Managerial Economics

Topic: The Analysis of Competitive Markets

Class: PGPM-TERM 1
2024-26

1
 Evaluating the Gains and Losses from Government Policies—
9.1
Consumer and Producer Surplus

➢ Consumer and producer surplus can be used to study the welfare

effects of a government policy

➢ We also use consumer and producer surplus to demonstrate the

efficiency of a competitive market.

➢ You will see how to calculate the response of markets to changing

economic conditions or government policies and to evaluate the
resulting gains and losses to consumers and producers.
 CONSUMER AND PRODUCER SURPLUS

➢ The consumer surplus refers to the the

difference between what a consumer is
willing to pay for a good and what the
consumer actually pays when buying it.

➢ The producer surplus is the difference

between the market price and the lowest
price a producer is willing to accept to
produce a good.

Aggregate Surplus = Consumer surplus + producer surplus

Together, consumer and producer surplus measure the welfare benefit of a competitive market.
Imagine a popular musician is coming to town, and concert tickets are priced at $100
each. However, fans value the experience differently:
•Fan A is willing to pay $200 for the ticket.
•Fan B is willing to pay $150.
•Fan C is willing to pay $120.
•Fan D is willing to pay $100.
•Fan E is willing to pay $80.

In this case, Fans A, B, C and D will all buy tickets because the price is less than or equal
to what they are willing to pay.
•Fan A experiences a consumer surplus of $100 ($200 - $100).
•Fan B experiences a consumer surplus of $50 ($150 - $100).
•Fan C experiences a consumer surplus of $20 ($120 - $100).
•Fans D experiences no consumer surplus
Fan E won’t buy a ticket because the price exceeds his or her willingness to pay.
1. If the market is in equilibrium, total consumer 2. If the market is in equilibrium, total producer surplus is:
surplus is: A) $30.
A) $30. B) $70.
B) $70. C) $400.
C) $400. D) $800.
D) $800. E) $1200.
E) $1200.
Answer: C
Answer: D
In an unregulated competitive market, supply and demand have been
estimated as follows:
Demand P = 25 - 0.10Q Supply P = 4 + 0.116Q,
where P represents unit price in dollars, and Q represents number of
units sold per year.

a. Calculate annual aggregate consumer surplus.

b. Calculate annual aggregate producer surplus.
b.
The producer surplus is the area of the triangle formed by the area bounded by the
equilibrium price line and the supply curve.
Height of triangle is = 15.28 - 4 (S at Q = 0). = 11.28
Area of triangle = 1/2 b ∙ h = (0.5)(97.22)(11.28) = $548.21 per year.
 Application of Consumer and Producer Surplus
● welfare effects Gains and losses to consumers and producers.

● deadweight loss Net loss of total (consumer plus producer) surplus.

FIGURE 9.2
CHANGE IN CONSUMER
AND PRODUCER SURPLUS
FROM PRICE CONTROLS
The price of a good has been regulated to be no
higher than Pmax, which is below the market-clearing
price P0.
The gain to consumers is the difference between
rectangle A and triangle B.
The loss to producers is the sum of rectangle A and
triangle C.
Triangles B and C together measure the deadweight
loss from price controls.

Deadweight loss refers to the benefits lost to either consumers or producers when markets do not operate efficiently.
Application of Consumer and Producer Surplus

FIGURE 9.3
EFFECT OF PRICE CONTROLS
WHEN DEMAND IS INELASTIC
If demand is sufficiently
inelastic, triangle B can be
larger than rectangle A. In
this case, consumers suffer
a net loss from price
controls.
Source: https://www.youtube.com/watch?v=sq1zIj8s8R0
An effective price ceiling causes a loss of:
A) producer surplus for certain and possibly consumer surplus as well.
B) consumer surplus only.
C) producer surplus only.
D) consumer surplus for certain and possibly producer surplus as well.
E) neither producer nor consumer surplus.

