Section 4: Costs, Perfect Competition, Analysis of Competitive Markets

● Outline
○ Costs
■ Different Types of Costs
■ Cost in the Short-Run
■ Cost in the Long-Run
■ Relationship between Short-Run and Long-Run
■ Efficiencies in the Long-Run
○ Perfect Competition
■ Firm’s Optimization Problems
■ Optimality Condition
■ Short-Run
■ Long-Run
■ Market Supply
○ Analysis of Competitive Markets
■ Welfare Taxes and Subsidies
■ Price Controls
■ Price Supports and Production Quotas
■ Import Quotas and Tariffs
● Different Types of Costs
○ Total cost (TC or C): Total economic cost of production, consisting of fixed and variable costs.
■ 𝑇𝐶 = 𝐹𝐶 + 𝑉𝐶
○ Fixed cost (FC): Cost that does not vary with the level of output and that can be eliminated only
by shutting down.
○ Variable cost (VC): Cost that varies as output varies.
○ Marginal cost (MC): Increase in cost resulting from the production of one extra unit of output.
∆𝑇𝐶 ∆(𝐹𝐶+𝑉𝐶) ∆𝑉𝐶
■ 𝑀𝐶 = ∆𝑞
= ∆𝑞
= ∆𝑞
𝑑𝑇𝐶 𝑑𝐹𝐶 𝑑𝑉𝐶 𝑑𝑉𝐶
■ 𝑀𝐶 = 𝑑𝑞
= 𝑑𝑞
+ 𝑑𝑞 = 𝑑𝑞
○ Average total cost (ATC or AC): Firm’s total cost divided by its level of output
𝑇𝐶
■ 𝐴𝐶 = 𝑞
○ Average fixed cost (AFC): Fixed cost divided by the level of output.
𝐹𝐶
■ 𝐴𝐹𝐶 = 𝑞
○ Average variable cost (AVC): Variable cost divided by the level of output.
𝑉𝐶
■ 𝐴𝑉𝐶 = 𝑞
● Short-Run Cost Curves
○ VC and FC on the graph: in the long run all costs are variable so there is no fixed cost curve
○ Since FC does not vary with quantity it is just a horizontal line
○ Since VC differs from TC by FC (a constant), VC and TC are “parallel”
○ MC is the slope of the TC or VC
■ Decreases in the beginning, becomes flatter and then rises
■ This means marginal costs are decreasing at first
○ MC crosses ATC and AVC at their minimums
■ If MC is less than either, average is decreasing
■ If MC is greater than either, average is increasing
○ Average fixed cost is decreasing to 0 asymptotically
● Exercise (Ch.7 Problem 9)
 ○ The short-run cost function of a company is given by the equation TC = 200 + 55q, where TC is
the total cost and q is the total quantity of output, both measured in thousands.
○ What is the company’s fixed cost?
■ 𝐹𝐶 = 200
○ If the company produced 100,000 units of goods, what would be its average variable cost?
𝑉𝐶 55𝑞
■ 𝑉𝐶 = 55𝑞 ⇒ 𝐴𝑉𝐶(100) = 𝑞
= 𝑞
= 55
○ What would be its marginal cost of production?
■ 𝑀𝐶(100) = 𝑇𝐶'(100) = 55
○ What would be its average fixed cost?
𝐹𝐶 200
■ 𝐴𝐹𝐶 = 𝑞
= 100
=2
○ The company borrows money and expands its factory. Its fixed cost rises by $50,000, but its
variable cost falls to $45,000 per 1000 units. The cost of interest (i) also enters into the equation.
Each 1-point increase in the interest rate raises costs by $3000. Write the new cost equation.
■ 𝑇𝐶 = 250 + 45𝑞 + 3𝑖
● Isocost
○ Isocost: The set of combinations of labor and capital that yield the same total cost for the firm.
○ Cost increases as you move away from the origin (northeast) because you are using more inputs
𝑇𝐶 𝑇𝐶
○ With labor on the horizontal and capital on the vertical: x-intercept = 𝑤
, y-intercept = 𝑟
○ More generally, for an arbitrary level of total cost TC, and input prices w and r, the equation of the
𝑇𝐶 𝑤 −𝑤
isocost line is 𝐾 = 𝑟
− 𝑟
𝐿, where the slope is 𝑟
(marginal rate of technical substitution)
● Cost Minimization Problem
○ (Long-Run) Cost minimization problem (CMP): The problem of finding the input combination
that minimizes a firm’s total cost of producing a particular level of output.
○ Let 𝐶 = 𝑤𝐿 + 𝑟𝐾 be the cost function and 𝑞 = 𝐹(𝐿, 𝐾) be the production function. To achieve a
production 𝑞0, our problem is: 𝑚𝑖𝑛𝐿,𝐾 𝑤𝐿 + 𝑟𝐾 subject to 𝑞0 = 𝐹(𝐿, 𝐾)
* *
○ The solutions to the CMP 𝐿 (𝑤, 𝑟, 𝑞0) and 𝐾 (𝑤, 𝑟, 𝑞0) are the firm’s (long-run) input demand for
the production.
■ Interpretation: given production function F(L, K) and input prices w and r, to most
effectively produce 𝑞0 goods, we need L* labor and K* capital.
■ Push isocost curves as low as possible
○ Similar to a consumer problem, the optimal production set is the tangency point of the isoquant
curve and isocost curve.
○ Therefore, we have the following optimality condition for a cost minimization problem:
𝑀𝑃𝐿 𝑤
■ 𝑀𝑃𝐾
= 𝑟
𝑀𝑃𝐿 𝑤
■ 𝑀𝑃𝐾
is the (negative) slope of the isoquant and 𝑟
is the (negative) slope of the isocost
○ Standard procedure to solve a CMP:
■ First, we use the optimality condition to find the relationship between optimal L* and K*
■ Then, we apply the relationship above to the isoquant, and solve for L* and K*
respectively as a function of w, r, and q0.
● Allocation Rules of Inputs
𝑀𝑃𝐿 𝑀𝑃𝐾
○ 𝑤
= 𝑟
⇒𝐿+𝐾
𝑀𝑃𝐿 𝑀𝑃𝐾
○ 𝑤
> 𝑟
⇒ ↑𝐿 + ↓𝐾
 𝑀𝑃𝐿 𝑀𝑃𝐾
○ 𝑤
< 𝑟
⇒ ↓𝐿 + ↑𝐾
○ If the “bang-per buck” (marginal product over price ratio) is greater, consume more of that input
because you are getting more in return
● Exercise (Ch.7 Appendix Q2)
○ The production function for a product is given by 𝑞 = 100𝐾𝐿. If the price of capital is $120 per
day and the price of labor $30 per day, what is the minimum cost of producing 1000 units?
○ 𝑚𝑖𝑛𝐿,𝐾 30𝐿 + 120𝐾 s.t. 100𝐾𝐿 = 1000
𝑀𝑃𝐿 100𝐾 𝐾
○ 𝑀𝑅𝑇𝑆𝐿,𝐾 = 𝑀𝑃𝐾
= 100𝐿
= 𝐿
𝑤 𝐾 30
○ 𝑀𝑅𝑇𝑆 = 𝑟
⇒ 𝐿
= 120
⇒ 4𝐾 = 𝐿
2
○ 100𝐾𝐿 = 1000 ⇒ 100𝐾(4𝐾) = 400𝐾 = 1000
* * *
○ 𝐾 = 1. 58, 𝐿 = 4𝐾 = 6. 32
* * * * *
○ 𝑇𝐶 = 𝑇𝐶(𝐿 , 𝐾 ) = 30𝐿 + 120𝐾 = 30(6. 32) + 120(1. 58) = $379. 2
● Long-Run Total Cost Curve
○ By changing the isoquant curve you can optimize TC at various q values and thus create a TC
curve as a function of q
● Inflexibility of Short-Run Production
○ Figure 5 illustrates an example: capital is fixed at level K1 in the short-run.
○ Therefore, if we increase output level from q1 to q2, the firm can only increase input L. So, we
have a horizontal short-run expansion path.
