CHAPTER

Efficiency and Equity

Self Interest and Social Interest

Self-Interest
When you shop at a supermarket, as a consumer, you
express your view about how scarce resources should
be used.
Y make
You
k choices
h i
that
th t are in
i your self-interest.
lf i t
t
Markets coordinate your choices with those of
everyone else
else. Do markets do a good job?
Do they enable our self-interest choices to be in the
social interest?
And do markets produce a fair outcome?
D Si
Do
Singaporeans use too
t many plastic
l ti bags?
b
?

Resource Allocation Methods

Scare resources might be allocated by using any or
g methods:
some combination of the following
Market price
Command
Majority rule
Contest
First-come, first-served
Sharing equally
Lottery
L tt
Personal characteristics
Force
How does each method work?

Resource Allocation Methods

Market Price
When a market allocates a scarce resource, the
people who get the resource are those who are
willing to pay the market price.
price
Most of the scarce resources that you supply get
allocated by market price.
You sell your labor services in a market, and you
buy most of what you consume in markets.
For most goods and services, the market turns out
to do a good job.

Resource Allocation Methods

Command
Command system allocates resources by the order
(command) of someone in authority.
For example, if you have a job, most likely someone
tells you what to do. Your labor time is allocated to
specific tasks by command.
command
A command system works well in organizations
with clear lines of authority but badly in an entire
economy.
cceptab e in the
t e military.
ta y
Acceptable

Resource Allocation Methods

Majority Rule
Majority rule allocates resources in the way that a
majority of voters choose.
Societies use majority rule for some of their biggest
decisions.
For example,
p , tax rates that allocate resources
between private and public use and tax dollars
between competing uses such as defense and
health care.
Majority rule works well when the decision affects
lots of people and self-interest must be suppressed
to use resources efficiently
efficiently.

Resource Allocation Methods

Contest
A contest
t t allocates
ll
t resources to
t a winner
i
(or
( group
of winners).
The most obvious contests are sporting events but
they occur in other arenas:
For example,
example The Oscars are a type of contest
contest.
Contest works well when the efforts of the players
are hard to monitor and reward directly.

Resource Allocation Methods

First-Come, First-Served
A first-come, first-served allocates resources to
those who are first in line.
Casual restaurants use first-come, first served to
allocate tables. Supermarkets also uses first-come,
first-served at checkout.
First-come, first-served works best when scarce
resources can serves just one person at a time in a
sequence.

Resource Allocation Methods

Sharing Equally
Wh a resource is
When
i shared
h d equally,
ll everyone gets
t
the same amount of it.
You might use this method to share a dessert in a
restaurant.
To make sharing equally work,
work people must be in
agreement about its use and implementation.
It works best for small groups who share common
goals and ideals.

Resource Allocation Methods

Lottery
L tt i allocate
Lotteries
ll
t resources to
t those
th
with
ith the
th
winning number, draw the lucky cards, or come up
lucky
y on some other g
gaming
g system.
y
State lotteries and casinos reallocate millions of
dollars worth of goods and services each year.
But lotteries are more widespread. For example,
they are used to allocate landing slots at some
airports.
i
t
Lotteries work well when there is no effective way to
distinguish among potential users of a scarce
resource.

Resource Allocation Methods

Personal Characteristics
Personal characteristics allocate resources to those
with the right characteristics.
For example, people choose marriage partners on
the basis of personal characteristics.
Butt this method gets used
B
sed in unacceptable
nacceptable ways:
a s
Allocating the best jobs to white males and
discriminating against minorities and women.
Affirmative actions in USA and Malaysia

Resource Allocation Methods

Force
Force plays a role in allocating resources.
For example, war has played an enormous role
historically in allocating resources.
Theft, taking property of others without their
consent, also plays a large role.
But force provides an effective way of allocating
resourcesfor the state to transfer wealth from the
rich to the poor and establish the legal framework in
which voluntary exchange can take place in
markets.

Demand and Marginal Benefit

Demand, Willingness to Pay, and Value
Value is what we get, price is what we pay.
The value of one more unit of a good or service is its
marginal benefit.
We measure value as the maximum price that a
person is willing
illing to pay.
pa
But willingness to pay determines demand.
A demand curve is a marginal benefit curve.

Demand and Marginal Benefit

Individual Demand and Market Demand
The relationship between the price of a good and the
quantity demanded by one person is called individual
demand.
The relationship between the price of a good and the
quantity demanded by all buyers in the market is called
market demand
demand.