Answer: A
If the government establishes a price ceiling of $1.00, consumer surplus will
A) fall by $50.
B) fall by $150.
C) remain the same.
D) rise by $50.
E) rise by $150.

Answer: E
If the government establishes a price ceiling of $1.00, producer surplus will
A) fall by $150.
B) fall by $300.
C) remain the same.
D) rise by $150.
E) rise by $300.
Answer: B
Ex: The elected officials in a west coast university town are concerned about the "exploitative" rents being
charged to college students. The town council is contemplating the imposition of a $350 per month rent
ceiling on apartments in the city. An economist at the university estimates the demand and supply
curves as:
QD = 5600 - 8P
QS = 500 + 4P
where P = monthly rent, and Q = number of apartments available for rent. For purposes of this analysis,
apartments can be treated as identical.

a. Calculate the equilibrium price and quantity that would prevail without the price ceiling. Calculate
producer and consumer surplus at this equilibrium (sketch a diagram showing both).
b. What quantity will eventually be available if the rent ceiling is imposed? Calculate any gains or losses
in consumer and/or producer surplus.
c. Does the proposed rent ceiling result in net welfare gains? Would you advise the town council to
implement the policy?
 Answer:
a.
To calculate equilibrium set QD = QS and solve for P.
5600 - 8P = 500 + 4P
5100 = 12P
P = 425
Substitute P into QD to solve for Q.
QD = 5600 - 8(425)
Q = 2200
We calculate these areas by finding the intercepts:
The demand curve intercepts the price axis when QD=0:
0=5600−8
P=700
The supply curve intercepts the price axis when QS=0:
0=500+4P
P=−125Given that a price of -125 is not realistic, the supply curve starts at 0 when QS=500.
In a competitive market, the following supply and demand equations are given:
Supply P = 5 + 0.036Q
Demand P = 100 - 0.04Q,
where P represents price per unit in dollars, and Q represents rate of sales in
units per year.

a. Determine the equilibrium price and sales rate.

b. Determine consumer surplus, producer surplus and deadweight loss that
would result if the government were to impose a price ceiling of 40 dollars per
unit.
Answer: a. Equate supply and demand to get equilibrium values.
5 + 0.036Q = 100 - 0.04Q
0.076Q = 95
Q = 1,250 units per year

The equilibrium price is

P = 5 + 0.036(1250) = $50.00 per unit.

b. With a price ceiling of $40, the deadweight loss is the triangle between supply and demand bounded by Q of
1250 and the new sales rate at P of 40.
Rearrange supply in terms of P.
P = 5 + 0.036Q or Q = -138.89 + 27.78P
At P = 40, Q = -138.89 + 27.78(40)
Q' = 972.31 units per year.
The base of the triangle (rotated 90 degrees) is the vertical distance between the heights of supply and demand
when Q = 972.31

Height of demand = P = 100 - 0.04(972.31) = 61.11

Height of supply = P = 5 + 0.036(972.31) = 40.00
Triangle base is the difference =21.11

Height of triangle = Q - Q' = 1250 - 972.31 = 277.69

Deadweight loss = 1/2 b ∙ h = (1/2)(21.11)(277.69) = $2,931.
 PRICE FLOORING

FIGURE 9.5
WELFARE LOSS WHEN PRICE IS
HELD ABOVE MARKET-CLEARING
LEVEL
When price is regulated to be no lower
than P2, only Q3 will be demanded.
If Q3 is produced, the deadweight loss
is given by triangles B and C.
At price P2, producers would like to
produce more than Q3. If they do, the
deadweight loss will be even larger.
 9.3 Minimum Prices

FIGURE 9.7
PRICE MINIMUM
Price is regulated to be no lower than
Pmin.
Producers would like to supply Q2,
but consumers will buy only Q3.
If producers indeed produce Q2, the
amount Q2 − Q3 will go unsold and
the change in producer surplus will
be A − C − D. In this case, producers
as a group may be worse off.

