Chapter 9 Applying the Competitive Model
Consumer Surplus
Consumer surplus is the extra value individuals receive from consuming a good over what they pay for it.
Alternatively, it is what people would be willing to pay for the right to consume a good at its current price.
In Figure 9.1, the equilibrium price and quantity are P* and Q*.
The demand curve, D, shows what people are willing to pay for the good.
The total value of the good to buyers is given by the area below the demand curve from Q = 0 to Q = Q* (AEQ*0).
Consumers expenditures for Q* are given by the area P*EQ*0.
Consumers receive a "surplus" (total value less what they pay) equal to the area AEP*, which is shaded gray in Figure 9.1.
FIGURE 9.1: Competitive Equilibrium and Consumer/Producer Surplus
Producer Surplus
Producer surplus is the extra value producers get for a good in excess of the opportunity costs they incur for producing it.
It can also be defined as what all producers would pay for the right to sell a good at its current market price.
At the equilibrium shown in Figure 9.1, producers receive total revenue equal to the area P*EQ*0.
If producers sold one unit at a time at the lowest possible price, producers would have been willing to produce Q* for the payment of BEQ*0.
Thus, producer surplus the the area P*EB shaded in green in Figure 9.1.
Short-Run Producer Surplus
The positive slope of the short-run supply curve, S, in Figure 9.1 results from the diminishing returns to variable inputs that are encountered as output is increased.
For production up to Q*, price exceeds marginal cost, so total short-run profits equal the area P*EB less fixed costs
Producer surplus, the area P*EB, reflects the sum of total short-run profits and short-run fixed costs.
Short-run producer surplus is the part of total profits that is in excess of the profits firms would have if they chose to produce nothing at all.
As such, it is similar to consumer surplus.
Long-Run Producer Surplus
Since long-run economic profits are zero and there are no fixed costs in the long-run, producer surplus is much different in the long run.
The positive slope of the long-run supply curve reflects increasing input costs as output is expanded.
Consider the area P*EB in Figure 9.1 as long-run producer surplus.
It measures all of the increased payments relative to the situation in which the industry produces no output.
The inputs would have received lower prices if this industry had not produced output.
Ricardian Rent
Ricardian rent is the long-run profits earned by owners of low-cost firms.
It may be capitalized into the prices of these firms’ inputs.
Assume there are many parcels of land on which tomatoes might be grown.
These farms range from very fertile land (low cost) to poor, dry land (high cost).
At low prices, only the most fertile land is used.
As output increases, higher-cost plots of land are brought into production because higher prices make this land profitable.
The long-run supply curve is positively sloped because of the increasing costs associated with using less fertile land.
The market equilibrium price and quantity, P*, Q*, are shown in Figure 9.2 (d).
Low-cost farms, Figure 9.2 (a) and medium-cost farms, Figure 9.2 (b), earn long-run economic profits.
Marginal farms, Figure 9.2 (c) earn zero economic profits
FIGURE 9.2: Ricardian Rent
Profits earned by the intramarginal farms can persist in the long run because they reflect the returns to a scarce resource, low-cost land.
Entry can not erode these profits because of the scarcity of the low-cost land.
The sum of these long run profits (P*EB) is the producer surplus ( Ricardian rent).
Economic Efficiency
The competitive equilibrium is efficient in that it produces the largest surplus equal to the sum of producer and consumer surplus.
In Figure 9.1, an output level of Q1 results in a loss of surplus equal to the area FEG.
Consumers would be willing to pay P1 for a good that producers are willing to produce for P2, so mutually beneficial transactions exit.
FIGURE 9.1: Competitive Equilibrium and Consumer/Producer Surplus
APPLICATION 9.1: E-Commerce
Transaction costs associated with conducting business on the internet have been reduced due to
Technical innovations
significant network externalities.
Prior to this, transaction costs exceed the difference between consumers’ willingness to pay and producers costs.
Prior to the decline in internet costs, transaction costs exceeded P2 - P1 in Figure 1, so no transactions occurred.
Assuming transaction costs fell to zero, trading would start and a competitive equilibrium would occur at P*, Q*.