For the first pizza, John is prepared to pay

$3.5; then $3, etc
Price
($
$ per
ticket)

40
4.0
3.5
3.0
2.5
2.0
1.5
1.0
05
0.5

Pizzas

When the price per slice is $1, John will

purchase 6 slices
Price
($
$ per
ticket)

The consumer surplus of

purchasing 6 pizzas is the sum
off the
th surplus
l derived
d i d from
f
each one individually.

40
4.0
3.5
3.0
2.5
2.0
1.5

The price

1.0
05
0.5

Pizzas

Demand and Marginal Benefit

Lisa and Nick are the only buyers in the market for pizza.
At $1 a slice, the quantity demanded by Lisa is 30 slices.
At $1 a slice, the quantity demanded by Nick is 10 slices.

Demand and Marginal Benefit

At $1 a slice
slice, the quantity demanded by Lisa is 30 slices and by
Nick is 10 slices.
The quantity demanded by all buyers in the market is 40 slices.
The market demand curve is the horizontal sum of the
individual demand curves.

Demand and Marginal Benefit

Consumer Surplus
Consumer surplus is the value of a good minus the
price paid for it, summed over the quantity bought.
It is measured by the area under the demand curve
and above the price paid, up to the quantity bought.

Demand and Marginal Benefit

The consumer surplus (CS) is the value from pizza in excess of the
expenditure on it.
At $1 a slice, Lisa spends $30, so her CS is the area of the triangle
above
b
the
th $1 price
i line.
li
At $1 a slice, the CS for the economy is the area under the market
demand curve above the market price, over the 40 slices bought.

Nick spends
p
$10,, and together
g
they
y spend
p
$40 on pizza.
p

Supply and Marginal Cost

Supply,
pp y, Cost,, and Minimum Supply-Price
pp y
Cost is what the producer gives up, price is what the
producer receives.
The cost of one more unit of a good or service is its
marginal cost.
Marginal cost is the minimum price that a firm is willing
to accept.
But the minimum supply-price determines supply.
A supply curve is a marginal cost curve.

Supply and Marginal Cost

Individual Supply
pp y and Market Supply
pp y
The relationship between the price of a good and the
quantity supplied by one producer is called individual
supply.
The relationship between the price of a good and the
quantity supplied by all producers in the market is called
market supply
supply.

Supply and Marginal Cost

Max and Mario are the only producers of pizza.

pizza
At $15 a pizza, the Q supplied by Max is 100 pizzas and by Mario is 50
The market supply curve is the horizontal of the individual supply curves.

Supply and Marginal Cost

Producer Surplus
Producer surplus is the price received for a good
minus the minimum-supply price (marginal cost),
summed over the quantity sold.
It is measured by the area below the market price and
above
b
the
th supply
l curve, summed
d over the
th quantity
tit
sold.

Supply and Marginal Cost

The pink areas show the cost of producing the pizzas sold.
The producer surplus is the value of the pizza sold in excess of the cost
of producing it.
At $15 a pizza,
i
M
Mario
i sells
ll 50 pizzas,
i
so hi
his PS is
i the
th area off the
th blue
bl

Is the Competitive Market Efficient?

In equilibrium, quantity
demanded = quantity
supplied.
li d
At the equilibrium
quantity marginal
quantity,
benefit = marginal cost,
so the quantity is the
efficient
ffi i t quantity.
tit
When the efficient
quantity is produced,
produced
total surplus (the sum of
consumer surplus and
producer
d
surplus)
l ) is
i
maximized.

Is the Competitive Market Efficient?

The Invisible Hand
Adam Smiths invisible hand idea in the Wealth of
Nations implied that competitive markets send
resources to
t th
their
i highest
hi h t valued
l d use in
i society.
i t
Consumers and producers pursue their own selfinterest and interact in markets.
markets
Market transactions generate an efficienthighest
valueduse of resources.
resources

Is the Competitive Market Efficient?

Underproduction
p
and Overproduction
p
Inefficiency
y can occur because too little of an item
is producedunderproductionor too much of an
item is producedoverproduction.

Is the Competitive Market Efficient?

Underproduction
The efficient quantity is
10,000 pizzas a day.
If production is restricted
t 5,000
to
5 000 pizzas
i
ad
day,
there is underproduction
and the quantity is
inefficient.
A deadweight loss equals
th decrease
the
d
in
i total
t t l
surplusthe gray
g
triangle.
This loss is a social loss.