○ Point P denotes the short-run input set to produce q2 of output. It lies on the isocost curve EF,
which is higher than the long-run isocost curve CD.
○ The cost of production is higher in the short-run, because the firm is unable to substitute relatively
inexpensive capital for more costly labor when it expands production.
○ In the long run, we can achieve a lower cost because we can vary capital to the optimal level
○ In the short run, in order to increase output, labor must be increased which is increasingly
expensive and thus makes the short run costs more costly
● Short-Run vs. Long-Run Cost
○ Long run cost curve is the lower envelope of the short run costs
■ Smooths out over infinite short run curves
○ LAC curve will be lower than SAC because you can adjust inputs to the optimal levels
○ Connecting all the SMC curves and their corresponding quantities forms the LMC

● Economies of Scale
○ Economies of Scale: A characteristic of production in which AC decreases as output goes up.
 %∆𝐶 ∆𝐶/𝐶 ∆𝐶/∆𝑞 𝑀𝐶
■ 𝐸𝑂𝑆 = %∆𝑞
= ∆𝑞/𝑞
= 𝐶/𝑞
= 𝐴𝐶
● If 𝐸𝑂𝑆 < 1% we have economies of scale (EOS)
● If 𝐸𝑂𝑆 = 1% we have unit economies of scale
● If 𝐸𝑂𝑆 < 1% we have diseconomies of scale (DEOS)
%∆𝑞
■ 𝑅𝑇𝑆 = %∆𝑖𝑛𝑝𝑢𝑡𝑠
● 𝑅𝑇𝑆 > 1 increasing returns to scale (IRS)
● 𝑅𝑇𝑆 = 1 constant returns to scale (CRS)
● 𝑅𝑇𝑆 < 1 decreasing returns to scale
○ If you increase q by 1%
■ and need less than a 1% increase in inputs you have IRS
■ and costs goes up by less than 1% you have EOS
○ IRS and EOS are the same: one is about production directly and the other is about costs
■ Both are saying that production is very efficient
○ Returns to scale and economies of scale are closely related, because the returns to scale of the
production function determine how long-run average cost varies with output. When the production
uses only one input, the relationship between returns to scale and economies of scale can be
summarized in Figure 7: 1 If average cost decreases as output increases (when q < q2), we have
economies of scale and increasing returns to scale. 2 If average cost increases as output increases
(when q > q2), we have diseconomies of scale and decreasing returns to scale. 3 If average cost
stays the same as output increases (when q = q2), we have neither economies nor diseconomies of
scale and constant returns to scale
● Production and Cost (of One-Input Technology)
○ If MC is at a minimum
■ TC is flattest (lowest slope)
■ MP of the input is at a maximum
■ TP is increasing at the highest rate
○ If AC is at a minimum
■ 𝑀𝐶 = 𝐴𝐶
■ 𝑀𝑃 = 𝐴𝑃
■ AP of the input is at a maximum
○ EOS: 𝑀𝐶 < 𝐴𝐶, 𝐴𝐶 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑖𝑛𝑔
○ CRS: 𝑀𝐶 = 𝐴𝐶, 𝐴𝐶 𝑎𝑡 𝑚𝑖𝑛
○ DEOS: 𝑀𝐶 > 𝐴𝐶, 𝐴𝐶 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑖𝑛𝑔
○ IRS: 𝑀𝑃 > 𝐴𝑃, 𝐴𝑃 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑖𝑛𝑔
○ CRS: 𝑀𝑃 = 𝐴𝑃, 𝐴𝑃 𝑎𝑡 𝑚𝑎𝑥
○ DRS: 𝑀𝑃 < 𝐴𝑃, 𝐴𝑃 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑖𝑛𝑔
● Economies of Scope
○ Economies of Scope: A production characteristic in which the total cost of producing given
quantities of two goods in the same firm is less than the total cost of producing those quantities in
two single product firms.
○ Economies of scope happens if 𝐶(𝑞1) + 𝐶(𝑞2) > 𝐶(𝑞1, 𝑞2)
𝐶(𝑞1)+𝐶(𝑞2)−𝐶(𝑞1,𝑞2)
○ We can also measure the degree of economies of scope: 𝑆𝐶 = 𝐶(𝑞1,𝑞2)

● Exercise (Ch.7 Appendix Q4)

○ Suppose the process of producing lightweight parkas by Polly’s Parkas is described by the
0.8 0.2
function 𝑞 = 10𝐾 (𝐿 − 40) where q is the number of parkas produced, K the number of
 computerized stitching-machine hours, and L the number of person-hours of labor. In addition to
capital and labor, $10 worth of raw materials is used in the production of each parka.
○ By minimizing cost subject to the production function, derive the cost-minimizing demands for K
and L as a function of output (q), wage rates (w), and rental rates on machines (r). Use these
results to derive the total cost function: that is, costs as a function of q, r, w, and the constant $10
per unit materials cost.
■ 𝑇𝐶 = 𝑤𝐿 + 𝑟𝐾 + 10𝑞
0.8 0.2
■ 𝑚𝑖𝑛𝐿,𝐾 𝑤𝐿 + 𝑟𝐾 + 10𝑞 𝑠. 𝑡. 𝑞 = 10𝐾 (𝐿 − 40)
𝑀𝑃𝐿 0.8
2𝐾 (𝐿−40)
−0.8
𝐾
■ 𝑀𝑅𝑇𝑆𝐿,𝐾 = 𝑀𝑃𝐿
= −0.2 0.2 = 4(𝐿−40)
8𝐾 (𝐿−40)
𝑤 𝐾 𝑟𝐾
■ 𝑀𝑅𝑇𝑆𝐿,𝐾 = 𝑟
= 4(𝐿−40)
⇒𝐿 = 4𝑤
+ 40
0.8 0.2 0.8 𝑟𝐾 0.2
■ 𝑞 = 10𝐾 (𝐿 − 40) = 10𝐾 ( 4𝑤 + 40 − 40)
* 𝑞 𝑤 0.2 * 𝑞 𝑟 0.8
■ 𝐾 = 7.6
( 𝑟
) , 𝐿 = 30.3
(𝑤) + 40
0.2 0.8 0.8 0.2
* * 𝑤 𝑟 𝑞 𝑟 𝑤 𝑞
■ 𝑇𝐶 = 𝑤𝐿 + 𝑟𝐾 + 10𝑞 = 30.3
+ 40𝑤 + 7.6
+ 10𝑞
○ This process requires skilled workers, who earn $32 per hour. The rental rate on the machines used
in the process is $64 per hour. At these factor prices, what are total costs as a function of q? Does
this technology exhibit decreasing, constant, or increasing returns to scale?
* 𝑞 𝑤 0.2 𝑞 32 0.2
■ 𝐾 = 7.6
(
𝑟
) = 7.6 ( 64 ) =
* 𝑞 𝑟 0.8 𝑞 64 0.8
■ 𝐿 = 30.3
( 𝑤 ) + 40 = 30.3 ( 32 ) + 40
■ 𝑇𝐶 = 19. 2𝑞 + 1280
1280
■ 𝐴𝐶 = 19. 2 + 𝑞
decreasing as q increases → IRS
.8 .2
■ α𝑞(𝐾, 𝐿) = α10𝐾 (𝐿 − 40)
.8 .2 .8 40 .2
■ 𝑞(α𝐾, α𝐿) = 10(α𝐾) (α𝐿 − 40) = α10𝐾 (𝐿 − α
)
■ α𝑞(𝐾, 𝐿) < 𝑞(α𝐾, α𝐿) →increasing returns to scale
○ Polly’s Parkas plans to produce 2000 parkas per week. At the factor prices given above, how many
workers should the firm hire (at 40 hours per week) and how many machines should it rent (at 40
machine-hours per week)? What are the marginal and average costs at this level of production?
