Competitive markets Microéconomie, chapter 9 Solvay Business School Université Libre de Bruxelles 1
List of subjects Evaluation of public policies Efficiency of competitive markets Minimum prices Support prices and production quotas Import quotas and tariffs Effects of taxes and subsidies Solvay Business School Université Libre de Bruxelles 2
Evaluation of public policies Example: If a maximum price is imposed Some will benefit since they will be able to buy at a lower cost Others will be harmed since they will not get the best possible price for their goods But how can we evaluate the net effect? Solvay Business School Université Libre de Bruxelles 3
Evaluation of public policies To evaluate the effect of a public policy one can measure the variation of the consumers and producers surpluses Solvay Business School Université Libre de Bruxelles 4
Consumers and producers surplus The aggregate demand curve gives the willingness to pay of consumers The consumers surplus is the area under the demand curve and above the market price The consumers surplus measures the total benefit they obtain Solvay Business School Université Libre de Bruxelles 5
Consumers and producers surplus The aggregate supply curve gives the price producers are willing to accept to produce each level of output The producers surplus is the area below the market price and above the supply curve The producers surplus measures the total net benefit they obtain Solvay Business School Université Libre de Bruxelles 6
Consumers and producers surplus Price Consumers surplus S Between 0 and Q 0 consumers obtain a net benefit from buying the good Producers surplus D Between 0 and Q 0 the producers obtain a net benefit from selling the good Q 0 quantity Solvay Business School Université Libre de Bruxelles 7
Consumers and producers surplus 1. Consumers surplus: value they get in excess of their payments Assume the price is 5 Some consumers are willing to pay more than 5 for the good Those willing to pay up to 9 and get it for 5 obtain a surplus of 4 Solvay Business School Université Libre de Bruxelles 8
Consumers and producers surplus 2. Producers surplus revenue they get in excess of the cost of production Some firms would continue to produce even at a lower price For instance, some would accept a price of 3 instead of 5 These firms obtain a surplus of 2 per unit Solvay Business School Université Libre de Bruxelles 9
The efficiency of competitive markets The market is efficient when it maximizes the aggregate surplus of producers and consumers The control of prices can have a cost in terms of efficiency Solvay Business School Université Libre de Bruxelles 10
Some market failures 1. Externalities Costs and benefits not taken into account by the market (e.g., pollution) 2. Imperfect information Missing information may prevent producers and consumers to make optimal decisions In these situations a public intervention can improve the efficiency Solvay Business School Université Libre de Bruxelles 11
The efficiency of competitive markets In principle, no intervention is the best policy if efficiency is the goal But there is often market failures Prices do not convey the correct information to consumers and producers In such cases unregulated competitive markets lead to inefficient allocations Solvay Business School Université Libre de Bruxelles 12
Price controls and changes in surplus Consider a maximum price too low Demand increases and supply decreases Leads to rationing the good Firms will get a lower price Some firms will go out of business All firms will see their surpluses decrease Solvay Business School Université Libre de Bruxelles 13
Price controls and changes in surplus Some consumers willing to pay the price will not find the good They will lose some surplus Those consumers who manage to get the good will buy it at a lower price They will gain some surplus Solvay Business School Université Libre de Bruxelles 14
Price controls and changes in surplus Price Some consumers gain A S Some consumers lose B B Firms lose the sum of A and C P 0 A C The total net loss is B and C P max D Q 1 Q 0 Q 2 Solvay Business School Université Libre de Bruxelles Quantity 15
