Lecture-4: Applications of Market Equilibrium

Abdul Quadir
XLRI

June 28, 2023

Readings

Chapter 10 and Section 5.3 of Chapter 5

Introduction

▶ To evaluate the efficiency of market

▶ How to measure welafre of consumers and producers?
▶ Consumers’ surplus (CS) and producers’ surplus (PS)
▶ To evaluate the government policies
– who gains and who losses from a government policy such as rent control, MSP, or
minimum wage
Introduction

▶ To evaluate the efficiency of market

▶ How to measure welafre of consumers and producers?
▶ Consumers’ surplus (CS) and producers’ surplus (PS)
▶ To evaluate the government policies
– who gains and who losses from a government policy such as rent control, MSP, or
minimum wage
Consumer Surplus

▶ Consumers buy goods because the purchases make them better off
▶ Each consumer assigns a different value to a good
▶ Consumer’s Surplus: The difference between the maximum amount that a
consumer is willing to pay and what she is actually paying
▶ For instance, suppose you are willing to pay 1 lac rupees for a Macbook Air, but
the price of a Macbook Air is 90k
▶ Then 10k is your consumer surplus.
▶ CS=Maximum willingness to pay − Actual Payment
▶ Suppose a consumer wishes to consume more than 1 unit; how can we compute
CS?
▶ We can trace the consumer’s willingness to pay through the demand curve.
Consumer Surplus

▶ Consumers buy goods because the purchases make them better off
▶ Each consumer assigns a different value to a good
▶ Consumer’s Surplus: The difference between the maximum amount that a
consumer is willing to pay and what she is actually paying
▶ For instance, suppose you are willing to pay 1 lac rupees for a Macbook Air, but
the price of a Macbook Air is 90k
▶ Then 10k is your consumer surplus.
▶ CS=Maximum willingness to pay − Actual Payment
▶ Suppose a consumer wishes to consume more than 1 unit; how can we compute
CS?
▶ We can trace the consumer’s willingness to pay through the demand curve.
Graph: CS

price per litre CS=25+15+5=45

50

40

30
25 Price
20

10

q (litres)
1 2 3 4 5
Graph: Consumer’s Surplus
▶ The CS is the area under the demand curve and above the price
▶ For a smooth demand curve, it is depicted below:

price per litre

CS=Area of Black Triangle

p∗

q (litres)
q∗
Example: Consumer Surplus
Suppose the firm sells 20 rupees per litre
price per litre How many litres a consumer will consume?
What is firm’s revenue?
50 What is consumer’s surplus?
What is the total value of 3 litres to a consumer?
40 Total Value to a consumer = Cosnumer Surplus + Firm Revenue

30

20

10

q (litres)
1 2 3 4 5
Example: CS

Suppose the equation Q = 400 − 4P represents a consumer’s monthly demand curve

for milk, where Q is the number of litres of milk purchased when the price is P rupees
per litre.
1. What is the monthly consumer surplus if the milk price is Rs. 30 per litre?
2. What is the increase in consumer surplus if the price falls to Rs. 20 per litre?
Example: CS
CS=9800
P CS=12800
∆CS = 3000
100 you do not have to draw the graph to find CS unless asked to do so,
you can also imagine the triangle in head
step 1 - calculate Q kya chahiye hoga for a given P
step 2 - max P (yaha 100) - given P (yaha 30) = Height (70)
step 3 - min Q (yaha 0) - calculated Q (yaha 280) = Base (280)
step 4 - consumer surplus = 1/2*base*height

30
20

Q
280 320 400
Producer Surplus

▶ Unlike consumers, producers would like the prices as high as they could be
▶ Producer Surplus: It is the amount of money producers receive in excess of the
amount necessary to induce them to produce the good
▶ Geometrically, producer surplus is the area above the supply curve but below the
market price of the good
Example: Producer Surplus
px = 400 1
3 + 3q
p PS = Area of triangle ABC
PS=106, 668

S
B
400 A

400
3 C
q
800
Social Surplus and Deadweight Loss

▶ Social Surplus: It is the sum of consumer surplus and producer surplus

▶ Deadweight loss The net loss of producer and consumer surplus
▶ When supply and demand interact freely, competitive markets produce what
people want at the least cost; that is, they are efficient
Market Efficiency
competitive markets maximize the sum of CS and PS
p

