Question

 

Assume the market for home pest control services (spraying to kill unwanted bugs and creepy crawlies around the exterior of your home) is perfectly competitive and is currently in equilibrium.

a. Draw a carefully labeled graph, showing the supply and demand in the market. Show the following on your graph:

i. the equilibrium price and quantity, labeled as Pe and Qe.

ii. the area showing the consumer surplus, labeled as CS.

iii.the area showing the producer surplus, labeled as PS.

b. Assume that an effective price ceiling is imposed by the government at Pc which is less than Pe. Show the ceiling price on your graph and discuss the following:

i. what will the result be of the ceiling?

ii. what will happen to the consumer and producer surpluses you identified above.

c. Now assume that the price ceiling is abolished but that the industry is taken over by "Gotnobugs," a large firm that forms a monopoly in the home pest control market. Draw a new graph showing the new price and quantity equilibrium and compare the results under monopoly with those in part a, above.

Answer 1

The market for home pest control services is perfectly competitive and is currently in equilibrium.

1. In perfectly competitive market, output is set at P = MR = MC.

Again, for perfectly competitive market, MR = AR = Demand.

Thus, using these two equations, we have drawn the Demand and the MC curve for the perfectly competitive home pest control market.

1. The equilibrium price and quantity are labelled as Pe and Qe respectively in the above diagram. They are determined when the Demand curve DD and the Marginal cost (MC) curve intersect at the equilibrium point E.
2. The area below the demand curve DD and above the equilibrium price Pe is the Consumer Surplus (CS).
3. The area above the Marginal cost curve and below the equilibrium price Pe is the Producer Surplus (CS).

2. Price ceiling is a result of government intervention, when the price ceiling (Pc) is below the equilibrium market price (Pe). This price control is also called binding price celling because Pc < Pe.

1. Because of price ceiling, the quantity supplied reduces from Qe to Qc. The quantity demanded exceeds the quantity of services supplied, thus creating excess demand.
2. The effects on CS and PS are explained as follows:

• Change in CS – Some consumers are worse off because of the binding price ceiling and some are better off. The ones who are worse off are those who are rationed out of the market because of the reduction in quantity supplied from Qe to Qc. Since they can no longer buy the service, they lose surplus. This is given by the area B. Other consumers are better off because they can purchase the pest control services at a lower price. So, they enjoy an increase in CS. This is shown in the area A in the following diagram. The net change in CS is therefore A – B. Since in this case, the area of the rectangle A is larger than the triangle B, thus we know that the change in CS is positive. However, the effect on CS due to price ceiling is ambiguous and it depends in the areas of A and B.
• Change in PS – Due to price controls, some providers of pest control will stay in the market but will receive a lower price for their services, while some of the producers will leave the market. So, both will lose PS. Thus, the PS will decrease because of price ceiling. It is given by the area PcMN in the following diagram.

3. Now suppose that the price ceiling is abolished and the industry is taken over by “Gotnobugs”, a large firm that forms a monopoly in the home pest control market.

In monopoly, MR ≠ Demand. Output is set where MC = MR. Price is set by the demand curve at the quantity.

1. The equilibrium price and quantity in the monopoly market are labelled as Pm and Qm respectively in the above diagram.

Qm < Qe and Pm > Pe

1. The area below the demand curve and above the market price Pm is the Consumer Surplus (CS), which is given by the area PmBA.
2. The area above the Marginal cost curve and below the market price Pm is the Producer Surplus (CS), which is given by the area PmCDB.

In perfect competition, consumer surplus and producer surplus is at its maximum possible but in monopoly we have deadweight loss where we lose both CS and PS and an increase in PS with a simultaneous decrease in CS. The deadweight loss where we lose CS is given by the area BEF and the deadweight loss where we lose PS is given by the area DEF.