Price controls and changes in surplus The net loss of surplus (of both consumers and firms) is the inefficiency caused by the price control If the demand is very inelastic, the consumers losses can be very important Solvay Business School Université Libre de Bruxelles 16
Price controls with an inelastic demand Price D S B P 0 P max A C With an inelastic demand B can be larger than A so that consumers suffer a net loss Q 1 Q 2 Quantity Solvay Business School Université Libre de Bruxelles 17
Evaluating price controls Price D S 2.40 2.00 B C The consumers gain is A minus B, and the firms loss is A plus C A (P max )1.00 0 5 10 15 18 20 25 30 Quantity Solvay Business School Université Libre de Bruxelles 18
Evaluating price controls Impact of the price control A = 18 x 1 = 18 B = 1/2 x 2 x 0,40 = 0,4 C = 1/2 x 2 x 1 = 1 Solvay Business School Université Libre de Bruxelles 19
Evaluating price controls Variation of the consumers surplus A - B = 18 0,4 = 17,6 gain Variation of the firms surplus A + C = 18 + 1 = 19,0 loss Net loss B + C = 0,4 + 1 = 1,4 loss Solvay Business School Université Libre de Bruxelles 20
Price controls and changes in surplus Price S P min P 0 A B C When a minimum price P min is imposed, the loss of surplus is the sum of B and C D Q 0 Q 1 Q 2 Quantity Solvay Business School Université Libre de Bruxelles 21
Price controls and changes in surplus The loss of surplus in B and C is a good estimate of the cost in terms of efficiency of the price control policy The policy can then be evaluted estimating the areas B and C Solvay Business School Université Libre de Bruxelles 22
Minimum price Often governments try to guarantee some incomes setting minimum prices Minimum wage Agricultural policies Solvay Business School Université Libre de Bruxelles 23
Minimum price When a minimum price is set above the equilibrium price: Demand decreases Firms expand supply due to the higher price An additional loss comes from the cost of the production in excess of demand Solvay Business School Université Libre de Bruxelles 24
Minimum price Price S If firms expand output up to Q 2, the difference Q 2 Q 1 will remain unsold P min P 0 A B C D mesures the cost of the unsold additional output D The change of the producers surplus is A C D Q 1 Q 0 Q 2 D Quantity Solvay Business School Université Libre de Bruxelles 25
Minimum price Consumers surplus change: Some surplus is lost from buying some output at a higher price (rectangle A) Some surplus is lost from the decrease in the amount purchased (triangle B) Producers surplus change (if output is not increased): Some surplus is obtained from selling some output at a higher price (rectangle A) Some surplus is lost from the decrease in the amount sold (triangle C) Solvay Business School Université Libre de Bruxelles 26
Minimum price But firms increase output up to Q 2 to adjust to a higher price Since they only sell Q 1 no revenue covers the cost of additional production (Q 2 -Q 1 ) Since the supply curve gives the CMg, the cost of the additional output is the area under the supply curve between Q 1 and Q 2 (area D) The producers surplus change is then A C D Solvay Business School Université Libre de Bruxelles 27
Minimum wage Wage is fixed above the equilibrium level Employed workers receive a higher wage The number of employed workers decreases Involuntary unemployment appears (some workers willing to work at the minimum wage will not find a job) Some workers will see their surplus increase, other will lose some surplus Solvay Business School Université Libre de Bruxelles 28
Minimum wage w A minimum wage W min creates involutary unemployment S w min w 0 A B C A is the gain of those who keep their jobs at the minimum wage The loss of surplus is the sum of B and C unemployment L 1 L 0 L 2 D L Solvay Business School Université Libre de Bruxelles 29
Production quotas The government can also support prices limiting supply Solvay Business School Université Libre de Bruxelles 30
Production quotas Price S output limited to Q 1 the supply curve becomes S S P S P 0 A C B ΔSC = A B ΔSP = + A C ΔST = B C The social loss is B + C D Q 1 Q 0 Quantity Solvay Business School Université Libre de Bruxelles 31
