Lecture 15 Competitive Markets Applications Lecturer Martin Paredes

Lecture # 15 Competitive Markets: Applications Lecturer: Martin Paredes

Efficiency of Perfect Competition 2. Government Intervention 3. Examples of Various Government Policies l Excise Taxes l Price Ceilings l Production Quotas 1. 2

l l l A perfectly competitive market allocates resources efficiently Alternatively, at a perfectly competitive equilibrium, (Q*, P*), total surplus is maximized. It assumes there is no outside intervention 3

Example: Maximisation of Surplus in Competitive Equilibrium P Supply A P* B C D Demand Q* Q 4

Example: Maximisation of Surplus in Competitive Equilibrium P Supply A : Consumer Surplus: ABC P* B C D Demand Q* Q 5

Example: Maximisation of Surplus in Competitive Equilibrium P Supply A : Consumer Surplus: ABC P* B C : Producer Surplus: BCD D Demand Q* Q 6

Example: Maximisation of Surplus in Competitive Equilibrium P Supply A : Consumer Surplus: ABC P* B C : Producer Surplus: BCD + : Total Surplus D Demand Q* Q 7

Definition: Economic Efficiency means that the total surplus is maximized. Definition: A deadweight loss is a reduction in net economic benefits resulting from an inefficient allocation of resources. l Deadweight losses occur when there is government intervention 8

Example: Deadweight Loss P Supply A P* B C D Demand Q* Q 9

Example: Deadweight Loss P Supply A P* C B D Demand Q 1 Q* Q 10

Example: Deadweight Loss P Supply A Pd P* C B D Demand Q 1 Q* Q 11

Example: Deadweight Loss P Supply A Pd P* C B Ps D Demand Q 1 Q* Q 12

Example: Deadweight Loss P Supply A Pd P* C B : Deadweight Loss Ps D Demand Q 1 Q* Q 13

l l There are several instruments that the government can use to modify the equilibrium in a perfectly competitive market Deadweight losses occur when there is government intervention 14

l Examples of Government Intervention: 1. Excise taxes 2. Subsidies to producers 3. Price floors 4. Price ceilings 5. Production quotas 6. Import tariffs and quotas 7. Government Purchase programs 8. Acreage Limitation program 15

Definition: An excise tax (or a specific tax) is an amount paid per unit of the good at the point of sale. l It is paid by either the consumer or the producer. l If consumers pay price PD and producers receive PS, then the tax is given by T = PD – PS. 16

Example: Excise Tax P S P* Demand Q* Q 17

Example: Excise Tax S’ = S + T P S T P* Demand Q* Q 18

Example: Excise Tax S’ = S + T P S T P* Demand Q 1 Q* Q 19

Example: Excise Tax S’ = S + T P S T Pd P* Demand Q 1 Q* Q 20

Example: Excise Tax S’ = S + T P S T Pd P* Ps Demand Q 1 Q* Q 21

Example: Excise Tax S’ = S + T P S : Consumer Surplus T Pd P* Ps Demand Q 1 Q* Q 22

Example: Excise Tax S’ = S + T P S : Consumer Surplus T : Producer Surplus Pd P* Ps Demand Q 1 Q* Q 23

Example: Excise Tax S’ = S + T P S : Consumer Surplus T : Producer Surplus Pd : Tax Revenue P* Ps Demand Q 1 Q* Q 24

Example: Excise Tax S’ = S + T P S : Consumer Surplus T : Producer Surplus Pd : Tax Revenue P* : Deadweight Loss Ps Demand Q 1 Q* Q 25

Definition: l The amount by which the price paid by consumers, PD, rises over the non-tax equilibrium price, P*, is the incidence of the tax on consumers. l The amount by which the price received by sellers, PS, falls below P* is called the incidence of the tax on producers. 26

Definition: A price ceiling is a minimum price that consumers can legally pay for a good. l If the price floor is above the pre-control competitive equilibrium price, then it said to be binding. 27

