Price Controls and Shortages • The welfare consequences of price control can be analyzed using consumer and producer surplus. • Consumers would gain surplus of P3CEP1 (colored in gray) due to the lower price. • This is a direct transfer of surplus from producers to consumers with no gain in total surplus.

41. FIGURE 9.4: Price Controls and Shortages Price SS A LS P 2 C P 3 E’ P 1 E D’ D Q Q Q Quantity 1 3 4 per period

42. Price Controls and Shortages • If output had expanded, consumers would gain the area AE’C. • Since output is reduced by the price control, this is a loss of surplus to consumers. • Similarly, producers don’t gain the area CE’E that would have resulted from increased output. • The area AE’E is the total welfare loss.

43. Application 9.2: Rent Control: Why This Bad Idea Never Dies • History of Rent Control • Controls were adopted in man U.S. and European cities in response to rapidly rising rents during World War II which continued after the war in several European countries and New York City. • Inflation of the 1970s resulted in several U.S. cities introducing more “flexible” rent controls • More than 10 percent of U.S. rentals are controlled.

44. Application 9.2: Rent Control: Why This Bad Idea Never Dies • Rent Control and Housing Quality • Studies have confirmed the prediction that rent controls will benefit current tenants and harm landlords and new tenants. • However, the most important effect is that landlords effectively reduce the supply of housing by reducing the quality of their units.

45. Application 9.2: Rent Control: Why This Bad Idea Never Dies • Effects of the “New” Rent Control Laws • By allowing landlords to pass on increases in taxes or utility costs, post World War II laws were more flexible. • Many also allow rents to be increased to market levels when current tenants leave. • Some economists suggest that such laws help to deal with the landlords market power, but few economists support this position.

46. Tax Incidence • The study of the final burden of a tax after considering all market reactions to it is tax incidence theory. • The incidence of a “specific tax” of a fixed amount per unit of output that is imposed on all firms in a constant cost industry is illustrated in Figure 9.5

47. FIGURE 9.5: Effect of the Imposition of a Specific Tax on a Perfectly Competitive Constant Cost Industry Price Price S’ S SMC MC P 4 AC P 3 P 1 LS P 2 Tax D D’ 0 q2 q1 Output 0 Q Q Q Quantity 3 2 1 per week (a) Typical Firm (b) The Market

48. Tax Incidence • Since for any price, P, consumers pay the firm gets to keep P - t (where t is the per unit tax), the effect of the tax on firms can be shown as a decrease in demand. • The vertical distance between the demand curves is t. • It creates a wedge between the consumers’ price, P, and the price firms receive.

49. Short-Run Tax Incidence • The short-run effect is to decrease output from Q1 to Q2, where firms receive P2 and consumers pay P3 (P3 - P2 = t). • So long as P2 is above minimum variable costs, the firm continues to produce and the tax incidence is shared by consumers, whose price increased to P3, and by firm’s who now receive only P2 rather than P1.

50. Long-Run Tax Incidence • Firms will not operate at a loss in the long run, so exit will take place shifting the short-run supply curve back to S’. • In the new long-run equilibrium, output will return to Q3 where the firm’s will receive P1 again and consumers will pay P4. • The long-run tax incidence is all on the consumer although the firms pays the tax.