S
consumer surplus

p∗
producer surplus

q
q∗
Dead-weight Loss: Underproduction
sum of the area of green and red triangles is the deadweight loss
p

S
consumer surplus

pu
producer surplus

p∗

q
qu q∗
Exercise

▶ When demand is estimated to be p = 50 − 0.5x, calculate the loss in consumer

surplus when a tax drives price from 1 to 5.
▶ Let the demand and supply functions for a product be

20
p = p(q d ) = and p = p(q s ) = q + 2.
q+1
Find the equilibrium price and quantity. Then compute the consumer and
producer surplus.
Applications of Demand and Supply
Price Rationing

▶ Market system is also known as price system provides an automatic mechanism

for distributing scarce goods and services
▶ In other words, it serves as price rationing device
▶ Price rationing: The process by which the market system allocates goods and
services to consumers when quantity demanded exceeds quantity supplied
Example: Price Rationing
p
S1

S0
2200

2000

q (metric ton)
600 720 800
Demand-determined Price

▶ Is there always a price that will clear p

the market?
▶ What about you owns a piece of land S
and you do not want to sell it
▶ The price of scarce resources is very
high if there are many demanders,
e.g., paintings, antiques, etc.
▶ In this situation, we say that price is D
painting
demand-determined 1
Example: Competitive Market
Unfettered marked of wheat leads to equilibrium point E
Farmers’ union think that Rs. 2000 per quintal is too low a price
p Consumers think that Rs. 2000 per quintal is too high a price

S0

E
2000

q (metric ton)
800
Example: Competitive Market
Unfettered marked of wheat leads to equilibrium point E
Farmers’ union think that Rs. 2000 per quintal is too low a price
p Consumers think that Rs. 2000 per quintal is too high a price

S0

E
2000

q (metric ton)
800
Price Controls

▶ Farmers argue that they require higher prices because of cut-throat competition;
they are incurring losses at the current price
▶ If the government buys farmers’ argument, it will fix a minimum price.
▶ The legislated minimum price is known as price floor
▶ Consumers always want to pay lower prices
▶ Therefore, if they succeed in lobbying the government, then it will fix a maximum
price
▶ The legislated maximum price is known as price ceiling
Price Controls

▶ Farmers argue that they require higher prices because of cut-throat competition;
they are incurring losses at the current price
▶ If the government buys farmers’ argument, it will fix a minimum price.
▶ The legislated minimum price is known as price floor
▶ Consumers always want to pay lower prices
▶ Therefore, if they succeed in lobbying the government, then it will fix a maximum
price
▶ The legislated maximum price is known as price ceiling
Price Ceiling
▶ The government legislates a maximum price (price ceiling) moved by consumers’
lobby

Price ceiling of 2500 is not binding Price ceiling is binding constraint

p p

S S
2500

2000 2000

1500
D D

q q
800 800
Price Ceiling
▶ The government legislates a maximum price (price ceiling) moved by consumers’
lobby

Price ceiling of 2500 is not binding Price ceiling is binding constraint

p p

S S
2500

2000 2000

1500
D D

q q
800 800
Price Ceiling
▶ What does price ceiling do?
▶ It leads to shortage in the market
p

2000

1500
D

q
600 800 1000
Price Ceiling
▶ What does price ceiling do?
▶ It leads to shortage in the market
p

2000

1500
D

q
600 800 1000
Price Ceiling

▶ Then, how will you allocate the product among those who want it?
▶ There could develop various mechanisms to allocate the goods:
– a long line: buyers who are willing to arrive early and wait in line to get wheat
– sellers could ration the amount of wheat according to their personal biases
- selling them only to friends, relatives, or members of their own racial or ethnic group
▶ no mechanism will distribute it in a way such that everyone is happy
▶ Because of artificially created shortages, many problems crop up:
– wastage of buyers’ time standing in the line (opportunity cost of time)
– discriminatory allocation leads to tension and other problems
▶ The price system does this job very elegantly through prices
▶ Does it do it fairly?
▶ No. But unfairness is not the result of the market system; it is the result of
scarcity
Price Ceiling

