Lecture 3: The Analysis of Competitive Markets PDF

Lecture 3 The Analysis of Competitive Markets 5ECON010C-n Intermediate Microeconomics  The Analysis of Competitive Markets CHAPTER OUTLINE In this lecture we return to supply–demand analysis...

Lecture 3 The Analysis of Competitive Markets 5ECON010C-n Intermediate Microeconomics  The Analysis of Competitive Markets CHAPTER OUTLINE In this lecture we return to supply–demand analysis 1.Evaluating the Gains and Losses from to show how it can be applied to a wide variety of Government Policies — Consumer and problems, including situations in which: Producer Surplus a consumer faced with a purchasing decision a firm faced with a long-range planning problem 2.Minimum Prices a government agency that has to design a policy and evaluate its likely impact 3.Price Supports and Production Quotas We also use consumer and producer surplus to demonstrate the efficiency of a competitive market. 4.Import Quotas and Tariffs 5.The Impact of a Tax or Subsidy Copyright © 2016, 2012, 2009 Pearson Education, Inc. All Rights Reserved Consumer and producer surplus Even if competitive market brings the price to equilibrium, there are some consumers who are ready to buy at a higher price. These consumers are willing to pay higher price – but paying lower one – are benefiting from equilibrium price. The sum of those benefits is the consumer surplus 5ECON010C-n Intermediate Microeconomics  Consumer and producer surplus Similarly, there are some producers who are ready to supply goods at a lower price with smaller profit. Those producers are also benefiting from profits which are higher than they are ready to accept. The sum of those benefits is the producer surplus 5ECON010C-n Intermediate Microeconomics Price control: maximum price People often complain about the rising prices and expect the government to control them However, price controls create inefficiency For instance, setting price limit will increase/decrease consumer surplus and reduce producer surplus, creating a shortage in the market 5ECON010C-n Intermediate Microeconomics  9.1 Evaluating the Gains and Losses from Government Policies—Consumer and Producer Surplus welfare effects Gains and losses to consumers and producers. deadweight loss Net loss of total (consumer plus producer) surplus. FIGURE 9.2 CHANGE IN CONSUMER AND PRODUCER SURPLUS FROM PRICE CONTROLS The price of a good has been regulated to be no higher than Pmax, which is below the market- clearing price P0. The gain to consumers is the difference between rectangle A and triangle B. The loss to producers is the sum of rectangle A and triangle C. Triangles B and C together measure the deadweight loss from price controls.  Price control: maximum price FIGURE 9.3 If demand is sufficiently inelastic, triangle B can be larger than rectangle A. In this case, consumers suffer a net loss from price controls. The deadweight loss is especially heavy when demand is inelastic. Here losses outweigh gains. 5ECON010C-n Intermediate Microeconomics  9.3 Minimum Prices FIGURE 9.7 PRICE MINIMUM Price is regulated to be no lower than Pmin. Producers would like to supply Q2, but consumers will buy only Q3. If producers indeed produce Q2, the amount Q2 − Q3 will go unsold and the change in producer surplus will be A − C − D. In this case, producers as a group may be worse off. The total change in consumer surplus is : CS = - A - B The total changes in producer surplus is : PS = A - C - D  Minimum price: example FIGURE 9.8 Wage – is the price of labor. Many governments set minimum wage requirements (social welfare purposes). If minimum wage is above market- determined wage, this will create deadweight loss and unemployment. Although the market-clearing wage is w , firms are not allowed to pay less 0 than wmin. This results in unemployment of an amount L2 − L1 and a deadweight loss given by triangles B and C. 5ECON010C-n Intermediate Microeconomics  9.4 Price Supports and Production Quotas Price Supports price support Price set by government above free-market level and maintained by governmental purchases of excess supply. FIGURE 9.11 PRICE SUPPORTS To maintain a price Ps above the market-clearing price P0, the government buys a quantity Qg. The gain to producers is A + B + D. The loss to consumers is A + B. The cost to the government is the speckled rectangle, the area of which is Ps(Q2 − Q1).  