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Chapter 9
The Analysis of Competitive
Markets
Consumer and Producer
Surplus
 When government controls price, some
people are better off
May be able to buy a good at a lower price
 But what is the effect on society as a
whole?
Is total welfare higher or lower and by how
much?
 A way to measure gains and losses from
government policies is needed
©2005 Pearson Education, Inc.
Chapter 9
2
Consumer and Producer
Surplus
Price
9
Consumer
Surplus
S
Between 0 and Q0
consumer A receives
a net gain from buying
the product-consumer surplus.
5
Producer
Surplus
3
D
QD
©2005 Pearson Education, Inc.
QS
Q0
Chapter 9
Between 0 and Q0
producers receive
a net gain from
selling each product-producer surplus.
Quantity
3
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 to producers and
consumers
©2005 Pearson Education, Inc.
Chapter 9
4
Consumer and Producer
Surplus
 When price is held too low, the quantity
demanded increases and quantity
supplied decreases
 Some consumers are worse off because
they can no longer buy the good
Decrease in consumer surplus
 Some consumers are better off because
they can buy it at a lower price
Increase in consumer surplus
©2005 Pearson Education, Inc.
Chapter 9
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Consumer and Producer
Surplus
 Producers sell less at a lower price
 Some producers are no longer in the
market
 Both of these producer groups lose and
producer surplus decreases
 The economy as a whole is worse off
since surplus that used to belong to
producers or consumers is simply gone
©2005 Pearson Education, Inc.
Chapter 9
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Price Control and Surplus
Changes
Price
Consumers that
cannot buy, lose B
Consumers that can
buy the good gain A
S
The loss to producers
is the sum of
rectangle A and
triangle C
B
P0
A
C
Triangles B and C are
losses to society –
dead weight loss
Pmax
D
Q1
©2005 Pearson Education, Inc.
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Q2
Quantity
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Price Controls and Welfare
Effects
 The total loss is equal to area B + C
 The deadweight loss is the inefficiency
of the price controls – the total loss in
surplus (consumer plus producer)
 If demand is sufficiently inelastic, losses
to consumers may be fairly large
This can have effects in political decisions
©2005 Pearson Education, Inc.
Chapter 9
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Price Controls With Inelastic
Demand
D
Price
S
B
P0
Pmax
A
Q1
©2005 Pearson Education, Inc.
With inelastic demand,
triangle B can be larger
than rectangle A and
consumers suffer net
losses from price controls.
C
Q2
Chapter 9
Quantity
9
The Efficiency of
a Competitive Market
 In the evaluation of markets, we often talk
about whether it reaches economic
efficiency
Maximization of aggregate consumer and
producer surplus
 Policies such as price controls that cause
dead weight losses in society are said to
impose an efficiency cost on the
economy
©2005 Pearson Education, Inc.
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The Efficiency of
a Competitive Market
 If efficiency is the goal, then you can
argue that leaving markets alone is the
answer
 However, sometimes market failures
occur
Prices fail to provide proper signals to
consumers and producers
Leads to inefficient unregulated competitive
market
©2005 Pearson Education, Inc.
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Types of Market Failures
1. Externalities
 Costs or benefits that are not reflected in market
supply and demand (e.g. pollution)
 Costs or benefits are experienced by a third party
not involved in transaction
2. Lack of Information
 Imperfect information prevents consumers from
making utility-maximizing decisions
 Government intervention may be desirable in
these cases
©2005 Pearson Education, Inc.
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Price Control and Surplus
Changes
Price
S
Pmin
A
When price is
regulated to be no
lower than Pmin, the
deadweight loss given
by triangles B and C
results.
B
P0
C
D
Q1
©2005 Pearson Education, Inc.
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Quantity
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The Market for Human Kidneys
 The 1984 National Organ Transplantation
Act prohibits the sale of organs for
transplantation
 What has been the impact of the Act?
 We can measure this using the supply
and demand for kidneys from estimated
data
Supply: QS = 8,000 + 0.2P
Demand: QD = 16,000 - 0.2P
©2005 Pearson Education, Inc.
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The Market for Human Kidneys
 Since the sale of organs is not allowed,
the amount available depends on the
amount donated
Supply of donated kidneys is limited to 8,000
 The welfare effect of this supply
constraint can be analyzed using
consumer and producer surplus in the
kidney market
©2005 Pearson Education, Inc.