Price support Agricultural policies are based on price supports Prices are supported above equilibrium levels by government purchases of excess supplies Prices can also be artificially supported by retricting production through quotas or incentive schemes What are the consequences from consumers, producers and the government budget? Solvay Business School Université Libre de Bruxelles 32
Price support Price P s P 0 Q g D A B C S To support P s the government buys Q g = Q 2 Q 1 ΔSC = A B ΔSP = + A + B + D coût = E B D C ΔST = E B C The social net loss is E + B + C E D + Q g D Q 1 Q 0 Q 2 Quantity Solvay Business School Université Libre de Bruxelles 33
Price support consumers Demand decreases and supply increases Government buys the excess supply Consumers pay a higher price The loss of surplus is for the consumers A+B Solvay Business School Université Libre de Bruxelles 34
Price support producers Their surplus increases since they sell more at a higher price The increase in surplus is A+B+D government The purchase of excess supply is a cost for the consumers (it is paid by taxes) This cost is the area (Q 2 -Q 1 )P S Solvay Business School Université Libre de Bruxelles 35
Price support The government could sell the excess supply in the world market But then it competes against its own producers in the world market Total impact on surplus: ΔSC + ΔSP gov. cost = D (Q 2 -Q 1 )P S Social loss E + B + C Solvay Business School Université Libre de Bruxelles 36
Limiting supply Incentive schemes The government can pay producers to decrease supply Payments for non cultivated land Solvay Business School Université Libre de Bruxelles 37
Limiting supply Price S S P S P 0 A C B D ΔSC = A B ΔSP = + A + B + D cost = B D C ΔST = B C Net loss for society: B + C D Q 1 Q 0 Quantity Solvay Business School Université Libre de Bruxelles 38
Limiting supply Incentive schemes The higher price charged to the amount sold increases the producers surplus in A The decrease in output decreases the producers surplus in C The government pays producers (sufficiently) for not producing beyond Q 1 : B+C+D total change in the producers surplus SP = A C + (B+C+D) = A + B + D Solvay Business School Université Libre de Bruxelles 39
Limiting supply What is the most costly policy? The (direct) cost for consumers is the same in both cases Producers obtain the same surplus in both cases Supporting prices is costlier than imposing quotas and incentive schemes to reduce output Solvay Business School Université Libre de Bruxelles 40
Price support example Consider the following equilibrium supply: Q S = 1800 + 240P demand: Q D = 3550-266P Equilibrium at 3,46 and 2630 units sold The government wants to increase the price up to 3,70 buying excess supply Solvay Business School Université Libre de Bruxelles 41
Price support example How much would the government have to buy to support a price of 3,70? Q DTotal = Q D + Q g = 3550-266P + Q g Q S = Q DT 1800 + 240P = 3550-266P + Q g Q g = 506P - 1750 Q g = 506 x 3,70 1750 = 122,2 units Solvay Business School Université Libre de Bruxelles 42
Price support example Price -A-B consumers loss A+B+C producers gain S Q g P S = 3,70 P 0 = 3,46 A B C D D + Q g 1800 2566 2630 2688 Quantity Solvay Business School Université Libre de Bruxelles 43
Price support example Change in consumers surplus A = (3,70 3,46) x 2566 = 615,84 B = 0,5 x (3,70 3,46)(2630 2566) = 7,68 ΔCS = A B = 623,52 Solvay Business School Université Libre de Bruxelles 44
Price support example Cost of the intervention: Cost for the government 3,70 x 122,2 = 452,14 Total cost 623,52 + 452,14 = 1075,66 Producers gain A + B + C = $638,2 million Loss of surplus = 1075,66-638,2 = 437,46 Solvay Business School Université Libre de Bruxelles 45
Import quotas and tariffs Many countries impose import quotas and tariffs to support domestic prices above world prices Import quotas: a limit to the amount that can be imported tariffs: taxes on imported goods This allows domestic producers to obtain higher profits But consumers pay a high cost Solvay Business School Université Libre de Bruxelles 46