FIGURE 1: Reduced Transaction Costs Promote Internet Commerce
Some early evidence
Electronic retailing directly to consumers totaled about $10 billion in 1999.
Business to business sales represented another $30 to $40 billion.
Most sales are in travel-related goods, financial services, and some narrow categories of consumer goods such as books.
Retailers as Infomediaries
The role for retailing "middlemen" on the internet is to provide information to the consumer.
- Internet automobile sellers provide comparative information about the features of cars and point to dealers with the best price.
- Internet airline services search for the lowest price or most convenient departure.
A Numerical Example
The market equilibrium is P* = $6 and Q* = 4.
The equilibrium is shown as point E in Figure 9.3.
At point E consumers are spending $24 ($6·4).
At point E in Figure 9.3, consumer surplus is $8 (= ½·$4·4).
Producers also gain a producer surplus of $8 at point E.
Total consumer and producer surplus is $16.
If price stays at $6 but output falls to 3, total surplus falls to $15.
FIGURE 9.3: Efficiency in Tape Sales
For any output level, total surplus is the area between the demand and supply curves out to that level of output.
Once output is specified, the price affects the distribution of the surplus between producers and consumers, but does not affect the total amount of the surplus.
If output > 4 tapes per period with P = $6, total surplus is less than $16.
At Q = 5, consumer surplus falls to $7.50.
- $8 for four tapes less $.50 because the fifth tapes sells for more than people want to pay for the fifth tape.
- Producer surplus also equals $7.50 reflecting the loss of $.50 on the production of the fifth tape.
Total surplus is $15 for Q = 5 tapes per week.
Price Controls and Shortages
In Figure 9.4 the market initially is in equilibrium at P1, Q1 (point E).
Then demand increases from D to D’.
This would cause price to rise to P2 encouraging entry in the short-run.
Eventually entry would bring the price down to P3 and the market would be in long-run equilibrium.
FIGURE 9.4: Price Controls and Shortages
Suppose the government imposed a price control at the below equilibrium price of P1 when demand increased.
Firms would only supply Q1 and no entry would take place.
Since customers would demand Q4 at this price, there would be a shortage of Q4 - Q1.
The welfare consequences of price control can be analyzed using consumer and producer surplus.
Consumers would gain surplus of P3CEP1 (colored in gray) due to the lower price.
This is a direct transfer of surplus from producers to consumers with no gain in total surplus.
If output had expanded, consumers would gain the area AE’C.
Since output is reduced by the price control, this is a loss of surplus to consumers.
Similarly, producers don’t gain the area CE’E that would have resulted from increased output.
The area AE’E is the total welfare loss.
Application 9.2: Rent Control
History of Rent Control
Controls were adopted in man U.S. and European cities in response to rapidly rising rents during World War II which continued after the war in several European countries and New York City.
Inflation of the 1970s resulted in several U.S. cities introducing more "flexible" rent controls
More than 10 percent of U.S. rentals are controlled.
Rent Control and Housing Quality
Studies have confirmed the prediction that rent controls will benefit current tenants and harm landlords and new tenants.
However, the most important effect is that landlords effectively reduce the supply of housing by reducing the quality of their units.
Effects of the "New" Rent Control Laws
By allowing landlords to pass on increases in taxes or utility costs, post World War II laws were more flexible.
Many also allow rents to be increased to market levels when current tenants leave.
Some economists suggest that such laws help to deal with the landlords market power, but few economists support this position.
Tax Incidence
The study of the final burden of a tax after considering all market reactions to it is tax incidence theory.
The incidence of a "specific tax" of a fixed amount per unit of output that is imposed on all firms in a constant cost industry is illustrated in Figure 9.5
FIGURE 9.5: Effect of the Imposition of a Specific Tax on a Perfectly Competitive Constant Cost Industry
Since for any price, P, consumers pay the firm gets to keep P - t (where t is the per unit tax), the effect of the tax on firms can be shown as a decrease in demand.
The vertical distance between the demand curves is t.
It creates a wedge between the consumers’ price, P, and the price firms receive.
