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Microeconomic Theory

ECON2101/ECON2210

Bei Qin

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Competitive Market cont., Monopoly and Monopsony

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Welfare analysis: Price supports


Price support:
Price set by government above free market level and maintained by government purchases of excess supply.

9.4

Price Supports =Total welfare change:

CS = A B Producer surplus: PS = A + B + D Price Supports and Production Quotas Cost to government: (Q2 Q1 )Ps
Consumer surplus:

price support Price set by government above free-market level and cost to Govt.= maintained by governmental purchases of excess supply.

welfare = CS + PS

D (Q2 Q1 )Ps

FIGURE 9.10
PRICE SUPPORTS To maintain a price Ps above the market-clearing price P0, the government buys a quantity Qg. The gain to producers is A + B + D. The loss to consumers is A + B. The cost to the government is the speckled rectangle, the area of which is Ps(Q2 Q1).

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Welfare analysis: production quotas


To maintain a price

Ps

above the market-clearing price

government can restrict supply to reduce output.

Q1 , either by imposing

P0 , the

production quotas or by giving producers a nancial incentive to

roduction Quotas

Quotas:

the government can reduce the supply by decree - by

GURE 9.11

setting quotas on how much each rm can produce.

PPLY RESTRICTIONS

maintain a price Ps above the arket-clearing price P0, the vernment can restrict supply to Q1, her by imposing production quotas s with taxicab medallions) or by ving producers a financial incentive reduce output (as with acreage mitations in agriculture).

r an incentive to work, it must be at ast as large as B + C + D, which ould be the additional profit earned planting, given the higher price Ps. e cost to the government is erefore at least B + C + D.

Q1

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Welfare analysis:production quotas


To maintain a price

Ps

above the market-clearing price

government can restrict supply to reduce output.

Q1 , either by imposing

P0 , the

production quotas or by giving producers a nancial incentive to

Quotas:

the government can reduce the supply by decree - by

setting quotas on how much each rm can produce. The quantity supplied is restricted to market clearing level

S at Q1 CS : A B PS : A C welfare : B C
vertical line

Q0 .

Q1 rather than the

The supply curve becomes the

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Welfare analysis:production quotas

Incentive programs:
inelastic at

give incentive to producers if they agree

Q1 , and the market price is increased from P0 to P1 . CS : A B Cost to gvt.: Incentive given to producers B + C + D PS : A C + incentive (B + C + D )= A + B + D welfare : B C

to reduce the supply. Supply curve becomes completely

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Welfare analysis: price supports Vs. production quotas


Compare incentive programs and price supports

Consumer surplus and producer surplus: no change Cost to gvt: (Q2 Q1 )Ps > B + C + D Deadweight loss: Dprice support > Dincentive programs
Which policy is better is determined by the goal of policies.

If the govt. just want to protect the benet of farmer for rice, wheat etc., price support or incentive programs is better?
Neither. How about lump sum transfer? A + B + D to farmers, no deadweight loss.

If the goal is to protect the productivity of land, incentive programs is better.


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Welfare analysis: tax


Specic tax/quantity tax: tax of a certain amount of money per unit sold or bought, ex. t cents per unit. If the tax is levied on sellers then it is an excise tax; If the tax is levied on buyers then it is a sales tax.
The price the buyer pays must exceed the net price the seller

Quantity Taxes & Market receives by the amount of tax, ex. t cents. Market Equilibrium Market
p demand supply No tax

p*

q*

D(p), S(p)

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Welfare analysis: tax


Specic tax/quantity tax: tax of a certain amount of money per unit sold or bought, ex. t cents per unit. If the tax is levied on sellers then it is an excise tax; If the tax is levied on buyers then it is a sales tax.
The price the buyer pays must exceed the net price the seller

Quantity Taxes & Market receives by the amount of tax, ex. t cents. Market Equilibrium Market
p demand $t supply

An excise tax raises the market supply curve by $t

p*

q*

D(p), S(p)

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Welfare analysis: tax


Specic tax/quantity tax: tax of a certain amount of money per unit sold or bought, ex. t cents per unit. If the tax is levied on sellers then it is an excise tax; If the tax is levied on buyers then it is a sales tax.
The price the buyer pays must exceed the net price the seller receives by the amount of tax, ex.