Limits to imports Price Without intervention, the domestic price and the world price P W coincide S A zero quota increases the domestic price up to P 0 P 0 A B C the loss for consumers is A+B+C the gain for producers is A the loss of surplus is B +C. P W Imports D Q S Q 0 Q D Quantity Solvay Business School Université Libre de Bruxelles 47
Tariffs Tariffs increase domestic prices Supply Q S increases and demand Q D decreases The gain for domestic producers is A The loss for consumers is A + B + C + D The government income is D = tariff x imports The loss of surplus is B + C P P* P w A Q S B S D C Q S Q D Q D D Q Solvay Business School Université Libre de Bruxelles 48
Import quotas With an equivalent quota, the rectangle D goes to the world producers The loss for consumers is A+B+C+D The gain for domestic producers is A The net national loss is B + C + D P P* P w A B D S C D Q S Q S Q D Q D Q Solvay Business School Université Libre de Bruxelles 49
Impact of a tax If the government imposes a tax of 1 for each unit sold it can Charge firms 1 for each unit they sell Charge consumers 1 for each unit they buy What is the best option for consumers? Solvay Business School Université Libre de Bruxelles 50
The impact of a tax Every tax is actually paid partly by the consumer and partly by the firm How the tax is divided between the two depends of the relative elasticities of supply and demand Solvay Business School Université Libre de Bruxelles 51
Impact of a tax Price S Tax P b price paid P 0 P S price received A D B C loss for consumers A + B tax revenue A + D loss for producers D + C loss of surplus B + C D Q 1 Q 0 Quantity Solvay Business School Université Libre de Bruxelles 52
Impact of a tax After the introduction of a tax: 1. The quantity purchased Q D and the price paid P b are on the demand curve Consumers are only interested in the price (including taxes) they pay 2. The quantity sold Q S and the price received P S are on the supply curve 5. Q D = Q S Producers are only interested in the price (excluding taxes) they receive 6. The difference P b - P s is the tax Solvay Business School Université Libre de Bruxelles 53
Impact of a tax When demand is relatively more inelastic, most of the tax is paid by the consumers When supply is relatively more inelastic, most of the tax is paid by the producers Solvay Business School Université Libre de Bruxelles 54
Impact of a tax Price the consumers pay most D Price the producers pay most S P b t S P b P 0 P 0 P S t D P S Q 1 Q 0 Quantity Q 1 Q 0 Quantity
Impact of a subsidy A subsidy works like a negative tax Makes the price paid by the consumer lower than the price received by the firm It increases the amount exchanged in the market Solvay Business School Université Libre de Bruxelles 56
Impact of a subsidy Price S Subsidy P S P 0 P b The benefits from a subsidy are also shared by consumers and producers, according to the relative elasticities of supply and demand D Q 0 Q 1 Quantity Solvay Business School Université Libre de Bruxelles 57
Impact of a subsidy Most of a subsidy goes to consumers if E D /E S is small Most of a subsidy goes to the firms if E D /E S is big Solvay Business School Université Libre de Bruxelles 58
Impact of a tax - example Consider a tax of 50 cents on demand Q D = 150-50P supply Q S = 60 + 40P equilibrium Q S = Q D = 100 at a price 1 Solvay Business School Université Libre de Bruxelles 59
Impact of a tax - example After introducing the tax: Q D = Q S 150-50P B = 60 + 40P S 150-50(P S + 0,50) = 60 + 40P S P S = 0,72 P B = P S + 0,50 = 1,22 Q D = Q S = 89 Solvay Business School Université Libre de Bruxelles 60
Impact of a tax - example After introducing the tax: Q decreases 11% The price paid increases 22 cents The price received decreases 20 cents The tax revenue is 44,5 Solvay Business School Université Libre de Bruxelles 61
Imopact of a tax - example Price D S 0,5 Tax P b = 1,22 P 0 = 1,00 A D B C Loss for consumers = A + B Loss for firms = C + D Split of the tax : 22 on consumers, 28 cents on firms P S =,72 Tax revenue = A + D = 0,50 x 89 = 44,5 11 50 60 89100 150 Quantity Solvay Business School Université Libre de Bruxelles 62