Chapter 9
The Analysis of
Competitive
Markets
Chapter 9 Slide 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 3
Topics to be Discussed
? Price Supports and Production Quotas
? Import Quotas and Tariffs
? The Impact of a Tax or Subsidy
Chapter 9 Slide 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,
Producer
Surplus
Between 0 and Q0
producers receive
a net gain from
selling each product--
producer surplus,
Consumer
Surplus
Consumer and Producer Surplus
Quantity
0
Price
S
D
5
Q0
Consumer C
10
7
Consumer B Consumer A
Between 0 and Q0
consumers A and B
receive a net gain from
buying the product--
consumer surplus
Chapter 9 Slide 6
? 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,
Evaluating the Gains and Losses from
Government Policies--Consumer and Producer Surplus
Chapter 9 Slide 7
The loss to producers is
the sum of rectangle
A and triangle C,Triangle
B and C together measure
the deadweight loss,
B
A C
The gain to consumers is
the difference between
the rectangle A and the
triangle B,
Deadweight Loss
Change in Consumer and
Producer Surplus from Price Controls
Quantity
Price
S
D
P0
Q0
Pmax
Q1 Q2
Suppose the government
imposes a price ceiling Pmax
which is below the
market-clearing price P0,
Chapter 9 Slide 8
? 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,
Change in Consumer and
Producer Surplus from Price Controls
Chapter 9 Slide 9
? Observation
? Consumers can experience a net loss in
consumer surplus when the demand is
sufficiently inelastic
Change in Consumer and
Producer Surplus from Price Controls
Chapter 9 Slide 10
B
A P
max
C
Q1
If demand is sufficiently
inelastic,triangle B can
be larger than rectangle
A and the consumer
suffers a net loss from
price controls,
Example
Oil price controls
and gasoline shortages
in 1979
S
D
Effect of Price Controls
When Demand Is Inelastic
Quantity
Price
P0
Q2
Chapter 9 Slide 11
Price Controls and
Natural Gas Shortages
? 1975 Price controls created a shortage
of natural gas,
? What was the deadweight loss?
Chapter 9 Slide 12
? 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,
Price Controls and
Natural Gas Shortages
Data for 1975
Chapter 9 Slide 13
? PO = $8/b
? Equilibrium PG = $2/mcf and Q = 20 Tcf
? Price ceiling set at $1
? This information can be seen
graphically,
Price Controls and
Natural Gas Shortages
Data for 1975
Chapter 9 Slide 14
B
A
2.40
C
The gain to consumers is
rectangle A minus triangle
B,and the loss to
producers is rectangle
A plus triangle C,
S D
2.00
Quantity (Tcf) 0
Price
($/mcf)
5 10 15 20 25 30 18
(Pmax)1.00
Price Controls and
Natural Gas Shortages
Chapter 9 Slide 15
? 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
Price Controls and
Natural Gas Shortages
Chapter 9 Slide 16
? 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
Price Controls and
Natural Gas Shortages
Chapter 9 Slide 17
? 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,
Price Controls and
Natural Gas Shortages
Chapter 9 Slide 18
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 19
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 20
? Government intervention in these
markets can increase efficiency,
? Government intervention without a
market failure creates inefficiency or
deadweight loss,
The Efficiency of
a Competitive Market
Chapter 9 Slide 21
P1
Q1
A
B
C
When price is
regulated to be no
higher than P1,the
deadweight loss given by
triangles B and C results,
Welfare Loss When Price
Is Held Below Market-Clearing Level
Quantity
Price
S
D
P0
Q0
Chapter 9 Slide 22
P2
Q3
A B
C
Q2
What would the deadweight
loss be if QS = Q2?
