Sources of Market Failure

Recall: Adam Smiths invisible hand of the

marketplace leads self-interested buyers and sellers in
a market to maximize the total benefit that society can
derive from a market.

But market failures can still

happen.
Market Failure
A market failure occurs when the market
outcome is not the socially efficient outcome.
Some action by the government is sometimes
necessary to ensure that the market does work
well.
Action is also necessary as a result of rent
seeking: the use of resources to transfer wealth
from one group to another without increasing
production or total wealth.
 Private costs and benefits: are costs and
benefits that are borne solely by the individuals
involved in the transaction.

Social cost: the total social cost of a

transaction is the private cost plus the
external cost.
EXTERNALITIES AND MARKET
INEFFICIENCY
An externality refers to the uncompensated impact of
one persons actions on the well-being of a bystander.
Externalities cause markets to be inefficient, and thus
fail to maximize total surplus.
EXTERNALITIES AND MARKET
INEFFICIENCY
When the impact on the bystander is adverse, the
externality is called a negative externality.
When the impact on the bystander is beneficial, the
externality is called a positive externality.
EXTERNALITIES AND MARKET
INEFFICIENCY
Negative Externalities
Automobile exhaust
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building
EXTERNALITIES AND MARKET
INEFFICIENCY
Positive Externalities
Immunizations
Restored historic buildings
Research into new technologies
Externalities and Market Failure

When there is a divergence between social costs and

private costs, the result is either too much or too little
production and consumption.

In either case, resources are not being used in their

highest-valued activity and market failure can occur.
Welfare Economics
Welfare economics is the study of how the allocation
of resources affects economic well-being.

Buyers and sellers receive benefits from taking part in

the market.

The equilibrium in a market maximizes the total

welfare of buyers and sellers.
CONSUMER SURPLUS
Consumer surplus is the buyers willingness to pay for a
good minus the amount the buyer actually pays for it.

Willingness to pay is the maximum amount that a

buyer will pay for a good.

It measures how much the buyer values the good or

service.

The area below the demand curve and above the price
measures the consumer surplus in the market.
Table 1 Four Possible Buyers Willingness to Pay

Copyright2004 South-Western
The Demand Schedule and the
Demand Curve
Figure 2 Measuring Consumer Surplus with the Demand Curve

(a) Price = $80

Price of
Album

$100
Johns consumer surplus ($20)

80

70

50

Demand

0 1 2 3 4 Quantity of
Albums

Copyright2003 Southwestern/Thomson Learning

Figure 3 How the Price Affects Consumer Surplus

(a) Consumer Surplus at Price P

Price
A

Consumer
surplus
P1
B C

Demand

0 Q1 Quantity

Copyright2003 Southwestern/Thomson Learning

Figure 3 How the Price Affects Consumer Surplus

(b) Consumer Surplus at Price P

Price
A

Initial
consumer
surplus
C Consumer surplus
P1
B to new consumers

F
P2
D E
Additional consumer Demand
surplus to initial
consumers
0 Q1 Q2 Quantity

Copyright2003 Southwestern/Thomson Learning

PRODUCER SURPLUS
Producer surplus is the amount a seller is paid for a
good minus the sellers cost.

It measures the benefit to sellers participating in a

market.

The area below the price and above the supply curve
measures the producer surplus in a market.
Table 2 The Costs of Four Possible Sellers

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The Supply Schedule and the
Supply Curve
Figure 5 Measuring Producer Surplus with the Supply Curve
(a) Price = $600

Price of
House
Painting Supply

$900
800

600
500
Grandmas producer
surplus ($100)

0 1 2 3 4
Quantity of
Houses Painted
Copyright2003 Southwestern/Thomson Learning
Figure 5 Measuring Producer Surplus with the Supply Curve
(b) Price = $800

Price of
House
Painting Supply
Total
producer
$900 surplus ($500)

800

600 Georgias producer

500 surplus ($200)

Grandmas producer
surplus ($300)

0 1 2 3 4
Quantity of
Houses Painted
Copyright2003 Southwestern/Thomson Learning
 Figure 7 Consumer and Producer Surplus in the Market
Equilibrium
Price A

D
Supply

Consumer
surplus

Equilibrium E
price
Producer
surplus

Demand
B

0 Equilibrium Quantity
quantity
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MARKET EFFICIENCY
Three Insights Concerning Market Outcomes
Free markets allocate the supply of goods to the buyers
who value them most highly, as measured by their
willingness to pay.
Free markets allocate the demand for goods to the
sellers who can produce them at least cost.
Free markets produce the quantity of goods that
maximizes the sum of consumer and producer surplus.
This policy of leaving well enough alone goes by the
French expression laissez faire.
The Market for Aluminum
The quantity produced and consumed in the market
Welfare Economics: A Recap
equilibrium is efficient in the sense that it
maximizes the sum of producer and consumer
surplus.
If the aluminum factories emit pollution (a negative
externality), then the cost to society of producing
aluminum is larger than the cost to aluminum
producers.
For each unit of aluminum produced, the social cost
includes the private costs of the producers plus the
cost to those bystanders adversely affected by the
pollution.
 Figure 2 Pollution and the Social Optimum

Price of
Social
Aluminum
cost
Cost of
pollution
Supply
(private cost)

Optimum

Equilibrium

Demand
(private value)

0 QOPTIMUM QMARKET Quantity of

Aluminum
Copyright 2004 South-Western
 Figure 3 Education and the Social Optimum

Price of
Education
Supply
(private cost)

Social
value
Demand
(private value)

