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Transcript of 1 Ch 10: Competitive Markets: Applications Often government intervene in markets, even perfectly...
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Ch 10: Competitive Markets: Applications
Often government intervene in markets, even perfectly competitive markets, for a variety of reasons
Equity (instead of efficiency)Fixing Market FailuresAchieving Policy GoalsPolitics
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Sidenote: Partial Equilibrium Analysis
•In this chapter we’ll use
partial equilibrium analysis
we’ll assume government intervention only affects 1 market
•We will also assume no externalities exist – no extra results will arise from these programs
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Chapter 10: Competitive Markets: Applications
In this chapter we will cover:
10.1 Maximum Efficiency10.2 Policy: Excise Tax
10.2.1 Tax Incidence10.3 Policy: Subsidy10.4 Policy: Price Ceiling10.5 Policy: Price Floor10.6 Policy: Production Quotas10.7 Agricultural Support10.8 Policy: Import Quotas and Tariffs
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In 1776, Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations mentioned an “Invisible Hand” that guided competitive markets to maximize efficiency.
Although no “Invisible Hand” actually exists, perfectly competitive markets do work to maximize producer and consumer surplus
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For any given good:
Consumer Surplus is difference between the consumer’s willingness to pay and the price
Producer Surplus is the difference between the price and the producer’s willingness to provide
Total Surplus is the difference between the consumer’s willingness to pay and the producer’s willingness to provide
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For example:
Jacob is willing to pay $20 for the assignment answers, and Beth is willing to sell her answers for $10. The PC market price for answers is $14.
Consumer Surplus =$20-$14= $6Producer Surplus =$14-$10= $4Total Surplus =$20-$10= $10
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Consumer and Producer Surplus
Demand
Consumer Surplus
Q
P
Q*
P*
A
B C
D
Q1
Producer Surplus
Supply
8
Definition: An excise tax is an amount paid by either the consumer or the producer per unit of the good at the point of sale.
(The amount paid by the demanders exceeds the total amount received by the sellers by amount T)
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Example: Excise Tax
T
S+T
S
Q
P
Q1 Q*
Pd
Ps
Demand
P*
Q*=Original Q
P*=Original PPd=Price Paid
by buyers
Ps=Price received by sellers
T(ax)=Pd-Ps
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Consumer and Producer Surplus
D
OldConsumer Surplus
Q
P
Q*
P*
A
B C
D
Q1
Old Producer Surplus
S
S+T
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Consumer and Producer Surplus
D
NewConsumer Surplus
Q
P
Q*
P*
A
B C
D
Q1
New Producer Surplus
S
S+T
Government Income
Deadweight Loss
Pd
Ps
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Originally, efficiency was maximized.
After the tax was imposed, portions of consumer and producer surplus was transferred to the government
-this transfer is still efficient-WHO gets the surplus is irrelevant
After the tax, production decreases, and a small triangle of producer and consumer surplus is lost – this triangle is the deadweight loss
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Deadweight loss – reduction in net economic benefit due to inefficient allocation of resources
Taxes create inefficiencies!!
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S + tax
Sales Tax Imposed on the Sellers
Quantity (thousands of CD players per week)
Pric
e (d
olla
rs p
er p
laye
r)
3 4 5 6
95
100
105
110 S
DA
Taxrevenue
$10 tax
After Tax Market Price
Supply is affected
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D-tax
Tax applied to buyer: Same Effect as tax on seller
Quantity (thousands of CD players per week)
Pric
e (d
olla
rs p
er p
laye
r)
3 4 5 6
95
100
105
110 S
DA
$10
tax
Original Market Price
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Summary:
• Taxes discourage market activity
• Tax incidence measures the effect of a tax on buyers’ and sellers’ prices
•Tax burden falls most heavily on the side of the market that is least elastic in its response to a price change:
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S + tax
The Sales Tax: Who Pays? Demand Relatively Inelastic
Quantity (thousands of CD players per week)
Pric
e (d
olla
rs p
er p
laye
r)
3 4 5 6
95
100
105
110 S
DA
98
108 $10 tax
Consumer Price Rises
from 100 to 108
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S + tax
The Sales Tax: Who Pays? Demand Relatively More Elastic.
Quantity (thousands of CD players per week)
Pri
ce (
dolla
rs p
er
pla
yer)
3 4 5 6
95
100
105
110 S
DA $10 tax
Original Market Price
103
93
Consumer Price Rises
from 100 to 103
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The relationship between tax incidence and elasticity is as follows:
Pd/Ps = /
where: is the own-price elasticity of supply is the own-price elasticity of demand
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Example: Let = -.5 and = 2. What is the relative incidence of a specific tax on consumers and producers?
