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Introduction to Microeconomics Chapter 7

Introduction to Microeconomics Chapter 7. Economics of Perfect Competition Economic Surplus. Perfect Competition. Some markets (e.g., foreign exchange, many agricultural products) are closer to perfect competition than to other market types.

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Introduction to Microeconomics Chapter 7

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  1. Introduction to MicroeconomicsChapter 7 Economics of Perfect Competition Economic Surplus

  2. Perfect Competition • Some markets (e.g., foreign exchange, many agricultural products) are closer to perfect competition than to other market types. • When individuals with equal means complete make mutually beneficial transactions in a perfectly competitive market, their self-interested behaviour is harmonized with the common good. • Perfect competition serves as a reference for the other more common situation LO1: How markets can maximize total economic surplus

  3. Invisible Hand As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other eases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. Adam Smith (1723 – 1790) It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.

  4. FIGURE 7.1: The Demand Curve Facing a Perfectly Competitive Firm S P0 P0 Di D Q0 Panel (a): The market demand and supply curves intersect to determine the market price of the product. Panel (b): The individual firm’s demand curve (Di) is a horizontal line at the market price. LO1: How markets can maximize total economic surplus

  5. A Market in Which Price Is Below Equilibrium Level – Excess Demand S $0.50 D In this market, milk is currently selling for $1/litre, $0.50 below the equilibrium price of $1.50/litre

  6. Consumer Surplus • Consumer Surplus • The difference between what consumers would have been willing to pay and what they actually did pay. • Economic surplus gained by the buyers of a product. • Measured by the cumulative difference (adding up over all consumers) between their reservation price for each unit of the good, and the price they pay . LO3: Graphical representation of consumer surplus, producer surplus, and total economic surplus

  7. Producer Surplus • Producer Surplus • The difference between what producers do get for output and the minimum price they would have been willing to accept. • Economic surplus gained by the sellers of a product. • Measured by the cumulative difference (adding up over all producers) between the price they receive and their reservation price for each unit of the good. LO3: Graphical representation of consumer surplus, producer surplus, and total economic surplus

  8. FIGURE 7.5: Consumer and Producer Surplus S Consumer surplus Producer surplus D LO3: Graphical representation of consumer surplus, producer surplus, and total economic surplus

  9. : How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction S $0.75 1.25 $0.25 D • At a market price of $1/litre, the most intensely dissatisfied buyer is willing to pay $2 for an additional litre, which a seller can produce at a cost of only $1. If this buyer pays the seller $1.25 for the extra litre, the buyer gains an economic surplus of $0.75 and the seller gains an economic surplus of $0.25.

  10. FIGURE 7.4: How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction At a market price of $2/litre, dissatisfied sellers can produce an additional litre of milk at a cost of only $1, which is $1 less than a buyer would be willing to pay for it. If the buyer pays the seller $1.75 for an extra litre, the buyer gains an economic surplus of $0.25 and the seller gains an economic surplus of $0.75. S $0.25 1.75 $0.75 D Market Equilibrium and Mutually Beneficial Exchange

  11. Reservation Price • Supplier’s reservation price • The lowest price they will accept in return for providing a good or service. • Consumer reservation price • The highest price a demander will offer in order to obtain a good or service. LO3: Graphical representation of consumer surplus, producer surplus, and total economic surplus

  12. Case study – welfare reform • Before welfare reform, a social assistance recipient (SAR) who earned any income (even a paper route) would have their welfare payments reduced by the amount of the increased income? • What would you do? • The 100% tax discouraged work • Now, SARs get to keep a portion of wage earned (until they make too much to qualify)

  13. If I were on welfare, what wage do I need to start working? • SARs receive a basic benefit, rental housing allowance, transportation allowance, medical (pharmaceuticals)… • What is their reservation wage – what wage do they need to go off welfare. • This experiment used recipients of the National Child Benefit (98% women at the time) • Some received social assistance; others worked (usually at minimum wage) • Use discrete choice model • Randomly assign SAR to several groups • Ask each group – would you be prepared to take a job (40 hr/week) at “$w/hour”

  14. Test wages used(2002)

  15. The average reservation wage ($/hour) needed to entice these respondents to come off social assistance was $4 more than the minimum wage prevalent. The rational person on social assistance would not give it up if he/she could not get a job that paid at least what was in the table. This called the welfare trap

  16. Example 7.2: How much do buyers and sellers benefit from their participation in the market for milk? S Market for milk: an equilibrium price of $2/litre and an equilibrium quantity of 4000 litres/day D LO4:Calculation of consumer surplus, producer surplus, and total economic surplus

  17. FIGURE 7.6: Total Economic Surplus in the Market for Milk Consumer surplus 2000/Day S The total economic surplus from this milk market is the sum of consumer and producer surplus, or $6000/day 4000/Day Producer surplus D LO4:Calculation of consumer surplus, producer surplus, and total economic surplus

  18. Social Surplus Total economic (social) surplus • The sum of all the individual economic surpluses gained by buyers and sellers participating in the market. • In a market economy, the goal of economic policy should be to maximize the social surplus • Other goals?

