Chapter 9

The Analysis of
Competitive
Markets
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
Topics to be Discussed

 Price Supports and Production Quotas

 Import Quotas and Tariffs
 The Impact of a Tax or Subsidy

Chapter 9 Slide 3
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
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
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
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

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
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
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

P0
A C Example
Pmax
Oil price controls
and gasoline shortages
in 1979

Quantity
Q1 Q2

Chapter 9 Slide 10
Price Controls and
Natural Gas Shortages

 1975 Price controls created a shortage

of natural gas.
 What was the deadweight loss?

Chapter 9 Slide 11
Price Controls and
Natural Gas Shortages

Data for 1975

 Supply: QS = 14 + 2PG + 0.25PO

 Quantity supplied in trillion cubic feet (Tcf)

 Demand: QD = -5PG + 3.75PO

 Quantity demanded (Tcf)

 PG = price of natural gas in $/mcf and PO =

price of oil in $/b.

Chapter 9 Slide 12
Price Controls and
Natural Gas Shortages

Data for 1975

 PO = $8/b

 Equilibrium PG = $2/mcf and Q = 20 Tcf

 Price ceiling set at $1

 This information can be seen
graphically:

Chapter 9 Slide 13
Price Controls and
Natural Gas Shortages
Price
($/mcf) D S
The gain to consumers is
rectangle A minus triangle
2.40 B, and the loss to
producers is rectangle
B A plus triangle C.
2.00
C
A

(Pmax)1.00

0 5 10 15 18 20 25 30 Quantity (Tcf)

Chapter 9 Slide 14
Price Controls and
Natural Gas Shortages
 Measuring the Impact of Price Controls
 1 Tcf = 1 billion mcf
 If QD = 18, then P = $2.40
[18 = -5PG + 3.75(8)]
 A = (18 billion mcf) x ($1/mcf) = $18 billion
 B = (1/2) x (2 b. mcf) x ($0.40/mcf) = $0.4 billion
 C = (1/2) x (2 b. mcf) x ($1/mcf) = $1 billion

Chapter 9 Slide 15
Price Controls and
Natural Gas Shortages

 Measuring the Impact of Price Controls

 1975
 Change in consumer surplus
= A - B = 18 - 0.04 = $17.6 billion
 Change in producer surplus
= -A - C = -18-1 = -$19.0 billion

Chapter 9 Slide 16
Price Controls and
Natural Gas Shortages

 Measuring the Impact of Price Controls

 1975 dollars, deadweight loss
 = -B - C = -0.4 - 1 = -$1.4 billion
 In 2000 dollars, the deadweight loss is
more than $4 billion per year.

Chapter 9 Slide 17
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 18
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 19
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 20
Welfare Loss When Price
Is Held Below Market-Clearing Level

Price

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

Q1 Q0

Chapter 9 Quantity Slide 21

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
by triangles B and C S

P2
A B

P0 What would the deadweight

C
loss be if QS = Q2?

Q3 Q0 Q2

Chapter 9 Quantity Slide 22

The Market for Human Kidneys

 The 1984 National Organ

Transplantation Act prohibits the sale of
organs for transplantation.
 Analyzing the Impact of the Act
 Supply: QS = 8,000 + 0.2P
If P = $20,000, Q = 12,000
 Demand: QD = 16,000 - 0.2P

Chapter 9 Slide 23
The Market for Kidneys, and Effects
of the 1984 Organ Transplantation Act
The 1984 act effectively
Price S’ makes the price zero.

S
$40,000

The loss to suppliers

is given by rectangle A
$30,000 D and triangle C.
If consumers received
B kidneys at no cost, their
gain would be given by
$20,000 rectangle A less triangle B.

C Rectangles A and D
measure the total value
of kidneys when
$10,000 A supply is constrained.
D

0 4,000 8,000 12,000 Quantity

Chapter 9 Slide 24
The Market for Human Kidneys

 The act limits the quantity supplied

(donations) to 8,000.
 Loss to supplier surplus:
 A+C=
(8,000)($20,000) + (1/2)(4,000)($20,000) =
$200/m.