.8 .2
■ 𝑞 = 10𝐾 (𝐿 − 40)
■ 𝐾 = 2(𝐿 − 40)
.8 .2
■ 𝑞 = 10[2(𝐿 − 40)] (𝐿 − 40) = 17. 411(𝐿 − 40)
■ 2000 = 17. 411(𝐿 − 40) ⇒ 114. 870 = 𝐿 − 40 ⇒ 𝐿 = 154. 870, 𝐾 = 229. 740
154.87 229.74
■ 𝐿= 40
= 3. 87 𝑤𝑜𝑟𝑘𝑒𝑟𝑠/𝑤𝑘, 𝐾 = 40
= 5. 73 𝑚𝑎𝑐ℎ𝑖𝑛𝑒𝑠/𝑤𝑘
■ 𝑀𝐶 = 𝑇𝐶'(2000) = $19. 190
𝑇𝐶(𝑞) 𝑇𝐶(2000) 19.190(2000)+1280
■ 𝐴𝑇𝐶 = 𝑞
= 2000
= 2000
= $19. 830
● Firm’s Optimization Problems
○ There are many possible short-run goals a firm can seek to achieve, e.g., maximize revenue,
maximize market share, satisfying, ...
○ In this class, we assume that profit maximization is the goal of a firm to govern its behavior
○ So far, we have two optimization problems. They answer different questions
■ How can we use the technology properly?
● This is the cost minimization problem.
 ● In other words, to achieve a certain amount of production, how much input do
we use so that we minimize our costs? 𝑚𝑖𝑛𝐿,𝐾 𝑟𝐾 + 𝑤𝐿 𝑠. 𝑡. 𝐹(𝐿, 𝐾) = 𝑞0
● Result: 𝑇𝐶(𝑟, 𝑤, 𝑞0), 𝐴𝐶, 𝑀𝐶
■ Firms do not want to produce as much as they can. Essentially, they want to make profit.
How can we get the most from the technology?
● This is the profit maximization problem.
● In other words, given the market demand (revenue) and the technology (costs),
how much do we produce so that we maximize our profits?
● Let π(𝑞) denote profit (which is a function of production q), then
𝑚𝑎𝑥𝑞 𝑇𝑅(𝑞) − 𝑇𝐶(𝑞, 𝑟, 𝑤)
● So solve for the optimal q, we derive the first-order condition of the profit
𝑑π 𝑑𝑇𝑅(𝑞) 𝑑𝑇𝐶(𝑞)
function 𝑑𝑞
= 𝑑𝑞
− 𝑑𝑞
= 𝑀𝑅(𝑞) − 𝑀𝐶(𝑞) = 0
● Result: the optimality condition for profit maximization is 𝑀𝑅(𝑞) = 𝑀𝐶(𝑞)
● Profit Maximization
○ Profit is the difference between revenue and cost → profit curve is the difference between the
revenue curve and the cost curve: π(𝑞) = 𝑅(𝑞) − 𝐶(𝑞)
○ Slope of cost curve is MC and slope of revenue curve is MR
○ We want to maximize profit so we want the gap between C(q) and R(q) to be at its greatest
○ This occurs when 𝑀𝑅 = 𝑀𝐶
● Perfect Competition: Setup
○ Firm’s optimal decision depends on the market structure – whether the firm has ability to
manipulate the market price (market power).
○ We start from the simplest setting: firms do not have ability to manipulate the market price. If this
is the case, the market is perfectly competitive.
○ Conditions of a perfectly competitive market:
■ Many individual consumers
● Implication: no dominant consumer group has power in the marketplace
■ Many small individual producing firms
● Implication: no dominant (large) firm or collective of firms can influence the
quantity supplied to the marketplace
● Firms are price takers
■ Homogeneous product
● Implication: if a firm decides to lower its price from the existing market price,
all consumers overwhelm it with demand
● If the firm decided to lower its price, demand for its product would fall to zero.
● This assumption ensures a single market price.
■ Free entry and free exit
● Implication: no special costs that prevent firms from entering/exiting a market 5
■ Complete Information
● Implication: everyone has full information about the prices, the quality of the
goods, and factors that may influence market price.
● Profit Maximization under Perfect Competition
○ Under perfect competition, since firms are price takers, 𝑀𝑅 = 𝑝.
○ Interpretation: a firm earns $p (the market price) for each good it sells → Refined optimality
condition for profit maximization under perfect competition: 𝑀𝐶(𝑞) = 𝑀𝑅 = 𝑝
● Optimal Output in the Short-Run
○ In the short-run, capital K is fixed, so a fixed cost is incurred anyway
 ○ Since the firm is a price-taker, 𝐴𝑅 = 𝑀𝑅 = 𝑝
○ Therefore, the firm’s profit is: π(𝑞) = 𝑇 − 𝑇𝐶 = 𝑝𝑞 − 𝑇𝐶(𝑞)
■ 𝑞[𝑝 − 𝐴𝑇𝐶(𝑞)]
■ 𝑝𝑞 − 𝑉𝐶(𝑞) − 𝐹𝐶 = 𝑞[𝑝 − 𝐴𝑉𝐶(𝑞)] − 𝐹𝐶
−1
○ When 𝑝 ≥ 𝐴𝑇𝐶(𝑞), π(𝑞) ≥ 0, great!The firm produce 𝑞 = 𝑀𝐶 (𝑝) since 𝑀𝐶(𝑞) = 𝑝
○ When 𝑝 < 𝐴𝑇𝐶(𝑞), π(𝑞) < 0, the firm will incur losses
○ The firm has two options:
■ Operate (𝑞 > 0): π(𝑞) = 𝑞(𝑝 − 𝐴𝑉𝐶(𝑞)) − 𝐹𝐶
■ Shutdown (𝑞 = 0): π(0) =− 𝐹𝐶
○ The relationship b/tw π(𝑞) and π(0) depends on the relationship b/tw p and AVC(q). For q > 0,
■ If 𝐴𝑉𝐶(𝑞) ≤ 𝑝 ≤ 𝐴𝑇𝐶(𝑞), then π(0) ≤ π(𝑞) < 0, it is better to still operate
■ If 𝑝 < 𝐴𝑉𝐶(𝑞), then π(𝑞) < π(0), it is better to shutdown (𝑞 = 0)
○ According to the optimality condition, the firm produces such that MC(q) = p
○ Also, MC curve passes through the minimum points of the ATC and AVC curve
○ To sum up, we have the firm’s optimal output in the short-run
𝑆 −1
■ 𝑞 (𝑝) = 𝑀𝐶 (𝑝) if 𝑝 ≥ 𝑚𝑖𝑛𝑞 𝐴𝑉𝐶(𝑞)
𝑆
■ 𝑞 (𝑝) = 0 if 𝑝 < 𝑚𝑖𝑛𝑞 𝐴𝑉𝐶(𝑞)
■ The short-run supply curve is the MC curve above the AVC curve and 0 otherwise
● Producer Surplus in the Short-Run
○ Producer surplus: The difference between the amount that a firm actually receives from selling a
good in the marketplace and the minimum amount the firm must receive in order to be willing to
supply the good in the marketplace
■ Difference between price and willingness to sell (the marginal cost)
○ The minimum price that the firm is willing to supply is represented by MC(q).
*
𝑞
■ Technically, 𝑃𝑆 = ∫(𝑃 − 𝑀𝐶(𝑞))𝑑𝑞
0
○ Therefore the producer surplus can be measured by the yellow area below the market price and
above the marginal cost curve, between outputs 0 and q∗ , the profit-maximizing output
* *
𝑞 𝑞
* * * *
○ Also, ∫ 𝑃𝑑𝑞 = 𝑃𝑞 and ∫ 𝑀𝐶(𝑞)𝑑𝑞 = 𝑉𝐶(𝑞 ) = 𝐴𝑉𝐶(𝑞 )𝑞
0 0
* * *
○ Therefore, the producer surplus has an alternative representation: 𝑃𝑆 = 𝑃𝑞 − 𝐴𝑉𝐶(𝑞 )𝑞
● Exercise (Ch.8 Q7)
2
○ Suppose the firm’s cost function is 𝐶(𝑞) = 4𝑞 + 16
○ Find the VC, FC, ATC, AVC, and AFC.
