ch09 08 31 08

CHAPTER
9
The Analysis
of Competitive
Markets
Prepared by:
Fernando & Yvonn Quijano
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e.
CHAPTER 9 OUTLINE
9.1 Evaluating the Gains and Losses from

Government Policies—Consumer and
Producer Surplus
Chapter 9: The Analysis of Competitive Markets
9.2 The Efficiency of a Competitive Market

9.3 Minimum Prices
9.4 Price Supports and Production Quotas
9.5 Import Quotas and Tariffs
9.6 The Impact of a Tax or Subsidy
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e. 2 of 28
9.1 EVALUATING THE GAINS AND LOSSES
FROM GOVERNMENT POLICIES—
CONSUMER AND PRODUCER SURPLUS
Review of Consumer and Producer Surplus
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.
Review of Consumer and Producer Surplus
Figure 9.1
Consumer and Producer
Surplus (continued)
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.
Application of Consumer and Producer Surplus
● welfare effects Gains and losses to consumers and producers.
● deadweight loss Net loss of total

Figure 9.2
(consumer plus producer) surplus.
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.
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.
EVALUATING THE GAINS AND LOSSES FROM GOVERNMENT
9.1 POLICIES—CONSUMER AND PRODUCER SURPLUS
Supply: QS = 15.90 + 0.72PG + 0.05PO

Figure 9.4 Demand: QD = 0.02 − 0.18PG + 0.69PO
Effects of Natural Gas Price
Controls
The market-clearing price
of natural gas is $6.40
per mcf, and the
(hypothetical) maximum
allowable price is $3.00.
A shortage of 29.1 − 20.6
= 8.5 Tcf results.
The gain to consumers is
rectangle A minus
triangle B,
and the loss to producers
is rectangle A plus
triangle C.
The deadweight loss is
the sum of triangles B
plus C.
9.2 THE EFFICIENCY OF A COMPETITIVE MARKET
● economic efficiency Maximization of aggregate

consumer and producer surplus.
Market Failure
● market failure Situation in which an unregulated
competitive market is inefficient because prices fail to

provide proper signals to consumers and producers.
There are two important instances in which market failure can occur:
1. Externalities
2. Lack of Information
● externality Action taken by either a producer or a

consumer which affects other producers or consumers
but is not accounted for by the market price.
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.
Figure 9.6
The Market for Kidneys and the Supply: QS = 16,000 + 0.4P
Effect of the National Organ
Transplantation Act Demand: QD = 32,0000.4P
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.
Figure 9.6 Supply: QS = 16,000 + 0.4P

The Market for Kidneys and the Demand: QD = 32,0000.4P
Effect of the National Organ
Transplantation Act (continued)

In practice, kidneys are often
rationed on the basis of
willingness to pay, and many
recipients pay most or all of
the $40,000 price that clears
the market when supply is
constrained.
Rectangles A and D measure
the total value of kidneys
when supply is constrained.
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.
9.3 MINIMUM PRICES
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.
9.3 MINIMUM PRICES
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.
9.3 MINIMUM PRICES
TABLE 9.1 Airline Industry Data

1975 1980 1985 1990 1995 2000 2005
Number of Carriers 36 63 102 70 96 94 80

Passenger Load Factor (%) 54 58 61 62 67 72 78
Passenger Mile Rate
(Constant 1995 dollars)
.218 .210 .165 .150 .129 .118 .092
Real Cost Index (1995 = 100) 101 122 111 109 100 101 93
Real Fuel Cost Index (1995 =
100)
249 300 204 163 100 125 237
Real Cost Index Corrected for
Fuel Cost Changes
71 73 88 95 100 96 67
By 1981, the airline industry had been completely deregulated. Since that time, many
new airlines have begun service, others have gone out of business, and price
competition has become much more intense. Because airlines have no control over
oil prices, it is more informative to examine a “corrected” real cost index which
removes the effects of changing fuel costs.
9.4 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).
Total change in welfare: ΔCS + ΔPS − Cost to Govt. = D − (Q2 − Q1)Ps
Production Quotas
Figure 9.11
Supply Restrictions
To maintain a price Ps above the
market-clearing price P0, the
government can restrict supply to

Q1, either by imposing production
quotas (as with taxicab medallions)
or by giving producers a financial
incentive to reduce output (as with
acreage limitations in agriculture).
For an incentive to work, it must be
at least as large as B + C + D,
which would be the additional profit
earned by planting, given the higher
price Ps. The cost to the
government is therefore at least B +
C + D.
ΔCS = −A − B
ΔPS = A − C + Payments for not producing
ΔWelfare = −A − B + A + B + D − B − C − D = −B − C
1981 Supply: QS = 1800 + 240P