When price is
regulated to be no
lower than P2 only Q3
will be demanded,The
deadweight loss is given
by triangles B and C
Welfare Loss When Price
Is Held Above Market-Clearing Level
Quantity
Price
S
D
P0
Q0
Chapter 9 Slide 23
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 24
D
Rectangles A and D
measure the total value
of kidneys when
supply is constrained,A
C
The loss to suppliers
is given by rectangle A
and triangle C,
The Market for Kidneys,and Effects
of the 1984 Organ Transplantation Act
Quantity
Price
8,000 4,000 0
$10,000
$30,000
$40,000
S’ The 1984 act effectively makes the price zero,
B If consumers received kidneys at no cost,their
gain would be given by
rectangle A less triangle B,
S
D
12,000
$20,000
Chapter 9 Slide 25
? 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,
The Market for Human Kidneys
Chapter 9 Slide 26
? 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
The Market for Human Kidneys
Chapter 9 Slide 27
? 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,
The Market for Human Kidneys
Chapter 9 Slide 28
? Arguments in favor of prohibiting the
sale of organs,
1) Imperfect information about donor’s
health and screening
The Market for Human Kidneys
Chapter 9 Slide 29
? 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
The Market for Human Kidneys
Chapter 9 Slide 30
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 31
B A
The change in producer
surplus will be
A - C - D,Producers
may be worse off,
C
D
Price Minimum
Quantity
Price
S
D
P0
Q0
Pmin
Q3 Q2
If producers produce
Q2,the amount Q2 - Q3
will go unsold,
Chapter 9 Slide 32
B The deadweight loss is given by
triangles B and C,
C
A
wmin
L1 L2
Unemployment
Firms are not allowed to
pay less than wmin,This
results in unemployment,
S
D
w0
L0
The Minimum Wage
L
w
Chapter 9 Slide 33
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 34
B
A
C After deregulation,Prices fell to P
O,The
change in consumer
surplus is A + B,
Q3
D
Area D is the cost
of unsold output,
Effect of Airline Regulation
by the Civil Aeronautics Board
Quantity
Price S
D
P0
Q0 Q1
Pmin
Q2
Prior to deregulation
price was at Pmin and
QD = Q1 and Qs = Q2,
Airline Industry Data
Number of carriers 33 72 86 60 86 96
Passenger load factor(%) 54 59 61 62 67 69
Passenger-mile rate
(constant 1995 dollars),218,210,166,150,129,126
Real cost index (1995=100) 101 122 111 107 100 99
Real cost index corrected
for fuel cost increases 94 98 98 100 100 98
1975 1980 1985 1990 1995 1996
Chapter 9 Slide 36
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 37
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 38
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 39
B
D A
To maintain a price Ps
the government buys
quantity Qg, The change in
consumer surplus = -A - B,
and the change in producer
surplus is A + B + D
D + Qg
Qg
Price Supports
Quantity
Price
S
D
P0
Q0
Ps
Q2 Q1
Chapter 9 Slide 40
D + Qg
Qg
B A
Price Supports
Quantity
Price
S
D
P0
Q0
Ps
Q2 Q1
The cost to the
government is the
speckled rectangle
Ps(Q2-Q1)
D
Total
Welfare
Loss
Total welfare loss
D-(Q2-Q1)ps
Chapter 9 Slide 41
Price Supports
? Question,
? Is there a more efficient way to increase
farmer’s income by A + B + D?
Chapter 9 Slide 42
? Production Quotas
? The government can also cause the price of
a good to rise by reducing supply,
Price Supports and
Production Quotas
Chapter 9 Slide 43
? What is the impact of,
1) Controlling entry into the taxicab
market?
2) Controlling the number of liquor
licenses?
Price Supports and
Production Quotas
Chapter 9 Slide 44
B
A
?CS reduced by A + B
?Change in PS = A - C
?Deadweight loss = BC
C
D
Supply Restrictions
Quantity
Price
D
P0
Q0
S
PS
S’
Q1
?Supply restricted to Q1
?Supply shifts to S’ @ Q1
Chapter 9 Slide 45
B
A
C
D
Supply Restrictions
Quantity
Price
D
P0
Q0
S
PS
S’
Q1
?Ps is maintained with
and incentive
?Cost to government = B + C + D
Chapter 9 Slide 46
Supply Restrictions
B
A
Quantity
Price
D
P0
Q0
PS
S
S’
D
C
? = A - C + B +
C + D = A + B + D,
? The change in
consumer and
producer surplus is
the same as with
price supports,
? = -A - B +
A + B + D - B - C -
D = -B - C,
PS?
w e lfa re?
Chapter 9 Slide 47
Supply Restrictions
? Questions,
? How could the
government reduce
the cost and still
subsidize the farmer?
? Which is more costly,
supports or acreage
limitations?