Is the Competitive Market Efficient?

Overproduction
Again,
g , the efficient
quantity is 10,000 pizzas
a day.
If production is
expanded to 15,000
pizzas a day, a
deadweight loss arises
from overproduction.
This loss is a social loss.

Is the Competitive Market Efficient?

Obstacles to Efficiency
In competitive markets, underproduction or
overproduction arises when there are
Price and quantity regulations
Taxes and subsidies
Externalities
Public goods and common resources
Monopoly
M
l
High transactions costs

Is the Competitive Market Efficient?

Price and Q
Quantity
y Regulations
g
Price regulations sometimes put a block of the
price adjustments and lead to underproduction.
Quantity regulations that limit the amount that a
farm is permitted to produce also leads to
underproduction.

Is the Competitive Market Efficient?

Taxes and Subsidies
Taxes increase the prices paid by buyers and lower
the prices received by sellers.
So taxes decrease the quantity produced and
lead to underproduction.
Subsidies lower the prices paid by buyers and
increase the prices received by sellers.
So subsidies
S
b idi increase
i
the
th quantity
tit produced
d
d
and lead to overproduction.

Is the Competitive Market Efficient?

Externalities
An externality is a cost or benefit that affects
someone other than the seller or the buyer of a
good.
An electric utility creates an external cost by
burning coal that creates acid rain.
The utility doesnt consider this cost when it
chooses the quantity of power to produce.
produce
Overproduction results.

Is the Competitive Market Efficient?

An apartment
p
owner would provide
p
an external
benefit if she installed an smoke detector. But she
doesnt consider her neighbors marginal benefit
and decides not to install the smoke detector
detector.
The result is underproduction.

Is the Competitive Market Efficient?

Public Goods and Common Resources
A public good benefits everyone and no one can
be excluded from its benefits.
It is in everyones self-interest to avoid paying for a
public good (called the free-rider problem), which
leads to underproduction.

Is the Competitive Market Efficient?

A common resource is owned by no one but can
be used by everyone.
It is in everyones self interest to ignore the costs
of their own use of a common resource that fall on
others ((called tragedy
g y of the commons).
)
The tragedy of the commons leads to
overproduction.

Is the Competitive Market Efficient?

Monopoly
p y
A monopoly is a firm that has sole provider of a
good or service.
The self-interest of a monopoly is to maximize its
profit. To do so, a monopoly sets a price to achieve
its self-interested
f
goal.
As a result, a monopoly produces too little and
underproduction results
results.

Is the Competitive Market Efficient?

High
g Transactions Costs
Transactions costs are the opportunity cost of
making trades in a market.
To use the market price as the allocator of scarce
resources, it must be worth bearing the opportunity
cost of establishing a market.
market
Some markets are just too costly to operate.
When
Wh ttransactions
ti
costs
t are hi
high,
h the
th market
k t might
i ht
underproduce.
Examples of transaction costs need to get a
licence, a loan, etc.

C
Conclusions
l i
Markets can under-produce
p
or over-produce
p
What can the government do to ensure that optimal
production takes place
When there is a good externality, the government
can use subsidy to increase production
When there is a bad externality
externality, the government
can use tax to reduce production
In other words, we impose tax for raising revenue.
But tax can also correct market distortion.

CHAPTER

Government Action in
Markets

Can governments cap rents to help renters?

Can governments make housing more affordable
by raising incomes with minimum wage laws?

The government taxes almost everything we buy

buy.
But who actually pays and who benefits when a
tax is cut: buyers or sellers?

The government subsidizes some farmers and

limit the quantities that other farmers may produce
produce.

Do subsidies and production limits help to make

markets efficient?

Housing Markets and Rent Ceilings

A Regulated Housing Market

A price ceiling is a regulation that makes it illegal

to charge a price higher than a specified level.

Wh a price
When
i ceiling
ili is
i applied
li d to
t a housing
h
i
market it is called a rent ceiling.
If the rent ceiling is set above the equilibrium rent,
it has no effect. The market works as if there were
no ceiling.
B t if th
But
the rentt ceiling
ili is
i sett below
b l
th equilibrium
the
ilib i
rent, it has powerful effects.

A Housing Market with a Rent Ceiling

Housing Shortage
The equilibrium rent
is $1,000 a month.
A rent ceiling is set
at $800 a month.
So the equilibrium
rent is in the illegal
region.

