chapter 11 © 2006 thomson learning/south-western applying the competitive model
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Chapter 11Chapter 11
© 2006 Thomson Learning/South-Western
Applying the Competitive Model
2
Consumer Surplus
In Figure 11-1, the equilibrium price and quantity are P* and Q*.
The demand curve, D, shows what people are willing to pay for the good.
The total value of the good to buyers is given by the area below the demand curve from Q = 0 to Q = Q* (AEQ*0).
3
Price
P*
S
D
E
A
B
Quantityper periodQ*0
FIGURE 11-1: Competitive Equilibrium and Consumer/Producer Surplus
4
Consumer Surplus
Consumers expenditures for Q* are given by the area P*EQ*0.
Consumers receive a “surplus” (total value less what they pay) equal to the area AEP*, which is shaded gray in Figure 11-1.
5
Price
P*
S
D
E
A
B
Quantityper periodQ*0
FIGURE 11-1: Competitive Equilibrium and Consumer/Producer Surplus
6
Producer Surplus
At the equilibrium shown in Figure 11-1, producers receive total revenue equal to the area P*EQ*0.
If producers sold one unit at a time at the lowest possible price, producers would have been willing to produce Q* for the payment of BEQ*0.
Thus, producer surplus the the area P*EB shaded in green in Figure 11-1.
7
Price
P*
S
D
E
A
B
Quantityper periodQ*0
FIGURE 11-1: Competitive Equilibrium and Consumer/Producer Surplus
8
Short-Run Producer Surplus
The positive slope of the short-run supply curve, S, in Figure 11-1 results from the diminishing returns to variable inputs that are encountered as output is increased.
For production up to Q*, price exceeds marginal cost, so total short-run profits equal the area P*EB less fixed costs
9
Short-Run Producer Surplus
Producer surplus, the area P*EB, reflects the sum of total short-run profits and short-run fixed costs.
Short-run producer surplus is the part of total profits that is in excess of the profits firms would have if they chose to produce nothing at all.
As such, it is similar to consumer surplus.
10
Long-Run Producer Surplus
Consider the area P*EB in Figure 11-1 as long-run producer surplus.
It measures all of the increased payments relative to the situation in which the industry produces no output.
The inputs would have received lower prices if this industry had not produced output.
11
Ricardian Rent
The market equilibrium price and quantity, P*, Q*, are shown in Figure 11-2 (d).
Low-cost farms, Figure 11-2 (a) and medium-cost farms, Figure 11-2 (b), earn long-run economic profits.
Marginal farms, Figure 11-2 (c) earn zero economic profits
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FIGURE 11-2 (d): The Market
Price
P*
B
E
S
D
Q perperiodQ*
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FIGURE 11-2 (a): Low-Cost Farm
Price
P*
MC
AC
q perperiodq*
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FIGURE 11-2 (b): Medium-Cost Farm
Price
P*
MCAC
q perperiodq*
15
FIGURE 11-2 (c): Marginal Farm
q perperiod
Price
P*
q*
MC AC
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Price
P*MC AC
q perperiod
q*
(a) Low-Cost Farm
Price
P*
MC AC
q perperiod
q*
(b) Medium-Cost Farm
Price
P*
MC AC
q perperiod
q*
(c) Marginal Farm
Price
P*
B
E
S
D
Q perperiod
Q*
(d) The Market
FIGURE 11-2: Ricardian Rent
17
Ricardian Rent
Profits earned by the intramarginal farms can persist in the long run because they reflect the returns to a scarce resource, low-cost land.
Entry can not erode these profits because of the scarcity of the low-cost land.
The sum of these long run profits (P*EB) is the producer surplus ( Ricardian rent).
18
Economic Efficiency
The competitive equilibrium is efficient in that it produces the largest surplus equal to the sum of producer and consumer surplus.