Chapter 9 Slide 25
The Market for Human Kidneys

 Gain to recipients:
 A-B=
(8,000)($20,000) - (1/2)(4,000)($20,000) =
$120/m.

 Deadweight loss:
 B + C or
$200 million - $120 million = $80 million

Chapter 9 Slide 26
The Market for Human Kidneys

 Other Inefficiency Cost

1) Allocation is not necessarily to

those who value the kidney’s the
most.

2) Price may increase to $40,000, the

equilibrium price, with
hospitals getting the price.

Chapter 9 Slide 27
The Market for Human Kidneys

 Arguments in favor of prohibiting the

sale of organs:

1) Imperfect information about

donor’s health and screening

Chapter 9 Slide 28
The Market for Human Kidneys

 Arguments in favor of prohibiting the

sale of organs:

2) Unfair to allocate according to the

ability to pay
 Holding price below equilibrium will
create shortages
 Organs versus artificial substitutes

Chapter 9 Slide 29
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 30
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
Q3 Q0 Q2 Quantity

Chapter 9 Slide 31
The Minimum Wage
Firms are not allowed to
w pay less than wmin. This
results in unemployment.

wmin
A The deadweight loss
B
w0 is given by
C
triangles B and C.

Unemployment
D
L1 L0 L2 L

Chapter 9 Slide 32
Airline Regulation

 During 1976-1981 the airline industry in

the U.S. changed dramatically.
 Deregulation lead to major changes in
the industry.
 Some airlines merged or went out of
business as new airlines entered the
industry.

Chapter 9 Slide 33
Effect of Airline Regulation
by the Civil Aeronautics Board
Prior to deregulation
Price price was at Pmin and S
QD = Q1 and Qs = Q2.
Area D is the cost
Pmin of unsold output.

A
B
P0
C After deregulation:
Prices fell to PO. The
change in consumer
surplus is A + B.

D
D

Q1 Q3 Q0 Q2 Quantity

Chapter 9 Slide 34
 Airline Industry Data
1975 1980 1985 1990 1995 1996

Number of carriers 3372 8660 8696

Passenger load factor(%) 5459 6162 6769

Passenger-mile rate (constant 1995 dollars) .218.210.166

.150.129.126

Real cost index (1995=100) 101122 11110710099

Real cost index corrected for fuel cost increases 9498 98

100 10098
Airline Industry Data

 Airline industry data show:

1) Long-run adjustment as the

number of carriers increased and
prices decreased

2) Higher load factors indicating more

efficiency

Chapter 9 Slide 36
Airline Industry Data

 Airline industry data show:

3) Falling rates

4) Real cost increased slightly

(adjusted fuel cost)

5) Large welfare gain

Chapter 9 Slide 37
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 38
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

Q1 Q0 Q2 Quantity

Chapter 9 Slide 39
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

Q1 Q0 Q2 Quantity

Chapter 9 Slide 40
Price Supports

 Question:
 Is there a more efficient way to increase
farmer’s income by A + B + D?

Chapter 9 Slide 41
Price Supports and
Production Quotas

 Production Quotas
 The government can also cause the price of
a good to rise by reducing supply.

Chapter 9 Slide 42
Price Supports and
Production Quotas

 What is the impact of:

1) Controlling entry into the taxicab

market?

2) Controlling the number of liquor

licenses?

Chapter 9 Slide 43
Supply Restrictions
S’ •Supply restricted to Q1
Price
•Supply shifts to S’ @ Q1

PS
D
A
B
P0 •CS reduced by A + B
C •Change in PS = A - C
•Deadweight loss = BC

Q1 Q0 Quantity

Chapter 9 Slide 44
Supply Restrictions
S’ •Ps is maintained with
Price
and incentive
•Cost to government = B + C + D

PS
D
A
B
P0
C

Q1 Q0 Quantity

Chapter 9 Slide 45
Supply Restrictions

 PS = A - C + B + Price S’
C + D = A + B + D.
S
 The change in PS
consumer and D
A
producer surplus is B
the same as with P0
C
price supports.