  19. Changing Market Outcomes • Price Ceiling • Law or regulation that prevents sellers from charging more than a specified price. • Price ceiling prevents some transactions – which would have generated an economic surplus. • Applications? • Scalping Jets Tickets • Rent Control LO5: How price controls affect total economic surplus

  20. FIGURE 7.7: Economic Surplus in an Unregulated Market for Home Heating Oil Consumer surplus S • For the supply and demand curves shown, the equilibrium price of oil is $14/bbl, and the equilibrium quantity is 3000 bbl/day. Consumer surplus is $9000/day. Producer surplus D LO5: How price controls affect total economic surplus

  21. FIGURE 7.8: The Economic Surplus Lost by Price Controls Consumer surplus Lost economic surplus 20 S 18 • By limiting output in the oil market to 1000 bbl/day, price controls cause a loss in economic surplus of $8000/day. 16 Price ($/bbl) 14 12 Price ceiling 10 Producer surplus D 8 0 1 2 3 4 5 Quantity (1000’s of bbl/day) LO5: How price controls affect total economic surplus

  22. Does it matter how we share the economic surplus • Occupy movement • Voluntary price controls in times of emergency (war, natural disasters….) • Price controls to reduce income inequality • Rent control • Minimum wage LO6: Why Distribution is Important

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  24. Price Elasticity and the Size of Total Economic Surplus • Size of economic surplus depends on the price elasticity of supply and demand – surplus is larger when: • Demand is inelastic. • Supply is inelastic. • For the same demand curve, when supply is more inelastic, price ceilings: • Have a smaller impact on the total level of output. • Cause a smaller reduction in total economic surplus. • Have a larger redistributive effect. • Example: compare the impact of rent controls in 2 cities • where housing differs in elasticity of supply. LO7: Price Elasticity and Total Economic Surplus

  25. Rent Controls – Winnipeg, Vancouver • Winnipeg • where new apartments can be constructed either by making buildings taller or by extending new construction further out on the plain. • Vancouver • mountains or the sea confine growth, except up.. LO7: Price Elasticity and Total Economic Surplus

  26. Long-run supply of apartments will be more elastic in Winnipeg than in Vancouver.

  27. FIGURE 7.9: Economic Surplus in Two Unregulated Housing Markets 1,600,000/ month 1,600,000/ month Consumer surplus Consumer surplus S CS = ½(4000)(800) S Supply is less elastic 400,000/ month 700,000/ month Producer surplus Producer surplus PS = ½(4000)(200) PS = ½(3000+4000)(200) D D LO7: Price Elasticity and Total Economic Surplus

  28. Inelastic Supply or Demand: • Price controls have minor impact. • Implication: • Small changes in total surplus. • Large changes in shares of surplus. • Elastic Supply and Demand • the surplus lost due to price controls is greater. LO7: Price Elasticity and Total Economic Surplus

  29. Rent Control: Rents capped at $100 per month in both cities D D Redistributed surplus Redistributed surplus Consumer surplus Consumer surplus S Loss of total economic surplus S Loss of total economic surplus Producer surplus Rent control Producer surplus Loss of total economic surplus = ½ (2000)(500) = 500 000 Redistributed surplus = (2000)(100) = 200 000 Loss of total economic surplus = ½ (500)(200) = 500 00 Redistributed surplus = (3500)(100) = 350 000 LO7: Price Elasticity and Total Economic Surplus

  30. Removing Rent Control - Winnipeg • Supply rises from 2000 to 4000/month. • Total economic surplus up by $500 000/month. • Better off • Renters who choose to rent the 2000 new apartments • Landlords who choose to make them available will be better off. • Worse off • Renters who paid $100/month for each of 2000 apartments will be worse off by ($100)(2000) =$200 000 /month (rectangle in black) transferred to the landlord. LO7: Price Elasticity and Total Economic Surplus

  31. Removing Rent Control – Vancouver • Supply rises by 500/month. • Total economic surplus up by $50 000/month. • Better off • Renters who choose to rent the 500 new apartments • Landlords who choose to make them available will be better off. • Worse off • Renters who paid $100/month for each of 500 apartments will be worse off by ($100)(3500) =$350 000 /month (rectangle in black) transferred to the landlord. LO7: Price Elasticity and Total Economic Surplus

  32. Congestion Pricing • ..\..\..\..\Videos\reasontv_video_6.mp4

  33. Price Floors • Law or regulation that prevents buyers from paying less than a specified amount • Keeps prices high. • Reduces total economic surplus. • Guarantees those suppliers a minimum price for their product. • It requires the regulator to take care of the ensuing market surplus. LO5: How price controls affect total economic surplus

  34. Lost Surplus from Price Supports for Wheat S Lost economic surplus D tonnes/month ) • A price support of $40/million tonnes results in 4 tonnes of wheat/month being produced, of which the government buys half and the public buys half. Lost economic surplus from the program is equal to $10 million/month.

