ECONOMICS FOR MANAGERS

BA533
MODULE 4: Supply and
Demand in Competitive
Markets
“Just How Far Can Trading of Emissions be Extended?”
“Not So Fair Pay”
“Report Fuels Wage Debate”
“Fuel Fee May Raise Pa. Gas Prices”

Fall 2017 Economics for Managers: Module 4 1

 Topics...
Efficiency and Equity (or “fairness”)
Price Ceilings and Price Floors
Deadweight Loss (Welfare Loss
Estimation)
Externalities
Tax Incidence
Quotas and Tariffs on imports

Fall 2017 Economics for Managers: Module 4 2

 Module 4 Assignments
Background reading from P&R, and the
readings, listed in the syllabus
Practice problems 20 - 27.
Study Guide:
Chapter 2 Problems:
1-6, 10, 11, 17-19, 24-26

Chapter 9 Problems:
1-3, 5, 8 -18, 20-25
Fall 2017 Economics for Managers: Module 4 3
 CAVEATS
What were our implicit
assumptions when we examined
the results of competitive
markets?

Fall 2017 Economics for Managers: Module 4 4

 Caveats: Our Implicit
Assumptions
Consumer Sovereignty: Consumers are
the best judge of what is good for them.
A counterexample: laws prohibiting driving
without seatbelts or motorcycle helmets
Income Distribution: A competitive market
maximizes the total benefits of production
given the initial distribution of income.
What if the initial wealth distribution is unjust
or unfair?
Fall 2017 Economics for Managers: Module 4 5
 More Assumptions….
No Externalities: Producers bear all of
the costs of production, and purchasers
receive all of the benefits of
consumption.
Two types of Externalities:
Spillover Costs
Spillover Benefits

Fall 2017 Economics for Managers: Module 4 6

 Spillover Costs
An Example: A paper mill that pollutes a river
Social Cost
MCSOCIAL

MCPRIVATE

E
Demand

Q* QC Q
TBP Max Mkt Eq
Fall 2017 Economics for Managers: Module 4 7
 Spillover Costs: Results
In a competitive market with spillover
costs, the equilibrium:
Results in overproduction
Does not maximize the total benefits of
production
The Problem: The firm does not bear
all of the costs of production when it
selects the quantity where P = MC

Fall 2017 Economics for Managers: Module 4 8

 Spillover Benefits
An Example: NAPSTER!
Social Cost
MC
TBP Max

Mkt Eq DSOCIAL
E

DPRIVATE

QC Q* Q
Fall 2017 Economics for Managers: Module 4 9
 Spillover Benefits: Results
In a competitive market with spillover
benefits, the equilibrium:
Results in underproduction
Does not maximize the total benefits of
production
The Problem: The consumer does not
bear all of the benefits of consumption
when she makes her purchase decision
Other examples: Defense, lighthouses,
beekeepers
Fall 2017 Economics for Managers: Module 4 10
 A Real-World Example:

Trading permits for SO2

Emissions

Fall 2017 Economics for Managers: Module 4 11

 Using the Competitive Model

Let’s examine the effects of some

“popular” government policies

Fall 2017 Economics for Managers: Module 4 12

 Wage and Price Controls
In the United States :
During World War II (included rationing)
Early 1970’s to deal with inflationary
pressures
Gasoline price controls during the Oil
Embargo during the 1970’s
Recent “rolling blackouts” of electricity in
California
In non-market economies:
Soviet Union, China and Eastern Europe
Fall 2017 Economics for Managers: Module 4 13
 An Example: Price Ceilings
A recent example in the US: Natural Gas
1954 “Phillips” Decision: Gave the Federal
Government the ability to regulate the price
of gas sold in interstate commerce
First Attempt: Cost-based regulation on a
well-by-well basis
The 1960 caseload wouldn’t be finished until
2043
Second Attempt: Area rates set in 1960
Fall 2017 Economics for Managers: Module 4 14
 Price Ceilings: Natural Gas
Third Attempt: National price of 24
cents per mcf in 1974
The result: Shortages of gas in
interstate markets by the winter of 1975.

What Happened?
Let’s Look at the Competitive Model!

Fall 2017 Economics for Managers: Module 4 15

 Price Ceilings for Natural Gas
“Deadweight
Loss” S

Mkt.
Eq. P*
transfer
PC
D
Ceiling
Price QD
QS
shortage

Fall 2017 Economics for Managers: Module 4 16

 Price Ceilings: Results
Shortages (Demand > Supply)
Consumers who get gas pay less than
the (unregulated) market price
Some consumers, who would be willing
to pay the (unregulated) market price,
don’t get any natural gas
Deadweight Loss (Total Benefits of
Production are not maximized)

Fall 2017 Economics for Managers: Module 4 17

 We might expect consumers to line up to get
the good. This represents an additional
deadweight loss. We might also see
consumers lobbying to maintain the ceiling
and sellers lobbying to eliminate it. These
expenditures are also wasteful.
On the other hand, we might expect some
forces to attenuate the deadweight losses.
For example, secret bribes or even legal or
quasi-legal ways to get around the price
ceiling. This undermines the goal of the price
ceiling but reduces the deadweight loss.

Fall 2017 Economics for Managers: Module 4 18

Another Example: Price Floors
This entails the setting of a price above
that which would prevail in an unregulated
market
Common Examples:
Price Supports for agricultural products
Minimum wage laws

What Happens?
Let’s Look at the Competitive Market Model!