▶ Then, how will you allocate the product among those who want it?
▶ There could develop various mechanisms to allocate the goods:
– a long line: buyers who are willing to arrive early and wait in line to get wheat
– sellers could ration the amount of wheat according to their personal biases
- selling them only to friends, relatives, or members of their own racial or ethnic group
▶ no mechanism will distribute it in a way such that everyone is happy
▶ Because of artificially created shortages, many problems crop up:
– wastage of buyers’ time standing in the line (opportunity cost of time)
– discriminatory allocation leads to tension and other problems
▶ The price system does this job very elegantly through prices
▶ Does it do it fairly?
▶ No. But unfairness is not the result of the market system; it is the result of
scarcity
Price Ceiling

▶ Then, how will you allocate the product among those who want it?
▶ There could develop various mechanisms to allocate the goods:
– a long line: buyers who are willing to arrive early and wait in line to get wheat
– sellers could ration the amount of wheat according to their personal biases
- selling them only to friends, relatives, or members of their own racial or ethnic group
▶ no mechanism will distribute it in a way such that everyone is happy
▶ Because of artificially created shortages, many problems crop up:
– wastage of buyers’ time standing in the line (opportunity cost of time)
– discriminatory allocation leads to tension and other problems
▶ The price system does this job very elegantly through prices
▶ Does it do it fairly?
▶ No. But unfairness is not the result of the market system; it is the result of
scarcity
Price Ceiling

▶ Then, how will you allocate the product among those who want it?
▶ There could develop various mechanisms to allocate the goods:
– a long line: buyers who are willing to arrive early and wait in line to get wheat
– sellers could ration the amount of wheat according to their personal biases
- selling them only to friends, relatives, or members of their own racial or ethnic group
▶ no mechanism will distribute it in a way such that everyone is happy
▶ Because of artificially created shortages, many problems crop up:
– wastage of buyers’ time standing in the line (opportunity cost of time)
– discriminatory allocation leads to tension and other problems
▶ The price system does this job very elegantly through prices
▶ Does it do it fairly?
▶ No. But unfairness is not the result of the market system; it is the result of
scarcity
Price Ceiling

▶ Then, how will you allocate the product among those who want it?
▶ There could develop various mechanisms to allocate the goods:
– a long line: buyers who are willing to arrive early and wait in line to get wheat
– sellers could ration the amount of wheat according to their personal biases
- selling them only to friends, relatives, or members of their own racial or ethnic group
▶ no mechanism will distribute it in a way such that everyone is happy
▶ Because of artificially created shortages, many problems crop up:
– wastage of buyers’ time standing in the line (opportunity cost of time)
– discriminatory allocation leads to tension and other problems
▶ The price system does this job very elegantly through prices
▶ Does it do it fairly?
▶ No. But unfairness is not the result of the market system; it is the result of
scarcity
Price Ceiling

▶ Then, how will you allocate the product among those who want it?
▶ There could develop various mechanisms to allocate the goods:
– a long line: buyers who are willing to arrive early and wait in line to get wheat
– sellers could ration the amount of wheat according to their personal biases
- selling them only to friends, relatives, or members of their own racial or ethnic group
▶ no mechanism will distribute it in a way such that everyone is happy
▶ Because of artificially created shortages, many problems crop up:
– wastage of buyers’ time standing in the line (opportunity cost of time)
– discriminatory allocation leads to tension and other problems
▶ The price system does this job very elegantly through prices
▶ Does it do it fairly?
▶ No. But unfairness is not the result of the market system; it is the result of
scarcity
Example: Price Ceilings

p ▶ There is excess demand q d − q c at price p c

▶ There could be two reasons for this
shortage:
S
1. Fewer producers are willing to sell at this
price
p∗ 2. More consumers are willing to consume
B this product because it has become
A
pc cheaper
▶ Allocation mechanism is ‘first come, first
D served’
▶ This could result in a long queue
q ▶ There is an associated opportunity cost of
qc q∗ qd
waiting in the queue
Price Ceiling and Opportunity Cost
pf = pc + (p f − p c )
|{z} |{z} | {z }
p full price rupee price nonpecuniary price

pf

p∗

A B
pc

q
qc q∗ qd
Price Ceiling and Loss of Society
Loss in PS = green triangle
p
Loss in CS = red triangle

pf

p∗

A B
pc

q
qc q∗ qd
Example: Price Ceiling

▶ Suppose the supply and demand function for a product are given by

q d = 100 − 2p q s = 20 + 2p

▶ What is the market equilibrium price and quantity?

