3. Sources of Inefficiency
• Price & quantity restrictions
• Taxes & subsidies
• Monopoly – market power
• Externalities
These lead to either underproduction or
overproduction.
5. Efficiency and Equity (c)
Andrew Tibbitt 2008
Slide 5
Price Ceiling
If the market clearance price
is not charged welfare falls.
If a price is set below the
clearance price producers
reduce supply (to Q2).
There is excess demand.
Producer surplus is low (the
orange area).
The consumers who can get
the product get a big bonus
(the red area), but some
potential buyers go without.
Price
Quantity
Supply
Demand
Consumer
surplus
Producer
surplus
Q2
Deadweight
loss
6. Efficiency and Equity (c)
Andrew Tibbitt 2008
Slide 6
Price Floor
If the market clearance price
is not charged welfare falls.
If a price is set above the
clearance price consumers
reduce demand.
There is excess supply.
Consumer surplus is low
(the red area).
Producers who make a sale
get a big bonus (the orange
area), but some production
is left unsold.
Price
Quantity
Supply
Demand
Consumer
surplus
Producer
surplus
Deadweight
loss
7. Efficiency and Equity (c)
Andrew Tibbitt 2008
Slide 7
Market failure
Markets sometimes fail to produce efficient results
because the necessary conditions do not exist.
They fail, for example when :
1. Externalities are not taken into account (and bystanders
suffer collateral damage)
2. Producers have scarcity or monopoly power (and they
dominate the market, raise prices and earn excessive
profits
3. Key information is not known or shared evenly
4. Income distribution is unfair.
8. Efficiency and Equity (c)
Andrew Tibbitt 2008
Slide 8
When there are externalities
Bystanders (third parties) can be affected by economic
decisions made by others. These spin-off or side effects
of an economic decision are called externalities.
Bystanders can be affected in a good or positive way
(e.g. your neighbour has nice garden). These positive
externalities create social benefits.
Bystanders can be harmed or affected in a negative way
(e.g. people become sick from factory pollution). These
negative externalities create social costs.
9. Efficiency and Equity (c)
Andrew Tibbitt 2008
Slide 9
Ignoring externalities leads to inefficiency
If market players do not
take these negative
externalities or social
costs into account (do not
include them in their
demand and supply
decisions) the market will
not work efficiently.
Too much will be
produced and consumers
will pay too low a price.
D
S
airlines
Air travel
Price
Quantity
S total
Greenhouse Gases are emitted by planes.
So do free markets create too many flights
at too low a price?
10. Efficiency and Equity (c)
Andrew Tibbitt 2008
Slide 10
Scarcity or monopoly power
If one of the players in a market has power over the
other then the market outcome becomes distorted and
the result can be inefficient. If a producer has monopoly
power in a sense they have scarcity power.
Monopoly power comes from a lack of competition.
Producers can deliberately minimise competition (e.g.
by branding, innovation, take overs). Producers with
monopoly power can restrict supply or push up prices.
The price no longer reflects the costs of production.
11. Efficiency and Equity (c)
Andrew Tibbitt 2008
Slide 11
Monopolists restrict supply and push up prices.
Monopolists have the
power to control supply
in the market. This can
lead to prices that are
higher than those set in
competitive markets.
The result is inefficiency.
Price
Quantity
Supply
(competitive)
Demand
New Supply
(monopoly)
Deadweight
loss
Consumer
surplus
Producer
surplus
12. Market Efficiency
• The concepts of consumer and producer surplus
can be used to analyse a wide range of policy
issues:
– How do taxes affect market efficiency?
– How do price controls affect market efficiency?
– How do quantity restrictions affect market efficiency?
– Who wins and who loses when a country opens itself to
international trade?
– How do externalities, such as pollution, affect the
efficiency of market outcomes?
13. Efficiency and Equity (c)
Andrew Tibbitt 2008
Slide 13
In a similar way, if market
players do not take positive
externalities or social
benefits into account (do not
include them in their
demand and supply
decisions) the market will
not work efficiently.
Too little will be supplied and
consumers will pay too high
a price.
D
S total
Public transport
Price
Quantity
S
private
Free market public transport could be
too expensive if it forces people to
use their cars and cause congestion
Ignoring externalities leads to inefficiency
14. Review
Maria decides that she would pay as much as
$3000 for a new laptop computer. She buys the
computer and realises a consumer surplus of
$700. How much did Maria pay for her
computer?
A. $700
B. $2300
C. $3000
D. $3700
15. Review
Tony Bird values watching Legally Blonde for the
fourth time at $20. He finds a cinema showing
Legally Blonde for $5. Tony’s willingness to pay is
___ and his consumer surplus is ___
A. $5; $15
B. $5; $20
C. $20; $5
D. $20; $15
16. Review
• Tariffs raise prices, increase domestic production
and lower domestic consumption. They cause
consumer surplus to ____, producer surplus to
____, and total surplus to ____
a. decrease, decrease, decrease
b. increase, decrease, increase
c. decrease. increase, decrease
d. increase, increase, increase