Fall 2017 Economics for Managers: Module 4 19

“Facts” about the US minimum wage...
1938: $0.25 per hour.
January 1981 - March 1990: $3.35 per hour.
Beginning April 1990: $3.80 per hour.
Beginning April 1991: $4.25 per hour.
Beginning October 1, 1996: $4.75 per hour
Beginning September 1, 1997: $5.15 per hour
Beginning July 24, 2008: $6.55 per hour
Beginning July 24, 2009: $7.25 per hour
In 2013, about 3.3 million workers (4.3% of all hourly workers) were
at or below the minimum wage.
In 2013, about half of all workers paid at or less than the minimum
wage earners are less than 25 years old, yet these compose only
one-fifth of all hourly workers.
Some states, notably California, have higher minimum wages.

Fall 2017 Economics for Managers: Module 4 20

 Effect of Minimum Wage Laws
wage DWL
S
WMIN
transfer
Minimum By workers
W*
Wage
By Firms
Market
Eq. D

LD LS Labor
Excess
supply
Fall 2017 Economics for Managers: Module 4 21
 Price Floors: Results
There is an excess supply of labor at the
regulated wage (Supply > Demand)
Workers who still have jobs are better off
since their wage is higher than the non-
regulated market equilibrium wage
Some workers who would have had jobs
in the unregulated market are unemployed
Total Benefits of Production are not
maximized

Fall 2017 Economics for Managers: Module 4 22

Estimates of minimum wage effects
A 1993 study concluded that for every 1% hike, retail
employment dropped 0.8 to 0.9%, with teens
particularly vulnerable. (Carnegie Mellon)
Evidence from previous minimum-wage increases
suggests that workers who keep their jobs can expect
to lose both hours, as some full-time jobs are
converted to part-time, and benefits, especially on-
the-job training.
Alan Krueger and David Card (Princeton) showed that
for a minimum wage increase in New Jersey, there
was no significant change in employment growth.
Krueger says”I have little doubt that a really large
increase in the minimum wage would have an
adverse effect on employment.”
Fall 2017 Economics for Managers: Module 4 23
 The Incidence of a tax: Who
really pays the bill?
Suppose the Government levies a tax of “t”
on every unit sold.

Question: Does it matter whether the

tax is charged to the firm or to the
consumer?

Fall 2017 Economics for Managers: Module 4 24

 A Tax levied on the Firm
S’
t
S
Pafter Tax
RC
Pbefore Tax DWL
RS

Qt Q*

Fall 2017 Government Revenue:

Economics for RC4 + RS
Managers: Module 25
 A Tax levied on the Consumer

RC
Pbefore Tax t
DWL
RS
Pafter Tax
D
D’
Qt Q*

Fall 2017 Government Revenue:

Economics for RC4 + RS
Managers: Module 26
 Tax Incidence: Results
It doesn’t matter who the tax is levied on
The results are the same, whether the tax is
placed on the firm, or on the consumer
The equilibrium price in the market does
differ, however.
Who “Pays” the tax depends on the
relative elasticities of Supply and Demand
More elastic D more tax falls on seller
More elastic S more tax falls on consumer

Fall 2017 Economics for Managers: Module 4 27

 A Couple of Polar Cases
Consumer Pays Firm Pays

D S
S’

PAfter S
R t P Before
PBefore R t
D
PAfter
D’
Q* Q*
Tax levied on Firm, Tax levied on Consumer,
Totally Inelastic D Totally Inelastic S
Fall 2017 Economics for Managers: Module 4 28
 Now, Let’s Look at Some
Trade Policies

Begin with no trade

restrictions...

Fall 2017 Economics for Managers: Module 4 29

 The Effect of Imports
SDOMESTIC

No-trade
equilibrium
P*
Transfer Net
gain
PW
DDOMESTIC
“World”
price SD DD
Imports
Fall 2017 Economics for Managers: Module 4 30
One Trade Restriction: Tariffs

A tariff is a tax levied on imports that is

collected as they enter the country
The effect of the tariff is to increase the
price of buying on the world market by
the amount of the tax
So, the price to import is now PW + the tariff

Fall 2017 Economics for Managers: Module 4 31

 The Effect of Tariffs
Change in CS: A+B+C+D
Market SDOMESTIC
Price
with A: To domestic firms
Tariff
C: To the Tax Collector
PT
Tariff A B C D Net Loss: B + D
PW
Imports DDOMESTIC
World
Price SD DD
Imports
Fall 2017 Economics for Managers: Module 4 32
Another Trade Restriction: Import
Quotas
A quota is a restriction on the amount of a
product that can be imported into a country
Since the quota is generally less that imports
in the absence of the quota, the effect of the
quota is to generate excess demand for the
imported good at PW
The domestic price must increase to restore
market equilibrium, so that at the new price:

Domestic Supply + Quota = Domestic Demand

Fall 2017 Economics for Managers: Module 4 33

 The Effect of Import Quotas
Change in CS: A+B+C+D
Market SDOMESTIC
Price
with A: To domestic firms
Quota
C: To foreign firms
PQ
A B C D Net Loss: B + D
PW
DDOMESTIC

SD Quota DD

Fall 2017 Economics for Managers: Module 4 34