2 𝑇𝐶 16 𝑉𝐶 𝐹𝐶 16
■ 𝑉𝐶 = 4𝑞 , 𝐹𝐶 = 16, 𝐴𝑇𝐶 = 𝑞
= 4𝑞 + 𝑞
, 𝐴𝑉𝐶 = 𝑞
= 4𝑞, 𝐴𝐹𝐶 = 𝑞
= 𝑞
𝑑𝑇𝐶
■ 𝑀𝐶 = 𝑑𝑞
= 8𝑞
○ Show the ATC, MC, and AVC on a graph.
■ Draw MC and AVC curves first (linear): minimum of AVC is at the origin so they
intersect at that point
■ As ATC approaches 0 from the right, it gets infinitely large. It also intersects MC at the
minimum point.
■ ATC and AVC approach one another as q increases (AFC is getting closer an closer to 0)
○ Find the output that minimizes average cost.
 16 *
■ 𝐴𝑇𝐶 = 𝑀𝐶 ⇒ 4𝑞 + 𝑞
= 8𝑞 ⇒ 𝑞 = 2
■ 𝐴𝑇𝐶(2) = $16
○ At what range of prices will the firm produce a positive output? Identify the firm’s supply curve
on your graph.
𝑆 −1
■ 𝑞 (𝑝) = 𝑀𝐶 (𝑝) if 𝑝 ≥ 𝑚𝑖𝑛𝑞 𝐴𝑉𝐶(𝑞)
■ Since AVC goes through the origin, price is always greater than AVC and thus the supply
curve is just the marginal cost curve
𝑆
■ 𝑞 (𝑝) = 𝑀𝐶 = 8𝑞
○ At what range of prices will the firm earn a negative profit? A positive profit?
■ Positive profit: 𝑝 > 𝐴𝑇𝐶 ⇒ π(𝑞) > 0 for 𝑝 > 2
■ Negative profit: 𝑝 < 𝐴𝑇𝐶 ⇒ π(𝑞) < 0 for 𝑝 < 2
● Exercise (Ch.8 Q9) Suppose that a firm’s production function is q = 9x 1 2 in the short run, where there are
fixed costs of $1000, and x is the variable input whose cost is $4000 per unit. 1 What is the total cost of
producing a level of output q? In other words, identify the total cost function C(q). 2 Write down the
equation for the supply curve. 3 If price is $1000, how many units will the firm produce? What is the level
of profit? Illustrate your answer on a cost curve graph. 39 / 70 40 / 70 Optimal Output in the Long-Run In
the long-run, there is no fixed cost – the firm can choose the “right” level of capital Again, since the firm is
a price-taker, AR = MR = p Therefore, the firm’s profit is 휋(q) = pq − TC(q) = q(p − AC(q)) When p ≥
AC(q), 휋(q) ≥ 0, great! The firm produce q = MC−1 (p) When p < AC(q), 휋(q) < 0, the firm will incur
losses The firm has two options: I Operate (q > 0): 휋(q) = q(p − AC(q)) I Shutdown (q = 0): 휋(0) = 0 We
can see that as long as p < AC(q), 휋(q) < 휋(0) To sum up, we have the firm’s optimal output in the
long-run q S (p) = ( MC−1 (p) if p ≥ minq AC(q) 0 if p < minq AC(q) 41 / 70 Optimal Output in the
Long-Run (cont.) As shown in Figure 11, the long-run supply curve is the LMC curve above the LAC
curve and 0 otherwise. CHAPTER 8 PROFIT MAXIMIZATION AND COMPETITIVE SUPPLY 311 If
the firm believes that the market price will remain at $40, it will want to increase the size of its plant to
produce at output q3, at which its long-run marginal cost equals the $40 price. When this expansion is
complete, the profit margin will increase from AB to EF, and total profit will increase from ABCD to
EFGD. Output q3 is profit-maximizing because at any lower output (say, q2), the marginal revenue from
additional production is greater than the marginal cost. Expansion is, therefore, desirable. But at any output
greater than q3, marginal cost is greater than marginal revenue. Additional production would therefore
reduce profit. In summary, the long-run output of a profit-maximizing competitive firm is the point at
which long-run marginal cost equals the price. Note that the higher the market price, the higher the profit
that the firm can earn. Correspondingly, as the price of the product falls from $40 to $30, the profit also
falls. At a price of $30, the firm’s profit-maximizing output is q2, the point of long-run minimum average
cost. In this case, because P = ATC, the firm earns zero economic profit. Long-Run Competitive
Equilibrium For an equilibrium to arise in the long run, certain economic conditions must prevail. Firms in
the market must have no desire to withdraw at the same time that no firms outside the market wish to enter.
But what is the exact relationship between profitability, entry, and long-run competitive equilibrium? We
can see the answer by relating economic profit to the incentive to enter and exit a market. ACCOUNTING
PROFIT AND ECONOMIC PROFIT As we saw in Chapter 7, it is important to distinguish between
accounting profit and economic profit. Accounting profit is measured by the difference between the firm’s
revenues and its cash flows for labor, raw materials, and interest plus depreciation expenses. Economic
profit takes into account opportunity costs. One such opportunity cost E Dollars per unit of output P 5 MR
q3 q2 q1 F B $40 $30 C D G A SMC SAC LMC LAC Output FIGURE 8.13 OUTPUT CHOICE IN THE
LONG RUN The firm maximizes its profit by choosing the output at which price equals long-run marginal
cost LMC. In the diagram, the firm increases its profit from ABCD to EFGD by increasing its output in the
long run. Figure 11: Long-Run Supply Curve under Perfect Competition 42 / 70 43 / 70 Market Supply The
 industry supply of the market is the horizontal sum of the supply of all the individual firms, as shown in
Figure 12 306 PART 2 Producers, Consumers, and Competitive Markets Elasticity of Market Supply
Unfortunately, finding the industry supply curve is not always as simple as adding up a set of individual
supply curves. As price rises, all firms in the industry expand their output. This additional output increases
the demand for inputs to production and may lead to higher input prices. As we saw in Figure 8.7,
increasing input prices shifts a firm’s marginal cost curve upward. For example, an increased demand for
beef could also increase demand for corn and soybeans (which are used to feed cattle) and thereby cause
the prices of these crops to rise. In turn, higher input prices will cause firms’ marginal cost curves to shift
upward. This increase lowers each firm’s output choice (for any given market price) and causes the industry
supply curve to be less responsive to changes in output price than it would otherwise be. The price
elasticity of market supply measures the sensitivity of industry output to market price. The elasticity of
supply Es is the percentage change in quantity supplied Q in response to a 1-percent change in price P: ES
= (∆Q>Q)>(∆P>P) Because marginal cost curves are upward sloping, the short-run elasticity of supply is
always positive. When marginal cost increases rapidly in response to increases in output, the elasticity of
supply is low. In the short run, firms are capacity-constrained and find it costly to increase output. But
when marginal cost increases slowly in response to increases in output, supply is relatively elastic; in this
case, a small price increase induces firms to produce much more. In §2.4, we define the elasticity of supply
as the percentage change in quantity supplied resulting from a 1-percent increase in price. Quantity Dollars
per unit 2 4 5 7 8 10 15 21 S P3 MC3 P2 P1 MC1 MC2 FIGURE 8.9 INDUSTRY SUPPLY IN THE
SHORT RUN The short-run industry supply curve is the summation of the supply curves of the individual
firms. Because the third firm has a lower average variable cost curve than the first two firms, the market
supply curve S begins at price P1 and follows the marginal cost curve of the third firm MC3 until price
equals P2, when there is a kink. For P2 and all prices above it, the industry quantity supplied is the sum of
the quantities supplied by each of the three firms. Figure 12: Industry Supply in the Short-Run 44 / 70
● Market Equilibrium in the Long-Run
○ Since firms are price-takers, p is determined by the market equilibrium of supply and demand
○ Recall that we have the free entry and free exit assumption
○ Figure 13 illustrates the derivation of the long-run competitive equilibrium
○ When p > min LAC (e.g. p = P1):
■ The industry is profitable, so firms will enter the industry
■ Because of the entry of new firms, the industry supply will increase from S1, and
consequently the market price will decrease from P1
■ New firms will keep entering until the price drops to P2 where p = min LAC (so profit =
0)
○ When p < min LAC:
■ The industry is non-profitable, so firms will exit the industry
■ Because of the exit of the existing firms, the industry supply will decrease, and
consequently the market price will increase
■ Existing firms will keep exiting until the price rises to P2 where p = min LAC (so 휋 = 0)
○ Therefore, when it is the long-run equilibrium, p = min LAC, and all firms earn zero economic
profit
● Long-Run Supply Curve of the Industry
○ We can sketch out the industry’s long-run supply curve through demand shocks.
