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Week 12 chapter notes

Economics for Management Studies
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Chapter 9 The Analysis of Competitive Markets Notes
9.1 Evaluating Gains and Losses from Government Policies—Consumer & Producer Surplus
x a government-imposed price ceiling causes the quantity of a good demanded to rise (at the lower price, consumers want to buy
more) and the quantity supplied to fall (producers are not willing to supply as much at the lower price)
x the result is a shortage; of course, those consumers who can still buy the good will be better off because they will now pay less
Review of Consumer and Producer Surplus
x consumer surplus is the total benefit or value that consumers receive beyond what they pay for the good
x because consumer surplus measures the total net benefit to consumers, the gain or loss to consumers can be measured from a
government intervention by measuring the resulting change in consumer surplus
x for each unit, producer surplus is the difference between the market price the producer receives and the MC of producing it
x for the market as a whole, the producer surplus is the area above the supply curve up to the market price
x this is the benefit that lower-cost producers enjoy by selling at the market price
x because producer surplus measures the total net benefit to producers, the gain or loss to producers can be measured from a
government intervention by measuring the resulting change in producer surplus
Application of Consumer and Producer Surplus
x welfare effects Æ gains and losses to consumers and producers
x deadweight loss Æ net loss of total (consumer plus producer) surplus
9.2 The Efficiency of a Competitive Market
x economic efficiency Æ maximization of aggregate consumer and producer surplus
x policy imposes an efficiency cost: taken together, producer and consumer surplus are reduced by amount of deadweight loss
x market failure Æ situation in which an unregulated competitive market is inefficient because prices fail to provide proper signals
to consumers and producers (i.e., does not maximize aggregate consumer and producer surplus)
x there are 2 important instances in which market failure can occur:
1. externality Æ action taken by either a producer or a consumer which affects other producers or consumers but is not
accounted for by the market price (they are called externalities because they areexternal” to the market)
2. lack of information: market failure can also occur when consumers lack information about the quality or nature of a product
and so cannot make utility-maximizing purchasing decisions; government intervention may then be desirable
x in absence of externalities or lack of info, an unregulated competitive market does lead to the economically efficient output level
9.3 Minimum Prices
x government policy sometimes seeks to raise prices above market-clearing levels, rather than lower them
x one way to raise prices above market-clearing levels is by direct regulation—simply make it illegal to charge a lower price
x those consumers who still purchase the good must now pay a higher price and so suffer a loss of surplus
x some consumers have also dropped out of the market because of the higher price, with a corresponding loss of surplus
9.4 Price Supports and Production Quotas
x besides imposing a minimum price, the government can increase the price of a good in other ways
x price support Æ price set by government above free-market level and maintained by governmental purchases of excess supply
x the government can also increase prices by restricting production, either directly or through incentives to producers
Production Quotas
x besides entering the market and buying up output—thereby increasing total demand—the government can also cause the price of
a good to rise by reducing surplus by decree (that is, by setting quotas on how much each firm can produce)
x with appropriate quotas, the price can then be forced up to any arbitrary level
9.5 Import Quotas and Tariffs
x import quota Æ limit on the quantity of a good that can be imported
x tariff Æ tax on an imported good
x many countries use import quotas and tariffs to keep the domestic price of a product above world levels and thereby enable the
domestic industry to enjoy higher profits than it would under free trade
x without these, country will import good when its world price is below price that would prevail locally were there no imports
9.6 The Impact of a Tax or Subsidy
x the burden of a tax (or the benefit of a subsidy) falls partly on the consumer and partly on the producer
x specific tax Æ tax of a certain amount of money per unit sold
x market clearing requires four conditions to be satisfied after the tax is in place:
1. The quantity sold and the buyer’s price must lie on demand curve (because buyers are interested in the price they must pay).
2. The quantity sold and the seller’s price must lie on the supply curve (because sellers are concerned only with the amount of
money they receive net of the tax).
3. The quantity demanded must equal the quantity supplied.
4. The difference between the price the buyer pays and the price the seller receives must equal the tax t.
x in general, a tax falls mostly on the buyer if ED/ES is small, and mostly on the seller if ED/ES is large
x in fact, by using the following “pass-through” formula, the percentage of the tax borne by buyers can be calculated:
Pass-through fraction = ES / (ESED)
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