9.4 Price Supports and Production Quotas Resulting gains and losses to consumers, producers, and the government in Figure 9.10. CONSUMERS Some consumers pay a higher price, while others no longer buy the good. ΔCS = − A − B PRODUCERS Producers are now selling a larger quantity Q2 instead of Q0, and at a higher price Ps. ΔPS = + A + B + D THE GOVERNMENT The cost to the government (which is ultimately a cost to consumers) is: (Q 2 - Q1)Ps The total change in welfare (ΔW) is: 𝛥𝑊 = 𝛥𝐶𝑆 + 𝛥𝑃𝑆 − 𝐶𝑜𝑠𝑡 𝑡𝑜 𝐺𝑜𝑣𝑡. Or 𝛥𝑊 = 𝐷 − (𝑄2 − 𝑄1)Ps Copyright © 2016, 2012, 2009 Pearson Education, Inc. All Rights Reserved Production quotas The state can set quotas on production to keep prices above equilibrium. Consumers loose B, A goes to producers. Producers loose C. To ensure producers do not cheat and produce more than quota, government needs to compensate lost surplus (𝐶 + 𝐵 + 𝐷) to producers. Change in social welfare: ∆𝑾 = −𝑩 − 𝑪 5ECON010C-n Intermediate Microeconomics 9.4 Price Supports and Production Quotas INCENTIVE PROGRAMS In U.S. agricultural policy, output is reduced by incentives rather than by outright quotas. Acreage limitation programs give farmers financial incentives to leave some of their acreage idle. Figure 9.11 also shows the welfare effects of reducing supply in this way. As with direct production quotas, the change in consumer surplus is ΔCS = − A − B Farmers receive a higher price, produce less, and receive an incentive to reduce production. Thus, the change in producer surplus is now ΔPS = A − C + Payments for not producing The cost to the government is at least B + C + D, and the total change in producer surplus is ΔPS = A − C + B + C + D = A + B + D An acreage-limitation program is more costly to society than simply handing the farmers money. The total change in welfare ΔWelfare = − A − B + A + B + D − B − C − D = − B − C Copyright © 2016, 2012, 2009 Pearson Education, Inc. All Rights Reserved Import quotas and tariffs If the world price for a good is lower than domestic equilibrium price, the economy will import. At 𝑃𝑊 domestic producers will produce 𝑄𝑆 , and consumers will demand 𝑄𝐷 The shortage 𝑄𝑆 − 𝑄𝐷 will be compensated by imports. 5ECON010C-n Intermediate Microeconomics Import quotas and tariffs Government may impose import quotas or tariffs which totally eliminate imports. Domestic price will go up to 𝑃0 again. Consumers loose – 𝐴 − 𝐵 − 𝐶 Producers gain 𝐴 Change in welfare: ∆𝑊 = −𝐵 − 𝐶 5ECON010C-n Intermediate Microeconomics Import quotas and tariffs Government may impose import tariffs which partially eliminate imports. Domestic price will go up to 𝑃∗ Consumers loose – 𝐴 − 𝐵 − 𝐶 − 𝐷 Producers gain 𝐴 Government gains 𝐷 Change in welfare: ∆𝑊 = −𝐵 − 𝐶 5ECON010C-n Intermediate Microeconomics Taxes Government may impose tax. Part of the tax burden falls on consumers (−𝐴 − 𝐵) Part of the burden falls on producers ( – 𝐷 − 𝐶) Government gains 𝐴 + 𝐷 Change in welfare: ∆𝑊 = −𝐵 − 𝐶 5ECON010C-n Intermediate Microeconomics  Taxes: the impact The impact of the tax on welfare of one group or the other depends on the elasticity of demand and supply. If demand is inelastic and supply is elastic, the tax burden predominantly falls on consumers. If demand is elastic and supply is inelastic, tax burden falls mainly on producers. 5ECON010C-n Intermediate Microeconomics Subsidies Government may provide subsidies for consumption of certain goods. Think of subsidy as a negative tax. For this to work, government needs to find a way to match quantity demanded and supplied with the subsidy present: 𝑄𝐷 = 𝑄𝐷 𝑃𝑏 𝑄𝑆 = 𝑄𝑆 𝑃𝑠 𝑄𝐷 = 𝑄𝑆 𝑠 = 𝑃𝑠 − 𝑃𝑏 5ECON010C-n Intermediate Microeconomics  Subsidies: welfare effect What do you think: if tax creates deadweight loss, does subsidy create deadweight “gain”? 5ECON010C-n Intermediate Microeconomics Policy and efficiency Any policy which interferes with the market should be targeted at economic efficiency. Economic efficiency is achieved when social welfare is maximized (remember, economics is all about making happy as many people as possible). Therefore, any policy needs to be objectively assessed to check if it creates any inefficiency. 5ECON010C-n Intermediate Microeconomics Market failure However, unregulated competitive market sometimes fails to deliver the highest possible welfare for everyone. This can be due to externalities – a situation when actions of consumers or producers create harm (or sometimes benefit) for social welfare. Pollution Irresponsible consumption This also can be due to lack of information – a situation when consumers make choices based on incomplete or false information. In such cases government intervention is justified. 5ECON010C-n Intermediate Microeconomics Reading Mandatory reading Pindyck & Rubinfeld (2015). “Microeconomics”, 8th edition. Chapter 9 Optional reading https://link.springer.com/article/10.1007/s40258-020-00601-9 The Problems of Price Controls, https://www.cato.org/publications/commentary/problems-price-controls (1,840 words) 5ECON010C-n Intermediate Microeconomics