  35. Minimum Wage S Lost economic surplus D New workers at the higher wage Existing workers laid-off at the higher wage LO5: How price controls affect total economic surplus

  36. Measuring the effects of Minimum Wage • Campoleti/Gunderson (U of T) showed that a 10% increase in min wage reduces employment by 3 – 5% • Famous experiment • New Jersey/Pennsylvania have similar economic structure along their border • In 1992 NY raised its min wage from $4.25 to $5.05, while PA left its min wage at $4.25 • Card/Kreuger noted that teen employment increased. They argue that increased min wage increases worker commitment, reduces turnover and raises productivity • Debate. • Critics say the experiment was flawed – employers cut staff before changes Rational expectations – people make decisions in anticipation change, prior to the change actually occurring

  37. Equilibrium and Social Optimum • Equilibrium no incentive for anyone to change their behavior: • All opportunities for private gain have been exhausted. • Market equilibrium does not necessarily allocation of resources is socially optimal • Market equilibrium = social optimum Only when all prices reflect all the costs and benefits of a transaction (good’s production/exchange) LO8: Difference between maximum economic surplus and a social optimum

  38. Taxation: The Effect of a Tax S + tax With no tax, 3 million kilograms of potatoes are sold each month at a price of $3/kg. S Lost Surplus 3.50 With a tax of $1/kg collected from sellers, consumers end up paying $3.50/kg (including tax), while sellers receive only $2.50/kg (net of tax). 2.50 D 2.5 Equilibrium quantity falls from 3 million kilograms/ month to 2.5 million. LO9: Effect of Tax

  39. The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of Supply S + $100 $10 100 Price ($/car) S $10 000 D 1.9 2.0 Quantity (millions of cars/month) LO9: Effect of Tax

  40. FIGURE 7.14: The Effect of a $1/kg Tax on Potatoes S + tax 6 S 5 4 3.50 Price ($/kg) 3 2.50 2 1 D 0 1 2 3 4 5 2.5 Quantity (millions of kg/month) $1/kg tax on potatoes would cause an upward shift in the supply curve by $1. Total surplus would shrink to the area of the pale blue triangle, $6.25 million/month. x

  41. Taxes, Elasticity, and Economic Surplus • Deadweight loss is minimized when supply or demand are relatively inelastic. LO9: Effect of Tax

  42. FIGURE 7.16: Elasticity of Demand and the Deadweight Loss from a Tax Deadweight loss Deadweight loss S + T S + T 2.60 S S 2.40 2.00 2.00 1.60 1.40 D1 D2 19 24 21 24 • At the equilibrium price and quantity, price elasticity of demand is smaller for the good shown in panel (b) than for the good shown in panel (a). The area of the deadweight loss triangle in panel (b) ($1.50/day) is smaller than the area of the deadweight loss triangle in panel (a) ($2.50/day). LO9: Effect of Tax

  43. FIGURE 7.17:Elasticity of Supply and the Deadweight Loss from a Tax • At the equilibrium price and quantity, price elasticity of supply is smaller for the good shown in panel (b) than for the good shown in panel (a). The area of the deadweight loss triangle in panel (b) ($4.50/day) is smaller than the area of the deadweight loss triangle in panel (a) ($7.50/day). LO9: Effect of Tax

  44. Taxes, External Costs, and Economic Surplus • Taxes reduce the equilibrium quantity produced and consumed. • To a degree which depends on supply and demand elasticity for that commodity. • Therefore, taxing activities that people tend to pursue to excess (e.g., activities that cause pollution) can have a “double dividend”. LO9: Effect of Tax

  45. Chapter Summary • In a perfectly competitive market when the supply and demand curves for a product capture all the relevant costs and benefits of producing and consuming that product, then market equilibrium for that product will be efficient. • For an individual buyer, the economic surplus from a transaction is the difference between the most the buyer would have been willing to pay and the amount actually paid. • For an individual seller, the economic surplus from a transaction is the difference between the price received and the lowest amount at which the seller would have been willing to make the sale. • Total economic surplus in a market is the sum of all producer and consumer surplus in that market. Chapter Summary

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