In Figure 11-1, an output level of Q1 results in a loss of surplus equal to the area FEG. Consumers would be willing to pay P1 for a
good that producers are willing to produce for P2, so mutually beneficial transactions exit.
19
Price
P2
P*
S
D
E
F
G
P1
A
B
Quantityper periodQ*Q10
FIGURE 11-1: Competitive Equilibrium and Consumer/Producer Surplus
20
A Numerical Example
The market equilibrium is P* = $6 and Q* = 4. The equilibrium is shown as point E in Figure
11-3. At point E consumers are spending $24 ($6·4).
2.112
1.1110
PQ
PQ
:Supply
:Demand
21
A Numerical Example
At point E in Figure 11-3, consumer surplus is $8 (= ½·$4·4).
Producers also gain a producer surplus of $8 at point E.
Total consumer and producer surplus is $16.
If price stays at $6 but output falls to 3, total surplus falls to $15.
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Price
S
D
E6
10
2
Tapesper period43 51 2
FIGURE 11-3: Efficiency in CD Sales
23
Price Controls and Shortages
In Figure 11-4 the market initially is in equilibrium at P1, Q1 (point E).
Then demand increases from D to D’. This would cause price to rise to P2
encouraging entry in the short-run. Eventually entry would bring the price down to
P3 and the market would be in long-run equilibrium.
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Price
P
1P
3
SS
E
E’
LSP2
Quantityper periodQ1 Q3
D’
D
Q2
FIGURE 11-4: Price Controls and Shortages
25
Price Controls and Shortages
Suppose the government imposed a price control at the below equilibrium price of P1 when demand increased.
Firms would only supply Q1 and no entry would take place.
Since customers would demand Q4 at this price, there would be a shortage of Q4 - Q1.
26
Price Controls and Shortages
The welfare consequences of price control can be analyzed using consumer and producer surplus.
Consumers would gain surplus of P3CEP1 (colored in gray) due to the lower price. This is a direct transfer of surplus from
producers to consumers with no gain in total surplus.
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Price
P
1P
3
SSA
C
E
E’
LSP2
Quantityper periodQ1 Q3
D’
D
Q4
FIGURE 11-4: Price Controls and Shortages
28
Price Controls and Shortages
If output had expanded, consumers would gain the area AE’C. Since output is reduced by the price control,
this is a loss of surplus to consumers. Similarly, producers don’t gain the area
CE’E that would have resulted from increased output.
The area AE’E is the total welfare loss.
29
Tax Incidence
The study of the final burden of a tax after considering all market reactions to it is tax incidence theory.
The incidence of a “specific tax” of a fixed amount per unit of output that is imposed on all firms in a constant cost industry is illustrated in Figure 11-5
30
Price
P1
P2
SMC MC
AC
Output
(a) Typical Firm
q2 q10
Price
P4P3
Quantityper week
(b) The Market
Q3 Q2 Q1
D
S’S
D’
Tax
LS
0
FIGURE 11-5: Effect of the Imposition of a Specific Tax on a Perfectly Competitive Constant Cost Industry
31
Tax Incidence
Since for any price, P, consumers pay the firm gets to keep P - t (where t is the per unit tax), the effect of the tax on firms can be shown as a decrease in demand. The vertical distance between the demand curves is t.
It creates a wedge between the consumers’ price, P, and the price firms receive.
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Short-Run Tax Incidence
The short-run effect is to decrease output from Q1 to Q2, where firms receive P2 and consumers pay P3 (P3 - P2 = t).
So long as P2 is above minimum variable costs, the firm continues to produce and the tax incidence is shared by consumers, whose price increased to P3, and by firm’s who now receive only P2 rather than P1.
33
Long-Run Tax Incidence
Firms will not operate at a loss in the long run, so exit will take place shifting the short-run supply curve back to S’.
In the new long-run equilibrium, output will return to Q3 where the firm’s will receive P1 again and consumers will pay P4.
