Introduction to Microeconomics Chapter 7 Economics of Perfect Competition Economic Surplus

Introduction to MicroeconomicsChapter 7

Economics of Perfect CompetitionEconomic Surplus

• Some markets (e.g., foreign exchange, many agricultural products) are closer to perfect competition than to other market types.

• When individuals with equal means complete make mutually beneficial transactions in a perfectly competitive market, their self-interested behaviour is harmonized with the common good.

• Perfect competition serves as a reference for the other more common situation

Perfect Competition

LO1: How markets can maximize total economic surplus

© 2012 McGraw-Hill Ryerson Limited

Ch7-2

Invisible Hand

Adam Smith (1723 – 1790)

As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other eases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.

FIGURE 7.1: The Demand Curve Facing a Perfectly Competitive Firm

Di

S

D

P0P0

Q0

Panel (a): The market demand and supply curves intersect to determine the market price of the product. Panel (b): The individual firm’s demand curve (Di) is a horizontal line at the market price.


Ch7-4LO1: How markets can maximize total economic

surplus

A Market in Which Price Is Below Equilibrium Level – Excess Demand

S

D


$0.50

In this market, milk is currently selling for $1/litre, $0.50 below the equilibrium price of $1.50/litre

• Consumer Surplus– The difference between what consumers would

have been willing to pay and what they actually did pay.

– Economic surplus gained by the buyers of a product.

– Measured by the cumulative difference (adding up over all consumers) between their reservation price for each unit of the good, and the price they pay .

Consumer Surplus


Ch7-6

LO3: Graphical representation of consumer surplus, producer surplus, and total economic

surplus

• Producer Surplus– The difference between what producers do get for

output and the minimum price they would have been willing to accept.

– Economic surplus gained by the sellers of a product.

– Measured by the cumulative difference (adding up over all producers) between the price they receive and their reservation price for each unit of the good.

Producer Surplus


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surplus

FIGURE 7.5: Consumer and Producer Surplus

S

D

Consumer surplus

Producer surplus


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surplus

: How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction

S

D

1.25


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$0.75

$0.25

At a market price of $1/litre, the most intensely dissatisfied buyer is willing to pay $2 for an additional litre, which a seller can produce at a cost of only $1. If this buyer pays the seller $1.25 for the extra litre, the buyer gains an economic surplus of $0.75 and the seller gains an economic surplus of $0.25.

FIGURE 7.4: How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction

S

D

1.75

At a market price of$2/litre, dissatisfied sellerscan produce an additionallitre of milk at a cost of only$1, which is $1 less thana buyer would be willingto pay for it. If the buyerpays the seller $1.75 for anextra litre, the buyer gainsan economic surplus of$0.25 and the seller gains aneconomic surplus of $0.75.


Ch7-10Market Equilibrium and Mutually

Beneficial Exchange

$0.25

$0.75

• Supplier’s reservation price– The lowest price they will accept in return for

providing a good or service.• Consumer reservation price

– The highest price a demander will offer in order to obtain a good or service.

Reservation Price


Ch7-11


surplus

Case study – welfare reform

• Before welfare reform, a social assistance recipient (SAR) who earned any income (even a paper route) would have their welfare payments reduced by the amount of the increased income?

• What would you do?• The 100% tax discouraged work• Now, SARs get to keep a portion of wage earned (until they

make too much to qualify)

If I were on welfare, what wage do I need to start working?

• SARs receive a basic benefit, rental housing allowance, transportation allowance, medical (pharmaceuticals)…

• What is their reservation wage – what wage do they need to go off welfare.

• This experiment used recipients of the National Child Benefit (98% women at the time)

• Some received social assistance; others worked (usually at minimum wage)

• Use discrete choice model– Randomly assign SAR to several groups– Ask each group – would you be prepared to take a job (40 hr/week) at

“$w/hour”

Test wages used(2002)

Jurisdiction Low(Min wage)

Medium(1.5*Min)

High(2*Min)

Newfoundland 5.50 8.25 11.00Prince Edward Island 6.00 9.00 12.00Nova Scotia 5.80 8.70 11.60

New Brunswick 5.90 8.85 11.80Ontario 7.00 10.50 14.00Manitoba 6.85 10.30 13.70Saskatchewan 6.25 9.40 12.50Alberta 6.00 9.00 12.00British Columbia 8.00 12.00 16.00Yukon 7.20 10.80 14.40Northwest Territories 6.50 9.75 13.00Nunavut 6.50 9.75 13.00

Table 4: Reservation wage (Computed as the test wage accepted or the reservation wage offered if both test wages rejected)

GroupSA Non-SA Total

(Sample size in brackets)

All clients $9.97 (711)

$10.67 (1,011)

$10.39 (1,728)

Single parents $10.04 (509)

$10.77 (302)

$10.33 (814)

Dual parents $9.79 (202)

$10.63 (709)

$10.44 (914)

The average reservation wage ($/hour) needed to entice these respondents to come off social assistance was $4 more than the minimum wage prevalent.

