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Econ606 Chapter 04 2020
- 1. CHAPTER 4 Market Failures Caused by Externalities and Asymmetric Information
- 2. 4-2 Efficiently Functioning Markets Positive and Negative Externalities Society’s Optimal Amount of Externality Reduction Asymmetric Information 4-2
- 3. 4-3 Efficiently Functioning Markets • Competitive markets usually allocate economy’s scarce resources efficiently. • Efficient outcome requires • Demand curve must reflect full willingness to pay. • Supply curve must reflect all costs of production. LO4.1
- 4. 4-4 Value, Cost, and Market Price • There is only one price in the market (equilibrium price) at which every consumer pays and every producer receives. • At the equilibrium, the market clears – whoever willing to pay consumes products, and whoever willing to sell produces products. • However, each consumer may value the product differently, while each producer produces at different cost. LO4.1
- 5. 4-5 Consumer Surplus • Consumer surplus • Difference between what a consumer is willing to pay for a good and what the consumer actually pays. • Extra benefit from paying less than the maximum price. LO4.1
- 6. 4-6 Consumer Surplus: Example (1) Person (2) Maximum Price Willing to Pay (3) Actual Price (Equilibrium Price) (4) Consumer Surplus Bob $13 $8 $5 (= $13 – $8) Barb 12 8 4 (= $12 – $8) Bill 11 8 3 (= $11 – $8) Bart 10 8 2 (= $10 – $8) Brent 9 8 1 (= $9 – $8) Betty 8 8 0 (= $8 – $8) LO4.2 Price(perbag) Quantity (bags) D Q1 P1 Consumer surplus Equilibrium price = $8 0
- 7. 4-7 Producer Surplus • Producer surplus • Difference between the actual price a producer receives and the minimum price they would accept. • Extra benefit from receiving a higher price. LO4.2
- 8. 4-8 Producer Surplus Example (1) Person (2) Minimum Acceptable Price (3) Actual Price (Equilibrium Price) (4) Producer Surplus Carlos $3 $8 $5 (= $8 – $3) Courtney 4 8 4 (= $8 – $4) Chuck 5 8 3 (= $8 – $5) Cindy 6 8 2 (= $8 – $6) Craig 7 8 1 (= $8 – $7) Chad 8 8 0 (= $8 – $8) LO4.2 Price(perbag) S Q1 P1 Equilibrium price = $8 Quantity (bags) 0 Producer surplus
- 9. 4-9 Total Surplus • Total surplus • Sum of consumer surplus and producer surplus • Total benefits that an economy gains. • The economy should produce a quantity of product that maximizes total surplus - Efficiency. LO4.2
- 10. 4-10 Price(perbag) Quantity (bags) Total Surplus and Efficiency LO4.1 S Q1 P1 D 0 Consumer surplus Producer surplus
- 11. 4-11 Efficient Allocation in Market System Three Conditions at Equilibrium 1. MB = MC ‒ MB (Marginal benefit): the benefit that the last unit in market provides to consumers ‒ MC (Marginal cost): the producer’s cost to produce the last unit in market 2. Maximum willingness to pay = minimum acceptable price 3. Total surplus is at a maximum LO4.2
- 12. 4-12 Market Failures • Market failures: Markets fail to produce the right amount of the product • Relative to efficient allocation of resources, under market failure resources may be • Over-allocated: Produce and consume more than the optimal quantity • Under-allocated: Produce and consume less than the optimal quantity LO4.1
- 13. 4-13 Efficiency Losses • If the economy produces more or less than the optimal quantity at the equilibrium, its total surplus will be reduced. • Efficiency losses (or deadweight losses): reductions of total surplus. LO4.1
- 14. 4-14 Quantity (bags) (a) Price(perbag) Efficiency Losses from Underproduction LO4.1 c S Q1Q2 D b d a e Efficiency loss from underproduction 0
- 15. 4-15 Efficiency Losses from Overproduction LO4.1 c S Q1 Q3 D b f a g Quantity (bags) (b) Price(perbag) Efficiency loss from overproduction 0
- 16. 4-16 Demand-Side Market Failures • Demand-side market failures occur when it is not possible to charge consumers for the product • Some can enjoy benefits without paying • Firms not willing to produce since they cannot cover the costs • Firms produce too little (Under-production) LO4.2
- 17. 4-17 Supply-Side Market Failures • Supply-side market failures occurs when a firm does not pay the full cost of producing its output • External costs of producing the good are not reflected in supply • Firms produce too much (Over-production) LO4.2
- 18. 4-18 Causes of Market Failures • The economy may produce more or less than the optimal quantity under • Government’s control of the price or quantity in the market (Price ceiling and floor) • Externalities • Asymmetric Information • Public Goods • Government’s taxes and subsidies • Non-competitive markets LO4.2