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The Market for Human Kidneys
 Suppliers:
Those who supply them are not paid the
market price, estimated at $20,000
 Loss
of surplus equal to area A = $160 million
Some who would donate for the equilibrium
price do not donate in the current market
 Loss
of surplus equal to area C = $40 million
Total ‘producer’ loss of A + C = $200 million
©2005 Pearson Education, Inc.
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The Market for Human Kidneys
 Recipients:
Since they do not have to pay for the kidney,
they gain rectangle A ($160 million) since
price is $0
Those who cannot obtain a kidney lose
surplus equal to triangle B ($40 million)
Net increase in surplus of recipients of $160
- $40 = $120 million
 Dead Weight Loss of C + B = $80 million
©2005 Pearson Education, Inc.
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The Market for Human Kidneys
 Other Inefficiency Costs
Allocation is not necessarily to those who
value the kidneys the most
Price may increase to $40,000, the
equilibrium price, with hospitals getting the
price
©2005 Pearson Education, Inc.
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The Market for Kidneys
S’
Price
The loss to suppliers
is seen in areas A & C.
$40,000
S
D
$30,000
If kidneys are zero
cost, consumer gain
would be A minus B.
B
$20,000
A and D measure the
total value of kidneys
when supply is
constrained.
C
A
$10,000
D
0
4,000
©2005 Pearson Education, Inc.
8,000
Chapter 9
12,000
Quantity
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The Market for Human Kidneys
 Arguments in favor of prohibiting the
sale of organs:
1. Imperfect information about donor’s health
and screening
2. Unfair to allocate according to the ability to
pay

Holding price below equilibrium will create
shortages
 Organs versus artificial substitutes
©2005 Pearson Education, Inc.
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Minimum Prices
 Periodically, government policy seeks to
raise prices above market-clearing levels
Minimum wage law
Regulation of airlines
Agricultural policies
 We will investigate this by looking at the
minimum wage legislation
©2005 Pearson Education, Inc.
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Minimum Prices
Price
S
If producers produce
Q2, the amount Q2 - Q3
will go unsold.
Pmin
A
D measures total cost
of increased
production not sold.
B
C
P0
The change in producer
surplus will be
A - C - D. Producers
may be worse off.
D
D
Q3
©2005 Pearson Education, Inc.
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Q2
Quantity
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The Minimum Wage
Firms are not allowed to
pay less than wmin. This
results in unemployment.
w
S
wmin
A
A is gain to workers
who find jobs at
higher wage.
B
C
w0
The deadweight loss
is given by
triangles B and C.
Unemployment
L1
©2005 Pearson Education, Inc.
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D
L2
L
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Price Supports
 Much of agricultural policy is based on a
system of price supports
Prices set by government above free-market
level and maintained by governmental
purchases of excess supply
©2005 Pearson Education, Inc.
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Price Supports
 What are the impacts on consumers,
producers and the federal budget?
 Consumers
Quantity demanded falls and quantity
supplied increases
Government buys surplus
Consumers must pay higher price for the
good
Loss in consumer surplus equal to A+B
©2005 Pearson Education, Inc.
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Price Supports
 Producers
Gain since they are selling more at a higher
price
Producer surplus increases by A+B+D
 Government
Cost of buying the surplus, which is funded
by taxes, so indirect cost on consumers
Cost to government = (Q2-Q1)PS
©2005 Pearson Education, Inc.
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Price Supports
 Government may be able to “dump” some of the
goods in the foreign markets
 Hurts domestic producers that government is trying to
help in the first place
 Total welfare effect of policy
CS + PS – Govt. cost = D – (Q2-Q1)PS
 Society is worse off overall
 Less costly to simply give farmers the money
©2005 Pearson Education, Inc.
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Price Supports
Price
S
Qg
Ps
A
P0
To maintain a price Ps
the government buys
quantity Qg .
D
B
Net Loss to
society is E + B.
D + Qg
E
D
Q1
©2005 Pearson Education, Inc.
Q0
Q2
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Quantity
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Production Quotas
 The government can also cause the price
of a good to rise by reducing supply
Limitations of taxi medallions in New York
City
Limitation of required liquor licenses for
restaurants
©2005 Pearson Education, Inc.
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Supply Restrictions
S’
Price
S
PS
•Supply restricted to Q1
•Supply shifts to S’ & Q1
A
B
P0
•CS reduced by A + B
•Change in PS = A - C
•Deadweight loss = BC
C
D
Q1
©2005 Pearson Education, Inc.