▶ p ∗ = 20 and q ∗ = 60
▶ Suppose government puts a price ceiling of 15 rupees. How much will be supplied,
and what is the loss to society?
▶ p c = 15, q c = 50, q d = 70, q d − q c = 70 − 50 = 20, p f = 25
Example: Price Ceiling

▶ Suppose the supply and demand function for a product are given by

q d = 100 − 2p q s = 20 + 2p

▶ What is the market equilibrium price and quantity?

▶ p ∗ = 20 and q ∗ = 60
▶ Suppose government puts a price ceiling of 15 rupees. How much will be supplied,
and what is the loss to society?
▶ p c = 15, q c = 50, q d = 70, q d − q c = 70 − 50 = 20, p f = 25
Example: Price Ceiling

▶ Suppose the supply and demand function for a product are given by

q d = 100 − 2p q s = 20 + 2p

▶ What is the market equilibrium price and quantity?

▶ p ∗ = 20 and q ∗ = 60
▶ Suppose government puts a price ceiling of 15 rupees. How much will be supplied,
and what is the loss to society?
▶ p c = 15, q c = 50, q d = 70, q d − q c = 70 − 50 = 20, p f = 25
Example: Price Ceiling
p

50

S
25
20
15

q
20 50 60 70 100
Comments on Price Ceiling

▶ Note we have seen that price ceilings are not economically beneficial. Then why
price ceilings?
▶ The answer lies in who gets benefits and who gets harmed by ceilings
▶ People have varying opportunity costs of standing in a queue
▶ In case of a shortage arising because of ceilings, there are other ways of
distributing the objects
▶ most favored customers
▶ Coupons
Comments on Price Ceiling

▶ Note we have seen that price ceilings are not economically beneficial. Then why
price ceilings?
▶ The answer lies in who gets benefits and who gets harmed by ceilings
▶ People have varying opportunity costs of standing in a queue
▶ In case of a shortage arising because of ceilings, there are other ways of
distributing the objects
▶ most favored customers
▶ Coupons
Price Floor
▶ The government legislates a minimum price (price floor) moved by farmers’ lobby

Price floor is not binding Price floor is binding constraint

p p

S S
2500

2000 2000

1500
D D

q
800 800
Price Floor
▶ The government legislates a minimum price (price floor) moved by farmers’ lobby

Price floor is not binding Price floor is binding constraint

p p

S S
2500

2000 2000

1500
D D

q
800 800
Price Floor

S
▶ Minimum wage and minimum support 2500
price (MSP) are the common examples of
a price floor 2000
▶ Price floor causes the excess supply in the
economy
D

650 800 950 q

Price Floor

▶ There will be a surplus because of the price floor

▶ In the case of agricultural produce, the government buys out the surplus
▶ The total cost to the government is p f (q f − q d )
▶ Example: Suppose the supply and demand are given as

q d = 100 − 2p q s = 20 + 2p

▶ Price floor is fixed at p f = 40

▶ q f = 20 + 2 × 40 = 100, q d = 100 − 2 × 40 = 20, surplus=80
▶ Cost to the government is 40 × 80 = 3200
Minimum Support Price (MSP)
p ∆CS = −A − B
∆PS = A + B + C
S The Govt. cost=(Q2 − Q1 )p s
total change in welfare =
ps ∆CS + ∆PS − (Q2 − Q1 )p s =
A B C C − (Q2 − Q1 )p s
p∗

F D D + Gd

Q
Q1 Q∗ Q2

Why MSP not direct cash transfer to the farmer?

Minimum Support Price (MSP)
p ∆CS = −A − B
∆PS = A + B + C
S The Govt. cost=(Q2 − Q1 )p s
total change in welfare =
ps ∆CS + ∆PS − (Q2 − Q1 )p s =
A B C C − (Q2 − Q1 )p s
p∗

F D D + Gd

Q
Q1 Q∗ Q2

Why MSP not direct cash transfer to the farmer?

Minimum Support Price (MSP)
p ∆CS = −A − B
∆PS = A + B + C
S The Govt. cost=(Q2 − Q1 )p s
total change in welfare =
ps ∆CS + ∆PS − (Q2 − Q1 )p s =
A B C C − (Q2 − Q1 )p s
p∗

F D D + Gd

Q
Q1 Q∗ Q2

Why MSP not direct cash transfer to the farmer?