- 19. 4-19 Efficient Housing Market • Efficient housing market • The market is efficient with marginal benefit equal to marginal cost • Consumer surplus plus Producer surplus is as large as possible. LO4.2
- 20. 4-20 Price Ceiling • Inefficiency caused by a price ceiling. • A rent ceiling restricts the quantity supplied and marginal benefit exceeds marginal cost. • Consumer surplus increases. • Producer surplus shrinks. • A deadweight loss arises. • Resource use is inefficient. LO4.2
- 21. 4-21 Efficient Labor market • Efficient labor market. • At the market equilibrium, the marginal benefit of labor to firms equals the marginal cost of working. • Total surplus is as large as possible. LO4.2
- 22. 4-22 Price Floor • Inefficiency caused by a minimum wage. • The minimum wage restricts the quantity demanded and marginal benefit exceeds marginal cost. • The firms’ surplus shrinks. • The workers’ surplus increases. • A deadweight loss arises. • Resource allocation is inefficient. LO4.2
- 23. 4-23 Externalities • An externality is a cost or benefit accruing to a third party external to the market transaction. • Positive externalities (benefit to others) • When a person consumes a good, others who did not pay benefits from it. • Negative externalities (cost to others) • When a person consumes a good, it imposes costs to others. LO4.2
- 24. 4-24 Positive Externalities • Only a part of benefits is paid by buyers • Actual MB to the society is greater than market demand (MB of persons who pay) • Too little is produced • Demand-side market failures LO4.2
- 25. 4-25 Negative Externalities • Only a part of costs is incurred by producers • Actual MC (cost to the society) is greater than market supply (MC of producers) • Too much is produced • Supply-side market failures LO4.2
- 26. 4-26 Negative and Positive Externalities LO4.2 (a) Negative externalities (b) Positive externalities D S St Overallocation Negative externalities St Underallocation Qo QoQe Qe P P 0 Q D Dt a c z x 0 Q b y Positive externalities
- 27. 4-27 Government Intervention for NE • Correct negative externalities 1. Direct controls: Government restriction of production 2. Pigovian tax: Specific tax which raises MC to reflect true cost to the society. • Shift the supply curve up LO4.2
- 28. 4-28 Correcting for Negative Externalities LO4.2 (a) Negative externalities D S St Overallocation Negative externalities Qo Qe P 0 Q a c b (b) Correcting the overallocation of resources via direct controls or via a tax D S St P Q T 0 Qo Qe
- 29. 4-29 Government Intervention for PE • Correct positive externalities 1. Government provision: Government produces additional good to supplement the private production 2. Subsidies to consumers: lower the price that consumers pay and encourage consumers to purchase more • Shift demand curve up 3. Subsidies to producers: lower the cost that producers incur and encourage producers to produce more • Shift supply curve down LO4.2
- 30. 4-30 Correcting for Positive Externalities LO4.2 (a) Positive externalities St Underallocation Positive externalities QoQe D Dt z x y (b) Correcting the underallocation of resources via a subsidy to consumers 0 St QoQe D Dt (c) Correcting the underallocation of resources via a subsidy to producers S't D Subsidy St Subsidy U 00 P P P Q Qe Qo Q Q
- 31. 4-31 Methods for Dealing with Externalities Problem Resource Allocation Outcome Ways to Correct Negative externalities (spillover costs) Overproduction of output and therefore overallocation of resources 1. Private bargaining 2. Liability rules and lawsuits 3. Taxes on producers 4. Direct controls 5. Market for externality rights Positive externalities (spillover benefits) Underproduction of output and therefore underallocation of resources 1. Private bargaining 2. Subsidies to consumers 3. Subsidies to producers 4. Government provision LO4.4
- 32. 4-32 Eliminating Pollution LO4.3 0Society’smarginalbenefitandmarginal costofpollutionabatement(dollars) Q1 MB MC Socially optimal amount of pollution abatement Amount of pollution abatement • Although pollution is a negative externality imposed on society, reducing pollution is costly for the society. • Eliminating all pollution is not economically optimal. • Reduce pollution to the level where MB of reducing pollution = MC of pollution.