Q0
Chapter 9
Quantity
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Import Quotas and Tariffs
 Many countries use import quotas and
tariffs to keep the domestic price of a
product above world levels
Import quotas: Limit on the quantity of a
good that can be imported
Tariff: Tax on an imported good
 This allows domestic producers to enjoy
higher profits
 Cost to consumers is high
©2005 Pearson Education, Inc.
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Import Quotas and Tariffs
 With lower world price, domestic
consumers have incentive to purchase
from abroad
Domestic price falls to world price and
imports equal difference between quantity
supplied and quantity demanded
 Domestic industry might convince
government to protect industry by
eliminating imports
Quota of zero or high tariff
©2005 Pearson Education, Inc.
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Import Tariff to Eliminate
Imports
Price
In a free market, the
domestic price equals the
world price PW.
S
Quota of zero pushes
domestic price to P0 and
imports go to zero.
P0
A
B
Loss to consumers is
A+B+C.
Gain to producers is A.
Dead weight loss: B +C.
C
PW
Imports
D
QS
©2005 Pearson Education, Inc.
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Chapter 9
QD
Quantity
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Import Tariff (General Case)
 The increase in price can
P
be achieved by a tariff
 QS increases and QD
decreases
 Area A is the gain to
P*
domestic producers
 The loss to consumers is
Pw
A+B+C+D
 DWL = B + C
 Government Revenue is D
= tariff * imports
S
A
B
Chapter 9
C
D
QS
©2005 Pearson Education, Inc.
D
Q’S
Q’D
Q
QD
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Import Quota (General Case)
 If a quota is used,
rectangle D becomes
part of the profits to
foreign producers
 Consumers lose
A+B+C+D
 Producers gain A
 Net domestic loss is
B+C+D
S
P
P*
A
B
Pw
Chapter 9
C
D
QS
©2005 Pearson Education, Inc.
D
Q’S
Q’D
Q
QD
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The Sugar Quota Example
 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
 Sugar quotas have protected the sugar industry
but driven up prices
 Domestic producers have been better off and so
have some foreign producers that have quota
rights
 Consumers are worse off
©2005 Pearson Education, Inc.
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The Sugar Quota Example
 The Impact of a Sugar Quota in 2001
 US
production = 17.4 billion pounds
 US consumption = 20.4 billion pounds
 US price = 21.5 cents/pound
 World price = 8.3 cents/pound
 Price elasticity of US supply = 1.5
 Price elasticity of US demand = –0.3
©2005 Pearson Education, Inc.
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Impact of Sugar Quota
 The data can be used to fit the US supply
and demand curves
QS = -8.70 + 1.21P
QD = 26.53 - 0.29P
This situation led to little domestic supply and
most domestic consumption coming from
large imports
Government restricted imports to 3 billion
pounds raising price to 21.5 cents/pound
©2005 Pearson Education, Inc.
Chapter 9
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Sugar Quota in 1997
DUS
SUS
Price
(cents/lb.)
PUS = 21.5 after quota
20
A
16
D
C
B
11
The cost of the quotas
to consumers was
A + B + C + D = $2.4b.
The gain to producers
was area A = $1b.
PW = 8.3 before quota
8
4
1.4
©2005 Pearson Education, Inc.
17.4
Chapter 9
20.4 24.2
Quantity
(billions of pounds)
39
The Impact of a Tax or Subsidy
 The government wants to impose a $1.00
tax on movies. It can do it two ways:
Make the producers pay $1.00 for each
movie ticket they sell
Make consumers pay $1.00 when they buy
each movie
 In which option are consumers paying
more?
©2005 Pearson Education, Inc.
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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
 How the burden is split between the
parties depends on the relative
elasticities of demand and supply
©2005 Pearson Education, Inc.
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The Effects of a Specific Tax
 For simplicity we will consider a specific
tax on a good
Tax of a particular amount per unit sold
Federal and state taxes on gas and
cigarettes
 For our example, consider a specific tax
of $t per widget sold
©2005 Pearson Education, Inc.
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Incidence of a Specific Tax
Price
S
Pb price
buyers pay
Tax =
$1.00
•Buyers lose A + B
A
B
P0
PS price
producers
get
•Sellers lose D + C
•Government gains A
+ D in tax revenue.
C
D
•The deadweight
loss is B + C.
D
Q1
©2005 Pearson Education, Inc.