Quantity Taxes & Market t cents. Market Equilibrium Market


demand $t supply

pb p* ps qt q*

An excise tax raises the market supply curve by $t, raises the buyers price and lowers the quantity traded. D(p), S(p)
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And sellers receive only ps = pb - t.

Welfare analysis: tax


Specic tax/quantity tax: tax of a certain amount of money per unit sold or bought, ex. t cents per unit. If the tax is levied on sellers then it is an excise tax; If the tax is levied on buyers then it is a sales tax.
The price the buyer pays must exceed the net price the seller receives by the amount of tax, ex.

Quantity Taxes & tMarket cents. Market Equilibrium Market


demand supply

An sales tax lowers the market demand curve by $t

p*
$t

q*

D(p), S(p)
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Welfare analysis: tax


Specic tax/quantity tax: tax of a certain amount of money per unit sold or bought, ex. t cents per unit. If the tax is levied on sellers then it is an excise tax; If the tax is levied on buyers then it is a sales tax.
The price the buyer pays must exceed the net price the seller receives by the amount of tax, ex.

Quantity Taxes & Market t cents. Market Equilibrium Market


demand supply

pb p* ps qt q*

$t

An sales tax lowers the market demand curve by $t, lowers the sellers price and reduces the quantity traded. D(p), S(p)
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And buyers pay pb = ps + t.

Welfare analysis: tax


Specic tax/quantity tax: tax of a certain amount of money per unit sold or bought, ex. t cents per unit. If the tax is levied on sellers then it is an excise tax; If the tax is levied on buyers then it is a sales tax.
The price the buyer pays must exceed the net price the seller receives by the amount of tax, ex.

Quantity Taxes & Market $t . Market Equilibrium Market


demand $t supply

pb p* ps qt q*

$t

A sales tax levied at rate $t has the same effects on the markets equilibrium as does an excise tax levied at rate $t. D(p), S(p)
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Welfare analysis: tax


Who pays the tax of $ t per unit traded?

Quantity Taxes & Market Market Equilibrium Market


demand supply

pb p* ps qt q*
D(p), S(p)
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Welfare analysis: tax


Who pays the tax of $ t per unit traded?

Quantity Taxes & Market Market Equilibrium Market


demand supply Tax paid by buyers

pb p* ps

qt q*

D(p), S(p)

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Welfare analysis: tax


Who pays the tax of $ t per unit traded?

Quantity Taxes & Market Market Equilibrium Market


demand supply

pb p* ps qt q*

Tax paid by sellers D(p), S(p)


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Welfare analysis: tax


Who pays the tax of $ t per unit traded?

Quantity Taxes & Market Market Equilibrium Market


demand supply Tax paid by buyers Tax paid by sellers

pb p* ps

qt q*

D(p), S(p)
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Welfare analysis: tax


Equilibrium price and quantity after tax policy: Problem of market clearing.

1. The quantity sold and the buyer's price Pb must lie on the demand curve Q D = Q D (Pb ) 2. The quantity sold and the seller's price Ps must lie on the supply curve Q S = Q S (Ps ) 3. The quantity demanded must equal the quantity supplied 4. The dierence between the price the buyer pays and the price the seller receives must equal the tax t Pb Ps = t

QD = QS

Example
Midterm 3.2

D (p) = 42 p , S (p) = 20p, t = 2


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Welfare analysis: tax


The incidence of a quantity tax depends upon the own-price elasticities of demand and supply.

Tax Incidence and Own-Price Elasticities Market Market


demand $t supply

pb p* ps qt q* q

Change to buyers price is pb - p*. Change to quantity demanded is q.


D(p), S(p)

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Welfare analysis: tax

The incidence of a quantity tax depends upon the own-price elasticities of demand and supply.

Around p = p , the own-price elasticity of demand is q /q q p approximately ED = (pb = p p b p )/p E D q

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Welfare analysis: tax


The incidence of a quantity tax depends upon the own-price elasticities of demand and supply.

Tax Incidence and Own-Price Elasticities Market Market


demand $t supply

pb p* ps qt q* q

Change to sellers price is ps - p*. Change to quantity demanded is q.