- 33. 4-33 Government’s Role in the Economy • The government can correct externalities and bring the society to the optimal allocation (maximum total surplus), only if the government can • correctly identify the existence and cause of externalities. • know exactly the optimal quantity of the externality. • calculate exact amount of subsidy or tax. • Otherwise, government failure may occur. • Government actions may worsen the problem. LO4.4
- 34. 4-34 Private Remedies for Externalities Coase theorem: Assign the property right to either consumers or producers, then let them negotiate. • If it is assigned to producers, then consumers will offer to pay producers to reduce production of goods which cause negative externalities. • If it is assigned to consumers, then producers will offer to pay consumers to compensate negative externalities imposed on them. • Private sector bargaining can solve externality problem. LO4.4
- 35. 4-35 Controlling CO2 Emissions • Private remedy: Cap and trade • Sets a cap for the total amount of emissions • Assigns property rights to pollute • Rights can then be bought and sold • Government intervention: Carbon tax • Raises cost of polluting • Easier to enforce LO4.4
- 36. 4-36 Inadequate Information • It is assumed that both consumers and producers have all the information to make rational decisions. • Asymmetric information: One party in transaction does not know enough about the other party to make accurate decisions. • Under-allocation of resources • Better information too costly LO4.4
- 37. 4-37 Moral Hazard • Moral hazard problem: the risk that one party to a transaction will engage in activities that are undesirable from the other party’s point of view. • Occurs after the contract is signed • Examples: • Insurance: Sellers of insurance do not have enough information about buyers. Once purchased an insurance, buyers may abuse using insurance. • Loan: Lenders do not have enough information about borrowers. Once borrowed, borrowers may use for different purpose and become less likely to pay back. LO4.4
- 38. 4-38 Adverse Selection • Adverse selection problem: the people who are the most undesirable from the other party’s point of view are the ones who are most likely to want to engage in the transaction. • Occurs before the contract is signed • Examples: • Insurance: Those buyers who need insurance most will be those who want purchase it most, but they will be costly for insurance company. To obtain the insurance, buyers may not reveal their existing problems. • Loan: Persons with highest risk are those who try to get loans most since they cannot get loans easily, but they may not reveal high risk. LO4.4
- 39. 4-39 Lemon Problem • A lemons problems arises when it is not possible to distinguish reliable products from lemons (defective products). • Buyers are only willing to pay at lemon price. • Sellers of reliable products exit from market. • Only lemon products remain in market. • Example: used car market LO4.4
- 40. 4-40 Principal-Agent Problem • The managers in control (the agent) act in their own interest rather than in the interest of the owners (the principal) due to different sets of the incentives. • Example: CEO of a corporation only cares about getting all kind of benefits (luxury office, chauffeured limousine, personal jet and cruiser, etc.) which may not bring any benefits or profits to shareholders of the corporation. LO4.4
- 41. 4-41 Conflict of Interest • Moral hazard problem that occurs when a person or institution has multiple objectives (interests) and has conflicts between them. • Example: Arthur Andersen was supposed to provide accurate financial information to holders of Enron stocks (owners of Enron), but instead it helped top managers of Enron in expense of stockholders. LO4.4
- 42. 4-42 Solutions for Asymmetric Information • Increase Information through • Screening • Disclosure requirement • Discourage behavior by • Risk-based premium • Monitoring & Restrictive provision • Collateral • Deductible & coinsurance • Government regulation & punishmentLO4.4
- 43. 4-43 Disclaimer Please do not copy, modify, or distribute this presentation without author’s consent. This presentation was created and owned by Dr. Ryoichi Sakano North Carolina A&T State University It includes copy-righted materials from ©2021 McGraw Hill Education. All rights reserved. No reproduction or further distribution without the prior written consent of McGraw Hill Education.