Pd/Ps = 2/-.5 = -4
interpretation: "consumers pay four times as much as the decrease in price producers receive. Hence, an excise tax of $1 results in an increase in consumer price of $.80 and a decrease in price received by producers of $.20"
Note: Subsidies are negative taxes…
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•Subsidies work as a negative tax, increasing the seller’s price by T (or reducing the buyer’s price by T, to the same effect)
•Subsidies will:•Encourage overproduction•Increase Consumer Surplus•Increase Producer Surplus•Be a government cost
•The cost to the government is always greater than gained consumer and producer surplus
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Subsidies
D
OLDConsumer Surplus
Q
P
Q1
P*
A
B C
D
Q*
OLD Producer Surplus
S-T
S
Ps
Pd
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Subsidies
D
NewConsumer Surplus
Q
P
Q*
P*
A
B C
D
Q1
S-T
S
Ps
Pd
24
Subsidies
D
Q
P
Q*
P*
A
B C
D
Q1
New Producer Surplus
S-T
S
Ps
Pd
25
Subsidies
D
Q
P
Q*
P*
A
B C
D
Q1
Government Cost
S-T
S
Ps
Pd
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Subsidies
D
Q
P
Q*
P*
A
B C
D
Q1
Deadweight Loss
S-T
S
Ps
Pd
Government Cost
New Producer Surplus
NewConsumer Surplus
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Definition: A price ceiling is a legal maximum on the price per unit that a producer can receive. If the price ceiling is below the pre-control competitive equilibrium price, then the ceiling is called binding.
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A price ceiling always has the following effects:
• Excess demand will exist• The market will underproduce• Producer surplus will decrease• Some producer surplus is transferred to
the consumer• Consumer surplus may increase or
decrease• There will be a deadweight loss
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Price Ceiling
Demand
OldConsumer Surplus
Q
P
Q*
P*
A
B C
DOldProducer Surplus
Supply
Price Ceiling
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The impact of a price ceiling depends on which consumer receive the available good. We will examine the 2 extreme cases:
•Consumers with greatest willingness to pay receive good (maximize consumer surplus)
•Consumers with least willingness to pay receive good (minimize consumer surplus)
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Price Ceiling: Maximize Consumer Surplus
Demand
NewConsumer Surplus
Q
P
Qd
P*
A
B C
D
Qs
NewProducer Surplus
Supply
Price Ceiling
ExcessDemandQs
Deadweight Loss
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Price Ceiling: Minimize Consumer Surplus
Demand
NewConsumer Surplus
Q
P
Qd
P*
A
B C
D
Qs
NewProducer Surplus
Supply
Price Ceiling
ExcessDemand
Qs
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Price Ceiling: Minimize Consumer Surplus
Demand
Q
P
Qd
P*A
B
Qs
Supply
Price Ceiling
ExcessDemand
Qs
Deadweight Loss=A-B
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•It is generally assumed that the consumers with the greatest willingness to pay receive the good, but this does not always occur
•Price ceilings are only effective if resale (black market) is prevented
•Price ceilings can also cause a reliance on imports to meet excess demand
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Definition: A price floor is a legal minimum on the price per unit that a producer can receive. (ie: minimum wage) If the price floor is above the pre-control competitive equilibrium price, then the floor is called binding.
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A price floor always has the following effects:
• Excess supply will exist• The market will underconsume• Consumer surplus will decrease• Some consumer surplus is transferred to
the producer• Producer surplus may increase or
decrease• There will be a deadweight loss
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Price Floor
Demand
OldConsumer Surplus
Q (L)
P (W)
Q*
P*
A
B C
DOldProducer Surplus
Supply
Price Floor(min. wage)
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The impact of a price floor depends on which producer will sell the good (which worker works). We will examine the 2 extreme cases:
•Producers with greatest efficiency supply good (maximize producer surplus)
•Producers with least efficiency supply good (minimize producer surplus)
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Price Floor: Maximize Producer Surplus
Demand
NewConsumer Surplus
Q (L)
P (W)
P*
A
B C
D
Qs
NewProducer Surplus
Supply
Price FloorIe: Min. Wage
ExcessSupplyQd
Deadweight Loss
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Price Floor: Minimize Producer Surplus
Demand
NewConsumer Surplus
Q
P
=Qd
P*
A
B C
D
Qd
NewProducer Surplus
Supply
Price FloorIe: Min. Wage
ExcessSupply
Qs
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Price Floor: Minimize Producer Surplus
Demand
Q
P
=Qd
P* YX
Qd
Supply
Price FloorIe: Min. Wage
ExcessSupply
Qs
Deadweight Loss=Y-X
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• The attempt of a union to increase wages has two effects:
1)Some workers receive a higher wage2)Some workers lose their jobs
• Note that there is a difference between negotiating a higher wage (a union’s publicized goal) and ensuring wages keep up with inflation (often a union’s achieved goal)
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• In place of a price floor, the government can instead impose a PRODUCTION QUOTA
• Production Quotas restrict the quantity supplied of any good• Ie: Taxi Cabs• Ie: Bear hunting permits
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Production Quotas have similar effects to price floors:
• There will be excess supply (some will want to supply but be prevented)
• Quantity purchased will decrease• Consumer surplus will decrease• Some consumer surplus will transfer to
producers• Producer surplus may increase or
decrease• There will be a deadweight loss
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Production Quota
Demand
OldConsumer Surplus
Q
P
Q*
P*
A
B C
DOldProducer Surplus
Supply
Production Quota
P1
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Production Quota: Maximize Producer Surplus
Demand
NewConsumer Surplus
Q (L)
P (W)
P*
A
B C
D
Qs
NewProducer Surplus
Supply
Production Quota
Qd
Deadweight Loss
P1
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Quota: Minimize Producer Surplus
Demand
NewConsumer Surplus
Q
P
=Qd
P*
A
B C
D
Qd
NewProducer Surplus
Supply
Quota
Qs
P1
48
Quota: Minimize Producer Surplus
Demand
Q
P
=Qd
P* YX
Qd
SupplyQuota
Qs
Deadweight Loss=Y-X
P1
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Production Quotas effect on producer surplus depends on which producers are allowed to produce:
• Producers with lowest willingness to produce (lowest costs – most efficient) – producer surplus is maximized
• Producers with highest (valid) willingness to produce (highest costs – most inefficient) – producer surplus is minimized
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•Agriculture is one area often receiving government support
•Often it is argued that farming is no longer a viable profession at market-clearing wages
•The government works to raise the price of agricultural outputs through 2 policies:
•Acre Limitation Programs•Government Purchase Programs
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Since demand is downward sloping, prices can be raised by reducing output.