○ The slope of the industry’s long-run supply curve depends on whether the industry is constant cost,
increasing cost, or decreasing cost.
● Exercise (Ch.8 Q10) Suppose you are given the following information about a particular industry:
○ Market demand: QD = 6500 − 100P; Market supply: QS = 1200P
○ Total cost: C(q) = 722 + q 2 200 ; Marginal cost: MC(q) = q 100
○ Assume that all firms are identical, and that the market is characterized by perfect competition.
 ○ Find the equilibrium price, the equilibrium quantity, the output supplied by the firm, and the profit
of each firm.
■ 6500 − 100𝑃 = 1200𝑃 ⇒ 𝑃 = $5, 𝑄 = 6000
𝑞
■ 𝑀𝐶 = 𝑃 ⇒ 100
= 5 ⇒ 𝑞 = 500
2
500
■ π = 5 * 500 − (722 + 200
) = 528
○ Would you expect to see entry into or exit from the industry in the long run? Explain. What effect
will entry or exit have on market equilibrium?
■ Profit is positive therefore firms will enter in the long run. This will cause market supply
to shift outward and thus the equilibrium price will be lower at a higher quantity.
○ What is the lowest price at which each firm would sell its output in the long run? Is profit positive,
negative, or zero at this price? Explain.
2 2
722 𝑞 𝑞 14400 𝑞 2𝑞
■ 𝐴𝑇𝐶 = 𝑀𝐶 ⇒ 𝑞
+ 200
= 100
= 200𝑞
+ 200𝑞
= 200𝑞
⇒ 𝑞 = 380
380
■ 𝑃= 100
= $3. 8
2
380
■ π = 3. 8 * 380 − (722 + 200
)=0
■ Profit in the long run is 0 because the market is stable and there is no entry or exit of
other firms. Here, each firm is employing all their resources to their maximum potential
thus they can do no better in another industry and they are no longer receiving benefits
over and above those possible with the resources at hand.
○ What is the lowest price at which each firm would sell its output in the short run? Is profit
positive, negative, or zero at this price? Explain.
𝑞
■ 𝐴𝑉𝐶 = 200
𝑞 𝑞
■ 𝐴𝑉𝐶 = 𝑀𝐶 ⇒ 200
= 100
⇒ 𝑀𝐶 > 𝐴𝑉𝐶
■ Since the marginal cost of production is always greater than the average variable cost
(and equal at a production level of 0) firms will produce for any price above 0. At just
above zero, the firm will be earning a negative profit.
● Consumer Surplus
○ Consumer surplus CS: The difference between the maximum amount that a consumer is willing to
pay for a good and the amount that the consumer actually pays The willingness-to-pay is depicted
by the demand curve, so the consumer surplus is the area between the demand curve and the price
line 152 PART 2 Producers, Consumers, and Competitive Markets 4.4 Consumer Surplus
Consumers buy goods because the purchase makes them better off. Consumer surplus measures
how much better off individuals are, in the aggregate, because they can buy goods in the market.
Because different consumers place different values on the consumption of particular goods, the
maximum amount they are willing to pay for those goods also differs. Individual consumer surplus
is the difference between the maximum amount that a consumer is willing to pay for a good and
the amount that the consumer actually pays. Suppose, for example, that a student would have been
willing to pay $13 for a rock concert ticket even though she only had to pay $12. The $1
difference is her consumer surplus.7 When we add the consumer surpluses of all consumers who
buy a good, we obtain a measure of the aggregate consumer surplus. Consumer Surplus and
Demand Consumer surplus can be calculated easily if we know the demand curve. To see the
relationship between demand and consumer surplus, let’s examine the individual demand curve for
concert tickets shown in Figure 4.14. (Although the following discussion applies to this particular
individual demand curve, a similar argument also applies to a market demand curve.) Drawing the
demand curve as a staircase rather than a straight line shows us how to measure the value that our
consumer obtains from buying different numbers of tickets. When deciding how many tickets to
buy, our student might reason as follows: The first ticket costs $14 but is worth $20. This $20
valuation is obtained consumer surplus Difference between what a consumer is willing to pay for a
good and the amount actually paid. 7 Measuring consumer surplus in dollars involves an implicit
assumption about the shape of consumers’ indifference curves: namely, that the marginal utility
associated with increases in a consumer’s income remains constant within the range of income in
question. In many cases, this is a reasonable assumption. It may be suspect, however, when large
changes in income are involved. Price (dollars per ticket) Rock concert tickets 20 19 18 17 16 15
14 13 0 1 2 34 5 6 Consumer Surplus FIGURE 4.14 CONSUMER SURPLUS Consumer surplus
is the total benefit from the consumption of a product, less the total cost of purchasing it. Here, the
consumer surplus associated with six concert tickets (purchased at $14 per ticket) is given by the
yellow-shaded area. CHAPTER 4 INDIVIDUAL AND MARKET DEMAND 153 by using the
demand curve to find the maximum amount that she will pay for each additional ticket ($20 being
the maximum that she will pay for the first ticket). The first ticket is worth purchasing because it
generates $6 of surplus value above and beyond its cost. The second ticket is also worth buying
because it generates a surplus of $5 ($19 - $14). The third ticket generates a surplus of $4. The
fourth, however, generates a surplus of only $3, the fifth a surplus of $2, and the sixth a surplus of
just $1. Our student is indifferent about purchasing the seventh ticket (which generates zero
surplus) and prefers not to buy any more than that because the value of each additional ticket is
less than its cost. In Figure 4.14, consumer surplus is found by adding the excess values or
surpluses for all units purchased. In this case, then, consumer surplus equals $6 + $5 + $4 + $3 +
$2 + $1 = $21 To calculate the aggregate consumer surplus in a market, we simply find the area
below the market demand curve and above the price line. For our rock concert example, this
principle is illustrated in Figure 4.15. Now, because the number of tickets sold is measured in
thousands and individuals’ demand curves differ, the market demand curve appears as a straight
line. Note that the actual expenditure on tickets is 6500 * $14 = $91,000. Consumer surplus,
shown as the yellow-shaded triangle, is 1/2 * ($20 - $14) * 6500 = $19,500 This amount is the
total benefit to consumers, less what they paid for the tickets. Of course, market demand curves
are not always straight lines. Nonetheless, we can always measure consumer surplus by finding the
area below the demand curve and above the price line. Price (dollars per ticket) Rock concert
tickets (thousands) Demand Curve Actual Expenditure Consumer Surplus 1 19 18 17 16 15 14 13
20 0 234567 Market Price FIGURE 4.15 CONSUMER SURPLUS GENERALIZED For the
market as a whole, consumer surplus is measured by the area under the demand curve and above
the line representing the purchase price of the good. Here, the consumer surplus is given by the
yellow-shaded triangle and is equal to 1/2 * ($20 - $14) * 6500 = $19,500. Figure 15: Consumer
Surplus 50 / 70 Welfare under Perfect Competition Recall that the producer surplus (PS) is the
difference between the price that a firm actually receives and the minimum amount the firm must
receive in order to be willing to supply It is the area between the supply curve and the price line
Together, we can visualize the CS and PS in Figure 16 328 PART 2 Producers, Consumers, and
Competitive Markets The result is a shortage—i.e., excess demand. Of course, those consumers
who can still buy the good will be better off because they will now pay less. (Presumably, this was
the objective of the policy in the first place.) But if we also take into account those who cannot
obtain the good, how much better off are consumers as a whole? Might they be worse off? And if
we lump consumers and producers together, will their total welfare be greater or lower, and by
how much? To answer questions such as these, we need a way to measure the gains and losses
from government interventions and the changes in market price and quantity that such