Editor's Notes
- This chapter defines market failure and the consequences of market failure. The chapter begins by looking at the demand side of market failures, the supply side of market failures, and the inefficiencies found. It goes on to describe and show consumer and producer surplus. It defines and describes private goods, public goods, the free-rider problem, and quasi-public goods. It shows how to find the optimal amount of public goods the government should produce using a cost-benefit approach and finishes with a discussion of government failure. The Last Word is about carbon dioxide emissions and different ways governments can deal with air pollution.
- Learning Objectives LO4.1 Explain consumer surplus, producer surplus, and how properly functioning markets maximize total surplus and allocate resources optimally. LO4.2 Explain how positive and negative externalities cause under- and overallocations of resources. LO4.3 Explain why society is usually unwilling to pay the costs of completely eliminating negative externalities, such as air pollution. LO4.4 Understand why asymmetric information may justify government intervention in some markets.
- When the consumers’ utility exceeds the price paid, consumer surplus is generated. You received consumer surplus any time you were willing to pay a higher price but paid a much lower price. Think about buying a new car; if you walk out of the dealership paying $2,000 less than the maximum price you were willing to pay, then you have realized a consumer surplus of $2,000.
- This table represents the consumer surplus that each buyer receives. The surplus is just the difference between the price that they were willing to pay and the price that they actually paid. It is assumed that all consumers will pay the equilibrium price for the good. As you can see, not all consumers will have a surplus. Consumer surplus, shown as the green triangle in this graph, is the difference between the maximum price consumers are willing to pay for a product and the lower equilibrium price. Here, the equilibrium price is assumed to be $8. For quantity Q1, consumers are willing to pay the sum of the amounts represented by the green triangle and the yellow rectangle. Because they need to pay only the amount shown as the yellow rectangle, the green triangle shows consumer surplus.
- When producers receive a price greater than their marginal cost, producer surplus is created. Think about being the seller of a car; you probably have an idea of the lowest possible price that you will accept. If you receive a price that is higher than this lowest possible price, then you have received an extra benefit that is called your producer surplus.
- This table reflects the lowest possible price each seller is willing to accept as payment. If the price that they receive (the equilibrium price) is greater than the minimum acceptable price, then they have a surplus. As you can see, not all producers will have a surplus. Producer surplus is shown as the blue triangle in this graph and is the difference between the actual price producers receive for a product (here $8) and the lower minimum payments they are willing to accept. For quantity Q1, producers receive the sum of the amounts represented by the blue triangle plus the yellow area. Because they only need to receive the amount shown by the yellow area to produce Q1, the blue triangle represents producer surplus.
- When there aren’t any market failures and demand fully reflects consumers’ willingness to pay and supply reflects all costs, then by producing at equilibrium the market is efficient. The market is producing the amount of output that society desires. An efficient market will maximize benefits to consumers and producers.
- When the market achieves efficiency, the maximum combined consumer and producer surplus is achieved. At quantity Q1, the combined amount of consumer surplus, shown as the green triangle, and producer surplus, shown as the blue triangle, is maximized. Efficiency occurs because, at Q1, maximum willingness to pay, indicated by the points on the demand curve, equals minimum acceptable price, shown by the points on the supply curve. Productive efficiency is achieved because competition forces producers to use the best available technology and best combination of resources available. Allocative efficiency is achieved because the correct quantity of product is produced relative to other goods and services.