1981 Demand: QD = 3550  266P
Figure 9.12
The Wheat Market in 1981
To increase the price to

$3.70, the government
must buy a quantity of
wheat Qg.
By buying 122 million
bushels of wheat, the
government increased 1981 Total demand: QDT = 3550  266P + Qg
the market-clearing
Qg= 506P  1750
price from $3.46 per
bushel to $3.70. Qg= (506)(3.70)  1750 = 122 million bushels
Loss to consumers = A + B = $624 million
Cost to the government = $3.70 x 122 million = $451.4 million
Total cost of the program = $624 million + $451.4 million = $1075 million
Gain to producers = A + B + C = $638 million
Figure 9.13
1985 Supply: QS = 1800 + 240P
1985 Demand: QD = 2580  194P
The Wheat Market in 1985
In 1985, the demand for

wheat was much lower

than in 1981, because
the market-clearing price
was only $1.80.
To increase the price to
$3.20, the government
bought 466 million
bushels and also
imposed a production
quota of 2425 million
bushels.
2425 = 2580  194P + Qg

Qg= 155 + 194P
Qg= 155 + 194($3.20) = 466 million bushels
Cost to the government = ($3.20)(466) = $1491 million
9.5 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 P0.
The gain to producers is
trapezoid A.
The loss to consumers is A + B
+ C, so the deadweight loss is B
+ C.
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.
Figure 9.16
U.S. supply: QS =  7.48 + 0.84P
U.S. demand: QD = 26.7  0.23P
Sugar Quota in 2005
At the world price of 12

cents per pound, about

23.9 billion pounds of sugar
would have been
consumed in the United
States in 2005, of which all
but 2.6 billion pounds
would have been imported.
Restricting imports to 5.3
billion pounds caused the
U.S. price to go up by 15
cents.
Figure 9.16
U.S. supply: QS =  7.48 + 0.84P
U.S. demand: QD = 26.7  0.23P
Sugar Quota in 2005 (continued)
The gain to domestic

producers was trapezoid A,

about $1.3 billion.
Rectangle D, $795 million,
was a gain to those foreign
producers who obtained
quota allotments.
Triangles B and C
represent the deadweight
loss of about $1.2 billion.
The cost to consumers, A +
B + C + D, was about $3.3
billion.
9.6 THE IMPACT OF A TAX OR SUBSIDY
● 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.
Market clearing requires four conditions to be satisfied after the tax is in place:
QD = QD(Pb) (9.1a)
QS = QS(Ps) (9.1b)
QD = QS (9.1c)
Pb − Ps = t (9.1d)
Figure 9.18
Impact of a Tax Depends on Elasticities of Supply and Demand
(a) If demand is very inelastic relative (b) If demand is very elastic relative to
to supply, the burden of the tax falls supply, it falls mostly on sellers.
mostly on buyers.
The Effects of a Subsidy
● subsidy Payment reducing the buyer’s price below the
seller’s price; i.e., a negative tax.
Conditions needed for the market to clear with a subsidy:
QD = QD(Pb) (9.2a)
QS = QS(Ps) (9.2b)
QD = QS (9.2c)
Ps − Pb = s (9.2d)
Figure 9.19
Subsidy
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.
Effect of a $1-per-gallon tax:

QD = 150 – 25Pb (Demand)
QS = 60 + 20Ps (Supply)
QD = QS (Supply must equal demand)

Pb – Ps = 1.00 (Government must receive $1.00/gallon)
150 − 25Pb = 60 + 20Ps

Pb = Ps + 1.00
150 − 25(Ps + 1) = 60 + 20Ps
20Ps + 25Ps = 150 – 25 – 60
45Ps = 65, or Ps = 1.44
Q = 150 – (25)(2.44) = 150 – 61, or Q = 89 bg/yr
Annual revenue from the tax tQ = (1.00)(89) = $89 billion per year
Deadweight loss: (1/2) x ($1.00/gallon) x (11 billion gallons/year = $5.5 billion
per year
Gasoline demand: QD = 150  25P

Figure 9.20 Gasoline supply: QS = 60 + 20P
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.

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CHAPTER

9.1 Evaluating the Gains and Losses from

9.2 The Efficiency of a Competitive Market

● deadweight loss Net loss of total

Supply: QS = 15.90 + 0.72PG + 0.05PO

● economic efficiency Maximization of aggregate

competitive market is inefficient because prices fail to

● externality Action taken by either a producer or a

Above Market-Clearing Level

The market-clearing price is

Figure 9.6 Supply: QS = 16,000 + 0.4P

Transplantation Act (continued)

Price is regulated to be no lower

The Minimum Wage

Although the market-clearing

At price Pmin, airlines would like to

TABLE 9.1 Airline Industry Data

Number of Carriers 36 63 102 70 96 94 80

To maintain a price Ps above the

Total change in welfare: ΔCS + ΔPS − Cost to Govt. = D − (Q2 − Q1)Ps

government can restrict supply to

1981 Supply: QS = 1800 + 240P

The Wheat Market in 1981

To increase the price to

In 1985, the demand for

wheat was much lower

2425 = 2580  194P + Qg

Import Tariff or Quota That

Import Tariff or Quota (General Case)

When imports are reduced, the

At the world price of 12

cents per pound, about

The gain to domestic

producers was trapezoid A,

Pb is the price (including the

price that sellers receive, less

Effect of a $1-per-gallon tax:

QD = QS (Supply must equal demand)

150 − 25Pb = 60 + 20Ps

Gasoline demand: QD = 150  25P

The price of gasoline at

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