Supply curve is the aggregate marginal cost

curve for the industry

The total change in consumer surplus is: CS = −A − B

The total change in producer surplus is: PS = A − C − D
FIGURE 9.8
THE MINIMUM WAGE
Although the market-clearing wage
is w0,
firms are not allowed to pay less
than wmin.
This results in unemployment of an
amount L2 − L1
and a deadweight loss given by
triangles B and C.
The market supply function is P = 10 + Q and the market demand function is P =
70 - 2Q. What is the change in consumer surplus associated with a minimum
floor price of $40?
A) -$25
B) -$150
C) -$175
D) -$200
Answer: C
Price Supports and Production Quotas
Price Supports
● price support Price set by government above free-market level and
maintained by governmental purchases of excess supply.

FIGURE 9.10
PRICE SUPPORTS
To maintain a price Ps above the
market-clearing price P0, the
government buys a quantity Qg.
The gain to producers is A + B + D.
The loss to consumers is A + B.
The cost to the government is the
speckled rectangle, the area of which
is Ps(Q2 − Q1).
CONSUMERS
Some consumers pay a higher price, while others no longer buy the good.
∆CS = −𝐴 − 𝐵
PRODUCERS
Producers are now selling a larger quantity Q2 instead of Q0, and at a higher price Ps.

∆PS = +𝐴 + 𝐵 + 𝐷
THE GOVERNMENT
The cost to the government (which is ultimately a cost to consumers) is
(𝑄2 −𝑄1 )𝑃𝑆
The total change in welfare is
∆CS + ∆PS − Cost to Govt. = 𝐷 − (𝑄2 − 𝑄1 )𝑃𝑆
 Thus the total change in welfare is

▪ This welfare loss can be very large. But the most unfortunate part of this policy is the fact
that there is a much more efficient way to help farmers.
▪ If the objective is to give farmers an additional income equal to A + B + D, it is far less
costly to society to give them this money directly rather than via price supports. Because
price supports are costing consumers A + B anyway, by paying farmers directly, society
saves the large speckled rectangle, less triangle D.
▪ So why doesn’t the government simply give farmers money? Perhaps because price
supports are a less obvious giveaway and, therefore, politically more attractive.
 Production Quotas

FIGURE 9.11
SUPPLY RESTRICTIONS
The cost to the government is therefore at
least B + C + D.

Q1
 INCENTIVE PROGRAMS
In U.S. agricultural policy, output is reduced by incentives rather than by outright quotas. Acreage
limitation programs give farmers financial incentives to leave some of their acreage idle. Figure 9.11
also shows the welfare effects of reducing supply in this way.

As with direct production quotas, the change in consumer surplus is

∆CS = −𝑨 − 𝑩

Farmers receive a higher price, produce less, and receive an incentive to reduce production. Thus, the
change in producer surplus is now
∆PS = 𝑨 − 𝑪 + Payments for not producing

The cost to the government is at least B + C + D, and the total change in producer surplus is
∆PS = 𝑨 − 𝑪 + 𝑩 + 𝑪 + 𝑫 = 𝑨 + 𝑩 + 𝑫
The total change in welfare

∆Welfare = − 𝑨 − 𝑩 + 𝑨 + 𝑩 + 𝑫 − 𝑩 − 𝑪 − 𝑫 = −𝑩 − 𝑪
Which policy costs the government more?
The answer depends on whether the sum of triangles B + C + D in Figure 9.11 is larger or
smaller than (Q2 − Q1)Ps (the large speckled rectangle) in Figure 9.10. Usually it will be
smaller, so that an acreage-limitation program costs the government (and society) less
than price supports maintained by government purchases.
Still, even an acreage-limitation program is more costly to society than simply handing
the farmers money. The total change in welfare (∆CS + ∆PS - Cost to Govt.) under the
acreage-limitation program is