However, supply and demand will force quantity up and price down.
In order to keep quantity down and price up, the government can pay farmers to reduce production:
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Acreage Limitation
Demand
OldConsumer Surplus
Q
P
P*
A
B C
DOldProducer Surplus
Supply
Production Limit
P1
53
Acreage Limitation
Demand
NewConsumer Surplus
Q
P
P*
A
B C
DNewProducer Surplus
Supply
Production Limit
P1
54
Acreage Limitation
Demand
NewConsumer Surplus
Q
P
P*
A
B C
DNewProducer Surplus
Supply
Production Limit
Government Cost
P1
55
Acreage Limitation
Demand
NewConsumer Surplus
Q
P
P*
A
B C
DNewProducer Surplus
Supply
Production Limit
Government Cost
Deadweight Loss
P1
56
Critics may criticize acreage limitation programs as being wasteful – if the land is there, why not use it?
Alternately, the government can purchase agricultural output in order to benefit farmers:
57
Gov. Purchase Programs
Demand
OldConsumer Surplus
Q
P
P*
A
B C
DOldProducer Surplus
Supply
Demand + Gov.Purchases
Q*Q1 Q1+G
P1
58
Gov. Purchase Programs
Demand
NewConsumer Surplus
Q
P
P*
A
B C
DNewProducer Surplus
Supply
Demand + Gov.Purchases
Q*Q1 Q1+G
Note: ChangeIn Consumer And ProducerSurplus is Equal to AcreLimitation
P1
59
Gov. Purchase Programs
Demand
NewConsumer Surplus
Q
P
P*
A
B C
D
Supply
Demand + Gov.Purchases
Q*Q1 Q1+G
Note: Gov.Costs areGreater
Gov.Cost
P1
60
Gov. Purchase Programs
Demand
NewConsumer Surplus
Q
P
P*
A
B C
D
Supply
Demand + Gov.Purchases
Q*Q1 Q1+G
Note:DeadweightLoss is Greater
DeadweightLoss
P1
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As seen previously, government purchase programs have greater deadweight loss than acreage limitation programs.
But acreage limitation programs also have deadweight loss.
The most efficient program is to simply give the farmers money. (No deadweight loss)
Often however, politics overrules economics.
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•Often foreign countries can produce a good cheaper than domestic industries
Pw<P*
•In order to protect domestic industries, governments often impose import quotas or tariffs
•These policies cause deadweight loss
63
Free Trade
Demand
OldConsumer Surplus
Q
P
P*
Old DomesticProducer Surplus
Supply
QDom
PW
At world prices, only a small amount of domestic industry can survive
64
Trade Prohibition (Zero Imports)
Demand
NewConsumer Surplus
Q
P
P*
New DomesticProducer Surplus
Supply
QDom
PW
DeadweightLoss
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Import Quota
Demand
NewConsumer Surplus
Q
P
P*
New DomesticProducer Surplus
Supply
PW
DeadweightLoss
Pq
QDom QDom+Quota
66
Import Tarrif (t)
Demand
NewConsumer Surplus
Q
P
P*
New DomesticProducer Surplus
Supply
PW
DeadweightLoss
PW+t
QDom QDom+Quota
GovernmentRevenue
67
•The greater the import quota, the smaller the benefit to domestic industries and the smaller the deadweight loss
•Import tariffs are better for the domestic economy as government revenue decreases deadweight loss
•This increased government revenue is equal to foreign producer surplus under a quota; worldwide surplus is simply transferred
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•Under normal perfectly competitive conditions, any government intervention will cause DEADWEIGHT LOSS
•The most efficient manner of government intervention is lump sum payments to the segment of society is desires to aid
•This however, is politically undesirable – Why should one segment of society get something for free?
69
Chapter 10 SummaryUnder Perfect Competition, efficiency is maximizedAll government intervention in Perfect Competition cause deadweight lossLump-sum cash transfers have the least distortion, but are unpopularWhenever government intervenes, it must be asked if
Benefit > Deadweight Loss