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Performance and Strategy in Performance and Strategy in Competitive MarketsCompetitive Markets
Chapter 8Chapter 8
Competitive Market Efficiency
Why is it Called Perfect Competition? Competitive markets balance supply and demand. Competitive markets maximize social welfare
Deadweight Loss Problem Deadweight losses occur when market
imperfections reduce transaction volume. Any benefit enjoyed by consumers or producers
that is not transferred but lost due to market imperfections is a deadweight loss.
Consumer Surplus
the difference between the maximum price a consumer is will to pay for something & its market price is called consumer surplus
one of the key elements in cost-benefit analysis
0
10
20
30
40
50
60
70
D=MBD=MBQQ
market pricemarket price
Q*Q*
Consumer Surplus
Mary’s consumer surplusMary’s consumer surplus
0
10
20
30
40
50
60
70
D=MBD=MBQQ
market pricemarket price
amountamountpaidpaid
Q*Q*
total consumer surplustotal consumer surplus
Consumer Surplus
Producer Surplus
Producer Surplus
the increase in the economic well-being of producers who are able to sell the product at a market price higher than the lowest price that would have drawn out their supply.
The difference between total revenues and total costs
PP
D=MBD=MB
PPcc
QQcc
S = MCS = MC
consumerconsumersurplussurplus
producerproducersurplussurplus
efficientefficientoutputoutput
efficientefficientoutputoutput
outcomes withoutcomes withpure competitionpure competitionoutcomes withoutcomes with
pure competitionpure competition
AA restriction in market supply restriction in market supply
Market Failure
Situation when competitive market outcomes fail to efficiently allocate economic resources.
Failure by market structure Failure can occur in markets with few participants.
Failure by incentive Externalities create incentive problems due to
differences between private and social costs or benefits.
A negative externality is an unpaid cost. A positive externality is an unrewarded
benefit.
Role for Government
How Government Influences Competitive Markets Tax policy or regulation is efficient if expected benefits
exceed expected costs. Fairness must be carefully weighed.
Broad Social Considerations Consumer sovereignty is an important benefit of
competitive markets. Public policy can control unfairly gained market power. Tax and regulatory policy limit concentration of
economic and political power.
© 2009, 2006 South-Western, a © 2009, 2006 South-Western, a part of Cengage Learningpart of Cengage Learning
Subsidy and Tax Policy Subsidy Policy
Subsidies can be indirect, like government highway spending that benefits the trucking industry.
Subsidies can be direct, as in agricultural programs.
Deadweight Loss From Taxes Taxes reduce economic activity and cause deadweight
losses. Pollution taxes explicitly recognize the public's right to a
clean environment.
How Taxes on Buyers (and Sellers) Affect Market Outcomes
Taxes discourage market activity. When a good is taxed, the
quantity sold is smaller. Buyers and sellers share
the tax burden.
How Taxes on Buyers Affect Market Outcomes
Elasticity and tax incidence Tax incidence is the manner in which the
burden of a tax is shared among participants in a market.
How Taxes on Buyers Affect Market Outcomes
Elasticity and Tax Incidence Tax incidence is the study of who bears
the burden of a tax. Taxes result in a change in market
equilibrium. Buyers pay more and sellers receive less,
regardless of whom the tax is levied on.
A Tax on Buyers
Quantity ofIce-Cream Cones
0
Price ofIce-Cream
Cone
Pricewithout
tax
Pricesellersreceive
Equilibrium without taxTax ($0.50)
Pricebuyers
pay
D1
D2
Supply, S1
A tax on buyersshifts the demandcurve downwardby the size ofthe tax ($0.50).
$3.30
90
Equilibriumwith tax
2.803.00
100
A Tax on Buyers
2.80
Quantity ofIce-Cream Cones
0
Price ofIce-Cream
Cone
Pricewithout
tax
Pricesellersreceive
Equilibriumwith tax
Equilibrium without tax
Tax ($0.50)
Pricebuyers
payS1
S2
Demand, D1
A tax on sellersshifts the supplycurve upwardby the amount ofthe tax ($0.50).
3.00
100
$3.30
90
A Tax on Sellers
Elasticity and Tax Incidence
What was the impact of tax? Taxes discourage market
activity. When a good is taxed, the
quantity sold is smaller. Buyers and sellers share
the tax burden.
Figure 8 A Payroll Tax
Quantityof Labor
0
Wage
Labor demand
Labor supply
Tax wedge
Wage workersreceive
Wage firms pay
Wage without tax
Elasticity and Tax Incidence
In what proportions is the burden of the tax divided?
How do the effects of taxes on sellers compare to those levied on buyers?
The answers to these questions depend on the elasticity of demand and the elasticity of supply.
Quantity0
Price
Demand
Supply
Tax
Price sellersreceive
Price buyers pay
(a) Elastic Supply, Inelastic Demand
2. . . . theincidence of thetax falls moreheavily onconsumers . . .
1. When supply is more elasticthan demand . . .
Price without tax
3. . . . than on producers.
