The Analysis of Competitive Markets (Chapter 9) We will now examine the problem of determining price and output levels in competitive market structures. The role of government policies will be discussed. Review of Consumer and Producer Surplus: Consumer surplus is graphically represented by the area under the demand curve for
a good, above its price. The amount that these consumers would be willing to pay, but do not have to pay is known as the consumer surplus.
Producer surplus is graphically represented by the area above the supply curve for a
good, below its price. The amount that these producers would be willing to sell at, but do not have to as market price is higher is known as the producer surplus. Together Consumer and Producer Surplus measure the welfare benefit of a competitive
market. Impact of Price Controls: Price ceiling Government intervention via a price control, sometimes called a price ceiling, may cause the quantity of the good supplied to decline. This is because sellers will have less of an incentive to supply the good to the market. At the same time of the decline in the quantity supplied, the price cap will cause the quantity demanded to increase. The result will be a shortage quantity demanded will exceed the quantity supplied. The graph below shows that a perfectly competitive market will in equilibrium achieve a price and quantity, Pe and Qe. A price cap, Pc, will lead to a reduction in the quantity supplied to Qs. The result is a shortage, and a decline in efficiency or deadweight loss (DWL) is the amount given by the shaded area.
Price Floor In this case, government sets prices higher than the free market level. The buyer’s price is shown on the y-axis in the following graphs. The original consumer surplus equals the area between the demand curve and the line of price Pe. The original producer surplus equals the area between the supply curve and the line of price Pe. The deadweight loss to the society as a result of the price floor is given by the shaded area.
Impact of a Tax When a tax is imposed, the effects on overall efficiency are similar to a price floor or price ceiling. The price paid by buyers rises to the higher price resembling the effect of a price floor. The price paid to sellers falls to the lower price resembling a price ceiling. However, instead of the sellers or buyers getting an increase in producer surplus or consumer surplus, the government collects a bit of the former surpluses of both consumers and producers. This collection is called "revenue" for the government. The tax will reduce total trade, just like a price floor or price ceiling, but the reduced consumer surplus and producer surplus is often called the "excess burden," instead of being called the "deadweight loss" (you can think of them as two names for the same idea). If demand is very inelastic, the tax burden falls mostly on buyers. If demand is relatively elastic compared to supply, the tax burden falls mostly on sellers.