A Housing Market with a Rent Ceiling

At the rent ceiling
ceiling, the

quantity of housing
demanded exceeds the
quantity supplied.
There is a shortage of
housing.
housing
Because the legal price
cannot eliminate the
shortage, other
mechanisms operate:
Search activity
Black markets
With a housing
g shortage,
g ,
people are willing to pay
up to $1,200 a month.

Housing Markets and Rent Ceilings

Search Activity: looking for houses
The time spent looking for someone with whom to do
business is called search activity.

When
Wh a price
i iis regulated
l t d and
d there
th
is
i a shortage,
h t

search activity increases.

Search activity is costly and the opportunity cost
of housing equals its rent (regulated) plus the
opportunity cost of the search activity
(unregulated).
(unregulated)
Because the quantity of housing is less than the
quantity
q
y in an unregulated
g
market,, the opportunity
pp
y
cost of housing exceeds the unregulated rent.

Housing Markets and Rent Ceilings

Black Markets

A black market is an illegal market that operates

alongside a legal market in which a price ceiling
or other restriction has been imposed
imposed.
A shortage of housing creates a black market in
housing.
Illegal arrangements are made between renters
and landlords at rents above the rent ceilingand
generally above what the rent would have been in
an unregulated market.

H
Housing
i Markets
M k t and
dR
Rentt C
Ceilings
ili
Inefficiency of Rent Ceilings

An effective rent ceiling leads to an inefficient use

of resources.
The quantity of rental housing is less than the
efficient quantity.
The marginal social benefit from housing services
exceeds its marginal social cost and a deadweight
loss arises.

Housing Markets and Rent Ceilings

Rent ceiling quantity

of housing supply below
the efficient quantity.
deadweight loss
Producer surplus
Consumer surplus
Social Cost of the rent
ceiling
ili =deadweight
d d i ht
loss plus search cost
The pink area
represents the
potential search cost

H
Housing
i Markets
M k t and
dR
Rentt C
Ceilings
ili
Are Rent Ceilings Fair?

According to the fair rules view, a rent ceiling is

unfair because it blocks voluntary exchange.
According to the fair results view, a rent ceiling is
unfair because it does not generally benefit the
poor.
poor
A rent ceiling decreases the quantity of housing
and allocates the scarce housing using:
Lotteries
Queues
Discrimination

H
Housing
i Markets
M k t and
dR
Rentt C
Ceilings
ili

A lottery
yg
gives scarce housing
g to the lucky.
y
A queue gives scarce housing to those who have
the greatest foresight and get their names on the
li t first.
list
fi t
Discrimination gives scarce housing to friends,
family members, or those of the selected race or
sex.
None of these methods leads to a fair outcome.

Th L
The
Labor
b Market
M k t and
d Minimum
Mi i
Wage
W

New labor-saving
g technologies
g
become available
every year, which mainly replace low-skilled labor.
Does the persistent decrease in the demand for
l
low-skilled
kill d labor
l b depress
d
the
th wage rates
t off these
th
workers?

The Labor Market and Minimum Wage

Fall in demand for

low-skilled workers
Equilibrium
q
moves
from B to C
Wage is too low

L
Long
Term
T
Solution
S l ti
Attract foreign investment
Encourage local investment
Provide people with training; as more people
receive training, the supply curve of
unskilled workers shifts upwards
p
And the wage rate is back to $5 per hour
e labour
abou market
a et can
ca be efficient
e ce ta
also
so
The
But wrong policy can lead to market
distortion

Minimum Wage
A Minimum Wage

A price floor is a regulation that makes it illegal to

trade at a price lower than a specified level.
When a price floor is applied to labor markets,
markets it is
called a minimum wage.
If the minimum wage is set below the equilibrium
wage rate, it has no effect. The market works as if
there were no minimum wage.
If the minimum wage is set above the equilibrium
wage rate, it has powerful effects.

A Labor Market with a Minimum Wage

If the minimum wage is set above the equilibrium

wage
g rate,, the quantity
q
y of labor supplied
pp
by
y workers
exceeds the quantity demanded by employers.
There is a surplus of labor.
The quantity of labor hired at the minimum wage is
less than the quantity that would be hired in an
unregulated labor market.
B
Because
th
the legal
l
l wage rate
t cannott eliminate
li i t the
th
surplus, the minimum wage creates unemployment.

A Labor Market with a Minimum Wage

Minimum Wage Brings
Unemployment
The quantity of labor
supplied exceeds the
quantity demanded
and unemployment
i created.
is
d
With only 20 million
hours demanded
demanded,
some workers are
willing to supply the
last hour
ho r demanded
for $8.