How the Burden of a Tax Is Divided
How the Burden of a Tax Is Divided
Quantity0
Price
Demand
Supply
Tax
Price sellersreceive
Price buyers pay
(b) Inelastic Supply, Elastic Demand
3. . . . than onconsumers.
1. When demand is more elasticthan supply . . .
Price without tax
2. . . . theincidence of the tax falls more heavily on producers . . .
Elasticity and Tax Incidence
So, how is the burden of the tax divided?
The burden of a tax falls more heavily on the side of the market that is less elastic.
Summary: Tax Incidence and Burden
Tax Incidence and Burden Tax incidence is the point of tax collection. Tax burden is borne by party who ultimately pays the tax.
Role of Elasticity Who pays the economic burden of a tax or operating control
depends on the elasticities of supply and demand. The burden of a tax falls more heavily on the side of the
market that is less elastic. Elasticity affects the deadweight loss of taxation.
Deadweight loss is small when supply (or demand) is inelastic.
Deadweight loss is large when supply (or demand) is elastic.
CONTROLS ON PRICES
Price Ceiling A legal maximum on the price at which a
good can be sold. Price Floor
A legal minimum on the price at which a good can be sold.
How Price Ceilings Affect Market Outcomes
Two outcomes are possible when the government imposes a price ceiling: The price ceiling is not binding if set above
the equilibrium price. The price ceiling is binding if set below the
equilibrium price, leading to a shortage.
A Market with a Price Ceiling(a) A Price Ceiling That Is Not Binding
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Equilibriumquantity
$4 Priceceiling
Equilibriumprice
Demand
Supply
3
100
The market clears at $3 and the price ceiling is ineffective.
A Market with a Price Ceiling(b) A Price Ceiling That Is Binding
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Demand
Supply
2 PriceceilingShortage
75
Quantitysupplied
125
Quantitydemanded
Equilibriumprice
$3
How Price Ceilings Affect Market Outcomes
Effects of Price Ceilings A binding price ceiling creates
Shortages because QD > QS. Example: Gasoline shortage of the 1970s
Nonprice rationing Examples: Long lines, discrimination by
sellers
CASE STUDY: Lines at the Gas Pump
Economists blame government regulations that limited the price oil companies could charge for gasoline.
In 1973, OPEC raised the price of crude oil in world markets. Crude oil is the major input in gasoline, so the higher oil prices reduced the supply of gasoline.
What was responsible for the long gas lines?
The Market for Gasoline with a Price Ceiling(a) The Price Ceiling on Gasoline Is Not Binding
Quantity ofGasoline
0
Price ofGasoline
1. Initially,the priceceilingis notbinding . . . Price ceiling
Demand
Supply, S1
P1
Q1
The Market for Gasoline with a Price Ceiling(b) The Price Ceiling on Gasoline Is Binding
Quantity ofGasoline
0
Price ofGasoline
Demand
S1
S2
Price ceiling
QS
4. . . . resultingin ashortage.
3. . . . the priceceiling becomesbinding . . .
2. . . . but whensupply falls . . .
P2
QD
P1
Q1
CASE STUDY: Rent Control in the Short Run and Long Run
Rent controls are ceilings placed on the rents that landlords may charge their tenants.
The goal of rent control policy is to help the poor by making housing more affordable.
One economist called rent control “the best way to destroy a city, other than bombing.”
Rent Control in the Short Run and in the Long Run
(a) Rent Control in the Short Run(supply and demand are inelastic)
Quantity ofApartments
0
Supply
Controlled rent
RentalPrice of
Apartment
Demand
Shortage
Rent Control in the Short Run and in the Long Run
(b) Rent Control in the Long Run(supply and demand are elastic)
0
RentalPrice of
Apartment
Quantity ofApartments
Demand
Supply
Controlled rent
Shortage
How Price Floors Affect Market Outcomes
When the government imposes a price floor, two outcomes are possible. The price floor is not binding if set below
the equilibrium price. The price floor is binding if set above the
equilibrium price, leading to a surplus.
A Market with a Price Floor(a) A Price Floor That Is Not Binding
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Equilibriumquantity
2
Pricefloor
Equilibriumprice
Demand
Supply
$3
100
The government says that ice-cream cones must sell for at least $2; this legislation is ineffective at the current market price.
A Market with a Price Floor(b) A Price Floor That Is Binding
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Demand
Supply
$4Pricefloor
80
Quantitydemanded
120
Quantitysupplied
Equilibriumprice
Surplus
3
How Price Floors Affect Market Outcomes
A binding price floor causes . . . a surplus because QS > QD. nonprice rationing is an alternative
mechanism for rationing the good, using discrimination criteria.
Examples: The minimum wage, agricultural price supports
CASE STUDY: The Minimum Wage
An important example of a price floor is the minimum wage.
Minimum wage laws dictate the lowest price possible for labor that any employer may pay.
How the Minimum Wage Affects the Labor Market
Quantity ofLabor
Wage
0
Labordemand
LaborSupply
Equilibriumemployment
Equilibriumwage
How the Minimum Wage Affects the Labor Market
Quantity ofLabor
Wage
0
LaborSupplyLabor surplus
(unemployment)
Labordemand
Minimumwage
Quantitydemanded
Quantitysupplied