Society would clearly be better off in efficiency terms if the government simply gave the
farmers A + B + D, leaving price and output alone. Farmers would then gain A + B + D and
the government would lose A + B + D, for a total welfare change of zero, instead of a loss
of B + C. However, economic efficiency is not always the objective of government policy.
 Case Study: Farm Laws of 2020
The Farm Reform Bills in India, also known as the Farm Laws of 2020, were a series of three laws passed by
the Indian Parliament aimed at transforming the agricultural sector. These laws sparked widespread
protests, particularly among farmers, and became a major point of political contention. Here's an overview
of the three laws and the surrounding context:
1. The Farmers' Produce Trade and Commerce (Promotion and Facilitation) Act, 2020
•Objective: This law aimed to create an ecosystem where farmers could sell their produce outside the
existing Agricultural Produce Market Committee (APMC) markets (mandis) directly to private players,
retailers, and agribusinesses. It allowed for trade in agricultural produce across state borders and within the
country without restrictions.
•Key Points:
• Farmers could sell their produce at prices negotiated directly with buyers.
• It sought to reduce the role of middlemen and give farmers more freedom to sell their goods.
• The law was intended to provide better price discovery and more competitive pricing.
•Controversy: Critics argued that this would weaken the APMC system and eventually lead to the
dismantling of the Minimum Support Price (MSP) regime, leaving farmers vulnerable to exploitation by
large corporations.
2. The Farmers (Empowerment and Protection) Agreement on Price Assurance and Farm Services Act, 2020
•Objective: This law was designed to create a framework for contract farming, where farmers could enter
into agreements with buyers (including companies) before the sowing season, thereby assuring them of a
predetermined price for their produce.
•Key Points:
• It allowed for the creation of written contracts between farmers and buyers.
• The law aimed to protect farmers by providing dispute resolution mechanisms.
• Farmers could benefit from better technology, inputs, and investment from private players.
•Controversy: Farmers feared that unequal bargaining power would leave them at the mercy of corporations.
They were concerned that the law lacked sufficient safeguards and could lead to unfair contracts.

3. The Essential Commodities (Amendment) Act, 2020

•Objective: This law amended the Essential Commodities Act of 1955 to deregulate the production, storage,
movement, and distribution of several food commodities such as cereals, pulses, potatoes, onions, and
edible oils, except in extraordinary circumstances like war, famine, or extraordinary price rises.
•Key Points:
• The amendment sought to encourage private investment in agricultural infrastructure and storage.
• It aimed to reduce wastage of produce by allowing large-scale storage and reduce supply chain
inefficiencies.
•Controversy: Critics argued that this could lead to hoarding and price manipulation by large agribusinesses,
which could harm both consumers and farmers.
Protests and Repeal
The introduction of these laws led to massive protests, particularly in Punjab, Haryana, and Western Uttar
Pradesh, where farming is a primary occupation. Farmers feared the erosion of the MSP system, exploitation
by large corporations, and the weakening of the APMC mandis.
The protests gained significant momentum, with farmers camping on the borders of Delhi for over a year,
demanding the repeal of the laws. Despite multiple rounds of negotiations between the government and
farmers' unions, the deadlock persisted.

Government's Response
On November 19, 2021, Prime Minister Narendra Modi announced the decision to repeal the three farm
laws. The formal repeal occurred on November 29, 2021, when the Parliament passed the Farm Laws Repeal
Bill, 2021.

Significance
The Farm Laws of 2020 and the subsequent protests were one of the largest and most sustained movements
in India in recent years. The debate highlighted the challenges of reforming India's agricultural sector and
the deep-rooted concerns of farmers regarding their livelihoods and the future of farming in India.
Farm Reform Bills
 Import Quotas and Tariffs
● import quota Limit on the quantity of a good that can be imported.

● tariff Tax on an imported good.