B
A
Quantity
Price
D
P0
Q0
PS
S
S’
D
C
Chapter 9 Slide 48
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 49
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 50
D + Qg
By buying 122
million bushels
the government
increased the
market-clearing
price,
P0 = $3.70
2,566 2,688
A B C
Qg
?AB consumer loss
?ABC producer gain S
D
P0 = $3.46
2,630 1,800
The Wheat Market in 1981
Quantity
Price
Chapter 9 Slide 51
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 52
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 53
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 54
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 55
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 56
The Wheat Market in 1985
Quantity
Price
1,800
S
D
P0 = $1.80
2,232
To increase the
price to $3.20,the
government bought
466 million bushels
and imposed
a production quota
of 2,425 bushels,
D + QS
S’
P0 = $3.20
1,959 2,425
QS
Chapter 9 Slide 57
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 58
Supporting the Price of Wheat
? Question,
? What is the change in consumer and
producer surplus?
Chapter 9 Slide 59
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 60
Supporting the Price of Wheat
? 1998 Wheat Market
?P = $2.65
?QD = 3244 - 283P
?QS = 1944 + 207P
?Q = 2493
?Government subsidy of,66/bushel or $1.6
billion
Chapter 9 Slide 61
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 62
QS QD
PW
Imports
A B C
By eliminating imports,
the price is increased to
PO,The gain is area A,The
loss to consumers A + B + C,
so the deadweight loss
is B + C,
Import Tariff or Quota
That Eliminates Imports
Quantity
Price
How high would
a tariff have
to be to get the
same result?
D
P0
Q0
S
In a free market,the
domestic price equals the
world price PW,
Chapter 9 Slide 63
D C B
QS QD Q’S Q’D
A
P*
Pw
Import Tariff or Quota
(general case)
Quantity
Price
D
S
? The increase in price can
be achieved by a quota
or a tariff,
? Area A is again the gain
to domestic producers,
? The loss to consumers is
A + B + C + D,
Chapter 9 Slide 64
Import Tariff or Quota
(general case)
? If a tariff is used the
government gains D,so
the net domestic product
loss is B + C,
? If a quota is used instead,
rectangle D becomes part
of the profits of foreign
producers,and the net
domestic loss is B + C + D,
D C B
QS QD Q’S Q’D
A
P*
Pw
Quantity
D
S
Price
Chapter 9 Slide 65
? Question,
? Would the U.S,be
better off or worse off
with a quota instead of
a tariff? (e.g,Japanese
import restrictions in
the 1980s)
Import Tariff or Quota
(general case)
D C B
QS QD Q’S Q’D
A
P*
Pw
Quantity
D
S
Price
Chapter 9 Slide 66
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 67
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 68
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
C
D
B
QS = 4.0 Q’S = 15.6 Q’d = 21.1
Qd = 24.2
A
The cost of the quotas
to consumers was
A + B + C + D,or $2.4b,
The gain to producers
was area A,or $1b,
Sugar Quota in 1997
Quantity
(billions of pounds)
Price
(cents/lb.)
SUS DUS
5 10 15 20 25 0
4
8
11
16
20
PW = 11
PUS = 21.9
30
C
D
B
QS = 4.0 Q’S = 15.6 Q’d = 21.1
Qd = 24.2
A
Sugar Quota in 1997
Quantity
(billions of pounds)
Price
(cents/lb.)
