Chapter 9

The Analysis of Competitive

Markets

CHAPTER 9 OUTLINE

9.1 Evaluating the Gains and Losses from

Government PoliciesConsumer and
Producer Surplus
9.2 The Efficiency of a Competitive Market
9.3 Minimum Prices
9.4 Price Supports and Production Quotas
9.6 The Impact of a Tax or Subsidy

EVALUATING THE GAINS AND LOSSES FROM

GOVERNMENT POLICIESCONSUMER AND PRODUCER
SURPLUS
Review of Consumer and Producer
Surplus

9.1

Consumer A would pay $10 for a

good whose market price is $5
and therefore enjoys a benefit of
$5.
Consumer B enjoys a benefit of
$2,
and Consumer C, who values the
good at exactly the market price,
enjoys no benefit.
Consumer surplus, which
measures the total benefit to all
consumers, is the yellow-shaded
area between the demand curve
and the market price.

Producer surplus is the greenshaded area between the

supply curve and the market
price.
Together, consumer and
producer surplus measure the
welfare benefit of a
competitive market.

Total Surplus= Consumer Surplus + Producer Surplus

Application of Consumer and Producer Surplus

welfare effects

Gains and losses to consumers and producers.

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.
(i.e., Price Ceiling)
C.S.= A-B
P.S. = -(A+C)
T.S. = -(B+C)

deadweight loss

deadweight loss Net loss of total (consumer

plus producer) surplus.

What if market demand Is Inelastic?

If demand is sufficiently
inelastic, triangle B can
be larger than rectangle
A.
In this case, consumers
suffer a net loss from
price controls.

EXAMPLE 9.1 PRICE CONTROLS AND NATURAL GAS SHORTAGES

Supply: QS = 15.90 + 0.72PG + 0.05PO
Demand: QD = 0.02 1.8PG + 0.69PO
The market-clearing price of
natural gas is $6.40, and
the (hypothetical) maximum
allowable price is $3.00.
At Pmax, Qd-Qs=29.1 20.6 = 8.5
(shortage)
Gain to consumers: rectangle A
minus triangle B,
Loss to producers : rectangle A plus
triangle C.
The deadweight loss is the sum of
triangles B plus C.

A = (20.6 billion mcf ) * ($3.40/mcf) = $70.04 billion

B = (1/2) x (2.4 billion mcf) * ($1.33/mcf ) = $1.60 billion
C = (1/2) x (2.4 billion mcf ) * ($3.40/mcf ) = $4.08 billion
The annual change in consumer
surplus that would result from these
hypothetical price controls would
therefore be A B = 70.04 1.60 =
$68.44 billion.
The change in producer surplus
would be A C = 70.04 4.08 =
$74.12 billion.
And finally, the annual deadweight
loss. would be B C = 1.60
4.08 = $5.68 billion.

Question: Refer to the figure, answer the

following questions:
(1) At price 0E and quantity Q*,
consumer surplus is the area:___EFC_____
producer surplus is the area:__AEC______
the deadweight loss is:__0______
(2) Redo question (1) when price is 0H,
-CS HFGB
-PS AHB
-DWL BGC

Practice Questions
True or False
I. Workers always benefit from minimum wage laws
II. Even in competitive markets firms have no incentives to control
costs, as they can always pass on cost increases to consumers.
Under a binding price ceiling, what does the change in
consumer surplus represent?
A) The gain in surplus for those buyers who can still purchase the
product at the lower price.
B) The loss in surplus for those buyers who previously purchased
some units of the good at the higher price, but these units are no
longer produced at the lower price.
C) The loss in surplus for those buyers who would like the purchase
the excess demand created by the price ceiling policy.
D) Both A and B are correct.
E) Both A and C are correct.

9.2

THE EFFICIENCY OF A COMPETITIVE

MARKET

economic efficiency
Maximization of aggregate consumer and producer surplus.

Market Failure

Situation in which an unregulated competitive market is inefficient because

prices fail to provide proper signals to consumers and producers.
Two important instances in which market failure can occur:
1. Externalities: Actions of consumers or producers result in costs or benefits to a
third party. Such an impact is not accounted for by the market price.
externality Action taken by either a producer or a consumer which affects other
producers or consumers but is not accounted for by the market price.
2. Lack of Information: Asymmetric information.

EXAMPLE 8.2 THE MARKET FOR HUMAN KIDNEYS

The market-clearing price is
$20,000; at this price, about
24,000 kidneys per year would
be supplied.
Supply: QS = 16,000 + 0.4P
Demand: QD = 32,0000.4P
The law effectively makes the
price zero. About 16,000
kidneys per year are still
donated; this constrained
supply is shown as S.
Loss to suppliers=rectangle A
+ triangle C.
If consumers received kidneys
at no cost, their gain=
rectangle A - triangle B.

In practice, kidneys are

often rationed on the basis
of willingness to pay, and
many recipients pay most
or all of the $40,000 price
when supply is
constrained to 16,000.
Rectangles A and D
measure the total value of
kidneys when supply is
constrained.

Conclusion: Economics shows that human organs have economic value that
cannot be ignored, and prohibiting their sale imposes a cost on society that
must be weighed against the benefits.

9.3

MINIMUM PRICES (OR PRICE FLOOR)

Price is regulated to be no lower

than Pmin.
Producers would like to supply
Q2,but consumers will buy only Q3.
CS = A B
PS = A C

The deadweight loss is given by

triangles B and C.

Think:
What if producers havent learned
Econ201 and supply Q2 ?

If producers 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.

Example: The Minimum Wage

The market-clearing wage is
w0, however firms are not
allowed to pay less than
wmin.
This results in
unemployment of an
amount L2 L1
and a deadweight loss
given by triangles B and C.