welfare = -A - B + D
A+B+D-B-C-D
= -B - C. Q0 Quantity

Chapter 9 Slide 46
Supply Restrictions

 Questions: Price S’
 How could the
S
government reduce
PS
the cost and still
A D
subsidize the farmer? B
 Which is more costly: P0
C
supports or acreage
limitations?
D

Q0 Quantity

Chapter 9 Slide 47
Supporting the Price of Wheat

 1981
 Supply: Qs = 1,800 + 240P
 Demand: QD = 3,550 - 266P
 Equilibrium price and quantity was $3.46
and 2,630 million bushels

Chapter 9 Slide 48
Supporting the Price of Wheat

 1981
 Price support was set at $3.70
 QD + QG = QDT = 3,440 -266P + QG
 QS = QD
1,800 + 240P = 3,550 - 266P + QG
QG = 506P -1,750
QG = (506)(3.70) -175=122 million bushels

Chapter 9 Slide 49
The Wheat Market in 1981
Price •AB consumer loss
•ABC producer gain
S

By buying 122
million bushels
Qg the government
increased the
P0 = $3.70
market-clearing
A B C price.
P0 = $3.46

D + Qg
D

1,800 2,566 2,630 2,688 Quantity

Chapter 9 Slide 50
Supporting the Price of Wheat

 1981
 The change in consumer surplus = (-A -B)
A = (3.70 - 3.46)(2,566) = $616 million
B = (1/2)(3.70-3.46)(2,630-2,566) = $8
million
Change in consumer surplus: -$624
million.

Chapter 9 Slide 51
Supporting the Price of Wheat

 1981
 Cost to the government:
$3.70 x 122 million bushels = $452 million
 Total cost = $624 + 452 = $1,076 million
 Total gain = A + B + C = $638 million
 Government also paid 30 cents/bushel =
$806 million

Chapter 9 Slide 52
Supporting the Price of Wheat

 In 1985, export demand fell and the

market clearing price of wheat fell to
$1.80/bushel.

Chapter 9 Slide 53
Supporting the Price of Wheat

 1985 Supply: QS = 1,800 + 240P

 1986 Demand: QD = 2580 - 194P

 QS = QD at $1.80 and 2,232 million bushels
 PS = $3.20
 To maintain $3.20/bushel a production
quota of 2,425 bushels was imposed

Chapter 9 Slide 54
Supporting the Price of Wheat

 1985
 Government Purchase:
2,425 = 2,580 - 194P + QG
QG = -155 + 194P
P = $3.20 -- the support price
QG = -155 + 194($3.20) = 466 million
bushels

Chapter 9 Slide 55
The Wheat Market in 1985
Price
S’

QS To increase the
price to $3.20, the
government bought
P0 = $3.20 466 million bushels
and imposed
a production quota
of 2,425 bushels.

P0 = $1.80

D + QS
D
1,800 1,959 2,232 2,425 Quantity
Chapter 9 Slide 56
Supporting the Price of Wheat

 1985
 Government Purchase:
 Government cost = $3.20 x 466 =
$1,491million
 80 cent subsidy = .80 x 2,425 = $1,940
million
 Total cost = $3.5 billion

Chapter 9 Slide 57
Supporting the Price of Wheat

 Question:
 What is the change in consumer and
producer surplus?

Chapter 9 Slide 58
Supporting the Price of Wheat

 1996 Freedom to Farm

 Reduces price supports and quotas until
2003 when they go back into effect under
the 1996 law.

Chapter 9 Slide 59
Supporting the Price of Wheat

 1998 Wheat Market

P = $2.65
Q = 3244 - 283P
D

Q = 1944 + 207P
S

Q = 2493
 Government subsidy of .66/bushel or $1.6
billion

Chapter 9 Slide 60
Import Quotas and Tariffs

 Many countries use import quotas and

tariffs to keep the domestic price of a
product above world levels

Chapter 9 Slide 61
Import Tariff or Quota
That Eliminates Imports

Price In a free market, the

domestic price equals the
world price PW.
S

By eliminating imports,
the price is increased to
PO. The gain is area A. The
P0 loss to consumers A + B + C,
so the deadweight loss
A is B + C.
B C
PW