Short-Run Tax Incidence
The short-run effect is to decrease output from Q1 to Q2, where firms receive P2 and consumers pay P3 (P3 - P2 = t).
So long as P2 is above minimum variable costs, the firm continues to produce and the tax incidence is shared by consumers, whose price increased to P3, and by firm’s who now receive only P2 rather than P1.
Long-Run Tax Incidence
Firms will not operate at a loss in the long run, so exit will take place shifting the short-run supply curve back to S’.
In the new long-run equilibrium, output will return to Q3 where the firm’s will receive P1 again and consumers will pay P4.
The long-run tax incidence is all on the consumer although the firms pays the tax.
Long-Run Incidence with Increasing Costs
When the long-run supply curve has a positive slope, both consumers and firms pay a portion of the tax.
The imposition of the tax shifts the long-run demand curve inward to D’ (as shown in Figure 9.6) which causes the price to fall from P1 to P2 as some firms exit and input prices fall.
FIGURE 9.6: Tax Incidence in an Increasing Cost Industry
Long-Run Incidence with Increasing Costs
Consumers pay a portion of the tax since the gross price of P3 exceeds the pre-tax price.
Total tax collection is the gray area P3ARE2P2.
The inputs to the firm pay the remainder of the tax as they are not paid based on a lower net price of P2.
Incidence and Elasticity
The economic actor who has the most elastic curve will be able to avoid more of the tax leaving the actor with the more inelastic curve to pay most of the tax.
If demand is relatively inelastic and supply is elastic, demanders will pay most of the tax.
If supply is relatively inelastic and demand is elastic, suppliers will pay most of the tax.
APPLICATION 9.3: The Tobacco Settlement
In November 1998 most U.S. states reached agreements with the tobacco companies that amounted to about $200 billion.
The Tobacco Settlement as a Tax Increase.
This can be treated as an increase in cigarette taxes.
The settlement added about $0.30 per pack, a 15 percent increase on the initial $3.00 price.
The Tobacco Settlement as a Tax Increase
With an elasticity of demand of -0.35 (Table 4.4), the quantity of cigarettes sold would be expected to fall by about 5.25 percent (0.35´
0.15) from 24 billion packs per year to 22.75 billion packs.
Total "tax collections" would be about $6.8 billion per year.
If tobacco companies continue to earn about $0.25 per pack, the 1.25 billion reduction in sales will cost them about $300 million per year.
Thus, consumers pay most of the "tax" resulting from this settlement.
Since tobacco consumers tend to have relatively low incomes, the tax is regressive.
Other Effects of the Settlements
Empirical evidence suggests that young smokers may have a larger price elasticity.
The goal of a decline in smoking by young people may be obtained.
Also, studies suggest that individuals who do not smoke as teenagers are much less likely to smoke later.
In addition, advertising aimed at young people was sharply restricted.
Special interest also benefited.
Many states adopted programs to aid tobacco farmers who were affected by the decline in tobacco sales.
The smallest tobacco company (Liggett) provided evidence for the states, and the higher cigarette prices will increase its profits.
The lawyers who represented the states each received between $1 - $2 million per year.
Taxation and Efficiency
Taxes reduce output of the taxed commodities and a reallocation of production to other areas.
Reallocation means that some mutually beneficial transactions will be foregone so economic welfare will decline.
In Figure 9.6, the total loss of consumer surplus is the area P3AE1P1.
The area P3ABP1 is transferred into tax revenue and the area AE1B is simply lost.
The loss in producer surplus is P1E1E2P2 of which P1BE2P2 is tax revenue and BE1E2 lost.
The effect of the transfer into tax revenue on welfare is ambiguous since consumers and producers may benefit from government expenditures.
However, the deadweight loss is the losses of consumer and producer surplus that are not transferred to other parties.
This is also called the "excess burden" of a tax.
A Numerical Illustration
Using the supply-demand equilibrium in the market for cassette tapes, suppose the government implements a $2 per tape tax that retailers add to the sales price of each tape sold.
Demanders, on the other hand, must pay P + t for each tape so the demand function becomes:
or P* = 5, Q* =3.
