AUGUST 28, 2017

ANALYSIS OF COMPETITIVE MARKET

BUS525.7
TABLE OF CONTENTS

EXECUTIVE SUMMARY 2

INTRODUCTION 3

CONSUMER AND PRODUCER SURPLUS 4

PRICE FLOOR/MINIMUM PRICE 6

MINIMUM WAGE 7

PRICE CEILING/CONTROL 8

PRICE SUPPORT 9

PRODUCTION QUOTA 11

SUBSIDY 12

IMPORT RESTRICTION 13

TARIFF 14

IMPORT QUOTA 15

TAX 17

THE EFFECT OF TAX 17

TYPES OF TAX 18

DIRECT TAX OR TAX ON BUYERS 19

INDIRECT TAX OR TAX ON SELLER OR PRODUCER 20

EXECUTIVE SUMMARY

Analysis of competitive market, we tried to put as much information as possible in this report.
Theoretical knowledge from our honorable faculty Dr. K.M. Zahidul Islam and our own
understanding of the topic is reflected in this report.

We started our discussion with Consumer and Producer surplus, the basis of a competitive
market. After the we focused on Ceiling price and floor price. Discussion of floor price includes
a popular example Minimum wage which is also discussed.

Moreover, we have discussed graphical and mathematical representation of price support,

production quota, subsidy, import restriction, tariff and Import quota. We have put suitable
examples and tried to explain as much as possible. We have also mentioned the reason and
result of implementing each of these.

After that, we have moved on to Tax. We have discussed definition, types of tax with graphical
representation. Later we discussed the effects of different types of tax and who bear these taxes and
how much government earns from taxes. We have also included effects of different types of tax on
consumers and producers.
INTRODUCTION

A competitive market is one where there are numerous producers that compete with one
another in hopes to provide goods and services that the consumers want and need. In other
words, not one single producer can dictate the market. In addition, like producers, not one
consumer can dictate the market either. This concept is also true where price and quantity of
goods are concerned. One producer and one consumer cannot decide the price of goods or
decide the quantity that will be produced.

A great example of competitive market is farming. There are thousands of farmers and not
one of them can influence the market or the price based on how much they grow. All the
farmer can do is grow the crop and accept whatever the current price is for that product. They
do not get to determine the price they want to sell the crop for.

In competitive market analysis consumer and producer surplus are used to study the welfare
effects of a government policy. So it determines who gain and who loses from the policy and
how much. It also demonstrates the efficiency of a competitive market- why the equilibrium
price and quantity in a competitive market maximizes the aggregate economic welfare of
producers and consumers.
CONSUMER AND PRODUCER SURPLUS

Consumer surplus is an economic measure of consumer benefit, which is calculated by

analyzing the difference between what consumers are willing and able to pay for a good or
service relative to its market price, or what they actually do spend on the good or service. A
consumer surplus occurs when the consumer is willing to pay more for a given product than
the current market price. The main objective of most economic activity is to provide what
people most desire. Because people's disposable income is limited, they must decide what
they want and what they are willing to pay. However, sellers must decide how much they
want to produce and at what price they must charge to make a profit. Although sellers want
to sell for the highest possible price, they will also want to sell all that they have produced, so
they will have to charge a price low enough to sell their supply. However, people vary greatly
in their desire for a particular product, which is measured by their willingness to pay, which is
the maximum amount that a buyer will pay for a good. Some people will not be willing to pay
the market price, so they will do without the product. Others are willing to pay much more
than the market price, but since the market price is set by competition and the demand for
the product, with the result that the same price will be charged to everyone, those people
who are willing to pay more for the good will be able to get it for the market price. The amount
that a consumer is willing to pay minus the amount that is actually paid, results in a consumer
surplus for the consumer.

For example, at price P, the total private benefit in terms of utility derived by consumers from
consuming quantity Q, is shown as the area ABQC in the graph.
 The amount consumers actually
spend is determined by the market
price they pay, P, and the quantity
they buy, Q - namely, P x Q, or area
PBQC. This means that there is a net
gain to the consumer, because area
ABQC is greater that area PBQC. This
net gain is called consumer surplus,
which is the total benefit, area ABQC,
less the amount spent, area PBQC.
Hence ABQC - PBQC = area ABP.
Figure: Consumer Surplus

Producer surplus is an economic measure of the difference between the amount a producer
of a good receives and the minimum amount the producer is willing to accept for the good.
The difference, or surplus amount, is the benefit the producer receives for selling the good in
the market. Producer surplus is generated by market prices in excess of the lowest price
producers would otherwise be willing to accept for their goods. In economics, the difference
between the amount that a producer receives from the sale of a good and the lowest amount
that producer is willing to accept for that good. The greater the difference between the two
prices, the greater the benefit to the producer. On graph of supply and demand, the producer
surplus is found above the supply curve and below the point at which the supply and demand
curves intersect.