9.4

PRICE SUPPORTS AND PRODUCTION QUOTAS

price support Price set by government above free-market level and

maintained by governmental purchases of excess supply.
To maintain a price Ps above the
market-clearing price P0, the
government buys a quantity Qg.
Gain to producers = A + B + D.
Loss to consumers= -(A + B).
Government cost= Ps(Q2 Q1).
Total Surplus = CS + PS
Cost to Gov.
= -(A+B) + (A + B + D) (Q2 Q1)Ps
= D (Q2 Q1)Ps

 Production Quotas (i.e. supply

restriction)
The government can restrict
supply to Q1 by imposing
production quotas.
(e.g. liquor license, import quota)
Set Q=Q1< Qo
CS=-(A+B)
PS=A-C
TS=-(B+C)

deadweight loss

 Alternative: Incentive
Program
The government can restrict supply
to Q1, by giving producers a financial
incentive to reduce output (e.g.
acreage limitations in agriculture).
For the financial incentive to work, it
must be at least as large as B + C +
D, which would be the additional
profit earned by planting, given the
higher price Ps.

CS = A B
PS = A C + Payments for not producing=(AC)+(B+C+D)=A+B+D
Gov. Cost= - (B + C + D)
TS = - (A + B) + (A + B + D ) (B +C + D) = (B + C)

deadweight loss

EXAMPLE 9.4 SUPPORTING THE PRICE OF WHEAT

To increase the price to
$3.70, the government
must buy a quantity of
wheat Qg=122 million
bushels of wheat

Supply: QS = 1800 + 240P

Demand: QD = 3550 266P

Buying Qg, the government

increased the marketclearing price from $3.46
per bushel to $3.70.

When P=3.70
Qg =Excess Supply =Qs-Qd=1800+240P-(3550-266P)= 506P1750= (506)(3.70) 1750 = 122 million
bushels
Loss to consumers= A + B =(3.70-3.46)(2566)+0.5*(2630-2566)(3.70-3.46)=$624million
Cost to the government = $3.70 x 122 million = $451.4 million
Gain to producers = A + B + C = $638 million

Practice Questions
What is the difference between a price support and a price
floor?
A) A price support is below equilibrium; a price floor is above it.
B) A price support is above equilibrium; a price floor is below it.
C) Government buys the excess supply to maintain a price floor,
but not a price support.
D) Government buys the excess supply to maintain a price
support, but not for a price floor.
E) There is no difference between the two.
A small decrease in a production quota will have a large
impact on the support price if:
A) demand is completely elastic.
B) demand is highly (but not completely) elastic.
C) demand is inelastic.
D) The demand elasticity does not affect the price outcomes of a quota
program.

9.6

THE IMPACT OF A TAX OR SUBSIDY

specific tax

Tax of a certain amount of money per unit sold.

Pb = price paid by buyers.

Ps = is the price that sellers receive.
The burden of the tax is split
between buyers and sellers.
Buyers lose A + B.
Sellers lose D + C.
The government earns A + D in tax
revenue.
The deadweight loss is B + C.

Four conditions:

QD = QD(Pb)
QS = QS(Ps)
QD = Q S
Pb Ps = t

(9.1a)
(9.1b)
(9.1c)
(9.1d)

Incidence of a Tax
S+t

Impact of a Tax Depends on Elasticities of Supply and Demand

(a) If demand is very inelastic

relative to supply, the burden of the
tax falls mostly on buyers.

(b) If demand is very elastic

relative to supply, it falls mostly
on sellers.

The Effects of a Subsidy

subsidy

Payment reducing the buyers price below the sellers price.

Conditions needed for the market to clear with a subsidy:

QD = QD(Pb)
QS = QS(Ps)
Q D = QS
Ps Pb = s
A subsidy can be thought of
as a negative tax. Like a tax,
the benefit of a subsidy is split
between buyers and sellers,
depending on the relative
elasticities of supply and
demand.

(9.2a)
(9.2b)
(9.2c)
(9.2d)

S-subsidy

Practice Question: a tax on gasoline

QD = 150 25Pb
QS = 60 + 20Ps

(Demand)
(Supply)

1. Find the effect of a $1-per-gallon tax:

Q D = QS
Pb Ps = 1.00

(Supply must equal demand)

(Government must receive $1.00/gallon)

150 25Pb = 60 + 20Ps

Pb = Ps + 1.00
150 25(Ps + 1) = 60 + 20Ps
20Ps + 25Ps = 150 25 60
45Ps = 65, or Ps = 1.44, Pb=2.44
Q = 150 (25)(2.44) = 150 61, or Q = 89 bg/yr
Annual revenue from the tax tQ = (1.00)(89) = $89 billion per year

2. Find the dead weight

loss caused by the tax:
Without tax, QD = QS
150 25P0 = 60 + 20P0
P0=$2.00 per gallon and the quantity sold
is100.
Deadweight loss: (1/2) x ($1.00) x (100-89
)billion gallons= $5.5 billion per year

Gasoline demand: QD = 150 25P

Gasoline supply: QS = 60 + 20P
S+t

Practice Questions
The burden of a tax per unit of output will fall heavily on
consumers when demand is relatively ________ and supply is
relatively ________.
A) inelastic; elastic
B) inelastic; inelastic
C) elastic; elastic
D) elastic; inelastic
What is the welfare impact of a subsidy policy?
A) Producer surplus increases, consumer surplus declines, and total
welfare declines.
B) Producer and consumer surplus increase, and these gains are
larger than the government cost.
C) Producer and consumer surplus increase, and these gains are
smaller than the government cost.
D) Producer surplus increases, consumer surplus declines, and total
welfare increases due to the subsidy program.