This chapter discusses the analysis of competitive markets and evaluating the effects of government policies. It covers topics such as consumer and producer surplus, price controls, minimum prices, price supports, production quotas, and taxes/subsidies. The key concepts are how these policies impact the gains and losses to consumers and producers through changes in surplus, and how this relates to the efficiency and potential deadweight loss in competitive markets when the government intervenes.

1. Chapter 9
The Analysis of
Competitive
Markets

2. Topics to be Discussed
 Evaluating the Gains and Losses from
Government Policies--Consumer and
Producer Surplus
 The Efficiency of a Competitive Market
 Minimum Prices
Chapter 9 Slide 2

3. Topics to be Discussed
 Price Supports and Production Quotas
 The Impact of a Tax or Subsidy
Chapter 9 Slide 3

4. Evaluating the Gains and Losses from
Government Policies--Consumer and Producer Surplus
 Review
 Consumer surplus is the total benefit or
value that consumers receive beyond what
they pay for the good.
 Producer surplus is the total benefit or
revenue that producers receive beyond
what it cost to produce a good.
Chapter 9 Slide 4

5. Consumer and Producer Surplus
Price
10
Consumer
Surplus S
7 Between 0 and Q0
consumers A and B
receive a net gain from
buying the product--
5 consumer surplus
Producer Between 0 and Q0
Surplus producers receive
a net gain from
selling each product--
D
producer surplus.
0
Q0 Quantity
Consumer A Consumer B Consumer C

6. Evaluating the Gains and Losses from
Government Policies--Consumer and Producer Surplus
 To determine the welfare effect of a
governmental policy we can measure
the gain or loss in consumer and
producer surplus.
 Welfare Effects
Gains and losses caused by government
intervention in the market.
Chapter 9 Slide 6

7. Change in Consumer and
Producer Surplus from Price Controls
Suppose the government
Price imposes a price ceiling Pmax
which is below the
market-clearing price P0.
S
Deadweight Loss
The gain to consumers is
the difference between
the rectangle A and the
triangle B.
B
P0
A C
The loss to producers is
the sum of rectangle
Pmax A and triangle C. Triangle
B and C together measure
the deadweight loss.
D
Q1 Q0 Q2
Chapter 9 Quantity Slide 7

8. Change in Consumer and
Producer Surplus from Price Controls
 Observations:
 The total loss is equal to area B + C.
 The total change in surplus =
(A - B) + (-A - C) = -B - C
 The deadweight loss is the inefficiency of
the price controls or the loss of the
producer surplus exceeds the gain from
consumer surplus.
Chapter 9 Slide 8

9. Change in Consumer and
Producer Surplus from Price Controls
 Observation
 Consumers can experience a net loss in
consumer surplus when the demand is
sufficiently inelastic
Chapter 9 Slide 9

10. Effect of Price Controls
When Demand Is Inelastic
If demand is sufficiently
inelastic, triangle B can
Price D be larger than rectangle
A and the consumer
suffers a net loss from
price controls.
S
B
P0
A C Example
Pmax
Oil price controls
and gasoline shortages
in 1979
Quantity
Q1 Q2
Chapter 9 Slide 10

11. The Efficiency of
a Competitive Market
 When do competitive markets generate
an inefficient allocation of resources or
market failure?
1) Externalities
 Costs or benefits that do not show up as
part of the market price (e.g. pollution)
Chapter 9 Slide 11

12. The Efficiency of
a Competitive Market
 When do competitive markets generate
an inefficient allocation of resources or
market failure?
2) Lack of Information
 Imperfect information prevents
consumers from making utility-
maximizing decisions.
Chapter 9 Slide 12

13. The Efficiency of
a Competitive Market
 Government intervention in these
markets can increase efficiency.
 Government intervention without a
market failure creates inefficiency or
deadweight loss.
Chapter 9 Slide 13

14. Welfare Loss When Price
Is Held Below Market-Clearing Level
Price
S
When price is
B regulated to be no
higher than P1, the
P0 deadweight loss given by
A C
triangles B and C results.
P1
D
Q1 Q0
Chapter 9 Quantity Slide 14

15. Welfare Loss When Price
Is Held Above Market-Clearing Level
When price is
Price regulated to be no
lower than P2 only Q3
will be demanded. The
deadweight loss is
given S
by triangles B and C
P2
A B
P0 What would the deadweight
C
loss be if QS = Q2?
D
Q3 Q0 Q2
Chapter 9 Quantity Slide 15

16. Minimum Prices
 Periodically government policy seeks to
raise prices above market-clearing
levels.
 We will investigate this by looking at a
price floor and the minimum wage.
Chapter 9 Slide 16

17. Price Minimum
If producers produce
Price Q2, the amount Q2 - Q3
will go unsold.
S
The change in producer
Pmin surplus will be
A - C - D. Producers
A may be worse off.
B
P0
C
D
D
Q3 Q0 Q2 Quantity
Chapter 9 Slide 17

18. The Minimum Wage
Firms are not allowed to
w pay less than wmin. This
results in unemployment.
S
wmin
A The deadweight loss
B
w0 is given by
C
triangles B and C.
Unemployment
D
L1 L0 L2 L
Chapter 9 Slide 18

19. Price Supports and
Production Quotas
 Much of agricultural policy is based on
a system of price supports.
This is support price is set above the
equilibrium price and the government buys
the surplus.
 This is often combined with incentives
to reduce or restrict production
Chapter 9 Slide 19