Consumers pay $7 for each tape and total tax collections are $6 per week.
Total consumer and producer surplus is decreased by $6 of tax revenue and the excess burden is $1.
Transactions Costs
Transaction costs, such as a real estate broker fee, also cause a wedge between buyers’ and sellers’ prices.
To the extent that transaction costs are on a per-unit basis, the same analysis as with a tax applies, so both parties bear some of the cost and output will be reduced.
If the wedge is a lump-sum amount per transaction, such as the cost of driving to the supermarket to buy groceries, the individual will seek to reduce the number of transactions.
While prices will not change significantly, persons will hold larger inventories to reduce their transaction costs.
Gains from International Trade
Figure 9.7 shows the domestic demand and supply curves for a particular good, say shoes.
Without international trade, the equilibrium price and quantity would be PD, QD.
If the world shoe price is PW, the opening of trade will cause prices to fall causing quantity to increase to Q1.
The quantity supplied by domestic producers will fall to Q2 with shoe imports of Q1 - Q2.
Consumer surplus increases by the area PDE0E1PW.
Part, PDE0APW, comes as a transfer from domestic producers, and the rest is an unambiguous gain in welfare (E0E1A).
FIGURE 9.7: Opening of International Trade Increases Total Welfare
Tariff Protection
Producers will resist their losses, and since the loss is spread over fewer producers than the gain for consumers, they have a stronger incentive to organize for trade protection.
A major trade protection is a tariff which is a tax on an imported good.
Effects of a tariff are shown in Figure 9.8.
FIGURE 9.8: Effects of a Tariff
Tariff Protection
Compared to the free trade equilibrium E1, the imposition of a per-unit tariff in the amount of t raises the effective price to PW + t = PR.
Quantity demanded falls to Q3 while domestic production expands to Q4.
Tariff revenue is the area BE2FC, equal to t(Q3 - Q4).
Total consumer surplus is reduced by the area PRE2E1PW.
Part becomes tariff revenue and part is transferred into domestic producer’s surplus (area PRBAPW).
The two colored triangles BCA and E2E1F represent losses that are not transferred; these are the deadweight losses from the tariff.
Other Types of Trade Protection
Because of the General Agreement on Tariffs and Trade (GATT), there has been a decline in tariffs.
However, other restrictive measures including quotas, "voluntary" export restrains, and a series of nonquantitative restrictions have been used for protectionism.
A quota that limits imports to Q3 - Q4 (in Figure 9.8) would have a similar effect to a tariff.
Market price would rise to PR.
Consumer surplus would be transferred to domestic producers (area PRBAPW).
A deadweight loss equal to the areas of the colored triangles would also occur.
However, with a quota, no tax revenue is generated.
The area BE2FC can go to foreign producers or to windfall gains to owners of import licenses.
Nonquantitative restrictions such as health or other inspections also impose costs like a a tariff on imports, and can be analyzed in a similar manner using Figure 9.8.
APPLICATION 9.4: Voluntary Export Restraints on Automobiles
Probably the most significant "voluntary" restriction was the voluntary export restraint (VER) negotiated between the U.S. and Japan in 1981.
This limited imports of Japanese automobiles into the U.S. to 1.68 million per year throughout the 1980s.
Transfers from Consumers and Deadweight Losses
Mandatory restrictions of imports from distance AE1 to BE2 would have the same effect on import prices as did the tariff shown in Figure 9.8.
During the period from 1983 to 1986, the VERs raised average automobile prices by about $1,000 to $1,500.
This transferred about $15 billion per year from U.S. consumers to domestic producers.
This also generated deadweight losses of about $1 billion per year.
Quota Rents and Product Upgrading
The VERs allowed Japanese producers to receive higher prices.
The division of the resulting rents were determined by the Japanese government.
Japanese producers had an incentive to increase these rents by upgrading their automobiles.
By increasing engine sizes and adding luxury features, profits per car were increased.
Japanese luxury automobiles were added in the late 1980s.
U.S. automakers tried to match these quality increases, but U.S. consumers more willing to purchase the Japanese luxury cars.