Consumer surplus is derived whenever the price a consumer actually pays is less than they
are prepared to pay. A demand curve indicates what price consumers are prepared to pay for
a hypothetical quantity of a good, based on their expectation of private benefit. A producer
always tries to increase his producer surplus by trying to sell more and more at higher prices.
However, it is simply not possible to increase the producer surplus indefinitely since at higher
prices there might be very little or no demand for goods. The producer surplus derived by all
firms in the market is the area from the supply curve to the price line, EPB.
 Figure: Producer Surplus

Price Floor/Minimum Price

A price floor is a government- or group-imposed price control or limit on how low a price can
be charged for a product. A price floor must be higher than the equilibrium price in order to
be effective.

A price floor set above the market equilibrium price has several side effects. Consumers find
they must now pay a higher price for the same product. As a result, they reduce their
purchases or drop out of the market entirely. Meanwhile, suppliers find they are guaranteed
a new, higher price than they were charging before. As a result, they increase production.

Taken together, these effects mean there is now an excess supply (known as a "surplus") of
the product in the market to maintain the price floor over the long term. The equilibrium price
is determined when the quantity demanded is equal to the quantity supplied. Further, the
effect of mandating a higher price transfer some of the consumer surplus to producer surplus,
while creating a deadweight loss as the price moves upward from the equilibrium price.
 A
B
C

Figure: Price Floor

CS =-A-B

PS = A-C

DWL = -B-C

MINIMUM WAGE

An example of a price floor is minimum wage laws; in this case, employees are the suppliers
of labor and the company is the consumer. When the minimum wage is set above the
equilibrium market price for unskilled labor, unemployment is created (more people are
looking for jobs than there are jobs available). A minimum wage above the equilibrium wage
would induce employers to hire fewer workers as well as allow more people to enter the labor
market; the result is a surplus in the amount of labor available. However, workers would have
higher wages. The equilibrium wage for workers would be dependent upon their skill sets
along with market conditions.
 Figure: Labor Market Surplus from Price Floor

Price Ceiling/Control

A price ceiling is a government-imposed price control or limit on how high a price is charged
for a product. Governments intend price ceilings to protect consumers from conditions that
could make commodities prohibitively expensive.

Charging a price higher than the ceiling price is illegal.

Government intervention through Price ceiling is inefficient because it creates Dead
Weight Loss (DWL).

Example: Rent control, rationing the price of gas or electricity etc.

 In this graph, Equilibrium point is E,
where price is 0 and quantity is 0 .
Now government sets a ceiling price
shows in . Therefore, supply is
reduced because of gaining less profit
and producer surplus loose the area A &
C. On the other hand, demand is
increased. So price goes up to 1 . So,
quantity reduced from 0 to 1. Thus,
consumer will lose area B. As a result,
there is a Dead weight loss which shows
in area B & C.
Figure: Price Ceiling/Control

PRICE SUPPORT

Price set by government above free market level and maintained by governmental purchases
of excess supply. Price supports are defined as subsidies or price controls that are leveraged
by the government to artificially increase or decrease prices, and thus alter the supply
consumed/quantity demanded by individuals within the system. Understanding the effects of
subsidies and price controls is critical in industries with a high degree of government
involvement, and agriculture is one of the most affected industries. A supply and demand
curve, that demonstrates the consumer surplus and producer surplus opportunities in basic
supply and demand chart. In this scenario, without external governmental intervention, the
price equilibrium will remain in the center of the graph. However, the government may
implement price supports that artificially consume some of the consumer surplus (in, this is
22 units). This drives the price upwards to 20 per unit despite the fact that the consumer is
not gaining additional quantity (it is artificial quantity, as purchased by the government).
 Figure: Price Support

To maintain a price above the market-clearing price 0 the government buys a quantity .

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 ( )

Assume now that government wants to support a price of 25 tk units and thus buys the additional
amount from the market.

CS = - A - B = -110-5 = -115 (Loss)

PS = A+B+D = 110+5+10= 125 (Gain)

Cost of Govt.

= (2 -1 )

= (26-22) 25 = 100tk

Total change in welfare

= D - (2 -1 )

= 10 100

= - 90 tk

A= 22*(25-20) =110

B= *(24-22)*(25-20) =5

D= * (26-22)*(25-20) =10
PRODUCTION QUOTA

A production quota is a goal for the production of a good. It is typically set by a government
or an organization, and can be applied to an individual worker, firm, industry or country.
Quotas can be set high to encourage production, or can be used to restrict production to
support a certain price level.

Figure: Supply Restriction

The above figure shows how price can be increased by reducing supply by imposing
production quota.