20. Price Supports
Price
S
Qg
To maintain a price Ps
the government buys
Ps quantity Qg . The change in
D consumer surplus = -A - B,
A
B and the change in producer
P0 surplus is A + B + D
D + Qg
D
Q1 Q0 Q2 Quantity
Chapter 9 Slide 20

21. Price Supports
The cost to the
government is the
Price speckled rectangle
Ps(Q2-Q1) S
Qg
Ps Total welfare loss
D D-(Q2-Q1)ps
A
B
P0
Total
Welfare
Loss
D + Qg
D
Q1 Q0 Q2 Quantity
Chapter 9 Slide 21

22. Price Supports
 Question:
 Is there a more efficient way to increase
farmer’s income by A + B + D?
Chapter 9 Slide 22

23. The Impact of a Tax or Subsidy
 The burden of a tax (or the benefit of a
subsidy) falls partly on the consumer
and partly on the producer.
 We will consider a specific tax which is
a tax of a certain amount of money per
unit sold.
Chapter 9 Slide 23

24. Incidence of a SpecificTax
Pb is the price (including
Price the tax) paid by buyers.
PS is the price sellers receive,
net of the tax. The burden
of the tax is split evenly.
S
Pb Buyers lose A + B, and
A sellers lose D + C, and
B
P0 the government earns A + D
t C in revenue. The deadweight
D
loss is B + C.
PS
D
Q1 Q0 Quantity
Chapter 9 Slide 24

25. Incidence of a Specific Tax
 Four conditions that must be satisfied
after the tax is in place:
1) Quantity sold and Pb must be on the
demand line: QD = QD(Pb)
2) Quantity sold and PS must be on the
supply line: QS = QS(PS)
Chapter 9 Slide 25

26. Incidence of a Specific Tax
 Four conditions that must be satisfied
after the tax is in place:
3) QD = QS
4) Pb - PS = tax
Chapter 9 Slide 26

27. Impact of a Tax Depends
on Elasticities of Supply and Demand
Burden on Buyer Burden on Seller
Price D Price S
Pb
S
t Pb
P0 P0
PS
t
D
PS
Q1 Q0 Quantity Q1 Q0 Quantity

28. The Impact of a Tax or Subsidy
 Pass-through fraction
 ES/(ES - Ed)
 For example, when demand is perfectly
inelastic (Ed = 0), the pass-through fraction
is 1, and all the tax is borne by the
consumer.
Chapter 9 Slide 28

29. The Effects of a Tax or Subsidy
 A subsidy can be analyzed in much the
same way as a tax.
 It can be treated as a negative tax.
 The seller’s price exceeds the buyer’s
price.
Chapter 9 Slide 29

30. Subsidy
Price
S
Like a tax, the benefit
PS of a subsidy is split
between buyers and
P0 s sellers, depending
upon the elasticities of
Pb supply and demand.
D
Q0 Q1 Quantity
Chapter 9 Slide 30

31. Subsidy
 With a subsidy (s), the selling price Pb is
below the subsidized price PS so that:
s = PS - Pb
Chapter 9 Slide 31

32. Subsidy
 The benefit of the subsidy depends
upon Ed /ES.
 If the ratio is small, most of the benefit
accrues to the consumer.
 If the ratio is large, the producer benefits
most.
Chapter 9 Slide 32

33. A Tax on Gasoline
 Measuring the Impact of a 50 Cent
Gasoline Tax
 Intermediate-run EP of demand = -0.5
QD = 150 - 50P
 EP of supply = 0.4
QS = 60 + 40P
 QS = QD at $1 and 100 billion gallons per
year (bg/yr)
Chapter 9 Slide 33

34. A Tax on Gasoline
 With a 50 cent tax
 QD = 150 - 50Pb = 60 + 40PS = QS
 150 - 50(PS+ .50) = 60 + 40PS
 PS = .72
 Pb = .5 + PS
 Pb = $1.22
Chapter 9 Slide 34

35. A Tax on Gasoline
 With a 50 cent tax
Q = 150 -(50)(1.22) = 89 bg/yr
Q falls by 11%
Chapter 9 Slide 35

36. Impact of a 50 Cent Gasoline Tax
D S
Price
($ per
1.50
gallon) Lost Consumer
Surplus
Pb = 1.22 The annual revenue
from the tax is .50(89)
A or $44.5 billion. The buyer
P0 = 1.00 pays 22 cents of the tax, and
t = 0.50 the producer pays 28 cents.
D
PS = .72 Lost Producer
Surplus
.50
11
Quantity (billion
0 50 60 89 100 150 gallons per year)
Chapter 9 Slide 36

37. Impact of a 50 Cent Gasoline Tax
D S
Price
($ per
1.50
gallon) Lost Consumer
Surplus
Pb = 1.22
A
P0 = 1.00 Deadweight loss = $2.75 billion/yr
t = 0.50
D
PS = .72 Lost Producer
Surplus
.50
11
Quantity (billion
0 50 60 89 100 150 gallons per year)
Chapter 9 Slide 37

38. Summary
 Simple models of supply and demand
can be used to analyze a wide variety of
government policies.
 In each case, consumer and producer
surplus are used to evaluate the gains
and losses to consumers and
producers.
Chapter 9 Slide 38

39. Summary
 When government imposes a tax or
subsidy, price usually does not rise or
fall by the full amount of the tax or
subsidy.
 Government intervention generally
leads to a deadweight loss.
Chapter 9 Slide 39

40. Summary
 Government intervention in a
competitive market is not always a bad
thing.
Chapter 9 Slide 40

41. End of Chapter 9
The Analysis of
Competitive
Markets