- When there aren’t any market failures and demand fully reflects consumers’ willingness to pay and supply reflects all costs, then by producing at equilibrium the market is efficient. The market is producing the amount of output that society desires. An efficient market will maximize benefits to consumers and producers.
- Market failure occurs when the competitive market system produces the “wrong” amounts of certain goods or services or fails to provide any at all. Resources are either over-allocated to the production of the good or under-allocated to the production of the good.
- Market failure occurs when the competitive market system produces the “wrong” amounts of certain goods or services or fails to provide any at all. Resources are either over-allocated to the production of the good or under-allocated to the production of the good.
- Efficiency losses (or deadweight losses) are reductions of combined consumer surplus and producer surplus. Quantity levels that are either less than or greater than the efficient quantity, Q1, create efficiency losses. Triangle dbe shows the efficiency loss associated with underproduction at output Q2.
- Efficiency losses (or deadweight losses) are reductions of combined consumer surplus and producer surplus. Quantity levels that are either less than or greater than the efficient quantity, Q1, create efficiency losses. Triangle bfg illustrates the efficiency loss associated with overproduction at output level Q3.
- Demand-side market failures occur because there are situations when it is impossible to charge all consumers, or any consumers, the price that they are willing to pay. A public fireworks display is an example where people don’t have to pay to enjoy the display. Private firms would be unwilling to produce outdoor displays as it will be impossible to raise enough revenue to cover production costs. Firm can’t prevent people from watching the fireworks if they didn’t pay.
- Supply-side market failures occur because there are extra costs associated with producing the good, but the extra costs are not reflected in the supply. A coal-burning power plant provides an example of this. The firm running the plant pays for the land, labor, capital, and entrepreneurship that it uses to generate electricity, but it does not pay for the smoke it releases into the atmosphere and the damage that it causes to the atmosphere.
- Positive externalities occur when a third person, or persons, is affected by the transaction in a positive way. The good is underproduced when positive externalities are present. The equilibrium output will be smaller than the efficient output because the consumer is willing to pay a price equal to the consumer’s individual marginal benefit, but no more. Since social benefits exist in addition to the private benefit, the government must either aid the producer to encourage more output or engage in its own production of the item with the external benefits. Negative externalities occur when a third person, or persons, external to the transaction is affected from the transaction in a negative way. The good is overproduced, and the equilibrium output will be greater than the efficient output. This is because the producer, who is not bearing the full cost of production, will be able to produce more at a lower price than the efficient level, which would exist if true costs were reflected in the production decision.
- Positive externalities occur when a third person, or persons, is affected by the transaction in a positive way. The good is underproduced when positive externalities are present. The equilibrium output will be smaller than the efficient output because the consumer is willing to pay a price equal to the consumer’s individual marginal benefit, but no more. Since social benefits exist in addition to the private benefit, the government must either aid the producer to encourage more output or engage in its own production of the item with the external benefits.
- Negative externalities occur when a third person, or persons, external to the transaction is affected from the transaction in a negative way. The good is overproduced and the equilibrium output will be greater than the efficient output. This is because the producer, who is not bearing the full cost of production, will be able to produce more at a lower price than the efficient level, which would exist if true costs were reflected in the production decision.
- With negative externalities borne by society, the producers’ supply curve S is to the right of (below) the total-cost supply curve St. Consequently, the equilibrium output Qe is greater than the optimal output Qo, and the efficiency loss is shown by the triangle abc. When positive externalities accrue to society, the market demand curve D is to the left of (below) the total-benefit demand curve Dt. As a result, the equilibrium output, Qe is less than the optimal output Qo, and the efficiency loss is shown by the triangle xyz.