To maintain a price above the market-clearing price Po, the government gives producers a
financial incentive to reduce output to 1. For the incentive to work, it must be at least as
large as B+C+D, the additional profit earned by planting, given the higher price . The cost to
the cost to the government is therefore at least B+C+D.

Therefore, Loss of consumer is the area A and B

Gain of the produce, A-C+ Payment for not producing = A-C+B+C+D= A+B+D
And the change of welfare is, -A-B+A+B+D-B-C-D = -B-C

Society would clearly be better off in efficiency terms if the government simply gave the
farmers A+B+D, leaving price and output alone. Farmers would then gain A+B+D, the
government would lose A+B+D, for a total welfare change of zero, instead of a loss of B+C.
However, economic efficiency is not always the objective of government policy.

SUBSIDY

A subsidy is an amount of money given directly to firms by the government to encourage

production and consumption. The effect of a specific per unit subsidy is to shift the supply
curve vertically downwards by the amount of the subsidy. In this case the new supply curve
will be parallel to the original. Depending on elasticity of demand, the effect is to reduce price
and increase output.

Figure: Subsidy

The effect of a specific per unit subsidy is to shift the supply curve vertically
downwards by the amount of the subsidy.
The gain to the consumer is the area PFB1 .
 The gain to the producer is C P per unit and the total gain to the producer is CAFP.
The overall cost of the subsidy to the government is the area, CAB1 .
The overall cost of the subsidy to the government is the area, CAB1 .

A subsidy can be thought of as a negative tax. Like a tax, the benefit of a subsidy is split
between buyers and sellers, depending on the relative elasticitys of supply and demand.

IMPORT RESTRICTION

Import restrictions are imposed by the Government for different reasons. Due to this initiative
suppliers cannot import any product and they increase the product price to supply more.
Import barriers also reduce the possible quantity of goods that can be consumed and
produced within an economy. Prices will be higher, and there will be fewer choices with
regards to consumer goods. Beneficiaries of a tariff include the government, which collects
the tariff, and domestic producers within the affected industries.

Arguments in favor of trade restrictions include:

Infant Industries - Start-up industries in a country may not be able to effectively

compete against foreign producers because of their small size. And most of the time
suppliers import products which are cheaper in price, so with competing with these
foreign producers it might affect the small start up industries. So to help those infant
industries government put import restriction.
Anti-Dumping - The term dumping is applied when foreign producers sell their goods
at prices below their production costs, or below the prices charged in their home
market. This unfair pricing practice will drive domestic producers out of business and
that the foreign producers will then impose monopoly pricing.

Figure: Import Restriction
This graph shows the effect of import
restriction. At world price Pw the demand
for the product is and suppliers will
supply . O there remains a shortage of
product from to . If government does
not allow importing goods from foreign
producers, the suppliers will increase the
product price to maintain an equilibrium
situation to maximize their profit. Due to
import restriction, Consumer surplus will
loss area A, B and C. And producer will gain
area A. So the dead weight loss for the
society is the area B and C.

TARIFF

Tariff is a tax or duty to be paid on a particular class of imports or exports for any particular
products. Tariffs are used to restrict trade, Government increase the price of imported goods
and services, making them more expensive to consumers. Tariffs provide additional revenue
for governments and domestic producers at the expense of consumers and foreign producers.
Example: Government imposed tariff of 25% of the selling price on imported car in
Bangladesh.
 In This graph, the world price of a product is
Pw. Now, government of the country
imposes tariff on the product. So, now the
price goes up to P. So now consumer will
have to pay extra due to tariff. So consumer
surplus will lose area A, B, C & D. So, demand
reduces from to . On the other hand,
the Producer surplus gain area A. and the
supply increase from to . As a result,
there is a dead weight loss occurs in area B
Figure: Tariff and C. And governments revenue is the area
of D.

IMPORT QUOTA

An import quota is a government-imposed trade restriction that limits the number, or

monetary value, of goods that can be imported during a particular time period. Quotas are
used in international trade to help regulate the volume of trade between countries. They are
sometimes imposed on specific goods to reduce imports, thereby increasing domestic
production. In theory, this helps protect domestic production by restricting foreign
competition.