SUS DUS
5 10 15 20 25 0
4
8
11
16
20
PW = 11
PUS = 21.9
30
Rectangle D was the
gain to foreign producers
who obtained quota
allotments,or $600 million,
Triangles B and C represent
the deadweight loss of
$800 million,
Chapter 9 Slide 71
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 72
D
S
B
D
A
Buyers lose A + B,and
sellers lose D + C,and
the government earns A + D
in revenue,The deadweight
loss is B + C,
C
Incidence of a SpecificTax
Quantity
Price
P0
Q0 Q1
PS
Pb
t
Pb is the price (including
the tax) paid by buyers,
PS is the price sellers receive,
net of the tax,The burden
of the tax is split evenly,
Chapter 9 Slide 73
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 74
Incidence of a Specific Tax
? Four conditions that must be satisfied
after the tax is in place,
3) QD = QS
4) Pb - PS = tax
Impact of a Tax Depends
on Elasticities of Supply and Demand
Quantity Quantity
Price Price
S
D S
D
Q0
P0 P0
Q0 Q1
Pb
PS
t
Q1
Pb
PS
t
Burden on Buyer Burden on Seller
Chapter 9 Slide 76
? 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,
The Impact of a Tax or Subsidy
Chapter 9 Slide 77
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 78
D
S
Subsidy
Quantity
Price
P0
Q0 Q1
PS
Pb
s
Like a tax,the benefit
of a subsidy is split
between buyers and
sellers,depending
upon the elasticities of
supply and demand,
Chapter 9 Slide 79
Subsidy
? With a subsidy (s),the selling price Pb is
below the subsidized price PS so that,
? s = PS - Pb
Chapter 9 Slide 80
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 81
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 82
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 = $1.22
Chapter 9 Slide 83
A Tax on Gasoline
? With a 50 cent tax
? Q = 150 -(50)(1.22) = 89 bg/yr
? Q falls by 11%
Chapter 9 Slide 84
D
A
Lost Consumer
Surplus
Lost Producer
Surplus PS =,72
Pb = 1.22
Impact of a 50 Cent Gasoline Tax
Quantity (billion
gallons per year)
Price
($ per
gallon)
0 50 150
.50
100
P0 = 1.00
1.50
89
t = 0.50
11
The annual revenue
from the tax is,50(89)
or $44.5 billion,The buyer
pays 22 cents of the tax,and
the producer pays 28 cents,
S D
60
Chapter 9 Slide 85
D
A
Lost Consumer
Surplus
Lost Producer
Surplus PS =,72
Pb = 1.22
Impact of a 50 Cent Gasoline Tax
Price
($ per
gallon)
0 50 150
.50
100
P0 = 1.00
1.50
89
t = 0.50
11
S D
60
Deadweight loss = $2.75 billion/yr
Quantity (billion
gallons per year)
Chapter 9 Slide 86
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 87
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 88
Summary
? Government intervention in a
competitive market is not always a bad
thing,
End of Chapter 9
The Analysis of
Competitive
Markets
The Analysis of
Competitive
Markets
Chapter 9 Slide 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 3
Topics to be Discussed
? Price Supports and Production Quotas
? Import Quotas and Tariffs
? The Impact of a Tax or Subsidy
Chapter 9 Slide 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,
Producer
Surplus
Between 0 and Q0
producers receive
a net gain from
selling each product--
producer surplus,
Consumer
Surplus
Consumer and Producer Surplus
Quantity
0
Price
S
D
5
Q0
Consumer C
10
7
Consumer B Consumer A
Between 0 and Q0
consumers A and B
receive a net gain from
buying the product--
consumer surplus
Chapter 9 Slide 6
? 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,
Evaluating the Gains and Losses from
Government Policies--Consumer and Producer Surplus
Chapter 9 Slide 7
The loss to producers is
the sum of rectangle
A and triangle C,Triangle
B and C together measure
the deadweight loss,
B
A C
The gain to consumers is
the difference between
the rectangle A and the
triangle B,
Deadweight Loss
Change in Consumer and
Producer Surplus from Price Controls
Quantity
Price
S
D
P0
Q0
Pmax
Q1 Q2
Suppose the government
imposes a price ceiling Pmax
which is below the
market-clearing price P0,
Chapter 9 Slide 8
? 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,
Change in Consumer and
Producer Surplus from Price Controls
Chapter 9 Slide 9
? Observation
? Consumers can experience a net loss in
consumer surplus when the demand is
sufficiently inelastic
Change in Consumer and
Producer Surplus from Price Controls
Chapter 9 Slide 10
B
A P
max
C
Q1
If demand is sufficiently
inelastic,triangle B can
be larger than rectangle
A and the consumer
suffers a net loss from
price controls,
Example
Oil price controls
and gasoline shortages
in 1979
S
D
Effect of Price Controls
When Demand Is Inelastic
Quantity
Price
P0
Q2
Chapter 9 Slide 11
Price Controls and
Natural Gas Shortages
? 1975 Price controls created a shortage
of natural gas,
? What was the deadweight loss?