- Negative externalities result in an overallocation of resources. Government can correct this overallocation in two ways, one of which is using direct controls which reduce supply by driving up costs of production and would shift the supply curve and reduce output. Another way would be to impose a Pigovian tax; that is a specific tax assessment on the related good, to the extent that the cost of producing the good increases, which would also shift the supply curve to the left, eliminating the overallocation of resources and thus the efficiency loss. When positive externalities are present, the equilibrium output will be smaller than the efficient output because the consumer is willing to pay a price equal to the consumer’s individual marginal benefit, but no more. Since social benefits exist in addition to the private benefit, the government must engage in its own production of the item or aid the producer with subsidies to encourage more production. In either case, the supply curve shifts to the right, which lowers the equilibrium price and leads to a greater equilibrium output level.
- Negative externalities result in an overallocation of resources. Government can correct this overallocation in two ways. One way would be by using direct controls, which would shift the supply curve from S to St and reduce output from Qe to Qo, or another way would be to impose a specific tax, T, which would also shift the supply curve from S to St, eliminating the overallocation of resources and thus the efficiency loss.
- Negative externalities result in an overallocation of resources. Government can correct this overallocation in two ways, one of which is using direct controls which reduce supply by driving up costs of production and would shift the supply curve and reduce output. Another way would be to impose a Pigovian tax; that is a specific tax assessment on the related good, to the extent that the cost of producing the good increases, which would also shift the supply curve to the left, eliminating the overallocation of resources and thus the efficiency loss. When positive externalities are present, the equilibrium output will be smaller than the efficient output because the consumer is willing to pay a price equal to the consumer’s individual marginal benefit, but no more. Since social benefits exist in addition to the private benefit, the government must engage in its own production of the item or aid the producer with subsidies to encourage more production. In either case, the supply curve shifts to the right, which lowers the equilibrium price and leads to a greater equilibrium output level.
- Positive externalities result in an underallocation of resources. This underallocation can be corrected through a subsidy to consumers, which shifts market demand from D to Dt and increases output from Qe to Q0. Alternatively, the underallocation can be eliminated by providing producers with a subsidy of U, which shifts their supply curve from St to S’t and increases output from Qe to Q0. This eliminates the underallocation of output and thus the efficiency loss.
- This table lists several methods for correcting externalities.
- Reducing pollution and negative externalities is not free. Society must decide how much pollution abatement it wants to “buy.” High costs may mean that totally eliminating pollution may not be desirable. The marginal cost rises as pollution is reduced more and more, and at some point, the marginal cost is higher than the marginal benefit. Additional actions to reduce pollution will therefore lower society’s well-being because total costs will rise more than total benefits. The optimal amount of externality reduction here in this graphical example, pollution abatement, occurs at Q1, where society’s marginal cost, MC, and marginal benefit, MB, of reducing the spillover are equal.
- Government can have a role in the economy to correct externalities. The socially optimal amount of externality abatement occurs where society’s marginal cost and marginal benefit of reducing the externality are equal. This is not easy; it is time consuming and costly. There is always the chance that a government failure may occur.
- The Coase theorem suggests that under the right conditions private bargaining can solve externality problems, thus government intervention may not always be necessary.
- With a cap and trade program, only firms that have purchased permits can pollute. Firms who need to pollute more have the opportunity to buy more pollution rights from other firms who don’t need to pollute as much. This limits the total amount of pollution, but how much each firm emits is based on a market system. The tax is imposed on the basis of how much carbon each good contains. This tax works by raising the cost of polluting and reducing the consumption and the amount of CO2.
- Asymmetric information is a source of potential market failure, causing society’s scarce resources to be allocated inefficiently. A potential party to a transaction may withdraw from the market due to fear of being exploited because he or she lacks information.
- A person who buys insurance may willingly incur more risk.
- Information know by the first party to a transaction is not known by the second party and the second party incurs a cost as a result. An example of this would be a life insurance company that offers a life insurance policy and advertises “no medical exam necessary” would attract those who have life-threatening diseases. The social security program, designed to insure against poverty in one’s old age, makes almost everyone participate creating a pool of both high and low risk individuals.
- The private sector can overcome some information problems by offering warrantees for products, no hassle return policies, and through publications that rate a product worthiness. Internet sites, like Facebook and Angie’s List, can be used as a source of finding information about different products and service providers.