Analysis of Competitive Markets

1. Analysis of Competitive Markets • In this section, we examine the social welfare implications of competitive markets. • The approach taken here (and not the only one possible), is to use the devices of Producer and Consumer Surplus. • The social welfare from the production and consumption of a particular amount of a good is assumed to be the sum of the producer and consumer surplus. Consumer & producer surplus

2. Optimality of competitive markets • The principal claim is that social welfare (the sum of producer and consumer surplus) is maximized at the competitive price and quantity for a good. • A series of examples are worked to show that a variety of policies and regulations, such as price fixing, taxes, and subsidies, will, in general, reduce social welfare from its maximum. Consumer & producer surplus

3. Key terms • Willingness to pay: The maximum amount a buyer will pay for an amount of a good. • Consumer surplus: A buyer's willingness to pay minus the amount actually paid. • Cost: The value of everything a seller must give up to produce an amount of a good. • Producer surplus: The amount the seller receives for the good minus the cost. Consumer & producer surplus

4. Consumer surplus can be measured using the demand curve for a product. P Demand for tacos P* D Q* Q Consumer & producer surplus

5. When Q* is sold, willingness to pay is the shaded area. P Demand for tacos P* D Q* Q Consumer & producer surplus

6. Consumer surplus Cost to consumers • When Q* is sold at a price P*, consumers pay P* times Q*. Click to see the cost to consumers. Click again to see the shaded area that is consumer surplus. P P* Demand for tacos D Q* Q Consumer & producer surplus

7. Producer surplus can be measured using the supply curve for a product. S P Supply of tacos P' Q' Q Consumer & producer surplus

8. Total revenue equals P' times Q'. • The shaded area is the cost of producing Q' of tacos. If the firm can sell at P', the total receipts are P' times Q'. P Supply of tacos Click to see the area that equals firms' revenues. P' Q' Q Consumer & producer surplus

9. Producer surplus is the shaded area. S P Supply of tacos P' Q' Q Consumer & producer surplus

10. A B When QE is sold at a price of PE, consumer surplus is A, and producer surplus is B. P S PE D Q QE Consumer & producer surplus

11. Notice on the previous slide that at the market equilibrium the sum of producer and consumer surplus (welfare) is maximized. Consumer & producer surplus

12. Suppose Q' is sold at a price P' . What's the effect on welfare compared to the market? P S P" P* D Q Q' Q* Consumer & producer surplus

13. Consumer surplus is A . Producer surplus is B plus C. Compared to the market, there is a loss of D plus E. (Note that producers gain B, while consumers lose B.) P S A P' B D PE E D C Q Q' QE Consumer & producer surplus

14. The next (hidden) slide shows the effects on welfare of producing less than the market amount. Hidden slide

15. P • What if MORE than the market equilibrium quantity is produced? S PE P' D Q Q' QE Consumer & producer surplus

16. P • What if MORE than the market equilibrium quantity is produced? S A F E P' B D C Q Q' Consumer & producer surplus

17. When Q' is sold at P': • CS is A + E • PS is (B + C) - (C + E + F) = B - E - F • Therefore: • CS +PS is A + B - F • This is less than CS + PS in the market (= A + B). Consumer & producer surplus

18. Conclusion • If the demand curve (willingness to pay) is a good measure of the value of a good, and • if the supply curve (the firm's cost) is a good measure of the cost to society to produce a good, • then the best amount of the good to produce is where supply and demand are equal. Consumer & producer surplus