interventions cause. Our method is to calculate the changes in consumer and producer surplus that
result from an intervention. In Chapter 4, we saw that consumer surplus measures the aggregate
net benefit that consumers obtain from a competitive market. In Chapter 8, we saw how producer
surplus measures the aggregate net benefit to producers. Here we will see how consumer and
producer surplus can be applied in practice. Review of Consumer and Producer Surplus In an
unregulated, competitive market, consumers and producers buy and sell at the prevailing market
price. But remember, for some consumers the value of the good exceeds this market price; they
would pay more for the good if they had to. Consumer surplus is the total benefit or value that
consumers receive beyond what they pay for the good. For example, suppose the market price is
$5 per unit, as in Figure 9.1. Some consumers probably value this good very highly and would pay
much more than $5 for it. Consumer A, for example, would pay up to $10 for the good. However,
because the market price is only $5, he enjoys a net benefit of $5—the $10 value he places on the
good, less the $5 he must pay to obtain it. Consumer B values the good somewhat less highly. She
would be willing to pay $7, and thus enjoys a $2 net benefit. Finally, Consumer C values the good
at exactly In §2.7, we explain that under price controls, the price of a product can be no higher
than a maximum allowable ceiling price. For a review of consumer surplus, see §4.4, where it is
defined as the difference between what a consumer is willing to pay for a good and what the
consumer actually pays when buying it. Consumer A Consumer B Consumer C S D Consumer
Surplus Producer Surplus Q0 $10 7 5 Price Quantity FIGURE 9.1 CONSUMER AND
PRODUCER SURPLUS Consumer A would pay $10 for a good whose market price is $5 and
therefore enjoys a benefit of $5. Consumer B enjoys a benefit of $2, and Consumer C, who values
the good at exactly the market price, enjoys no benefit. Consumer surplus, which measures the
total benefit to all consumers, is the yellow-shaded 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 benefit of a competitive market. Figure 16: Consumer
Surplus and Producer Surplus 51 / 70 52 / 70 Taxes When a tax is imposed on a specific good, it
creates a “tax wedge” T between the price consumers pay for the good P d and the price that
sellers receive P s One way to think about this wedge is to imagine a seller has the “administrative
responsibility” to collect the tax Therefore, the effect of the tax can be thought of as an increase in
the marginal cost, and the supply curve shifts horizontally upwards by the tax amount Figure 17
illustrates the welfare impact of the tax I With no tax, consumer surplus is the area of A + B + C +
E; producer surplus is the area of F + G + H I With tax, F consumer surplus shrinks to A; producer
surplus shrinks to H F tax revenue by the government is B + C + G, since tax = (P d − P s ) ∗ q F
the area of E + F is called the deadweight loss: E used to be the CS and F use to be the PS, but
they are gained by no one after the tax. 53 / 70 Taxes: Visualization 396 CHAPTER 10
COMPETITIVE MARKETS: APPLICATIONS per year). Producer surplus is the area above the
actual supply curve S and below the price producers receive (also $8) (producer surplus areas F G
H $18 million per year). There are no tax receipts, so the net economic benefit is $54 million per
year (consumer surplus producer surplus), and there is no deadweight loss. With the tax, consumer
surplus is the area below the demand curve and above the price consumers pay (Pd $12)
(consumer surplus area A $16 million per year). What about producer surplus? The producer
surplus on a unit sold is equal to the difference between the net after-tax price that sellers receive
(Ps $6) and the marginal cost of that unit. Because it is the actual supply curve S that shows the
relationship between the net after-tax price and the quantity supplied, we compute the producer
surplus as the area above the actual supply curve S and below the $6 net after-tax price that
producers receive (Ps ) (producer surplus area H $8 million per year). Quantity (millions of units
per year) 4 10 6 $20 Pd = $12 $8 $2 Ps = $6 Price (dollars per unit) A B G H S C F E S + $6 D
Area A B C E F G H Size (dollars/year) $16 million 8 million 8 million 4 million 2 million 8
million 8 million FIGURE 10.3 Impact of a $6 Excise Tax With no tax, the sum of consumer and
producer surplus is $54 million, the maximum net benefit possible in this market. The excise tax
of $6 reduces consumer surplus by $20 million, reduces producer surplus by $10 million,
generates government tax receipts of $24 million, and reduces the net benefit by $6 million (the
deadweight loss). With No Tax With Tax Impact of Tax C onsumer surplus A + B + C + E A ($16
million) –B – C – E ($36 million) ( –$20 million) Producer surplus F + G + H ($18 million) H ($8
million) –F – G (–$10 million) Government receipts from tax zero B + C + G ($24 million) B + C
+ G ($24 million) Net benefits (consumer surplus + A + B + C + E + A + B + C + G + H –E – F
producer surplus + g ov ernment F + G + H ($48 million) ( –$6 million) re c eipts) ($54 million)
Deadweight loss zero E + F ($6 million) E + F ($6 million) Figure 17: Impact of a $6 Tax 54 / 70
Incidence of a Tax The burden of a tax depends on the relative elasticity of the demand and supply.
In Figure 18, for example, a If demand is very inelastic relative to supply, the burden of the tax
falls mostly on buyers. b If demand is very elastic relative to supply, it falls mostly on sellers. Let
휀 D p (휀 S p ) be the price elasticity of demand (supply). Then Consumer pass-through fraction:
휀 S p /(휀 S p − 휀 D p ) Producer pass-through fraction: −휀 D p /(휀 S p − 휀 D p 358 PART 2
Producers, Consumers, and Competitive Markets ) In Figure 9.19, the burden of the tax is shared
almost evenly between buyers and sellers, but this is not always the case. If demand is relatively
inelastic and supply is relatively elastic, the burden of the tax will fall mostly on buyers. Figure
9.20(a) shows why: It takes a relatively large increase in price to reduce the quantity demanded by
even a small amount, whereas only a small price decrease is needed to reduce the quantity
supplied. For example, because cigarettes are addictive, the elasticity of demand is small (about
-0.4); thus federal and state cigarette taxes are borne largely by cigarette buyers.15 Figure 9.20 (b)
shows the opposite case: If demand is relatively elastic and supply is relatively inelastic, the
burden of the tax will fall mostly on sellers. So even if we have only estimates of the elasticities of
demand and supply at a point or for a small range of prices and quantities, instead of the entire
demand and supply curves, we can still roughly determine who will bear the greatest burden of a
tax (whether the tax is actually in effect or is only under discussion as a policy option). In general,
a tax falls mostly on the buyer if Ed/Es is small, and mostly on the seller if Ed/Es is large. In fact,
by using the following “pass-through” formula, we can calculate the percentage of the tax borne
by buyers: Pass @ through fraction = Es>(Es - Ed) D Price Quantity t S Price Quantity t D S P0
Pb Ps P0 Pb Q1 Q0 Q1 Q0 (a) (b) Ps FIGURE 9.20 IMPACT OF A TAX DEPENDS ON
ELASTICITIES OF SUPPLY AND DEMAND (a) If demand is very inelastic relative to supply,
the burden of the tax falls mostly on buyers. (b) If demand is very elastic relative to supply, it falls
mostly on sellers. 15See Daniel A. Sumner and Michael K. Wohlgenant, “Effects of an Increase in
the Federal Excise Tax on Cigarettes,” American Journal of Agricultural Economics 67 (May
1985): 235–42. Figure 18: Tax Incidence 55 / 70 Exercise (Ch.9 Q9) Among the tax proposals
regularly considered by Congress is an additional tax on distilled liquors. The tax would not apply
to beer. The price elasticity of supply of liquor is 4.0, and the price elasticity of demand is -0.2.