Example: Price Floors P S P* D Q* Q 28

Example: Price Floors P S PMI N P* D Q* Q 29

Example: Price Floors P S PMI N P* D Qd Q* Q 30

Example: Price Floors P S PMI N P* D Qd Q* Qs Q 31

Example: Price Floors P S PMI N P* Qs – Qd : Excess Supply D Qd Q* Qs Q 32

Example: Price Floors P S : Consumer Surplus PMI N P* D Qd Q* Qs Q 33

Example: Price Floors P S : Consumer Surplus PMI : Producer Surplus N P* D Qd Q* Qs Q 34

Example: Price Floors P S : Consumer Surplus PMI : Producer Surplus N P* : Deadweight Loss D Qd Q* Qs Q 35

Definition: A production quota is a limit either on the number of producers in the market or on the amount that each producer can sell. l The goal of a quota is to place a limit on the total quantity that producers can supply to the market. 36

Example: Production Quota P Original Supply Demand Q* Q 37

Example: Production Quota P Original Supply Demand QMAX Q* Q 38

Example: Production Quota P Supply with quota Original Supply Demand QMAX Q* Q 39

Example: Production Quota P Supply with quota Original Supply : Consumer Surplus : Producer Surplus : Deadweight Loss Demand QMAX Q* Q 40

Government Intervention: Who Wins and Who Loses? Intervention Type: Effect on (domestic) Is a (domestic) Quantity Consumer Producer Government Deadweight Traded Surplus Budget Loss created? Excise Tax Falls Positive Yes Subsidies to Producers Rises Negative Yes Maximum Price Ceilings for Producers Falls; Excess Demand Rise or Falls Zero Yes Minimum Price Floors for Producers Falls; Excess Supply Falls Rise or Fall Zero Yes Production Quotas Falls; Excess Supply Falls Rise or Fall Zero Yes Import Tariffs Falls Rises Positive Yes Import Quotas Falls Rises Zero Yes 41

1. An "invisible hand" guides the competitive market to the efficient level of production and consumption. 2. The government policies examined here all resulted in a deadweight loss compared to the perfectly competitive equilibrium. 42

3. Efficiency is obtained under the assumption that price fully reflects all costs and benefits to the market and that there is perfect information. 4. Government intervention may be efficient under imperfectly competitive markets. 43

Additional Slides 44

Definition: A subsidy is an amount paid by the government per unit of the good to the sellers. l If consumers pay price PD, then the government pays an amount T per unit on top of that price, so producers receive PS = PD + T. 45

Example: Subsidies P S P* D Q* Q 46

Example: Subsidies P S S’ = S – T T P* D Q* Q 47

Example: Subsidies P S S’ = S – T T P* D Q* Q 2 Q 48

Example: Subsidies P S S’ = S – T T P* Pd D Q* Q 2 Q 49

Example: Subsidies P S S’ = S – T T Ps P* Pd D Q* Q 2 Q 50

Example: Subsidies P S S’ = S – T T : Consumer Surplus Ps P* Pd D Q* Q 2 Q 51

Example: Subsidies P S S’ = S – T T Ps P* Pd : Producer Surplus D Q* Q 2 Q 52

Example: Subsidies P S S’ = S – T T Ps P* Pd : Government Expenditure D Q* Q 2 Q 53

Example: Subsidies P S S’ = S – T T Ps P* Pd : Deadweight Loss D Q* Q 2 Q 54

Definition: A price ceiling is a legal maximum on the price per unit that a producer can receive. l If the price ceiling is below the pre-control competitive equilibrium price, then the ceiling is called binding. 55

Example: Price Ceilings P S P* D Q* Q 56

Example: Price Ceilings P S P*P M AX D Q* Q 57

Example: Price Ceilings P S P*P M AX D Q* Qd Q 58

Example: Price Ceilings P S P*P M AX D Qs Q* Qd Q 59

Example: Price Ceilings P S Qd – Qs : Excess Demand P*P M AX D Qs Q* Qd Q 60

Example: Price Ceilings P S : Producer Surplus P*P M AX D Qs Q* Qd Q 61

Example: Price Ceilings P S : Consumer Surplus : Producer Surplus P*P M AX D Qs Q* Qd Q 62

Example: Price Ceilings P S : Consumer Surplus : Producer Surplus P*P M : Deadweight Loss AX D Qs Q* Qd Q 63