The long-run tax incidence is all on the consumer although the firms pays the tax.
34
Long-Run Incidence with Increasing Costs
When the long-run supply curve has a positive slope, both consumers and firms pay a portion of the tax.
The imposition of the tax shifts the long-run demand curve inward to D’ (as shown in Figure 11-6) which causes the price to fall from P1 to P2 as some firms exit and input prices fall.
35
Price
P
2
P3
P1
Quantityper periodQ2 Q1
D
LS
A
B E1
E2
D’
Tax
FIGURE 11-6: Tax Incidence in an Increasing Cost Industry
36
Long-Run Incidence with Increasing Costs
Consumers pay a portion of the tax since the gross price of P3 exceeds the pre-tax price.
Total tax collection is the gray area P3ARE2P2.
The inputs to the firm pay the remainder of the tax as they are not paid based on a lower net price of P2.
37
Incidence and Elasticity
The economic actor who has the most elastic curve will be able to avoid more of the tax leaving the actor with the more inelastic curve to pay most of the tax. If demand is relatively inelastic and supply is
elastic, demanders will pay most of the tax. If supply is relatively inelastic and demand is
elastic, suppliers will pay most of the tax.
38
Taxation and Efficiency
In Figure 11-6, the total loss of consumer surplus is the area P3AE1P1.
The area P3ABP1 is transferred into tax revenue and the area AE1B is simply lost.
The loss in producer surplus is P1E1E2P2 of which P1BE2P2 is tax revenue and BE1E2 lost.
39
Gains from International Trade
Figure 11-7 shows the domestic demand and supply curves for a particular good, say shoes.
Without international trade, the equilibrium price and quantity would be PD, QD.
If the world shoe price is PW, the opening of trade will cause prices to fall causing quantity to increase to Q1.
40
Gains from International Trade
The quantity supplied by domestic producers will fall to Q2 with shoe imports of Q1 - Q2.
Consumer surplus increases by the area PDE0E1PW. Part, PDE0APW, comes as a transfer from
domestic producers, and the rest is an unambiguous gain in welfare (E0E1A).
41
Price
PW
PD
Quantityper periodQ
2Q
1
E1
E0
QD
D
A
LS
FIGURE 11-7: Opening of International Trade Increases Total Welfare
42
Tariff Protection
Producers will resist their losses, and since the loss is spread over fewer producers than the gain for consumers, they have a stronger incentive to organize for trade protection.
A major trade protection is a tariff which is a tax on an imported good.
Effects of a tariff are shown in Figure 11-8.
43
Price
PW
PR
Quantityper periodQ2 Q3 Q1
E1
E2
Q4
D
B
A C F
LS
FIGURE 11-8: Effects of a Tariff
44
Tariff Protection
Compared to the free trade equilibrium E1, the imposition of a per-unit tariff in the amount of t raises the effective price to PW + t = PR. Quantity demanded falls to Q3 while domestic
production expands to Q4.
Tariff revenue is the area BE2FC, equal to t(Q3 - Q4).
45
Tariff Protection
Total consumer surplus is reduced by the area PRE2E1PW. Part becomes tariff revenue and part is
transferred into domestic producer’s surplus (area PRBAPW).
The two colored triangles BCA and E2E1F represent losses that are not transferred; these are the deadweight losses from the tariff.
46
Other Types of Trade Protection
A quota that limits imports to Q3 - Q4 (in Figure 11-8) would have a similar effect to a tariff. Market price would rise to PR. Consumer surplus would be transferred to
domestic producers (area PRBAPW). A deadweight loss equal to the areas of the
colored triangles would also occur.
47
Other Types of Trade Protection
However, with a quota, no tax revenue is generated. The area BE2FC can go to foreign producers
or to windfall gains to owners of import licenses.
Nonquantitative restrictions such as health or other inspections also impose costs like a a tariff on imports, and can be analyzed in a similar manner using Figure 11-8.
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