D(p), S(p)

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Welfare analysis: tax


The incidence of a quantity tax depends upon the own-price elasticities of demand and supply.

Around p = p , the own-price elasticity of demand is q /q q p approximately ED = (pb = p p b p )/p E D q Around p = p , the own-price elasticity of supply is q /q q p = p p approximately ES = (pS S p )/p ES q pb p ES Tax incidence = p pS E D
A tax falls mostly on the buyer if the seller if

ES is ED

ES ED

is large, and mostly on

small.

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Welfare analysis: tax


A tax falls mostly on the buyer if the seller if

ES is ED

ES ED

is large, and mostly on

small.

FIGURE 9.18
IMPACT OF A TAX DEPENDS ON ELASTICITIES OF SUPPLY AND DEMAND (a) If demand is very inelastic relative to supply, the burden of the tax falls mostly on buyers. 23 / 47

Welfare analysis: tax


A tax falls mostly on the buyer if the seller if

ES is ED

ES ED

is large, and mostly on

small.

(a)IMPACT inelastic demand, theON burden of theOF tax falls AND mostly on buyers; OF A TAX DEPENDS ELASTICITIES SUPPLY DEMAND If demand is very inelastic relative to supply, burden of the tax falls mostly on buyers. 24 / 47 (b) (a) elastic demand, it falls mostly on the sellers.

FIGURE 9.18

Welfare analysis: tax


Welfare analysis: a quantity tax imposed on a competitive market reduces the quantity traded and so reduces gains-to-trade (i.e. the sum of consumers' and producers' surpluses)

CS A B , PS = C D .6 The Impact of a= Tax or Subsidy Govt. tax revenue = tQ1 = A + D HE EFFECTS OF A SPECIFIC TAX
specific tax

= per unit sold. Tax of a certain amount of money

welfare

B C

GURE 9.17 CIDENCE OF A TAX b is the price (including the tax) paid y buyers. Ps is the price that sellers ceive, less the tax.

ere the burden of the tax is split venly between buyers and sellers.

uyers lose A + B.

ellers lose D + C.

he government earns A + D in venue.

he deadweight loss is B + C.

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Welfare analysis: subsidy


Subsidy:
payment reducing the buyer's price below the seller's price, i.e., a negative tax. With a subsidy, the sellers' price exceeds the buyers' price, and the dierence between the two is the amount of the subsidy. Equilibrium after subsidy:

1. 2. 3. 4.

Q D = Q D (Pb ) Q S = Q S (Ps ) QS = QD Ps Pb = s

Examples
Midterm 3.2.

D (p) = 42 p ,S (p) = 20p , s = 0.2


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of a Subsidy

Welfare analysis: subsidy


E ED

ayment reducing the buyers price below the sellers The benet of a subsidy accrues mostly to buyers if S is large ED gative tax. and mostly to sellers if ES is smaller .

e thought of as a e a tax, the benefit of between buyers and ng on the relative pply and demand.

ded for the market subsidy:


(9.2a) (9.2b) (9.3c) Q: (9.4d)

CS

PS

Govt . revenue ? welfare ?


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Welfare analysis: import quotas and taris


Goal: protect the domestic industry.

Import quota:

limit on the quantity of a good that can be

imported. 5 Import Quotas and Tariffs Without import: (Q0 , P0 ) mport quota Limit on the quantity of a good that can be imported. With import: (Qd , Pw ), where domestic ariff Tax on an and imported good. (Qd Qs ) import

industry provides

Qs ,

URE 9.14 ORT TARIFF OR QUOTA AT ELIMINATES IMPORTS

free market, the domestic price als the world price Pw.

otal Qd is consumed, of which Qs is plied domestically and the rest orted.

en imports are eliminated, the e is increased to P0.

e gain to producers is trapezoid A.

e loss to consumers is A + B + C, he deadweight loss is B + C.

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Welfare analysis: import quotas and taris


Goal: protect the domestic industry.

Import quota:
imported. Without import:

limit on the quantity of a good that can be

(Q0 , P0 ) With import: (Qd , Pw ), where and import (Qd Qs )


CS : A B C PSdomestic : A welfare : B C

domestic industry provides

Qs ,

From no quota limit to no import:

Usually, governments want to reduce import but not eliminate imports.