The rational person on social assistance would not give it up if he/she could not get a job that paid at least what was in the table.

This called the welfare trap

Example 7.2: How much do buyers and sellers benefit from their participation in the market for milk?

S

D

Market for milk: an equilibrium price of $2/litre and an equilibrium quantityof 4000 litres/day


Ch7-16LO4:Calculation of consumer surplus, producer surplus, and

total economic surplus

FIGURE 7.6: Total Economic Surplus in the Market for Milk

2000/Day

4000/Day

Consumer surplusS

DProducer surplus

The total economic surplus from this milk market is the sum of consumer andproducer surplus, or $6000/day


Ch7-17LO4:Calculation of consumer surplus, producer surplus, and


Social Surplus

Total economic (social) surplus – The sum of all the individual economic surpluses

gained by buyers and sellers participating in the market.

– In a market economy, the goal of economic policy should be to maximize the social surplus

– Other goals?

• Price Ceiling– Law or regulation that prevents sellers from

charging more than a specified price.– Price ceiling prevents some transactions – which

would have generated an economic surplus. • Applications?

– Scalping Jets Tickets– Rent Control

Changing Market Outcomes


Ch7-19LO5: How price controls affect


FIGURE 7.7: Economic Surplus in an Unregulated Market for Home Heating Oil

S

D

Consumer surplus

Producer surplus

For the supply and demand curves shown, the equilibrium price of oil is $14/bbl, and the equilibrium quantity is 3000 bbl/day. Consumer surplus is $9000/day.




FIGURE 7.8: The Economic Surplus Lost by Price Controls

Quantity (1000’s of bbl/day)

Pri

ce

($/b

bl)

Producer surplus

0 1 2 3 4 58

10

12

14

16

18

20

S

D

Consumer surplus

Lost economic surplus

Price ceiling

By limiting output in the oil market to 1000 bbl/day, price controls cause a loss in economic surplus of $8000/day.




Does it matter how we share the economic surplus


Ch7-22LO6: Why Distribution is

Important

• Occupy movement• Voluntary price controls in times of emergency

(war, natural disasters….)• Price controls to reduce income inequality

– Rent control– Minimum wage

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• Size of economic surplus depends on the price elasticity of supply and demand – surplus is larger when:– Demand is inelastic.– Supply is inelastic.

• For the same demand curve, when supply is more inelastic, price ceilings:– Have a smaller impact on the total level of output.– Cause a smaller reduction in total economic surplus.– Have a larger redistributive effect.

• Example: compare the impact of rent controls in 2 cities– where housing differs in elasticity of supply.

Price Elasticity and the Size of Total Economic Surplus


Ch7-24LO7: Price Elasticity and Total Economic

Surplus

• Winnipeg– where new apartments can be constructed either

by making buildings taller or by extending new construction further out on the plain.

• Vancouver – mountains or the sea confine growth, except up..

Rent Controls – Winnipeg, Vancouver


Ch7-25LO7: Price Elasticity and Total

Economic Surplus

Long-run supply of apartments will be more elastic in Winnipeg than in Vancouver.

FIGURE 7.9: Economic Surplus in Two Unregulated Housing Markets

700,000/month

1,600,000/month

400,000/month

1,600,000/month

Producersurplus

Consumer surplus

D

S

D

S

Consumer surplus

Producersurplus

Supply is less elastic

CS = ½(4000)(800)

PS = ½(4000)(200) PS = ½(3000+4000)(200)



Economic Surplus

• Inelastic Supply or Demand:– Price controls have minor impact.– Implication:

• Small changes in total surplus.• Large changes in shares of surplus.

• Elastic Supply and Demand – the surplus lost due to price controls is greater.



Economic Surplus

Rent Control: Rents capped at $100 per month in both cities

Producersurplus

Loss of totaleconomicsurplus

Consumer surplus

Redistributed surplusD

S

D

S

Redistributed surplus

Consumer surplus

Loss of totaleconomicsurplus

ProducersurplusRent control

Loss of total economic surplus= ½ (2000)(500) = 500 000Redistributed surplus = (2000)(100) = 200 000

Loss of total economic surplus= ½ (500)(200) = 500 00Redistributed surplus = (3500)(100) = 350 000


Economic Surplus

• Supply rises from 2000 to 4000/month.• Total economic surplus up by $500 000/month.• Better off

• Renters who choose to rent the 2000 new apartments • Landlords who choose to make them available will be better off.

• Worse off • Renters who paid $100/month for each of 2000 apartments will

be worse off by ($100)(2000) =$200 000 /month (rectangle in black) transferred to the landlord.

Removing Rent Control - Winnipeg

LO7: Price Elasticity and Total Economic Surplus


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LO7: Price Elasticity and Total Economic Surplus


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Removing Rent Control – Vancouver

• Supply rises by 500/month.• Total economic surplus up by $50 000/month.• Better off

• Renters who choose to rent the 500 new apartments • Landlords who choose to make them available will be better

off.