Chapter 9 Slide 12
? 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,
Price Controls and
Natural Gas Shortages
Data for 1975
Chapter 9 Slide 13
? PO = $8/b
? Equilibrium PG = $2/mcf and Q = 20 Tcf
? Price ceiling set at $1
? This information can be seen
graphically,
Price Controls and
Natural Gas Shortages
Data for 1975
Chapter 9 Slide 14
B
A
2.40
C
The gain to consumers is
rectangle A minus triangle
B,and the loss to
producers is rectangle
A plus triangle C,
S D
2.00
Quantity (Tcf) 0
Price
($/mcf)
5 10 15 20 25 30 18
(Pmax)1.00
Price Controls and
Natural Gas Shortages
Chapter 9 Slide 15
? 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
Price Controls and
Natural Gas Shortages
Chapter 9 Slide 16
? 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
Price Controls and
Natural Gas Shortages
Chapter 9 Slide 17
? 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,
Price Controls and
Natural Gas Shortages
Chapter 9 Slide 18
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 19
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 20
? Government intervention in these
markets can increase efficiency,
? Government intervention without a
market failure creates inefficiency or
deadweight loss,
The Efficiency of
a Competitive Market
Chapter 9 Slide 21
P1
Q1
A
B
C
When price is
regulated to be no
higher than P1,the
deadweight loss given by
triangles B and C results,
Welfare Loss When Price
Is Held Below Market-Clearing Level
Quantity
Price
S
D
P0
Q0
Chapter 9 Slide 22
P2
Q3
A B
C
Q2
What would the deadweight
loss be if QS = Q2?
When price is
regulated to be no
lower than P2 only Q3
will be demanded,The
deadweight loss is given
by triangles B and C
Welfare Loss When Price
Is Held Above Market-Clearing Level
Quantity
Price
S
D
P0
Q0
Chapter 9 Slide 23
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 24
D
Rectangles A and D
measure the total value
of kidneys when
supply is constrained,A
C
The loss to suppliers
is given by rectangle A
and triangle C,
The Market for Kidneys,and Effects
of the 1984 Organ Transplantation Act
Quantity
Price
8,000 4,000 0
$10,000
$30,000
$40,000
S’ The 1984 act effectively makes the price zero,
B If consumers received kidneys at no cost,their
gain would be given by
rectangle A less triangle B,
S
D
12,000
$20,000
Chapter 9 Slide 25
? 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,
The Market for Human Kidneys
Chapter 9 Slide 26
? 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
The Market for Human Kidneys
Chapter 9 Slide 27
? 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,
The Market for Human Kidneys
Chapter 9 Slide 28
? Arguments in favor of prohibiting the
sale of organs,
1) Imperfect information about donor’s
health and screening
The Market for Human Kidneys
Chapter 9 Slide 29
? 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
The Market for Human Kidneys
Chapter 9 Slide 30
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 31
B A
The change in producer
surplus will be
A - C - D,Producers
may be worse off,
C
D
Price Minimum
Quantity
Price
S
D
P0
Q0
Pmin
Q3 Q2
If producers produce
Q2,the amount Q2 - Q3
will go unsold,
Chapter 9 Slide 32
B The deadweight loss is given by
triangles B and C,
C
A
wmin
L1 L2
Unemployment
Firms are not allowed to
pay less than wmin,This
results in unemployment,
S
D
w0
L0
The Minimum Wage
L
w
Chapter 9 Slide 33
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 34
B
A
C After deregulation,Prices fell to P
O,The
change in consumer
surplus is A + B,
Q3
D
Area D is the cost
of unsold output,
Effect of Airline Regulation
by the Civil Aeronautics Board
Quantity
Price S
D
P0
Q0 Q1
Pmin
Q2
Prior to deregulation
price was at Pmin and
QD = Q1 and Qs = Q2,
Airline Industry Data
Number of carriers 33 72 86 60 86 96
Passenger load factor(%) 54 59 61 62 67 69
Passenger-mile rate
(constant 1995 dollars),218,210,166,150,129,126
Real cost index (1995=100) 101 122 111 107 100 99
Real cost index corrected
for fuel cost increases 94 98 98 100 100 98
1975 1980 1985 1990 1995 1996
Chapter 9 Slide 36
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 37
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 38
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 39
B
D A
To maintain a price Ps
the government buys
quantity Qg, The change in
consumer surplus = -A - B,
and the change in producer
surplus is A + B + D
D + Qg
Qg
Price Supports
Quantity
Price
S
D
P0
Q0
Ps
Q2 Q1
Chapter 9 Slide 40
D + Qg
Qg
B A
Price Supports
Quantity
Price
S
D
P0
Q0
Ps
Q2 Q1
The cost to the
government is the
speckled rectangle
Ps(Q2-Q1)
D
Total
Welfare
Loss
Total welfare loss
D-(Q2-Q1)ps
Chapter 9 Slide 41
Price Supports
? Question,
? Is there a more efficient way to increase
farmer’s income by A + B + D?