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Welfare analysis: import quotas and taris

Goal: protect the domestic industry.

(Q0 , P0 ) With import: (Qd , Pw ), where domestic industry and import (Qd Qs ) If Tarrif = P0 Pw , no import. Same eect on
Without import: as quota described above.

Tari:

tax on an imported good.

provides

Qs , PS

CS

and

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Welfare analysis: import quotas and taris


If ,

Tarrif = P Pw < P0 Pw CS = A B C D PS = A revenue to gvt.D welfare = B C FIGURE 9.15


When imports are reduced, the domestic price is increased from Pw to P*. This can be achieved by a quota, or by a tariff T = P* Pw. Trapezoid A is again the gain to domestic producers. The loss to consumers is A + B + C + D. If a tariff is used, the government gains D, the revenue from the tariff. The net domestic loss is B + C. If a quota is used instead, rectangle D becomes part of

IMPORT TARIFF OR QUOTA (GENERAL CASE)

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Welfare analysis: import quotas and taris

Compare quota and tari

For quota and tari that both raise the price from Pw to P , tari is better
quota: welfare = B D C tari: welfare = B C

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Non-competitive market
Perfectly competitive markets

Price taking: a large number of buyers and sellers, none of them individually can aect price Product homogeneity: no rm can raise its price without losing most or all of its business Free Entry and Exit.
Non-competitive markets

Monopoly: market with only one seller. Market in which only a few rms compete with one another, and entry by new rm is impeded. Monopsony: market with only one buyer.
Market power: ability of a seller or buyer to aect the price of a good.
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Monopoly
What causes monopolies?

Entry barriers: legal at (postal service); patent ( new drugs); sole ownership of a resource (nuclear energy) Large economies of scale: e.x. towngas Collaboration: formation of a cartel (e.x. OPEC)
The monopolist is the market and completely controls the amount of output provided. The monopolist's demand curve is the (downward sloping) market demand curve. So the monopolist can alter the market price by adjusting its output level.

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Monopoly: output decision


Maximize its prot

Maxy (y ) = p(y )y C (y ) d (y ) d (p(y )y ) dC (y ) optimal y satises F .O .C . = =0 dy dy dy d (p(y )y ) dC (y ) = i .e . dy dy Profit-Maximization


$

R(y) = p(y)y c(y)

y*

At the profit-maximizing output level the slopes of (y) the revenue and total cost curves are equal; MR(y*) = MC(y*).

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Monopoly: output decision


MR (y ) =
dp(y ) dy

Example
P

dp(y ) < 0, so dy marginal revenue MR (y ) < p (y ) average revenue for y > 0.


is the slope of the market demand so

d (p(y )y ) dp(y ) = p (y ) + y dyy dy

Linear demand:

p(y ) = 42 y , then R (y ) = p(y )y = 42y y 2 Then we have MR (y ) = 42 2y < 42 y = p (y ) for y > 0


42 P(y)=42-y Average revenue MR(y)=42-2y marginal revenue

21

42

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Monopoly: output decision


MC (y ) =
y increases

dC (y ) dy

Marginal cost is the rate-of-change of total cost as the output level

Example

suppose the cost function is

C (y ) = y 2 + 8, then MC (y ) = 2y At the prot-maximizing output level y , MR (y ) = MC (y ), y = 10.5. Then, the market price is p(y ) = 42 y = 31.5
P MC(y)=2y 42 P(y)=42-y MR(y)=42-2y

y*

21

42

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Monopoly: output decision


MC (y ) =
y increases

dC (y ) dy

Marginal cost is the rate-of-change of total cost as the output level

Example
P

suppose the cost function is

C (y ) = y 2 + 8, then MC (y ) = 2y At the prot-maximizing output level y , MR (y ) = MC (y ), y = 10.5. Then, the market price is p(y ) = 42 y = 31.5
MC(y)=2y P(y)=42-y MR(y)=42-2y

42 P*

y*

21

42

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Monopoly: pricing & elasticity of demand