Quotas are different than tariffs, or customs, which place a tax on imports or exports in and
out of a country. Both quotas and tariffs are protective measures imposed by governments
to try to control trade between countries, but quotas focus on providing limits by defining the
quantities of a particular good that will be accepted, while tariffs impose a specific fee on
those goods seeking entry into the country.
 Figure: Import Quota

This graph represents the effects of import quota. When the world price of a commodity is
Po, the demand for that product is and suppliers will supply quantity at that price. So
there will be a shortage of to . To overcome this problem, government permits the
suppliers to import a certain quantity of products by importing quota. So then the price of
that commodity increases to P*. For this the demand will decreased up to and supply will
increase up to . Due to this consumer will lose area A, B, C, D. And domestic producers will
gain are A. Here the area D will be foreign producers gain. So overall the society will lose the
area B, C, D. But in case of tariff the dead weight loss is area B and C. And government earns
area D. But in quota this portion goes to the foreign producer, thus lead to more loss to the
social welfare. So, tariff is better than quota for any country.
TAX

A tax is a financial charge or other levy imposed upon a taxpayer by a state or the functional
equivalent of a state to fund various public expenditures. Taxes are unrequited in the sense
that benefits provided by government to taxpayers are not normally in proportion to their
payments.

General government consists of supra-national authorities, the central administration and the
agencies whose operations are under its effective control, state and local governments and
their administrations, social security schemes and autonomous governmental entities,
excluding public enterprises.

THE EFFECT OF TAX

At equilibrium the price of the product is P and quantity of the product is 100. Without tax,
consumer will get area or consumer surplus is area A, D & B. the producer surplus or producer
will get area E, F & C. there is no government revenue at this time. So the total surplus is
areaA, B, C, D, E & F. Without tax, Consumer surplus= A+D+B Producer surplus= E+F+C
Government Tax revenue= 0 Total surplus = A+B+C+D+E+F When government impose tax,
new consumer surplus is area A. New producer surplus is area D, E & F.
 P
S

A
1
D t B
P
E C
0
F D

Q
80 100

Figure: Incident of a Tax

Then change of consumer surplus or consumer will loose area D and area B and producer will
Gain Area D and loose area C. Area D is redistributed from consumer to producer. Buyer will
lose area B because they can not buy this area and seller will loose area C because they cannot
sell area C because of tax. After tax imposed government revenue is area D and area E So we
can say that, Change of consumer surplus, CS= - D - B

Change of producer surplus, PS= D -Cc

Dead weight loss= - B C

TYPES OF TAX

Tax can be classified by two ways and they are given bellow-

1. Direct tax or tax on buyers

2. Indirect tax or tax on sellers or producers
DIRECT TAX OR TAX ON BUYERS

Direct tax or tax on buyers is a kind of tax paid by individually to whom tax have been imposed.
A direct tax is paid directly by an individual or organization to an imposing entity. A taxpayer,
for example, pays direct taxes to the government for different purposes, including real
property tax, personal property tax, income tax or taxes on assets. Direct taxes are different
from indirect taxes, where the tax is levied on one entity, such as a seller, and paid by another,
such as a sales tax paid by the buyer in a retail setting. A tax on buyer, shift the demand curve
down by the amount of tax. If tax imposed, then purchased power will fall or will go down
and buyer will demand less quantity.

How tax is shared:

At equilibrium, consumer can buy 500 units of product at Tk10. When government imposed
tax consumer buying power will fall and they can buy less quantity of goods and as a result
demand curve will shift left or demand curve will fall and there will be q new equilibrium point
at new demand curve. Buyer or consumer will bear or pay the amount above the equilibrium
price and producer will bear or pay under the equilibrium price.

Area B is loss of buyers and area C is loss of consumers. And the dead weight loss is area B &
C
Dead weight loss= -B-C
Buyer or consumer will pay = (11-10) = 1
Seller or producer will pay = (10-9.5) = 0.5
Total tax = 1+0.5 = 1.5
 P
S

10
Tax from Loss to
consumers B consumers
11
Tax from
C Loss to
9.5 Producers
Producers

Q
430 500

Figure: Direct Tax

INDIRECT TAX OR TAX ON SELLER OR PRODUCER

Tax burden is shared by two parties and they are consumer and producer. Government collect
all the amount of tax from producer and producer take it from consumer or buyer.

Example: Vat, Gst etc.

A tax increases the costs of production causing an inward shift in the supply curve
The vertical distance between the pre-tax and the post-tax supply curve shows the tax
per unit
With an indirect tax, the supplier may be able to pass on some or all of this tax onto
the consumer through a higher price
This is known as shifting the burden of the tax and the ability of businesses to do this
depends on the price elasticity of demand and supply
How tax is shared?
At equilibrium, consumer can buy 100 units of product at Tk18. When government imposed
indirect tax on producer or seller supply curve will shift left and there will be q new
equilibrium point at new supply curve.

2 (With tax)
P
S

1 25
Tax from Loss to
consumers B consumers
20
Tax from
C Loss to
2 18 Producers
Producers

500
Q
400

Figure: Indirect Tax

Area B is loss of buyers because they can not buy this area and area C is loss of consumers because
they can not sell the . And the dead weight loss is area B & C

DWL= -B-C

Buyer or consumer will pay = (25-20) = 5

Seller or producer will pay = (20-18) = 2

Total tax= 5+2= 7