The cross-elasticity of demand for beer with respect to the price of liquor is 0.1. 1 If the new tax is
imposed, who will bear the greater burden – liquor suppliers or liquor consumers? Why? 2
Assuming that beer supply is infinitely elastic, how will the new tax affect the beer market? 56 /
70 Subsidies We can think of a subsidy as a negative tax: buyers pay the market price P d , and the
government then pays each seller a subsidy of T per unit on top of this price so that the
after-subsidy price received by a seller, P s , is equal to P d + T The effect of the tax can be
thought of as a decrease in the marginal cost, and the supply curve shifts horizontally downwards
by the tax amount Figure 19 illustrates the welfare impact of the tax I With no subsidy, consumer
surplus is the area of A + B; producer surplus is the area of E + F I With subsidy, F consumer
surplus enlarges to A + B + E + G + K; producer surplus enlarges to B + C + E + F F subsidy
expenditure by the government is B + C + E + G + K + J, since subsidy = (P s − P d ) ∗ q F the
area of J is the deadweight loss: J didn’t belong to anyone before the subsidy, but it becomes the
government expenditure after the subsidy 57 / 70 Subsidies: Visualization 10.1 THE INVISIBLE
HAND, EXCISE TAXES, AND SUBSIDIES 403 The deadweight loss of $1.5 million (area J)
arises because the subsidy increases consumer surplus by $13 million and producer surplus by
$6.5 million (equals $19.5 million total), while necessitating government expenditures of $21
million ($19.5 million $21 million $1.5 million). Another way of looking at this is to say that the
deadweight loss arises because the quantity produced rises from 6 million units with no subsidy to
7 million units with the subsidy. Over that range of output, the supply curve lies above the demand
curve, so net benefits are reduced as each of these units is produced. Thus net economic benefits
are reduced because the subsidy causes the market to overproduce relative to the efficient level of
production. Quantity (millions of units per year) Q1 Q* = 6 = 7 10 $20 2 Ps = $9 P* = $8 Pd = $6
Price (dollars per unit) A B G K J S C F E D S – $3 Subsidy of $3 per unit produced S FIGURE
10.6 Impact of a $3 Subsidy With no subsidy, the sum of consumer and producer surplus is $54
million, the maximum net benefit possible in the market. The subsidy increases consumer surplus
by $13 million, increases producer surplus by $6.5 million, has a negative impact of $21 million
on the government budget, and reduces the net benefit by $1.5 million (the deadweight loss). With
No Subsidy With Subsidy Impact of Subsidy C onsumer surplus A + B A + B + E + G + K E + G
+ K ($36 million) ($49 million) ($13 million) Producer surplus E + F B + C + E + F B + C ($18
million) ($24.5 million) ($6.5 million) Impact on government zero –B – C – E – G – K – J –B – C
– E – G – K – J budget ( –$21 million) (–$21 million) Net benefits A + B + E + F A + B + E + F –
J – J (c onsumer surplus + ( $54 million) ($52.5 million) ( – $1.5 million) producer surplus – g ov
ernment expenditures) Deadweight loss zero J ($1.5 million) Figure 19: Impact of a $3 Subsidy 58
/ 70 Exercise (Ch.9 Q2) Suppose the market for widgets can be described by the following
equations: Demand: P = 10 − Q Supply: P = Q − 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 equilibrium 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? 59 / 70 60 / 70 Price Ceilings Price ceilings: The maximum
prices allowed in a market (e.g., food, housing, gas). 406 CHAPTER 10 COMPETITIVE
MARKETS: APPLICATIONS to supply 50,000 housing units (point W ), while consumers will
want to rent 140,000 units (point X ). Thus, rent control has reduced the supply by 30,000 units
(80,000 50,000) and increased the demand by 60,000 units (140,000 80,000), resulting in an
excess demand of 90,000 units (30,000 60,000). (Excess demand in the housing market is
commonly referred to as a housing shortage.) Y U S V X D Z Z A B C F E G Y U S V X D A B C
F E H T W W G 90 Qd Q = 140 d Q = 140 s = 50 Qs Q* = 80 80 = 50 P* = $1,600 PR = $1,000
Rental price (dollars per month) Housing shortage Quantity (thousands of housing units) Quantity
(thousands of housing units) Case 1: Maximum consumer surplus Case 2: Minimum consumer
surplus Housing shortage FIGURE 10.7 Impact of Rent Controls Rent controls require that
landlords charge no more than $1,000 per month for housing units that would rent for $1,600
without rent controls. The graph shows two cases (explained below). In both cases, producer
surplus is equal to area G. Case 1: If all 50,000 available housing units are rented by the
consumers with the highest willingness to pay (those between points Y and U on the demand
curve D), consumer surplus under rent control is maximized, net economic benefits are also
maximized, and deadweight loss is minimized. Case 2: If all 50,000 available housing units are
rented by the consumers with the lowest willingness to pay (those between points T and X on the
demand curve), consumer surplus under rent control is minimized, net economic benefits are also
minimized, and deadweight loss is maximized. With Rent Control Impact of Rent Control Case 1
Case 2 Case 1 Case 2 Free Market (maximum (minimum (maximum (minimum ( with no
consumer consumer consumer consumer r ent control) surplus) surplus) surplus) surplus) C
onsumer surplus A + B + E A + B + C H C – E –A – B – E + H Producer surplus C + F + G G G
–C – F –C – F Net benefits A + B + C + E + F + G A + B + H + G –E – F –A – B – C – (c
onsumer surplus + C + G E – F + H producer surplus) Deadweight loss zero E + F A + B + C + E
+ F A + B + C + E + E + F – H F – H Figure 20: Price Ceilings 61 / 70 Price Floors Price floors:
The minimum prices allowed in a market (e.g., minimum wages). 414 CHAPTER 10
COMPETITIVE MARKETS: APPLICATIONS Y S D A B R T C E I H Z W X G V J F 35 100
115 80 Excess labor supply L, quantity of labor (millions of hours per year) wmin = $6 w = $5 w,
wage rate (dollars per hour) FIGURE 10.10 Impact of Minimum Wage Law A minimum wage law
requires employers to pay at least $6 per hour, whereas in a free market (i.e., with no minimum
wage law) the equilibrium wage rate would be $5 per hour. The table shows two cases (explained
below). Consumer surplus is the same in both cases. Case 1: If the most efficient workers get all
the jobs (workers between points Z and W on the supply curve S), producer surplus with the
minimum wage is maximized, net economic benefits are somewhat reduced, and there is some
deadweight loss. Case 2: If the least efficient workers get all the jobs (workers between points X
and T on the supply curve), producer surplus with the minimum wage is minimized, net economic
benefits are less than in Case 1, and the deadweight loss is greater than in Case 1. With Minimum
Wage Case 1 Case 2 Free Market (maximum (minimum ( with no producer producer Impact of
Minimum Wage minimum wage) surplus) surplus) Case 1 Case 2 C onsumer surplus A + B + C +
E + F A + B A + B –C – E – F –C – E – F Producer surplus H + I + J C + E + H + I E + F + G + I
+ J C + E – J E + F + G – H Net benefits A + B + C + E + A + B + C + E + A + B + E + F + –F –
J –C – H + G (c onsumer surplus + F + H + I + J H + I G + I + J producer surplus) Deadweight
loss zero F + J C + H – G F + J C + H – G they pay ($6). Thus, with the minimum wage, consumer
surplus falls by an amount equal to areas C E F. This decline in consumer surplus explains why
businesses often strongly lobby policy makers to keep the minimum wage from being raised. Also
in both cases, employers of the 80 million hours hired at the minimum wage will pay $6 per hour
instead of $5 per hour, thereby incurring an extra cost measured by areas C E. Figure 21: Price
Floors 62 / 70 63 / 70 Price Supports Under a price support program, the government sets a
support price P s and then buys up whatever output is needed to keep the market price at this level.