A rule of thumb for pricing:

d (p(y )y ) dp(y ) MR (y ) = = p (y ) + y dyy dy


Marginal revenue has two components: producing one extra unit and selling it at price p brings in revenue 1 p = p Because of the downward-sloping demand curve, producing and selling this extra unit also results in a small drop in price dp(y ) , which reduces the revenue from all units sold, i.e., a dy (y ) change in revenue y dp dy

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Monopoly: pricing & elasticity of demand


A rule of thumb for pricing: rewrite the equation, we have

y dp(y ) MR (y ) = p + p[( )( )] p dy p )( dy ), so MR = p + p ( 1 ) = MC , where Ed = ( y dp Ed 1 p MC = = P Ed


The left-hand side percentage of price. The relationship says that this markup should equal minus the inverse of the elasticity of demand. Equivalently, we have

pMC is p

the markup over marginal cost as a

p=

+ (1/Ed )
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MC

A monopolist charges a price that exceeds marginal cost, but by an amount that depends inversely on the elasticity of demand.

Monopoly: pricing & elasticity of demand


Notice:

MR (y ) = p(y )(1 + E1d ) = MC


=

1 > 0=1+ E >0 d

Ed

> 1 = Ed < 1(|Ed | > 1)

So a prot-maximizing monopolist always selects an output level for which market demand is elastic.

p(y

)=

MC = p = MC + (p MC ) = MC + ( ) 1 + Ed
Markup pricing: output price is the marginal cost of production plus a markup.
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MC = p MC = 1 + Ed

+ (1/Ed )

MC

Monopoly: pricing & elasticity of demand


Suppose the monopolist's marginal cost of production is constant, at $c/output unit. For a prot-maximum

p(y
E.x. if

)=

+ (1/Ed )

The markup rises as the elasticity of demand rises towards -1. As

Ed = 4 , then p(y ) = 4 3c 3 if Ed = 3 , then p (y ) = c 2

Ed rises towards -1 the monopolist alters its output level to make


the market price of its product to rise.

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Monopoly: shifts in demand

A monopolistic market has no supply curve.

The monopolist's output decision depends not only on marginal cost but also on the shape of the demand curve. Shifts in demand do not trace out the series of prices and quantities that correspond to a competitive supply curve.
Optimal decision:

MR (y ) = MC (y ) = y D (p ) = y = p

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urve shows rket has no re is no p between duced.

Monopoly: shifts in demand

ve D1 shifts D 2.

evenue marginal as the old e MR1.

output same, m P1 to P2.

al revenue marginal level Q2.


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s now more

Monopoly: quantity tax


Eect of a quantity tax of $t /output unit. -distortionary

It raises the marginal cost of production by $t. So the tax reduces the prot-maximizing output level, causes the market Quantity price to rise. Tax Levied on a Monopolist
$/output unit p(y) p(y*) MC(y)

y* MR(y)

y
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Monopoly: quantity tax


Eect of a quantity tax of $t /output unit. -distortionary

MR (y ) = MC (y ) +Levied t Quantity Tax on a Monopolist


$/output unit p(y) p(yt) p(y*) MC(y) + t t MC(y)

It raises the marginal cost of production by $t. So the tax reduces the prot-maximizing output level, causes the market price to rise. The optimal production decision is given by

yt y*

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Monopoly: quantity tax

The Effect of a Tax

Suppose a specific S ifi t tax of f t dollars d ll per unit it i is l levied, i d so th that t the th monopolist must remit t dollars to the government for every unit it sells. If MC was the firms original marginal cost, its optimal production decision is now given by g y Eect of a quantity tax of $t /output unit.

The price can increase by less than or more than the tax.
FIGURE 10.5 10 5
EFFECT OF EXCISE TAX ON MONOPOLIST With a tax t per unit, unit the firm firms s effective marginal cost is increased by the amount t to MC + t. In this example, the increase in price P is i l larger than h the h tax t.

Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.

d p(y ) = 1cE +Ed , the tax increases MC to t )Ed (c + t ), changing price to p (y t ) = (c1+ +Ed . The amount of tax paid cEd (c +t )E t d by buyers is p (y ) p (y ) = 1+E d 1+E = 1tE + E d d d Ed Ed < 1, 1+ Ed > 1 and so the monopolist passes on to consumers
Suppose MC is constant,
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more than the tax

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