Microeconomics. Lecture Outline. Claudia Vogel. Winter Term 2009/2010. Part II Producers, Consumers, and Competitive Markets

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1 Microeconomics Claudia Vogel EUV Winter Term 2009/2010 Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28 Lecture Outline Part II Producers, Consumers, and Competitive Markets 9 Evaluating the Gains and Losses from Government Policies - Consumer and Producer Surplus The Eciency of a Competitive Market Minimum Prices Price Supports and Production Quotas Import Quotas and Taris The Impact of a Tax or Subsidy Summary Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28

2 Review of Consumer and Producer Surplus Evaluating the Gains and Losses from Government Policies - Consumer and Producer Surplus Consumer surplus, which measures the total benet to all consumers, is the yellowshaded area between the demand curve and the market price. Producer surplus measures the total profits of producers, plus rents to factor inputs. It is the green-shaded area between the supply curve and the market price. Together, consumer and producer surplus measure the welfare benet of a competitive market. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28 Evaluating the Gains and Losses from Government Policies - Consumer and Producer Surplus Application of Consumer and Producer Surplus welfare eects: Gains and losses to consumers and producers. deadweight loss: Net loss of total (consumer plus producer) surplus. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28

3 Evaluating the Gains and Losses from Government Policies - Consumer and Producer Surplus Example: Price Controls and Natural Gas Shortage Supply: QS = PG PO Demand: QD = PG PO Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28 The Eciency of a Competitive Market The Eciency of a Competitive Market economic eciency: Maximization of aggregate consumer and producer surplus. market failure: Situation in which an unregulated competitive market is inecient because prices fail to provide proper signals to consumers and producers. There are two important instance in which market failure can occur: 1 Externalities 2 Lack of information externality: Action taken by either a producer or a consumer which aects other producers or consumers but is not accounted for by the market price. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28

4 The Eciency of a Competitive Market Welfare Loss When price is regulated to be no lower than P 2 only Q 3 will be demanded. If Q 3 is produced, the deadweight loss is given by B and C. At price P 2, producers would like to produce more than Q 3. If they do, the deadweight loss will be even larger. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28 The Eciency of a Competitive Market Example: The Market for Human Kidneys Supply: QS = P Demand: QD = P Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28

5 Minimum Prices Minimum Prices price minimum minimum wage Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28 Minimum Prices Example: Airline Regulation Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28

6 Price Supports and Production Quotas Price Supports 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 marketclearing price P 0, the government buys a quantity Qg. Consumer Surplus: CS = A B Producer Surplus: PS = A + B + D Cost to government: Cgovt = PS (Q 2 Q 1 ) Total change in welfare: CS + CS Cgovt = D PS (Q 2 Q 1 ) Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28 Price Supports and Production Quotas Production Quotas To maintain a price PS above the marketclearing price P 0, the government can restrict supply to Q 1, either by imposing production quotas or by giving producers a nancial incentive to reduce output. Consumer Surplus: CS = A B Producer Surplus: PS = A C+Payments for not producing Total change in welfare: A B + A + B + D B C D = B C Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28

7 Price Supports and Production Quotas Example: Supporting the Price of Wheat 1/ Supply:QS = P 1981 Demand: QD = P To increase the price to $3.70, the government must buy a quantity of wheat Q g Total demand: Q DT = P + Q g Demand of government: Q g = 506P 1750 = Q g = 122 million bushels Loss to consumers: A + B = $624 mio Cost to government: = $451.4 mio Total cost of the program: $624 + $451.4 = $ mio Gain to producers: A + B + C = $638 mio Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28 Price Supports and Production Quotas Example: Supporting the Price of Wheat 2/ Supply:QS = P 1985 Demand: QD = P To increase the price to $3.20, the government bought 466 mio bushels and also imposed a production quota of 2425 mio bushels = P + Qg Demand of government: Qg = 194P 155 = 194 $ Qg = 466 million bushels Cost to government: $ = $ mio Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28

8 Import Quotas and Taris Elimination of Imports import quota: Limit on the quantity of a good that can be imported tari: Tax on imported good. In a free market, the domestic price equals the world price PW. A total Qd is consumed, of which Qs is supplied domestically and the rest imported. When imports are eliminated, the price is increased top 0. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28 Import Quotas and Taris Import Tari or Quota (General Case) When imports are reduced, the domestic price is increased from PW to P. This can be achieved by a quota, or by a tari T = P PW. If a tari is used, the government gains D, the revenue from the tari. The net domestic loss is B+C. If a quota is used instead, D becomes part of the prots of foreign producers, and the net domestic loss is B+C+D. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28

9 Import Quotas and Taris Example: The Sugar Quota in 2005 U.S. demand: QD = P U.S. supply: QS = P Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28 The Impact of a Tax or Subsidy The Impact of a Tax or Subsidy specic tax: Tax of a certain amount of money per unit sold. Market clearing requires four conditions to be satised after a tax is in place: QD = QD (Pb) QS = QS (Ps) QD = QS Pb Ps = t Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28

10 The Impact of a Tax or Subsidy Tax and Elasticities of Demand and Supply If demand is very inelastic relative to supply, the burden of the tax falls mostly on buyers. If demand is very elastic relative to supply, it falls mostly on sellers. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28 The Impact of a Tax or Subsidy The Eects of a Subsidy subsidy: Payment reducing the buyers's price below the seller's price; i.e. a negative tax. Conditions needed for the market to clear with a subsidy: QD = QD (Pb) QS = QS (Ps) QD = QS Pb Ps = s Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28

