Partly Based on the Notes Prepared by Fernando Quijano

ANALYSIS OF COMPETITIVE MARKETS

Managerial Economics, Lecture 6

Dr. YANG, Nan

Outline
4.4
8.6
9.2
9.3
9.4
9.5
9.6

Consumer Surplus
Producer Surplus
The Efficiency of Competitive Markets
Minimum Prices
Price Supports and Production Quotas
Import Quotas and Tariffs
The Impact of a Tax or Subsidy

Consumer Surplus and Demand

consumer surplus Difference between what a consumer is
willing to pay for a good and the amount actually paid.

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 yellowshaded area:
$6 + $5 + $4 + $3 + $2 + $1
= $21

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 x 6500 x ($20 $14) = $19,500.

Consumer Surplus is the Consumer Satisfaction

In marketing, a heavy focus is on consumer surplus, or consumer satisfaction
as it is often called.
Consumers purchase only when they are satisfied.
Package Deal
Your inverse demand for Tiger beer is given by P=13-2Q
If the price of the beer is $3 per bottle, how many bottles will you buy? 5

bottles.
The supermarket offers a package deal: you pay $16, but get a 6-bottle
package.
Which option do you choose? Buy 5 bottles or the 6-bottle package?

P
13
If the price is $3, you purchase 5
bottles. The consumer surplus is
given by the area of the blue triangle.
10

CS 5 10 2 25
3
5

6.5

P
13

For the 6th bottle, you are willing to pay 1 dollar.

Having 6 bottles, you receive a total benefit

TB (1 13) 6 2 42
On the other hand, you pay
16 dollars, so your consumer
surplus will be 42-16=26.
The package deal gives
you more surplus, more
satisfaction.

13

1
6

If the package is priced at

$17.5 (a lower per-bottle
price), you wont buy.
6.5

Producer Surplus
producer surplus Sum over all units produced by a firm of
differences between the market price of a good and the marginal cost of
production.

FIGURE 8.11
PRODUCER SURPLUS FOR
A FIRM
The producer surplus for a
firm is measured by the
yellow area below the market
price and above the marginal
cost curve, between outputs 0
and q*, the profit-maximizing
output.
Alternatively, it is equal to
rectangle ABCD because the
sum of all marginal costs up
to q* is equal to the variable
costs of producing q*.

PRODUCER SURPLUS VERSUS PROFIT

Producer surplus = PS = R VC
Profit = = R VC FC

FIGURE 8.12
PRODUCER SURPLUS FOR
A MARKET
The producer surplus for a
market is the area below the
market price and above the
market supply curve, between
0 and output Q*.

FIGURE 9.1
CONSUMER AND
PRODUCER SURPLUS

Together, consumer and producer

surplus measure the welfare benefit of
a competitive market (or any other
market).

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.

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.

9.2 The Efficiency of a Competitive Market

economic efficiency
producer surplus.

Maximization of aggregate consumer and

MARKET FAILURE

market failure
Situation in which an unregulated competitive market is
inefficient because prices fail to provide proper signals to consumers and
producers.

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.

Even at a price of zero (the effective price

under law), donors supply about 16,000
kidneys per year.

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.

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.

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.

No minimum wage in Singapore

Parliamentary debate in 2001, asiaone.com.sg
The MP for Bishan-Toa Payoh, Ms Josephine Teo, pointed out that to be
meaningful, a minimum wage must force some employers to pay more
than the market rate.
Companies that do not wish to engage in the illegal practice (of paying
below minimum wage) and find it too costly to operate in Singapore will
close shop or relocate, she said.

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.

EXAMPLE 8.2 AIRLINE REGULATION

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.

TABLE 9.1

AIRLINE INDUSTRY DATA

1975

1980

1990

2000

2010

36

63

70

94

63

Passenger Load Factor (%)

54.0

58.0

62.4

72.1

82.1

Passenger-Mile Rate (constant 1995 dollars)

0.218

0.210

0.149

0.118

0.094

Real Cost Index (1995 = 100)

101

145

119

89

148

Real Fuel Cost Index (1995 = 100)

249

300

163

125

342

Real Cost Index w/o Fuel Cost Increases (1995 = 100)

71

87

104

85

76

Number of U.S. carriers

Civil Aviation Administration of Chinas idiotic regulatory policy

From May 1, 1998, CAAC forbid any discounts of ticket price beyond the 20
percent limit for all routes.
Price floor to be set for air tickets, China.org.cn
Li Aiqing, a researcher with the CATA, , saying it is part of the CAAC's
measures to prevent "malicious competition". "Airlines use low prices to
attract the necessary numbers of passengers to stop their routes from being
canceled by the CAAC," Li said.
"At the moment, it's cheaper to fly home than it is to go by train. I can't
see why such a good thing has to be taken away," Beijinger Xu Lan said.

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).

Lets examine the resulting gains and losses to consumers, producers,

and the government in Figure 9.10.
CONSUMERS
Some consumers pay a higher price, while others no longer buy the good.
CS
PRODUCERS
Producers are now selling a larger quantity Q2 instead of Q0, and at a higher
price Ps.
PS
THE GOVERNMENT
The cost to the government (which is ultimately a cost to consumers) is

The total change in welfare is

CS

PS

Cost to Govt.

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
or by giving producers a financial
incentive to reduce output.
For an incentive to work, it must be at
least as large as B + C + D, which
would be the additional profit earned
by producing, given the higher price
Ps. 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
Farmers receive a higher price, produce less, and receive an incentive to
reduce production. Thus, the change in producer surplus is now
PS

Payments for not producing

The cost to the government is at least B + C + D, and the total change in

producer surplus is
PS
An acreage-limitation program is more costly to society than simply
handing the farmers money. The total change in welfare
Welfare

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.

9.6 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.
Market clearing requires four conditions to be satisfied after the tax is in place:
QD = QD(Pb)
QS = QS(Ps)
QD = QS
Pb Ps = t

(9.1a)
(9.1b)
(9.1c)
(9.1d)

EXAMPLE 9.7 A TAX ON GASOLINE

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 25Pb = 60 + 20Ps
20Ps + 25Ps = 150 25 60
45Ps = 65, or Ps = 1.44
QD = 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

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.

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.

The Effects of a Subsidy

subsidy Payment reducing the buyers price below the sellers
price; i.e., a negative tax.

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.

Conditions needed for the market

to clear with a subsidy:
QD = QD(Pb)
QS = QS(Ps)
QD = QS
Ps Pb = s

(9.2a)
(9.2b)
(9.3c)
(9.4d)