Th L
The
Labor
b Market
M k t and
d Minimum
Mi i
Wage
W
Inefficiency of a Minimum Wage

A minimum wage leads to an inefficient use of

resources.
The quantity of labor employed is less than the
efficient quantity and there is a deadweight loss.
loss
The supply of labor measures the marginal
social cost of labor to workers (leisure
forgone).
The demand for labor measures the marginal
social benefit from labor (value of goods
produced).

A Labor Market with a Minimum Wage

A minimum wage set

above the equilibrium
wage decreases
d
the
th
quantity of labor
employed.
A deadweight loss arises.
The potential loss from
i
increased
d job
j b search
h
decreases both workers
surplus
p
and firms
surplus.
The full loss is the sum of
the pink and gray areas
areas.

Th L
The
Labor
b Market
M k t and
d Minimum
Mi i
Wage
W
Is the Minimum Wage Fair?

It is unfair because it blocks voluntary exchange.

It is unfair because it does not g
generally
y benefit
the poor.
The Minimum Wage decreases the quantity of
labour supply and allocates jobs using:
Lotteries
Queues
Discrimination
Most economists believe that minimum wage laws
increase the unemployment rate of low-skilled
younger workers.

Conclusions

Price controls are bad as they create

deadweight loss; they are bad as they lead

to under-production.
How about quantity control? We limit the
no. of cars on the road.
Diagrammatically, we use the horizontal line
indicate the price ceiling.
How do you indicate quantity control
diagramatically?

Taxes

Who really
yp
pays
y the taxes?
Income tax is deducted from your pay and GST is
added to the price of the things you buy, so isnt it
obvious
b i
that
th t you pay these
th
taxes?
t
?
Youre going to discover that it isnt obvious who
pays a tax and that lawmakers dont
don t decide who
will pay!

Tax Incidence: Who pays the tax?

Tax incidence is the division of the burden of a
t between
tax
b t
the
th buyer
b
and
d the
th seller.
ll

When an item is taxed, its price might rise by the

y a lesser amount,, or not
full amount of the tax,, by
at all.
If the price rises by the full amount of the tax, the
buyer pays the tax
tax.
If the price rise by a lesser amount than the tax,
the buyer and seller share the burden of the tax.
If the price doesnt rise at all, the seller pays the
tax.

Taxes

Tax incidence doesnt depend

p
on tax law!
The law might impose a tax on the buyer or the
seller, but the outcome will be the same.
To see why, we look at the tax on cigarettes in
New York City.
On July 1,
1 2002,
2002 New York City raised the tax on
the sales of cigarettes from almost nothing to
$1.50 a pack.
What are the effects of this tax?

Taxes on sellers: From A to B

No ttax: equilibrium
N
ilib i
price
i
= $3.00/pack
Tax on sellers of
$1.50/pack:
Supply and the
supply
supp
y curve
cu e shifts
s ts to S
+ tax on sellers
New equilibrium p =
$4 00/pack quantity
$4.00/pack,
bought
Buyers pay $1.00 more
Price received by the
sellers falls to
$2 50/pack
$2.50/pack
Sellers receive 50 a
pack less

Tax on buyers: From A to B

No ttax: equilibrium
N
ilib i
P=
$3.00/pack.
Tax on buyers of
$1.50/pack:
Demand and the
demand curve shifts to
D tax on buyers.
Price received by sellers
falls to $2
$2.50/pack;
50/pack; and
quantity .
Price paid by buyers
rises to $4.00/pack.
So with tax of $1.50 a
pack, buyers pay $1.00
a pack more and sellers
receive 50 a pack less.

Taxes:
Same outcome whether tax on buyers
or sellers

Buyers pay $1
$1.00
00 of the tax
tax.
Sellers pay the other 50 of the tax.
Tax incidence is the same regardless of
whether the law says sellers pay or buyers
pay.
We can analyse tax using either the demand
curve or the supply curve but not both

Taxes
Tax Division and the Elasticity of Demand

The division
Th
di i i off the
th tax
t between
b t
the
th buyer
b
and
d the
th
seller depends on the elasticities of demand and
supply.
To see how, we look at two extreme cases.
Perfectly inelastic demand: buyers pay the
entire
ti tax.
t
Perfectly elastic demand: sellers pay the entire
tax.
The more inelastic the demand, the larger is
the buyers share of the tax.