11 The Impact of a Tax or Subsidy Example: The Tax on Gasoline 1/2 Eect of a $1-per gallon tax: QD = Pb QS = Ps QD = QS Pb Ps = 1.00 (Demand billion gallons per year) (Supply billion gallons per year) (Supply must equal demand) (Government must receive $1.00/gallon) Pb = Ps Pb = Ps (Ps + 1) = Ps 20Ps + 25Ps = Ps = 1.44 Q = = 89 Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28 The Impact of a Tax or Subsidy Example: The Tax on Gasoline 2/2 Gasoline demand: QD = Pb Gasoline supply: QS = Ps Annual revenue from the tax:tq = = 89 Deadweight loss: ( 1 2) ($1.00/gallon)(11 billion gallons/year = $5.5 billion per year Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28

12 Summary Summary Simple models of supply and demand can be used to analyze a wide variety of government policies such as price controls, minimum prices, price support programs, production quotas or incentive programs to limit output, import taris and quotas, and taxes and subsidies. When government imposes a tax or subsidy, price usually does not rise or fall by the full amount of the tax or subsidy. Also, the incidence of a tax or subsidy is usually split between producers and consumers. The fraction that each group ends up paying or receiving depends on the relative elasticities of supply and demand. Government intervention generally leads to a deadweight loss. This deadweight loss is a form of economic ineciency that must be taken into account when policies are designed and implemented. Government intervention in a competitive market is not always bad. Government - and the society it represents - might have objectives other than economic eciency. And there are situations in which government intervention can improve economic eciency. Examples are externalities and cases of market failure. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28 Problem 1 Exerxises 8 1 What is meant by deadweight loss? Why does a price ceiling usually result in a deadweight loss? 2 How can a price ceiling make consumers better o? Under what conditions might it make them worse o? 3 Suppose the government regulates the price of a good to be no lower than some minimum level. Can such a minimum price make producers as a whole worse o? 4 Suppose the government wants to increase farmer's incomes. Why do price supports or acreage-limitation programs cost society more than simply giving farmers money? 5 Suppose the government wants to limit imports of a certain good. Is it preferable to use an import quota or a tari? Why? Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28

13 Exerxises 8 Problem 2 Suppose the market for widgets can be described by the following equations: Demand: QD = 10 P Supply: QS = P 4 where P is the price in dollars per unit and Q is the quantity in thousands of units. 1 What is the equilibrium price and quantity? 2 Suppose the government imposes a tax of $1 per unit to reduce widget consumption and raise government revenues. What will the new quantity be? What price will the buyer pay? What amount per unit will the seller receive? 3 Suppose the government has a change of heart about the importance of widgets to the happiness of the American public. The tax is removed and a subsidy of $1 per unit granted to widget producers. What will the equilibrium quantity be? What price will the buyer pay? What amount per unit (including the subsidy) will the seller receive? What will be the total cost to the government? Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28 Problem 3 Exerxises 8 In Problem 6 in Exercise 1 we examined a vegetable ber traded in a competitive world market and imported into the United States at a world price of $9 per unit. U.S. domestic supply and demand for various price levels are shown below. U.S. Supply U.S. Demand Price (Million Lbs.) (Million Lbs.) As calculated in Exercise 1 the demand curve is given by Q D curve is given by Q S = 2 3 P. = 40 2P, and the supply 1 Conrm that if there were no restrictions on trade, the United States would import 16 million pounds. 2 If the United States imposes a tari of $3 per pound, what will be the U.S. price and level of imports? How much revenue will the government earn from the tari? How large is the deadweight loss? 3 If the United States has no tari but imposes an import quota of 8 million pounds, what will be the U.S. domestic price? What is the cost of this quota for U.S. consumers of the ber? What is the gain for U.S. producers? Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28

14 Exerxises 8 Problem 4 The United States currently imports all of its coee. The annual demand for coee by U.S. consumers is given by the demand curve Q = P, where Q is the quantity (in millions of pounds) and P is the market price per pound of coee. World producers can harvest and ship coee to the U.S. distributors at a constant cost of $8 per pound. U.S. distributors can in turndistribute for a constant $2 per pound. The U.S. coee market is competitive. Congress is considering a tari on coee imports of $2 per pound. 1 If there is no tari, how much do consumers pay for a pound of coee? What is the quantity demanded? 2 If the tari is imposed, how much will consumers pay for a pound of coee? What is the quantity demanded? 3 Calculate the lost consumer surplus. 4 Calculate the tax revenue collected by the government. 5 Does the tari result in a net gain or a net loss to society as a whole? Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28 Problem 5 Exerxises 8 In 2007, Americans smoked 19.2 billion packs of cigarettes. They paid an average retail price of $4.50 per pack. 1 Given that the elasticity of supply is 0.5 and the elasticity of demand is -0.4, derive linear demand and supply curves for cigarettes. 2 Cigarettes are subject to a federal tax, which was about 40 cents per pack in What does this tax do to the market-clearing price and quantity? 3 How much of the federal tax will consumers pay? What part will producers pay? Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 28