0 QMARKET QOPTIMUM Quantity of

Education

Copyright 2004 South-Western

Positive Externalities
The intersection of the supply curve and the social-
value curve determines the optimal output level.
The optimal output level is more than the equilibrium
quantity.
The market produces a smaller quantity than is socially
desirable.
The social value of the good exceeds the private value of
the good.
Negative Externalities
Internalizing an externality involves altering incentives
so that people take account of the external effects of
their actions.
The government can internalize an externality by
imposing a tax on the producer to reduce the
equilibrium quantity to the socially desirable quantity.
PUBLIC POLICY TOWARD
EXTERNALITIES
When externalities are significant and private
solutions are not found, government may attempt to
solve the problem through . . .
command-and-control policies.
market-based policies.
Direct Regulation
A program of direct regulation is where the amount
of a good people are allowed to use is directly limited
by the government.
Economists do not like this solution since it does not
achieve the desired end as efficiently and fairly as
possible.
Direct regulation is inefficient because it achieves a
goal in a more costly manner than necessary.
PUBLIC POLICY TOWARD
EXTERNALITIES
Market-Based Policies

Government uses taxes and subsidies to align

private incentives with social efficiency.
Pigovian taxes are taxes enacted to correct the
effects of a negative externality.
PUBLIC POLICY TOWARD
EXTERNALITIES
Examples of Regulation versus Pigovian Tax

If the EPA decides it wants to reduce the amount of

pollution coming from a specific plant. The EPA could
tell the firm to reduce its pollution by a specific amount
(i.e. regulation).
levy a tax of a given amount for each unit of pollution
the firm emits (i.e. Pigovian tax).
PUBLIC POLICY TOWARD
EXTERNALITIES
Market-Based Policies
Tradable pollution permits allow the voluntary transfer of
the right to pollute from one firm to another.

A market for these permits will eventually develop.

A firm that can reduce pollution at a low cost may prefer to
sell its permit to a firm that can reduce pollution only at a
high cost.
If a firm is able to employ a cleaner technology, then it can
enjoy additional revenues by selling its pollution rights to
someone else.
Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits

(a) Pigovian Tax

Price of
Pollution

P Pigovian
tax
1. A Pigovian
tax sets the
price of Demand for
pollution . . . pollution rights
0 Q Quantity of
Pollution
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.

Copyright 2004 South-Western

Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits

(b) Pollution Permits

Price of Supply of
Pollution pollution permits

Demand for
pollution rights
0 Q Quantity of
Pollution
2. . . . which, together 1. Pollution
with the demand curve, permits set
determines the price the quantity
of pollution. of pollution . . .
Copyright 2004 South-Western
TAXES
Governments levy taxes to raise revenue for public
projects.

Taxes discourage market activity.

When a good is taxed, the
quantity sold is smaller.
Buyers and sellers share
the tax burden.
 Tax incidence is the manner in which the burden of a
tax is shared among participants in a market.
Elasticity and Tax Incidence
Tax incidence is the study of who bears the burden of a
tax.
Taxes result in a change in market equilibrium.
Buyers pay more and sellers receive less, regardless of
whom the tax is levied on.
 Figure 6 A Tax on Buyers

Price of
Ice-Cream
Price Cone Supply, S1
buyers
pay
$3.30 Equilibrium without tax
Tax ($0.50)
Price 3.00 A tax on buyers
without 2.80
shifts the demand
tax
curve downward
by the size of
Price Equilibrium the tax ($0.50).
sellers with tax
receive

D1
D2

0 90 100 Quantity of
Ice-Cream Cones

Copyright2003 Southwestern/Thomson Learning

 Figure 7 A Tax on Sellers

Price of
Ice-Cream A tax on sellers
Price Cone Equilibrium S2 shifts the supply
buyers with tax curve upward
pay by the amount of
$3.30 S1
Tax ($0.50) the tax ($0.50).
Price 3.00
without 2.80 Equilibrium without tax
tax

Price
sellers
receive

Demand, D1

0 90 100 Quantity of
Ice-Cream Cones
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 Figure 8 A Payroll Tax

Wage

Labor supply

Wage firms pay

Tax wedge
Wage without tax

Wage workers
receive

Labor demand

0 Quantity
of Labor
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 In what proportions is the burden of the tax divided?
Elasticity and Tax Incidence
How do the effects of taxes on sellers compare to those
levied on buyers?

The answers to these questions depend on the

elasticity of demand and the elasticity of supply.

The burden of a tax falls more heavily on the side of

the market that is less elastic.
 Figure 9 How the Burden of a Tax Is Divided
(a) Elastic Supply, Inelastic Demand

Price
1. When supply is more elastic
than demand . . .
Price buyers pay
Supply

Tax
2. . . . the
incidence of the
Price without tax tax falls more
heavily on
Price sellers consumers . . .
receive

3. . . . than
Demand
on producers.

0 Quantity

Copyright2003 Southwestern/Thomson Learning

 Figure 9 How the Burden of a Tax Is Divided

(b) Inelastic Supply, Elastic Demand

Price
1. When demand is more elastic
than supply . . .
Price buyers pay Supply

Price without tax 3. . . . than on

consumers.
Tax

2. . . . the Demand
Price sellers incidence of
receive the tax falls
more heavily
on producers . . .

0 Quantity

Copyright2003 Southwestern/Thomson Learning

How Subsidies Affect Market
Outcomes
Subsidy is a payment to buyers and sellers to
supplement income or lower costs and which thus
encourages consumption or provides an advantage to
the recipient.
A subsidy is the opposite of a tax. Subsidies are levied
when governments want to encourage the
consumption of a good
Subsidies are generally given to sellers and have the
effect of reducing the cost of production, as opposed to
a tax which increases the cost of production