How high would

D a tariff have
Imports to be to get the
same result?
QS Q0 QD Quantity
Chapter 9 Slide 62
Import Tariff or Quota
(general case)

 The increase in price can

be achieved by a quota S
Price
or a tariff.
 Area A is again the gain
to domestic producers.
P*
 The loss to consumers is A D
A + B + C + D. B C
Pw

QS Q’S Q’D QD Quantity

Chapter 9 Slide 63
Import Tariff or Quota
(general case)

 If a tariff is used the

government gains D, so S
Price
the net domestic product
loss is B + C.
 If a quota is used instead,
rectangle D becomes part P*
of the profits of foreign A D
B C
producers, and the net Pw
domestic loss is B + C + D.

QS Q’S Q’D QD Quantity

Chapter 9 Slide 64
Import Tariff or Quota
(general case)

 Question:
S
 Would the U.S. be Price
better off or worse off
with a quota instead of
a tariff? (e.g. Japanese
import restrictions in P*
the 1980s) A D
B C
Pw

QS Q’S Q’D QD Quantity

Chapter 9 Slide 65
The Sugar Quota

 The world price of sugar has been as

low as 4 cents per pound, while in the
U.S. the price has been 20-25 cents per
pound.

Chapter 9 Slide 66
The Sugar Quota

 The Impact of a Restricted Market

(1997)
 U.S. production = 15.6 billion pounds
 U.S. consumption = 21.1 billion pounds
 U.S. price = 22 cents/pound
 World price = 11 cents/pound

Chapter 9 Slide 67
The Sugar Quota

 The Impact of a Restricted Market

 U.S. ES = 1.54
 U.S. ED = -0.3
 U.S. supply: QS = -7.83+ 1.07P
 U.S. demand: QD = 27.45 - 0.29P
 P = .23 and Q = 13.7 billion pounds

Chapter 9 Slide 68
Sugar Quota in 1997
Price SUS DUS
(cents/lb.) PUS = 21.9

20 The cost of the quotas

to consumers was
A A + B + C + D, or $2.4b.
D The gain to producers
16 was area A, or $1b.
B C

11 PW = 11

4
Qd = 24.2

0 5 10 15 20 25 30
Quantity
QS = 4.0 Q’S = 15.6 Q’d = 21.1 (billions of pounds)
Sugar Quota in 1997
Price SUS DUS
(cents/lb.) PUS = 21.9
Rectangle D was the
20 gain to foreign producers
A who obtained quota
D allotments, or $600 million.
16 Triangles B and C represent
the deadweight loss of
B C
$800 million.

11 PW = 11

4
Qd = 24.2

0 5 10 15 20 25 30
Quantity
QS = 4.0 Q’S = 15.6 Q’d = 21.1 (billions of pounds)
 Dampak dari pajak dan subsidi.

 Pembebanan pajak (atau benefit dari

subsidy) sebagian diterima oleh consumer
dan sebagian oleh producer.
 Ilmustrasi menggunakan specific tax: pajak
yang dibebankan per unit barang.

Chapter 9 Slide 71
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

Q1 Q0 Quantity

Chapter 9 Slide 72
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 73
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 74
 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
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 76
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 77
Subsidy Like a tax, the benefit of a subsidy is
split between buyers and sellers,
depending upon the elasticities of
supply and demand.
Price

PS

P0 s

Pb

Q0 Q1 Quantity

Chapter 9 Slide 78
Subsidy

 With a subsidy (s), the selling price Pb is

below the subsidized price PS so that:
 s = PS - Pb

Chapter 9 Slide 79
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 80
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 81
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 82
A Tax on Gasoline

 With a 50 cent tax

 Q = 150 -(50)(1.22) = 89 bg/yr
 Q falls by 11%

Chapter 9 Slide 83
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 84
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 85
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 86
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 87
Summary

 Government intervention in a
competitive market is not always a bad
thing.

Chapter 9 Slide 88
End of Chapter 9
The Analysis of
Competitive
Markets