• Worse off • Renters who paid $100/month for each of 500 apartments

will be worse off by ($100)(3500) =$350 000 /month (rectangle in black) transferred to the landlord.

Congestion Pricing

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• Law or regulation that prevents buyers from paying less than a specified amount– Keeps prices high.– Reduces total economic surplus.– Guarantees those suppliers a minimum price for

their product. – It requires the regulator to take care of the

ensuing market surplus.

Price Floors




Lost Surplus from Price Supports for Wheat


S

D

tonnes/month )

Ch7-34

A price support of $40/million tonnes results in 4 tonnes of wheat/month being produced, of which the government buys half and the public buys half. Lost economic surplus from the program is equal to $10 million/month.

Minimum Wage


S

D


Ch7-35LO5: How price controls affect total

economic surplus

New workers at the higher wageExisting workers

laid-off at the higher wage

Measuring the effects of Minimum Wage• Campoleti/Gunderson (U of T) showed that a 10% increase in min wage

reduces employment by 3 – 5%

• Famous experiment – New Jersey/Pennsylvania have similar economic structure along their

border– In 1992 NY raised its min wage from $4.25 to $5.05, while PA left its min

wage at $4.25 – Card/Kreuger noted that teen employment increased. They argue that

increased min wage increases worker commitment, reduces turnover and raises productivity

• Debate. – Critics say the experiment was flawed – employers cut staff before

changes

Rational expectations – people make decisions in anticipation change, prior to the change actually occurring

Equilibrium and Social Optimum

• Equilibrium no incentive for anyone to change their behavior:

• All opportunities for private gain have been exhausted.

• Market equilibrium does not necessarily allocation of resources is socially optimal

• Market equilibrium = social optimum


Ch7-37LO8: Difference between maximum economic

surplus and a social optimum

Only when all prices reflect all the costs and benefits of a transaction (good’s production/exchange)

Taxation: The Effect of a Tax

3.50

2.50

2.5

S + tax

S

D

Lost Surplus

With no tax, 3 millionkilograms of potatoesare sold each month at aprice of $3/kg.


Ch7-38LO9: Effect of Tax

With a tax of $1/kg collected from sellers, consumers end up paying $3.50/kg (includingtax), while sellers receiveonly $2.50/kg (net of tax).

Equilibrium quantity falls from 3 million kilograms/month to 2.5 million.

The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of Supply

$10 100 S + $100

S

D

$10 000

1.9 2.0

Quantity (millions of cars/month)

Pri

ce (

$/ca

r)


When the supply curve for a good is perfectly elastic, the burden of a tax collected from sellers falls entirely on buyers.

Ch7-39

LO9: Effect of Tax

FIGURE 7.14: The Effect of a $1/kg Tax on Potatoes

3.50

S + tax

S

D

2.50

2.50 1 2 3 4 5

1

2

3

4

5

6

Quantity (millions of kg/month)

Pri

ce (

$/kg

)


Ch7-40

$1/kg tax on potatoes would cause an upward shift in the supply curve by $1. Total surplus would shrink to the area of the pale blue triangle, $6.25 million/month.

x

• Deadweight loss is minimized when supply or demand are relatively inelastic.

Taxes, Elasticity, and Economic Surplus



FIGURE 7.16: Elasticity of Demand and the Deadweight Loss from a Tax

2.402.00

19

S + T

S

D1

Deadweight loss

2.60

2.00

1.401.60

D2

S + T

S

24 21 24

Deadweight loss

At the equilibrium price and quantity, price elasticity of demand is smaller for the good shown in panel (b) than for the good shown in panel (a). The area of the deadweight loss triangle in panel (b) ($1.50/day) is smaller than the area of the deadweight loss triangle in panel (a) ($2.50/day).



FIGURE 7.17:Elasticity of Supply and the Deadweight Loss from a Tax

At the equilibrium price and quantity, price elasticity of supply is smaller for the good shown in panel (b) than for the good shown in panel (a). The area of the deadweight loss triangle in panel (b) ($4.50/day) is smaller than the area of the deadweight loss triangle in panel (a) ($7.50/day).



• Taxes reduce the equilibrium quantity produced and consumed.– To a degree which depends on supply and demand

elasticity for that commodity.• Therefore, taxing activities that people tend to

pursue to excess (e.g., activities that cause pollution) can have a “double dividend”.

Taxes, External Costs, and Economic Surplus



• In a perfectly competitive market when the supply and demand curves for a product capture all the relevant costs and benefits of producing and consuming that product, then market equilibrium for that product will be efficient.

• For an individual buyer, the economic surplus from a transaction is the difference between the most the buyer would have been willing to pay and the amount actually paid.

• For an individual seller, the economic surplus from a transaction is the difference between the price received and the lowest amount at which the seller would have been willing to make the sale.

• Total economic surplus in a market is the sum of all producer and consumer surplus in that market.

Chapter Summary

Chapter Summary© 2012 McGraw-Hill Ryerson Limited

Ch7-45

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Introduction to Microeconomics Chapter 7 Economics of Perfect Competition Economic Surplus