Chapter 9
Q0
Quantity
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Effect of an Output
Tax on Industry Output
Price
($ per
unit of
output)
S2 = S1 + t
S1
t
P2
Tax shifts S1 to S2 and
output falls to Q2. Price
increases to P2.
P1
D
Q2
©2005 Pearson Education, Inc.
Q1
Chapter 9
Output
44
Incidence of a Specific Tax
 Four conditions that must be satisfied
after the tax is in place:
1. Quantity sold and buyer’s price, Pb, must be
on the demand curve

Buyers only concerned with what they must
pay
2. Quantity sold and seller’s price, PS, must be
on the supply curve

Sellers only concerned with what they receive
©2005 Pearson Education, Inc.
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Incidence of a Specific Tax
 Four conditions that must be satisfied
after the tax is in place (cont.):
3. QD = QS
4. Difference between what consumers pay
and what buyers receive is the tax
 If we know the demand and supply
curves as well as the tax, we can solve
for PB, PS, QD and QS
©2005 Pearson Education, Inc.
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Incidence of a Specific Tax
 In the previous example, the tax was
shared almost equally by consumers and
producers
 If demand is relatively inelastic, however,
burden of tax will fall mostly on buyers
Cigarettes
 If supply is relatively inelastic, the burden
of tax will fall mostly on sellers
©2005 Pearson Education, Inc.
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Impact of Elasticities on Tax Burdens
Burden on Buyer
Burden on Seller
D
Price
Price
S
Pb
S
t
Pb
P0
P0
PS
t
D
PS
Q1 Q0
Quantity
Q1 Q 0
Quantity
The Impact of a Tax or Subsidy
 We can calculate the percentage of a tax
borne by consumers using pass-through
fraction
ES/(ES - Ed)
Tells fraction of tax “passed through” to
consumers through higher prices
For example, when demand is perfectly
inelastic (Ed = 0), the pass-through fraction is
1 – consumers bear 100% of tax
©2005 Pearson Education, Inc.
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The Effects of a Tax or Subsidy
 A subsidy can be analyzed in much the
same way as a tax
Payment reducing the buyer’s price below
the seller’s price
 It can be treated as a negative tax
 The seller’s price exceeds the buyer’s
price
 Quantity increases
©2005 Pearson Education, Inc.
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Effects of a Subsidy
Price
S
Like a tax, the benefit
of a subsidy is split
between buyers and
sellers, depending
upon the elasticities of
supply and demand.
PS
Subsidy
P0
Pb
D
Q0
©2005 Pearson Education, Inc.
Chapter 9
Q1
Quantity
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Effects of a Subsidy
 The benefit of the subsidy accrues mostly
to buyers if ED /ES is small
 The benefit of the subsidy accrues mostly
to sellers if ED /ES is large
 As with a tax, using supply and demand
curves, and the size of the subsidy, one
can solve for resulting prices and
quantities
©2005 Pearson Education, Inc.
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52
A Tax on Gasoline
 We can measure the effects of a tax by
looking at an example of a gasoline tax
 The goal of a large gasoline tax is to:
Raise government revenue
Reduce oil consumption and reduce US
dependence on oil imports
 We will consider a gas tax in the market
during mid-1990’s
©2005 Pearson Education, Inc.
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53
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)
©2005 Pearson Education, Inc.
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A Tax on Gasoline
 With a 50 cent tax:
QD = QS
150 - 50Pb = 60 + 40PS
150 - 50(PS+ 0.50) = 60 + 40PS
PS = .72
Pb = PS + 0.50 = $1.22
QD = QS = 89 bg/yr
©2005 Pearson Education, Inc.
Chapter 9
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A Tax on Gasoline
 With a 50 cent tax:
Q
falls by 11%
 Price to consumers increases by 22 cents
per gallon
 Producers receive about 28 cents per gallon
less
 Both producers and consumers were
opposed to the tax
 Government revenue would be significant at
$44.5 billion per year
©2005 Pearson Education, Inc.
Chapter 9
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The Impact of a 50 Cent
Gasoline Tax
D
Price
($ per
gallon)
S
Consumer Loss = A + B
B
Producer Loss = C + D
Pb = 1.22
A
$0.50
Tax
P0 = 1.00
C
D
PS = .72
The buyer pays 22 cents of
the tax, and
the producer pays 28 cents.
Government revenue = A + D
= 0.50(89) = $44.5 billion.
11
50 60
©2005 Pearson Education, Inc.
89 100
Chapter 9
150
Quantity (billion
gallons per year)
57