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Chapter 11
OVERVIEW
Competitive Market Efficiency
Performance and Strategy Market Failure
in Competitive Markets Role for Government
Subsidy and Tax Policy
Chapter 11 Tax Incidence and Burden
Price Controls
Business Profit Rates
Market Structure and Profit Rates
1 2 Competitive Market Strategy
Chapter 11
Competitive Market Efficiency
KEY CONCEPTS
welfare economics tradable emission permits deadweight
social welfare loss of taxation
tax incidence
Why is it called Perfect Competition?
producer surplus
deadweight loss problem
welfare loss triangle
tax burden
price floor
Competitive markets balance supply and
market power
market failure
price ceiling
return on stockholders’ equity (ROE)
demand.
profit margin
failure by market structure
externalities total asset turnover Competitive markets maximize social
leverage
failure by incentive
economic efficiency reversion to the mean welfare
economic regulation disequilibrium profits
social equity disequilibrium losses
consumer sovereignty economic luck
limit concentration competitive strategy
subsidy policy economic rents
3 4
Why Do People Buy and Sell? Consumer Surplus
If the value of everything is equal to its
If the value of everything is equal to its
market price, nobody would be better off
market price, nobody would be better off
buying anything, and customers would do
buying anything, and customers would do
just as well by simply keeping their money.
just as well by simply keeping their money.
... But the value of everything to buyers is
... But the value of everything to buyers is
not the market price of the item. To say
not the market price of the item. To say
that it is so confuses the difference between
that it is so confuses the difference between
the marginal value of an item and its average
the marginal value of an item and its average
value.
value.
See page 348
See page 348
"Diamond -- water paradox."
"Diamond water paradox."
5 6
1
Producer Surplus
Consumer Surplus Definition
Some consumers then are receiving more in
Some consumers then are receiving more in
value than the market price they are paying;
value than the market price they are paying;
these consumers would pay more for the
these consumers would pay more for the
good or service if they had to.
good or service if they had to.
Economists call the extra value consumers
Economists call the extra value consumers
receive beyond the amount they pay
receive beyond the amount they pay
consumer surplus.
consumer surplus.
The reason people buy then is because they
The reason people buy then is because they
receive more value than they give up in a
receive more value than they give up in a
transaction!
transaction!
7 8
Producer Surplus No Price Controls
Definition
Producer surplus is the difference
Producer surplus is the difference
between what the firm receives on
between what the firm receives on
the market and what it costs the firm
the market and what it costs the firm
to supply the product.
to supply the product.
Law of One Price
Law of One Price
9 10
The Law of One Price
Market with Price Control
The Law of One Price
And
And
Market Efficiency
Market Efficiency
11 12
2
Market with Per Unit Tax
Tax Incidence and Burden
Role of Elasticity
Who pays the economic burden of a tax or operating
control regulation depends on the elasticity of supply
and demand.
Elasticity affects the amount of social welfare lost due
to the deadweight loss of taxation.
All else equal, the deadweight loss of a tax is small
when supply (or demand) is relatively price inelastic.
All else equal, the deadweight loss of a tax is large
when supply (or demand) is relatively price elastic.
Tax Cost Sharing Example
Local authorities find it difficult to tax or regulate
firms that operate in highly competitive markets.
See pages 348…
See pages 348…
13 14
Market Failure Role for Government
Structural Problems How Government Influences Competitive
Above-normal profits are unwarranted if they reflect Markets
the raw exercise of market power. Tax policy or regulation is efficient if expected
Failure occurs when competitive markets do not benefits exceed expected costs.
sustain socially desirable activity. Fairness must be carefully weighed when social
Failure can occur in markets with few participants. considerations bear heavily.
Incentive Problems Broad Social Considerations
Externalities are differences between private and Consumer sovereignty is an important benefit of
social costs or benefits. competitive markets.
A negative externality is an unpaid cost. Public policy can control unfairly gained market
A positive externality is an unrewarded benefit. power.
Tax and regulatory policy limit concentration of
economic and political power.
15 16
Subsidy and Tax Policy Price Controls
Subsidy Policy Price Floors
Subsidy policy can be indirect, like government
construction and highway maintenance grants that Price floors cause surplus production.
benefit the trucking industry.
Costly government-set price floors persist
Subsidy policy can be direct, like agricultural
payment-in-kind (PIK) programs. because of powerful special interest
Tradable emission permits are pollution licenses. groups
Deadweight Loss From Taxes
Taxes reduce economic activity and cause
deadweight losses.
Pollution taxes explicitly recognizes the public's right
to a clean environment.
17 18
3
Figure 11.6b
Figure 11.6a Demand and supply more elastic in long run
Demand and supply more elastic in long run
As buyers continue to shift to less costly alternatives
As buyers continue to shift to less costly alternatives
See page 364
See page 364 while producers try to increase supply.
while producers try to increase supply.
19 20
Price Ceilings
Price ceilings cause shortages.
Price ceilings are a popular, but ineffective,
means for restraining excess demand.
Cities use price ceilings in an effort to make
housing more affordable.
Figure 11.7a
See page 366
See page 366
21 22
Rental market in Long-run
Business Profit Rates
Return on Stockholders’ Equity
ROE is net income divided by the book value
of stockholders’ equity.
ROE = Net Income/Sales × Sales/Total Assets
× Total Assets/Stk. Equity
High margins, turnover or leverage boost ROE.
Typical Profit Rates
ROE averages 10% to 15% per year for
Figure 11.7b
successful companies.
Long-run demand and supply are more elastic causing shortages to grow
Long-run demand and supply are more elastic causing shortages to grow Sustained ROE ≥ 20% per year is rare.
As renters continue to expand their demand for low-cost housing, while
As renters continue to expand their demand for low-cost housing, while
Landlords fail to keep up in terms of ordering new supply.
Landlords fail to keep up in terms of ordering new supply.
23 24
4
Market Structure and Profit Rates Competitive Market Strategy
Profit Rates in Competitive Markets Short-run Firm Performance
Competitive markets have low profit margins. Profits reflect transitory influences.
In strong economic environments, competitive firms Disequilibrium profits and losses reflect adjustment
can earn disequilibrium profits. costs.
In weak economic environments, competitive firms Long-run Firm Performance
can suffer disequilibrium losses. Typical firms in competitive markets have the
Mean Reversion in Profit Rates potential for a normal rate of return on investment.
Expansion from entry and firm growth cause above- Abnormal profits or losses often reflect transitory
normal profits to regress toward the mean. disequilibrium conditions.
Contraction from bankruptcy and exit allow below- If above-normal returns persist for extended periods,
normal profits to rise toward the mean. elements of uniqueness are at work.
In long-run equilibrium, profit rates for typical firms The search for an economic advantage is called competitive
reflect only a risk-adjusted normal rate of return. strategy.
25 26 Uniquely productive firms earn above-normal profits.
Rate of Decay
Figure 11.8
See page 371
See page 371
27 28
Profit Margins
See data on page 381
Monopoly
Monopoly
29
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