Chapter 9   Analysis of Competitive Markets

This chapter will use the concept of consumer and producer surplus to see how government policy effects the efficiency of a competitive market.  That is, who gains and who losses when the government initiates and economic policy?
 

Using demand and supply show what happens when the government imposes a price ceiling.
 
 
 
 

Notice that those people who get to buy the good will get it cheaper than if there was no ceiling.  At the same time some consumers who would have wanted this good can’t get now.  Are consumers better off as a whole?   We can use the concept of consumer surplus to answer that question.

Insert Figure 9.1 here.
 
 
 
 
 
 
 
 
 
 
 
 
 
 

What is the definition of consumer surplus?
 
 
 

You should be able to explain why the consumer surplus in Figure 9.1 is the yellow shaded area.  That is the area between the demand curve and the market price.

If the government has a policy that changes the amount of consumer surplus then we can tell if that policy hurts (reduces consumer surplus) or helps consumers (increase consumer surplus).   We can do this because consumer surplus is the total net benefit to the consumer.

What is the definition of producer surplus?
 
 
 

Producer surplus is the area above the supply curve but below the market price.  You should be able to explain why this is so.  Producer surplus are benefits to those producers who can produce at a lower marginal cost and selling at the market price.

Since producer surplus is a benefit to producers if the government has a policy we can tell if the policy increases (benefits) or decreases (harms) producer surplus.

What are welfare effects?
 
 
 
 

Thus by examining both producer and consumer surplus we can see the welfare effects of a government policy.

Insert Figure 9.2 here.
 
 
 
 
 
 
 
 
 
 

The government imposes price controls on a product.  That is it has a price ceiling.  This can be what the government did with gasoline or natural gas or rent control in larger cities.

You should see how this creates a shortage of the good.  The question becomes what are the welfare effects of such a policy?  If social welfare goes up as a result then the policy was beneficial.  If social welfare declines then the policy harmed society (in the sense social welfare went down).

Since there are two sides to the market (consumers and producers) let’s examine the welfare effects by seeing what happens to both consumer and producer surplus.  While it is true that one side of the market can be harmed while the other side benefits the issues is after adding both harms and benefits is society overall better or worse off with the government policy of price controls?

Consumer surplus

Explain why some consumers are better off and some worse off as a result of the price ceiling.
 
 
 
 

Production is reduced from Q₀ to Q₁ thus the consumers who would have purchased that amount of output are hurt.  They have a loss of consumer surplus, which is equal to the triangle B.   Notice triangle B shows how much of the original consumer surplus is lost as a result of production going down to Q₁.

At the same time that this is occurring those consumers who are getting the goods at a lower price are increasing their consumer surplus since they would have been willing to pay the higher market price.  The rectangle A is showing how much additional consumer surplus these consumers are gaining.  Notice it is those consumers who purchase Q₁ units of output at the lower price Pmax.

The net gain to all consumers is the gains (rectangle A) minus the losses (triangle B).  Since A>B their is a gain to consumer surplus equal to A-B.

Of course if we only had consumers in the economy without any producers we would say the government price control policy had a positive welfare effect since consumer surplus increased.  But there are also producers in the economy who are now producing less output than they would have without the price controls and they are harmed.  We have to see how much they are harmed by (loss of producer surplus) and then compare that to the gains in consumer surplus.

Those producers that stay in the market producing the smaller quantity Q₁receive a lower price for that quantity and thus are hurt.  Producer surplus declines by the amount equal to the rectangle A.  (Note before the lower price they received P0 for the output Q₁ they would sell now they only receive Pmax. Thus they loss the difference in price on each unit of output they sell Q₁.)

In addition to this loss there is the loss due to the reduction out output from Q₀ to Q₁.  This loss is shown by the triangle C.  Thus the total loss of producer surplus due to the price controls of the government is,  –A-C,  or the area of A+C (both negative numbers so a loss).

Since the gains to consumers are offset by the losses to producers economist call this difference a dead weight loss, which is the net loss of total (consumer plus producer) surplus.

Look at figure 9.2 again.
The change in consumer surplus was A-B and the change in producer surplus was –A-C, the total change in surplus is consumer surplus plus producer surplus or (A-B) + (-A-C)= -B-C.  The two triangles B and C are the deadweight loss in the economy due to the price controls put on by the government.  The policy is inefficient because the loss to producers is greater than the gains to consumers.

This leads to some very interesting political questions.  If politicians are trying to get elected and if they believe the voters (consumers) will respond favorably to the price controls they might keep them even though it is inefficient for the economy.  On the other hand if the politicians get lots of campaign contributions from large corporations who are hurt by the policy, and if they think that money can be used to get more votes than they would lose by not having the price controls then they would not have such a policy.

Insert figure 9.3 here.
 
 
 
 
 
 
 
 
 

Interestingly if demand is very inelastic like in figure 9.3 then we see there is a very large loss in consumer who can’t get the goods (triangle A) is much bigger than those who get the good at lower price rectangle A.  Thus the deadweight loss is much bigger because there is a loss of both consumer and producer surplus.

Economic efficiency is when consumer and producer surplus is maximized.  If there is a deadweight loss then the policy of the government that caused the deadweight loss caused surplus to decline from what it would have been without the policy.  Thus there is an efficiency cost of the policy.

As economist we believe because of the deadweight loss of certain government policies society is better off without any government intervention into the market place.  That is, let the market place be competitive and the market will signal to producers and consumers what price and output levels should be produced to maximize consumer and producer surplus.  This would occur in a perfect world but sometimes there are market failures where the market place does not work.  This is called a market failure.  When this happens the government then can initiate a policy that will reduce the efficiency.

There are two types of market failures.

What are externalities?
 
 
 
 
 

Pollution is often used as an example of a negative externality.  Polluters can pollute without incurring any costs thus they tend to overproduce since it is cheaper and add more pollution.  If the government did not intervene in the market place to stop the pollution then they would continue to pollute. When the government makes pollution illegal or forces firms to clean up pollution then the cost of production increases and the firms do not over produce the item causing the pollution.

Lack of full information by consumers also can cause market failure because they will buy goods that if they had full information they might not buy.

Insert Figure 9.5 here.
 
 
 
 
 
 
 
 
 

Figure 9.5 shows what happens to welfare loss when the government has a price floor, a price above he equilibrium level price.  This we know causes a surplus.  Let examine the deadweight loss and see if this policy has an efficiency cost.

Note the price is now P₂ rather than P₀. Consumers want less at this price than producers are willing to produce.  If producers will only produce what they can sell they will produce Q₃ level of output.  And we see there is again a deadweight loss or a loss of net surplus.  Since producers are able to charge more than they would have before (it is illegal for them to charge less) they will gain extra revenue for every item they sell so producers are gaining surplus of rectangle A.  The amount of output they sell times the price.  This extra gain is coming at the expense of consumers thus there is a transfer from consumer surplus to producer surplus of rectangle A.  So the gains and losses represented by rectangle A are exactly offset.

Triangle B shows an additional loss to consumer surplus due to the higher price charged.  This triangle represents the lower output that consumers are no longer buying and the loss of surplus due to that output not being bought.  Triangle C shows the loss of producer surplus due to the reduction of goods produced from Q₀ to Q₃.

The two triangles B and C show the deadweight loss and efficiency cost of the government policy that forces the price to be above the market price.

As the examples in the book show, if the government regulates price above market (airline industry years ago) airlines would supply more flights than people wanted and they would have unsold inventory.  Thus we had lots of flights flying all over with few passengers because prices were above market price.

If the governments price floors caused too much overproduction then they would buy the excess output, which is what happens in agriculture