10. ApplicationsZero Profit for Competitive Firms in the Long RunProducer SurplusProducer SurplusProducer SurplusSlide Number 6Slide Number 7Slide Number 8Slide Number 9Slide Number 10Slide Number 11Slide Number 12Policies That Shift Supply CurvesRestricting the number of firms Raising entry and exit costs Policies That Create a Wedge Between Supply and Demand CurvesSales TaxSlide Number 18Slide Number 19Slide Number 20Slide Number 21Slide Number 22Slide Number 23Slide Number 24Slide Number 25Slide Number 26Slide Number 27Slide Number 28Slide Number 29Slide Number 30Slide Number 31Slide Number 32Slide Number 33Price FloorPrice FloorPrice CeilingPrice CeilingComparing Both Types of Policies: TradeComparing Both Types of Policies: Trading Crude OilFree Trade vs. No TradeTariffsTariffsQuotasQuotasRent Seeking10. Applications • Zero Profit for Competitive Firms in the Long Run • Producer Welfare • How Competition Maximizes Welfare • Policies That Shift Supply Curves • Policies That Create a Wedge Between Supply and Demand Curves • Comparing Both Types of Policies: Trade 1Zero Profit for Competitive Firms in the Long Run • With Free Entry into the Market • Along with identical costs and constant input prices, implies firms each face a horizontal LR supply curve • Firms operate at minimum LR average cost • Firms earn zero economic profit in the LR • When Entry into the Market is Limited • which may occur because of limited supply of an input • Bidding for scarce input drives up input price • LR economic profit is still driven to zero 2Producer Surplus • Producer surplus (PS) is the difference between the amount for which a good sells (market price) and the minimum amount necessary for sellers to be willing to produce it (marginal cost). • Step function 3Producer Surplus • Producer surplus (PS) is the area above the inverse supply curve and below the market price up to the quantity purchased by the consumer. • Smooth inverse supply function 4Producer Surplus • Producer surplus is closely related to profit. • Profit: • Subtracting off fixed costs yields PS: • Producer surplus is useful for examining the effects of any shock that doesn’t affect a firm’s fixed costs. 5Example: Total surplus (welfare) in a perfectly competitive market 10 / 22DSQPQP= −= −Solving DQSQ=, we have the competitive equilibrium: 10 / 2 23 / 2 12*8* * 2 6.PPPpQp−=−=== −=610 / 22DSQPQP= −= −7At the perfectly competitive equilibrium (Q*,P*), the consumer surplus is: AVR = ( ) (20 8)6/ 2 36CS area =−=The producer’s surplus is: (AWR) (8 2)6/2 18PS area= =−=The total surplus is: (WVR) 36 18 54TS CS PS area=+==+=8Economic Efficiency means that the total surplus is maximized. “Every consumer who is willing to pay more than the opportunity cost of the resources needed to produce extra output is able to buy; every consumer who is not willing to pay the opportunity cost of the extra output does not buy.” “All gains from trade (between buyers and suppliers) are exhausted at the efficient point.” The perfectly competitive equilibrium attains economic efficiency. 9At any other price, the total surplus is not maximized. For example, take price P=12, We can compute the surplus at p=12 and Q=4 as follows: At P=12, the quantity demanded: 10 12/2 4DQ =−=The quantity supplied: 12 2 10SQ = −=Since SDQQ>, transaction occurs at Q=4. 10(20 12)4/2 16(12 6)4 (6 2)4/2 3248CSPSTS CS PS=−== − +− ==+=Note that 48<54, so the efficiency loss is 6, which is the area of STR. This is called deadweight loss: a reduction in net economic benefits resulting from an inefficient allocation of resources. 11• The reason that competition maximizes welfare is that price equals marginal cost at the competitive equilibrium. • Consumers value the last unit of output by exactly the amount that it costs to produce it. • A market failure is inefficient production or consumption, sometimes because a prices exceeds marginal cost. • Example: Deadweight loss of Christmas presents 12Policies That Shift Supply Curves • Welfare is maximized at the competitive equilibrium • Government actions can move us away from that competitive equilibrium • Thus, welfare analysis can help us predict the impact of various government programs • We will examine several policies that shift supply: 1. Restricting the number of firms 2. Raising entry and exit costs 13Restricting the number of firms • Restricting the number of firms causes supply to shift left 14Raising entry and exit costs • Entry Barriers: raising entry costs • A LR barrier to entry is an explicit restriction or a cost that applies only to potential new firms (e.g. large sunk costs). • Indirectly restricts the number of firms entering • Costs of entry (e.g. fixed costs of building plants, buying equipment, advertising a new product) are not barriers to entry because all firms incur them. • Exit Barriers: raising exit costs • In SR, exit barriers keep the number of firms high • In LR, exit barriers limit the number of firms entering • Example: job termination laws 15Policies That Create a Wedge Between Supply and Demand Curves • Welfare is maximized at the competitive equilibrium • Government actions can move us away from that competitive equilibrium • Thus, welfare analysis can help us predict the impact of various government programs • We will examine several policies that create a wedge between S and D: 1. Sales tax and subsidy 2. Price floor 3. Price ceiling 16Sales Tax • Sales Tax (or excise tax, specific tax, per-unit tax) • A new sales tax causes the price that consumers pay to rise and the price that firms receive to fall. • The former results in lower CS • The latter results in lower PS • New tax revenue is also generated by a sales tax and, assuming the government does something useful with the tax revenue, it should be counted in our measure of welfare: 17A Sales tax (or excise tax, specific tax, per-unit tax) is an amount paid by either the consumer or the producer per unit of the good at the point of sale. - The amount paid by the consumers exceeds the total amount received by the sellers by amount T. Sales Tax 18Example: Sales Tax T Q P Q1 Q* Pd Ps P* S′S19The amount by which the price paid by buyers rises over the non-tax equilibrium price, , is the incidence of the tax on consumers; the amount by which the