FIGURE 9.14
IMPORT TARIFF OR QUOTA
THAT ELIMINATES IMPORTS
In a free market, the domestic price equals the world
price Pw.
A total Qd is consumed, of which Qs is supplied
domestically and the rest imported.
When imports are eliminated, the price is increased to
P 0.
The gain to producers is trapezoid A.
The loss to consumers is A + B + C, so the deadweight
loss is B + C.

Suppose the government wants to limit imports of a certain good. Is it preferable to use an import quota
or a tariff? Why?
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.
a. If there is no tariff, how much do consumers pay for a pound of coffee? What is the quantity
demanded?
If there is no tariff then consumers will pay $10 per pound of coffee, which is found by adding the $8
that it costs to import the coffee plus the $2 that it costs to distribute the coffee in the United States. In a
competitive market, price is equal to marginal cost. At a price of $10, the quantity demanded is 150
million pounds.

b. If the tariff is imposed, how much will consumers pay for a pound of coffee? What is the quantity
demanded?
Now add $2 per pound tariff to marginal cost, so price will be $12 per pound, and quantity demanded is
Q = 250 − 10(12) = 130 million pounds.
c. Calculate the lost consumer surplus.
Lost consumer surplus is (12 − 10)(130) + 0.5(12 − 10)(150 − 130) = $280
million.

d. Calculate the tax revenue collected by the government.

The tax revenue is equal to the tariff of $2 per pound times the 130 million
pounds imported.
Tax revenue is therefore $260 million.

e. Does the tariff result in a net gain or a net loss to society as a whole?
There is a net loss to society because the gain ($260 million) is less than the
loss ($280 million).
 The Impact of a Tax or Subsidy
THE EFFECTS OF A SPECIFIC TAX
● specific tax Tax of a certain amount of money per unit sold.
FIGURE 9.17
INCIDENCE OF A TAX
Pb is the price (including the tax) paid by
buyers. Ps is the price that sellers
receive, less the tax.
Here the burden of the tax is split evenly
between buyers and sellers.
Buyers lose A + B.
Sellers lose D + C.
The government earns A + D in
revenue.
The deadweight loss is B + C.
 FIGURE 9.18
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.
By using the following “pass-through” formula, we can calculate the percentage of the tax
that is “passed through” to consumers: Pass-through fraction = Es/(Es − Ed)
 The Effects of a Subsidy

● subsidy Payment reducing the buyer’s price below the seller’s price; i.e.,
a negative tax.

A subsidy can be thought of as a

negative tax. Like a tax, the benefit of
a subsidy is split between buyers and
sellers, depending on the relative
elasticities of supply and demand.

Conditions needed for the market to clear with a subsidy:

Ps − Pb = s
EXAMPLE 9.7 A TAX ON GASOLINE

FIGURE 9.20
IMPACT OF $1
GASOLINE TAX
The price of gasoline at the
pump increases from $2.00
per gallon to $2.44, and the
quantity sold falls from 100
to 89 bg/yr.
Annual revenue from the
tax is (1.00)(89) = $89
billion (areas A + D).
The two triangles show the
deadweight loss of $5.5
billion per year.
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.
a. If the new tax is imposed, who will bear the greater burden—liquor suppliers or liquor
consumers? Why?

Therefore, just over 95% of the tax is passed through to consumers because supply is highly elastic
while demand is very inelastic. So liquor consumers will bear almost all the burden of
the tax.
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. Then:
a. What is the equilibrium price and quantity?

Equate supply and demand and solve for Q: 10 − Q = Q – 4. Therefore Q = 7

thousand widgets.
Substitute Q into either the demand or the supply equation to obtain P.
P = 10 − 7 = $3.00,
or
P = 7 − 4 = $3.00.
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?