424 CHAPTER 10 COMPETITIVE MARKETS: APPLICATIONS both the same as with the
acreage limitation program discussed in the previous section. Government expenditures, however,
will be much greater than the $4.5 billion with the acreage limitation program—$30 billion (3
billion bushels $10 per bushel areas B C G H I J). This means that the net economic benefit
will be much smaller ($27 billion, versus $52.5 billion with the acreage limitation program) Price
(dollars per bushel) Quantity (billions of bushels per year) 6 D + government purchases S D 5 8 10
Support price $2 $8 $7 $10 $20 F A E C H I J B G W FIGURE 10.14 Impact of a Government
Purchase Program The government could support a price of $10 per bushel with a government
purchase program, buying up the excess supply of 3 billion bushels. With no program, the sum of
consumer and producer surplus is $54 billion, the maximum net benefit possible in the market.
The program decreases consumer surplus by $11 billion, increases producer surplus by $14 billion,
has a negative impact of $30 billion on the government budget, and reduces the net benefit by $27
billion (the deadweight loss). With Government With No Program Purchase Program Impact of
Program C onsumer surplus A + B + F F ($25 billion) –A – B ($36 billion) ( –$11 billion)
Producer surplus C + E A + B + C + E + G A + B + G ($18 billion) ($32 billion) ($14 billion)
Impact on government budget zero –B – C – G – H – –B – C – G – H – I – J (– $30 billion) I – J
(–$30 billion) Net benefits A + B + C + E + F A + E + F – H – I – J –B – C – H – I – J (c onsumer
surplus + producer ($54 billion) ($27 billion) ( –$27 billion) surplus – g ov ernment expenditures)
Deadweight loss zero B + C + H + I + J ($27 billion) Figure 22: Price Supports 64 / 70 Production
Quotas If the government wants to support the price at a level above the equilibrium price in a free
market, it may use a quota to restrict the quantity that producers can supply. 10.3 PRODUCTION
QUOTAS 419 Price (dollars per unit) Quantity (millions of units per year) 4 10 6 $2 $6 $8 $12
$20 F A E J K H K G C B L S D Quota Producer surplus Consumer surplus Deadweight loss
FIGURE 10.12 Impact of a 4 Million Unit Production Quota With no quota, the sum of consumer
and producer surplus is $54 million, the maximum net benefit possible in the market. The quota
decreases consumer surplus by $20 million, increases producer surplus by $14 million, and
reduces the net benefit by $6 million (the deadweight loss). With No Quota With Quota Impact of
Quota C onsumer surplus A + B + F F –A – B ($36 million) ($16 million) ( –$20 million)
Producer surplus C + E A + E A – C ($18 million) ($32 million) ($14 million) Net benefits A + B
+ C + E + F A + E + F –B – C (c onsumer surplus + producer surplus) ($54 million) ($48 million)
( –$6 million) Deadweight loss zero B + C ($6 million) B + C ($6 million) of the producer surplus
depends on which suppliers are in the market. Because producers would like to supply 10 million
units when the price is $12, there is no guarantee that the most efficient producers will supply the
4 million units allowed by the quota. The 4 million units might be supplied by inefficient
suppliers, such as those located between points G and K on the supply curve. Then producer
surplus will be much lower (area L $8 million). Note that in this case, the quota leads to a decrease
in producer surplus, and the deadweight loss is $30 million (can you verify this?). Figure 23:
Production Quota 65 / 70 66 / 70 Trade and Quotas Consumers in a country will want to import a
good when the world price of the good (Pw) is below the equilibrium price in the domestic market
with no imports A quota is a restriction on the total amount of a good that can be imported into a
country – that is, a quota is a restriction on free trade, which would allow unlimited imports of the
good. 67 / 70 10.5 IMPORT QUOTAS AND TARIFFS 427 Price (dollars per unit) Quantity
(millions of units per year) Domestic supply Domestic demand Q3 Q = 6 2 Q = 4 1 = 2 Q5 = 8 10
Q4 = 7 $2 $8 $6 Pw = $4 $20 E F H J L B A G K C FIGURE 10.15 Impact of a Trade Prohibition
versus Free Trade versus a Quota of 3 Million Units per Year With a trade prohibition, the market
would be in equilibrium at a price of $8 per unit and a quantity of Q3 6 million units per year.
With free trade, the good would sell at the world price Pw $4 per unit, with 2 million units
supplied domestically and 6 million units imported, for a total quantity of Q5 8 million units per
year. With a quota of 3 million units per year, the government could support a price of $6 per unit,
with 4 million units supplied domestically and 3 million units imported, for a total quantity of Q4
7 million units per year. Compared with free trade, a trade prohibition decreases domestic
consumer surplus, increases domestic producer surplus, decreases net benefit, and increases
deadweight loss; the quota does the same, but less dramatically, while also generating a producer
surplus for foreign suppliers. With Quota Impact of Quota Free Trade (with no quota) Trade
Prohibition Quota = 3 Million Impact of Trade Impact of Quota = 3 (quota = 0) Units Per Year
Prohibition Million Units Per Year Consumer A + B + C + A A + B + C + E –B – C – E – F – –F –
G – H – J – K surplus E + F + G + H + G – H – J – K (domestic) J + K Producer L B + F + L F +
L B + F F surplus (domestic) Net benefits A + B + C + E + A + B + F + L A + B + C + E + –C – E
– G – –G – H – J – K (domestic) F + G + H + J + F + L H – J – K (consumer K + L surplus +
domestic producer surplus) Deadweight zero C + E + G + H + G + H + J + K C + E + G + H + G
+ H + J + K loss J + K J + K Producer surplus zero zero H + J zero H + J (foreign) Figure 24:
Trade and Quotas 68 / 70 Tariffs A tariff is a tax on an imported good. Like a quota, a tariff
restricts imports, and the government can use a tariff to support the domestic price of the good.
430 CHAPTER 10 COMPETITIVE MARKETS: APPLICATIONS Price (dollars per unit)
Quantity (millions of units per year) Domestic supply Domestic demand Q3 Q = 6 2 Q = 4 1 = 2
Q5 = 8 10 Q4 = 7 $2 $8 Pw = $4 Pw + $2 tariff = $6 $20 E F H J L B A G K C FIGURE 10.16
Impact of a Tariff of $2 per Unit versus Free Trade With free trade, the good would sell at the
world price Pw $4 per unit, with 2 million units supplied domestically and 6 million units
imported, for a total quantity of Q5 8 million units per year. By imposing a tariff of $2 per unit, the
government could support a price of $6 per unit, with 4 million units supplied domestically and 3
million units imported, for a total quantity of Q4 7 million units per year. Compared with free
trade, a tariff has much the same impact as a quota (see Figure 10.15), but rather than generating a
producer surplus for foreign suppliers, it generates revenues for the government, which the
government can use to benefit the domestic economy. Free Trade (with no tariff) With Tariff
Impact of Tariff Consumer surplus (domestic) A + B + C+E+F+ A + B + C+E –F – G – H – J – K
G + H + J+K Producer surplus (domestic) L F + L F Impact on government budget zero H + J H +
J Net benefits (domestic) A + B + C + E +F+ A + B + C + E + –G – H – J – K (consumer surplus
+ domestic G + H + J + K + L F + L producer surplus + impact on government budget)
Deadweight loss zero G + K G + K Producer surplus (foreign) zero zero zero Figure 25: Trade and
Tariffs 69 / 70 Exercise (Ch.9 Q7) The United States currently imports all of its coffee. The annual
demand for coffee by U.S. consumers is given by the demand curve Q = 250–10P, where Q is
quantity (in millions of pounds) and P is the market price per pound of coffee. World producers
can harvest and ship coffee to U.S. distributors at a constant marginal (= average) cost of $8 per
pound. U.S. distributors can in turn distribute coffee for a constant $2 per pound. The U.S. coffee
market is competitive. Congress is considering a tariff on coffee imports of $2 per pound. 1 If
there is no tariff, how much do consumers pay for a pound of coffee? What is the quantity
demanded? 2 If the tariff is imposed, how much will consumers pay for a pound of coffee? What
is the quantity demanded? 3 Calculate the lost consumer surplus. 4 Calculate the tax revenue
collected by the government. 5 Does the tariff result in a net gain or a net loss to society as a
whole?