Chapter 9 Slide 42
? Production Quotas
? The government can also cause the price of
a good to rise by reducing supply,
Price Supports and
Production Quotas
Chapter 9 Slide 43
? What is the impact of,
1) Controlling entry into the taxicab
market?
2) Controlling the number of liquor
licenses?
Price Supports and
Production Quotas
Chapter 9 Slide 44
B
A
?CS reduced by A + B
?Change in PS = A - C
?Deadweight loss = BC
C
D
Supply Restrictions
Quantity
Price
D
P0
Q0
S
PS
S’
Q1
?Supply restricted to Q1
?Supply shifts to S’ @ Q1
Chapter 9 Slide 45
B
A
C
D
Supply Restrictions
Quantity
Price
D
P0
Q0
S
PS
S’
Q1
?Ps is maintained with
and incentive
?Cost to government = B + C + D
Chapter 9 Slide 46
Supply Restrictions
B
A
Quantity
Price
D
P0
Q0
PS
S
S’
D
C
? = A - C + B +
C + D = A + B + D,
? The change in
consumer and
producer surplus is
the same as with
price supports,
? = -A - B +
A + B + D - B - C -
D = -B - C,
PS?
w e lfa re?
Chapter 9 Slide 47
Supply Restrictions
? Questions,
? How could the
government reduce
the cost and still
subsidize the farmer?
? Which is more costly,
supports or acreage
limitations?
B
A
Quantity
Price
D
P0
Q0
PS
S
S’
D
C
Chapter 9 Slide 48
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 49
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 50
D + Qg
By buying 122
million bushels
the government
increased the
market-clearing
price,
P0 = $3.70
2,566 2,688
A B C
Qg
?AB consumer loss
?ABC producer gain S
D
P0 = $3.46
2,630 1,800
The Wheat Market in 1981
Quantity
Price
Chapter 9 Slide 51
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 52
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 53
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 54
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 55
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 56
The Wheat Market in 1985
Quantity
Price
1,800
S
D
P0 = $1.80
2,232
To increase the
price to $3.20,the
government bought
466 million bushels
and imposed
a production quota
of 2,425 bushels,
D + QS
S’
P0 = $3.20
1,959 2,425
QS
Chapter 9 Slide 57
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 58
Supporting the Price of Wheat
? Question,
? What is the change in consumer and
producer surplus?
Chapter 9 Slide 59
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 60
Supporting the Price of Wheat
? 1998 Wheat Market
?P = $2.65
?QD = 3244 - 283P
?QS = 1944 + 207P
?Q = 2493
?Government subsidy of,66/bushel or $1.6
billion
Chapter 9 Slide 61
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 62
QS QD
PW
Imports
A B C
By eliminating imports,
the price is increased to
PO,The gain is area A,The
loss to consumers A + B + C,
so the deadweight loss
is B + C,
Import Tariff or Quota
That Eliminates Imports
Quantity
Price
How high would
a tariff have
to be to get the
same result?