With the imposition of a $1.00 tax per unit, the price buyers pay is $1 more than the price suppliers receive. Also, at
the new equilibrium, the quantity bought must equal the quantity supplied. We can write these two conditions as
Pb − Ps = 1
Qb = Qs.
Let Q with no subscript stand for the common value of Qb and Qs. Then substitute the demand and supply equations
for the two values of P:
(10 − Q) − (Q − 4) = 1
Therefore, Q = 6.5 thousand widgets. Plug this value into the demand equation, which is the equation for Pb, to find
Pb = 10 − 6.5 = $3.50. Also substitute Q = 6.5 into the supply equation
to get Ps = 6.5 − 4 = $2.50.
The tax raises the price in the market from $3.00 (as found in part a) to $3.50. Sellers, however, receive only $2.50
after the tax is imposed. Therefore the tax is shared equally between buyers and sellers, each paying $0.50.
 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?
Now the two conditions that must be satisfied are
Ps − Pb = 1
Qb = Qs .
As in part b, let Q stand for the common value of quantity. Substitute the supply and
demand curves into the first condition, which yields
(Q − 4) − (10 − Q) = 1.
Therefore, Q = 7.5 thousand widgets. Using this quantity in the supply and demand
equations, suppliers will receive Ps = 7.5 − 4 = $3.50, and buyers will pay Pb = 10 −
7.5 = $2.50. The total cost to the government is the subsidy per unit multiplied by the
number of units. Thus the cost is ($1)(7.5) = $7.5 thousand, or $7500.
In 1983, the Reagan Administration introduced a new agricultural program
called the Payment-in-Kind Program. To see how the program worked, let’s
consider the wheat market.

a. Suppose the demand function is QD = 28 − 2P and the supply function is QS

= 4 + 4P, where P is the price of wheat in dollars per bushel, and Q is the
quantity in billions of bushels. Find the free-market equilibrium price and
quantity.
b. Now suppose the government wants to lower the supply of wheat by 25% from the free-
market equilibrium by paying farmers to withdraw land from production. However, the
payment is made in wheat rather than in dollars—hence the name of the program. The wheat
comes from vast government reserves accumulated from previous price support programs.
The amount of wheat paid is equal to the amount that could have been harvested on the land
withdrawn from production. Farmers are free to sell this wheat on the market. How much is
now produced by farmers? How much is indirectly supplied to the market by the
government? What is the new market price? How much do farmers gain? Do consumers gain
or lose?

c. Had the government not given the wheat back to the farmers, it would have stored or
destroyed it. Do taxpayers gain from the program? What potential problems does the
program create?
a. Equating demand and supply, QD = QS,
28 − 2P = 4 + 4P, or P = $4.00 per bushel.
To determine the equilibrium quantity, substitute P = 4 into either the supply equation or
the demand equation:
QS = 4 + 4(4) = 20 billion bushels
and
QD = 28 − 2(4) = 20 billion bushels.
b. Because the free-market supply by farmers is 20 billion bushels, the 25% reduction required by the new
Payment-In-Kind (PIK) Program means that the farmers now produce 15 billion bushels.
To encourage farmers to withdraw their land from cultivation, the government must give them
5 billion bushels of wheat, which they sell on the market, so 5 billion bushels are indirectly supplied by the
government.
Because the total quantity supplied to the market is still 20 billion bushels, the market price does not
change; it remains at $4 per bushel. Farmers gain because they incur no costs for the 5 billion bushels
received from the government. We can calculate these cost savings by taking the area under the supply
curve between 15 and 20 billion bushels. These are the variable costs of producing the last 5 billion bushels
that are no longer grown under the PIK Program. To find this area, first determine the prices when Q = 
and when Q = 20. These values are P = $2.75 and P = $4.00. The total cost of producing the last 5 billion
bushels is therefore the area of a trapezoid with a base of 20 −15 = 5 billion and an average height of (2.75
+ 4.00)/2 = 3.375. The area is 5(3.375) = $16.875 billion, which is the amount farmers gain under the
program.
The PIK program does not affect consumers in the wheat market because they purchase the same amount
at the same price as they did in the free-market case.
c. Taxpayers gain because the government does not incur costs to store or destroy
the wheat. Although everyone seems to gain from the PIK program, it can only last
while there are government wheat reserves. The program assumes that land
removed from production may be restored to production when stockpiles of wheat
are exhausted. If this cannot be done, consumers may eventually pay more for
wheat-based products. Another potential problem is verifying that the land taken out
of production is in fact capable of producing the amount of wheat paid to farmers
under the PIK program. Farmers may try to game the system by removing less
productive land.
Ex: The utilities commission in a city is currently examining pay telephone service in the city. The commission
has been asked to evaluate a proposal by a city council member to place a $0.10 price ceiling on local pay
phone service. The staff economist at the utilities commission estimates the demand and supply curves for
pay telephone service as follows:
QD = 1600 - 2400P
QS = 200 + 3200P,
where P = price of a pay telephone call, and Q = number of pay telephone calls per month.