Tax

▶ Suppose Govt. imposes a 10 rupees tax per ice cream sold

▶ What will be the price of ice cream?
▶ The increase in the final price of ice cream will not be by 10 rupees
▶ The final price depends on the curvature of demand and supply curves
▶ Particularly, it depends on their elasticities
▶ The burden of a tax (or the benefit of a subsidy) falls partly on the consumer and
partly on the producer
Tax

▶ Suppose Govt. imposes a 10 rupees tax per ice cream sold

▶ What will be the price of ice cream?
▶ The increase in the final price of ice cream will not be by 10 rupees
▶ The final price depends on the curvature of demand and supply curves
▶ Particularly, it depends on their elasticities
▶ The burden of a tax (or the benefit of a subsidy) falls partly on the consumer and
partly on the producer
Application: Taxes

▶ Taxes lead to two prices:

1. prices that consumers pay
2. prices that producers receive
▶ There are various forms of taxes. Two prominent ones are:
1. quantity taxes: per unit tax
2. value taxes (also called ad valorem taxes): It is a tax expressed in percentage units
▶ Let pd and ps be the demand and supply prices
▶ For quantity tax: pd = ps + t and for value tax: pd = (1 + τ )ps
▶ Now on, we consider only quantity tax
Quantity Tax

▶ The market clearing requires the following four conditions

1. The quantity sold and the buyer’s price pd must lie on the demand curve
2. The quantity sold and the seller’s price ps must lie on the supply curve
3. The quantity demanded must equal the quantity supplied
4. The difference between the price the buyer pays and the seller receives must equal
the tax t.
▶ To solve a problem with quantity tax, we solve the following four equations:

q d = q d (pd ) (1)
s s
q = q (ps ) (2)
qd = qs (3)
ps = pd − t (4)
Graph: Impact of Quantity Tax
p

Dead-weight loss

pd
A
p∗
ps B

pd (q)
q
q q∗
Example: Tax
▶ Suppose the demand and supply are given by

q d (p) = a − bp
q s (p) = c + dp

▶ Suppose the government imposes a per unit tax of t

▶ What is the new equilibrium?
▶ We solve the following system of equations:

q q = a − bpd
q s = c + dp
qd = qs
pd = ps + t
Example: Tax
▶ Suppose the demand and supply are given by

q d (p) = a − bp
q s (p) = c + dp

▶ Suppose the government imposes a per unit tax of t

▶ What is the new equilibrium?
▶ We solve the following system of equations:

q q = a − bpd
q s = c + dp
qd = qs
pd = ps + t
Example: Tax

▶ q d = q s =⇒ a − bpd = c + dps
▶ Substituting pd = ps + t into above equation

a − c − bt
a − b(ps + t) = c + dps =⇒ ps∗ =
b+d
a − c + dt
pd∗ =
b+d
Incidence of Taxes: Two Extreme Case

Entire t is borne by Entire t is borne by

the consumers the producers
p p

S
p∗ + t

p∗ S p∗
p∗ − t
D D
q q q
Incidence of Taxes

▶ The in-between case where the supply curve has an upward slope but is not
perfectly vertical
▶ The amount of the tax that gets passed along will depend on the steepness of
the supply curve relative to the demand curve
▶ If the supply curve is nearly horizontal, nearly all of the tax gets passed along to
the consumers
▶ If the supply curve is nearly vertical, almost none of the tax gets passed along
Incidence of Taxes

Most of t is borne by Most of t is borne by

the consumers the producers
p p

S
pd
S
∗
pps pd
p∗

D ps D
q q q q
Burden of Tax

▶ If demand is relatively inelastic and supply is relatively elastic, the tax burden will
fall mostly on buyers.
▶ If demand is relatively elastic and supply is relatively inelastic, the tax burden will
fall mostly on sellers.
▶ This means we just need prices and quantities for a small range, not the entire
demand curve, to determine the tax burden.
▶ In general, a tax falls mostly on the buyer if EEd is small, and mostly on the seller if
s
Ed
Es is large.
▶ Pass-through formula: It calculates the percentage of the tax borne by buyers:

Es
Pass-through fraction =
(Es − Ed )
Exercise

Consider per unit subsidy and work out all the problems that we have done for
the imposition of tax