Taxes

Demand for this

good is perfectly
g
p
y
inelasticthe
demand curve is
vertical.
vertical
When a tax is
imposed on this
good, buyers pay
the entire tax.

Taxes

The demand for this

good is perfectly
elastic the
elasticthe
demand curve is
horizontal.
When a tax is
imposed on this
good,, sellers pay
g
p y
the entire tax.

Taxes
Tax Division and Elasticity of Supply

To see the effect of the elasticity of supply on the

division of the tax payment, we again look at two
extreme cases
cases.
Perfectly inelastic supply: Sellers pay the
entire tax.
Perfectly elastic supply: Buyers pay the entire
tax.
Th more elastic
The
l ti the
th supply,
l the
th larger
l
is
i the
th
buyers share of the tax.

Taxes

The supply of this

good is perfectly
inelasticthe
supply curve is
vertical.
When a tax is
i
imposed
d on this
thi
good, sellers pay
the entire tax.

Taxes

The supply of this

good is perfectly
elasticthe supply
curve is
i horizontal.
h i
t l
When a tax is
imposed on this
good, buyers pay
the entire tax.

Who pays more, buyers or sellers?

Relative slope of
demand and
supply curves

From A to
F
t B
CB is the tax

Taxes
Taxes in Practice

Taxes usually are levied on goods and services

with an inelastic demand or an inelastic supply.
Alcohol, tobacco, and gasoline have inelastic
demand, so the buyers of these items pay most
the tax on them
them.
Labor has a low elasticity of supply, so the
sellerthe workerpays most of the income tax.

Taxes
Taxes and Efficiency

Except in the extreme cases of perfectly inelastic

demand or perfectly inelastic supply when the
quantity remains the same, imposing a tax creates
inefficiency.

Who pays more, buyers or sellers?

No tax: Marginal social benefit =
marginal social cost; market
is efficient.
efficient
Total surplus ( of consumer
surplus and producer
surplus)
l ) is
i maximized.
i i d
Tax: quantity , buyers price ,
and sellers p
price
Marginal social benefit >
marginal social costtax is
inefficient
inefficient.
The tax revenue takes part
of the total surplus.
Lower quantity creates a
deadweight loss.

C
A
B

S b idi and
Subsidies
d Quotas
Q t

Fluctuations in the weather bring

g big
g fluctuations
in farm output.
How do changes in farm output affect the prices
off ffarm products
d t and
d farm
f
revenues?
?
How might farmers be helped by intervention in
markets for farm products?

Poor Harvest: from A to B

Supply decreases but
higher price

Because demand
for wheat is
inelastic, total
revenue
increasesto $90
billion.

Bumper Harvest: from A to B

Supply increases
and price falls

Because demand
for wheat is
inelastic, total
revenue
decreasesto
$50 billion.

S b idi and
Subsidies
d Quotas
Q t

Intervention in markets for farm p

products takes
two main forms:
Subsidies
Production quotas
A subsidy is a payment made by the government
to a producer
producer.
A production quota is an upper limit to the
quantity of a good that may be produced during a
specified period.

Production Subsidies and Quotas

Subsidies

With no subsidy, the

price is $40 a ton and
40 million tons a year
are produced

With a subsidy of $20 a

ton, marginal cost falls
by $20 a ton and the
new supply
l curve iis S
subsidy.

Subsidies: From A to B

Market p falls to $30/ton

and farmers raise quantity
to 60 million tons a year.
y
But farmers marginal cost
rises to $50 a ton.
With the
th subsidy,
b id farmers
f
receive more on each ton
sold (price of $30 a ton +
subsidy of $20 a ton) = $50
a ton.
Farmers marginal cost =
Farmers
$30/ton but social cost
(subsidy included) =
$50/ton
Social cost is area ABC

C
A
B

Production Quotas
Limit production to 40: A to B
No quota: Price = $30/ton; 60
million tons a y
year p
produced.
Production quota of 40
million tons a year: market
price rises to $50/ton and
marginal cost falls to $20/ton

H
Hence
quotas
t higher
hi h price
i

Consumers lose
Producers
P d
gain
i
Social cost = area ABC

A
C

Market Failure and

Government Intervention
The competitive market does not deliver
efficient output level on the account of
say, externality. This is known as
Market Failure
Government intervention is therefore
jjustified. Public policy
p
y such as tax or
subsidy aims to correct under or over
production;; aims to produce
p
p
efficient
level of output
But government intervention can
become government failure

THE END