a. Determine the equilibrium price and quantity that will prevail without the price ceiling.
b. Analyze the quantity that will be available with the price ceiling (in the long-run).
c. The city council realizes that the telephone company could curtail pay phone service in response to the
ceiling. To prevent this, the council plans to impose a requirement that the telephone company must maintain
the current number of pay phones. In light of this additional restriction, what will be the likely impact of the
price ceiling?
Answer:
a.
Set QD = QS.
1600 - 2400P = 200 + 3200P
1400 = 5600P
P = $0.25
Substitute into QD.
QD = 1600 - 2400(0.25)
QD = 1000

b.
QS = 200 + 3200(0.10)
QS = 520
QD = 1600 - 2400(0.10)
QD = 1360
There will be a shortage of 1360 - 520 or 840 calls.

c.
The telephone company would be expected to allow service to decline by not servicing broken phones,
placing the required phones in very easily reserviced areas, and otherwise reducing the cost of
complying with the requirement.
EXAMPLE 8.2 THE MARKET FOR HUMAN KIDNEYS

FIGURE 9.6
THE MARKET FOR KIDNEYS AND
THE EFFECT OF THE NATIONAL
ORGAN TRANSPLANTATION ACT
The market-clearing price is
$20,000; at this price, about
24,000 kidneys per year would be
supplied.
The law effectively makes the price
zero. About 16,000 kidneys per
year are still donated; this
constrained supply is shown as S’.
The loss to suppliers is given by
rectangle A and triangle C.
If consumers received kidneys at
no cost, their gain would be given
by rectangle A less triangle B.

Economics, the dismal science, shows us that human organs have economic value that
cannot be ignored, and prohibiting their sale imposes a cost on society that must be
weighed against the benefits.
EXAMPLE 8.2 AIRLINE REGULATION

Airline deregulation in 1981 led to major changes in the

industry. Some airlines merged or went out of business as
new ones entered. Although prices fell considerably (to
the benefit of consumers), profits overall did not fall much.

FIGURE 9.9
EFFECT OF AIRLINE
REGULATION BY THE CIVIL
AERONAUTICS BOARD
At price Pmin, airlines would like to
supply Q2, well above the quantity
Q1 that consumers will buy.
Here they supply Q3. Trapezoid D is
the cost of unsold output.
Airline profits may have been lower
as a result of regulation because
triangle C and trapezoid D can
together exceed rectangle A.
In addition, consumers lose A + B.
FIGURE 9.15
IMPORT TARIFF OR QUOTA
(GENERAL CASE)
When imports are reduced,
the domestic price is
increased from Pw to P*. This
can be achieved by a quota,
or by a tariff T = P* − Pw.
Trapezoid A is again the gain
to domestic producers.
The loss to consumers is A +
B + C + D.
If a tariff is used, the
government gains D, the
revenue from the tariff. The
net domestic loss is B + C.
If a quota is used instead,
rectangle D becomes part of
the profits of foreign
producers, and the net
domestic loss is B + C + D.