D
P0
Q0
S
In a free market,the
domestic price equals the
world price PW,
Chapter 9 Slide 63
D C B
QS QD Q’S Q’D
A
P*
Pw
Import Tariff or Quota
(general case)
Quantity
Price
D
S
? The increase in price can
be achieved by a quota
or a tariff,
? Area A is again the gain
to domestic producers,
? The loss to consumers is
A + B + C + D,
Chapter 9 Slide 64
Import Tariff or Quota
(general case)
? If a tariff is used the
government gains D,so
the net domestic product
loss is B + C,
? If a quota is used instead,
rectangle D becomes part
of the profits of foreign
producers,and the net
domestic loss is B + C + D,
D C B
QS QD Q’S Q’D
A
P*
Pw
Quantity
D
S
Price
Chapter 9 Slide 65
? Question,
? Would the U.S,be
better off or worse off
with a quota instead of
a tariff? (e.g,Japanese
import restrictions in
the 1980s)
Import Tariff or Quota
(general case)
D C B
QS QD Q’S Q’D
A
P*
Pw
Quantity
D
S
Price
Chapter 9 Slide 66
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 67
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 68
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
C
D
B
QS = 4.0 Q’S = 15.6 Q’d = 21.1
Qd = 24.2
A
The cost of the quotas
to consumers was
A + B + C + D,or $2.4b,
The gain to producers
was area A,or $1b,
Sugar Quota in 1997
Quantity
(billions of pounds)
Price
(cents/lb.)
SUS DUS
5 10 15 20 25 0
4
8
11
16
20
PW = 11
PUS = 21.9
30
C
D
B
QS = 4.0 Q’S = 15.6 Q’d = 21.1
Qd = 24.2
A
Sugar Quota in 1997
Quantity
(billions of pounds)
Price
(cents/lb.)
SUS DUS
5 10 15 20 25 0
4
8
11
16
20
PW = 11
PUS = 21.9
30
Rectangle D was the
gain to foreign producers
who obtained quota
allotments,or $600 million,
Triangles B and C represent
the deadweight loss of
$800 million,
Chapter 9 Slide 71
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 72
D
S
B
D
A
Buyers lose A + B,and
sellers lose D + C,and
the government earns A + D
in revenue,The deadweight
loss is B + C,
C
Incidence of a SpecificTax
Quantity
Price
P0
Q0 Q1
PS
Pb
t
Pb is the price (including
the tax) paid by buyers,
PS is the price sellers receive,
net of the tax,The burden
of the tax is split evenly,
Chapter 9 Slide 73
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 74
Incidence of a Specific Tax
? Four conditions that must be satisfied
after the tax is in place,
3) QD = QS
4) Pb - PS = tax
Impact of a Tax Depends
on Elasticities of Supply and Demand
Quantity Quantity
Price Price
S
D S
D
Q0
P0 P0
Q0 Q1
Pb
PS
t
Q1
Pb
PS
t
Burden on Buyer Burden on Seller
Chapter 9 Slide 76
? 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,
The Impact of a Tax or Subsidy
Chapter 9 Slide 77
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 78
D
S
Subsidy
Quantity
Price
P0
Q0 Q1
PS
Pb
s
Like a tax,the benefit
of a subsidy is split
between buyers and
sellers,depending
upon the elasticities of
supply and demand,
Chapter 9 Slide 79
Subsidy
? With a subsidy (s),the selling price Pb is
below the subsidized price PS so that,
? s = PS - Pb
Chapter 9 Slide 80
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 81
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 82
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 = $1.22
Chapter 9 Slide 83
A Tax on Gasoline
? With a 50 cent tax
? Q = 150 -(50)(1.22) = 89 bg/yr
? Q falls by 11%
Chapter 9 Slide 84
D
A
Lost Consumer
Surplus
Lost Producer
Surplus PS =,72
Pb = 1.22
Impact of a 50 Cent Gasoline Tax
Quantity (billion
gallons per year)
Price
($ per
gallon)
0 50 150
.50
100
P0 = 1.00
1.50
89
t = 0.50
11
The annual revenue
from the tax is,50(89)
or $44.5 billion,The buyer
pays 22 cents of the tax,and
the producer pays 28 cents,
S D
60
Chapter 9 Slide 85
D
A
Lost Consumer
Surplus
Lost Producer
Surplus PS =,72
Pb = 1.22
Impact of a 50 Cent Gasoline Tax
Price
($ per
gallon)
0 50 150
.50
100
P0 = 1.00
1.50
89
t = 0.50
11
S D
60
Deadweight loss = $2.75 billion/yr
Quantity (billion
gallons per year)
Chapter 9 Slide 86
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 87
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 88
Summary
? Government intervention in a
competitive market is not always a bad
thing,
End of Chapter 9
The Analysis of
Competitive
Markets
