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390 CHAPTER 10 COMPETITIVE MARKETS: APPLICATIONS
This brings us to a second major lesson. In a perfectly competitive market, each
producer acts in its own self-interest, deciding whether to be in the market and, if so,
how much to produce to maximize its own producer surplus. Further, each consumer
also acts in his or her own self-interest, maximizing utility to determine how many
units of the good to buy. There is no omniscient social planner telling producers and
consumers how to behave so that the efficient level of output is produced. Nevertheless,
the output produced in a perfectly competitive market is the one that maximizes net economic
benefits (as measured by the sum of the surpluses). As Adam Smith described it in his
classic treatise in 1776 (An Inquiry into the Nature and Causes of the Wealth of Nations),
it is as though there is an “Invisible Hand” guiding a competitive market to the effi-
cient level of production and consumption. 2

EXCISE TAXES
An excise tax is a tax on a specific commodity, such as gasoline, alcohol, tobacco, or
airline tickets. Economists often use a partial equilibrium model to study the effects
of an excise tax on a competitive market. For example, we might ask how a gasoline
tax will affect the price consumers pay for gasoline, as well as the price producers re-
ceive. A partial equilibrium analysis of the gasoline market will treat the prices of
other goods (such as automobiles, tires, and even ice cream) as constant. However, if
a gasoline tax is imposed, the prices of other goods may change, and the partial equi-
librium framework will not capture the effects of those changes.
When there is no tax, the equilibrium in a competitive market will be like the one
depicted in Figure 10.1. Since the market clears in equilibrium, the quantity supplied
s
d
(Q ) equals the quantity demanded (Q ). In Figure 10.1 we observe that in equilibrium
s
d
d
Q Q 6 million units. With no tax, the price that consumers pay (call this P )
s
equals the price producers receive (P ). In the equilibrium illustrated in the figure,
d
s
P P $8 per unit.
Suppose the government imposes an excise tax of $6 per unit. The tax creates a
“tax wedge” between the price consumers pay for the good and the price that sellers
receive. One way to think about this wedge is to imagine a seller has the “administra-
tive responsibility” to collect the tax. (This is how most excise taxes actually work in
practice.) If buyers are charged a market price of, say, $10 per unit, the seller imme-
diately transfers $6 per unit to the government and pockets the remaining $4 per unit
s
as revenue. More generally, the price P that a seller receives will be $6 less than the
s
d
s
d
d
price P that a buyer pays, P P 6, or equivalently, P P 6. This relation-
ship holds for a tax of any amount: With a tax of T per unit (T $6 in this example),
d
s
P P T.
In a market with an upward-sloping supply curve and a downward-sloping de-
mand curve, the effects of an excise tax are as follows:
• The market will underproduce relative to the efficient level (i.e., the amount
that would be supplied with no tax).
• Consumer surplus will be lower than with no tax.
2 Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, printed for W. Strahan
and T. Cadell, London, 1776.