Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Lecture 4: Efficiency and Market Failures

Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Learning Outcomes

After reading chapter 5 and by the end of this

lecture, you should understand...
Equity and Efficiency
Consumer and producer surpluses
Efficient market outcomes
Taxation, surplus and efficiency –
deadweight loss
Various types of market failures
Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Equity vs Efficiency

Equity deals with how society’s goods and rewards are, and should be,
distributed among its different members, and how the associated costs should
be apportioned.
Efficiency addresses the question of how well the economy’s resources are
used and allocated.
Welfare economics assesses how well the economy allocates its scarce
resources in accordance with the goals of efficiency and equity.
Example: Consider subsidies for buyers of electric vehicles
If such subsidies go to wealthy buyers of Tesla cars, the subsidies are not
equitable.
If the subsidies go to buyers who would have purchased an electric vehicle
without the subsidy, the subsidies are not efficient.
Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Consumer and producer surpluses

Demand
Rent
Individual Demand Surplus Alex
valuation $900 Brian
Alex 900 400 Cathy
Brian 800 300
Cathy 700 200 Don Lynn
Don 600 100 Evan
Evan 500 0 Equilibrium
Frank 400 0 Frank price=$500.
Kirin
Jeff
Supply $300 Ian
Heward
Individual Reservation Surplus Gladys
value
Gladys 300 200
Heward 350 150 Q
Ian 400 100
Jeff 450 50
Kirin 500 0
Lynn 550 0
Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Consumer and producer surpluses

Consumer surplus is the excess of consumer

willingness to pay over the market price.

Producer surplus is the excess of market

price over the reservation price of the
supplier.

The producers and consumers are all willing

to participate in the market if they earn
surplus.
Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Consumer and producer surpluses

P
A
90

D
Consumer surplus = ?
S
B E
Producer surplus = ? 42
30
C

Q
48
Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Efficient Market

Efficient market maximizes the sum of producer

and consumer surpluses.

Efficient outcome leaves no scope for additional

agreements that would improve the producer’s
or consumer’s surplus.

Demand (MB) = Supply (MC)

Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Taxation and Efficiency

The tax shifts S to St and reduces the P

quantity traded from Q0 to Qt .

At Qt the demand value placed on an

additional unit exceeds the supply
St
valuation by Et A. B

Since the tax keeps output at this lower Tax

wedge
level, the economy cannot take S
advantage of the additional potential Et
Pt
surplus between Qt and Q0 . E0
P0
Pts
Deadweight loss = AEt E0 . A

Note the importance of elasticities in F

determining the deadweight loss of a tax. D
Q
Qt Q0
Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Taxation and Efficiency

Deadweight losses occur because the tax P

results in a lower equilibrium level of
output.
At the margin, demanders and suppliers
would both benefit if more units were St
traded, but the tax reduces quantity by B
raising the price. Tax
wedge
Deadweight losses imply an efficiency Et
S
loss. Pt
The magnitude of deadweight losses E0
P0
depends on the elasticities of demand Pts
A
and supply: elastic demands and
supplies imply larger quantity F
adjustments, and these give rise to larger
D
deadweight losses. Q
Qt Q0
Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Taxation and Efficiency: Summary

The government gains through the revenue collected.

The equilibrium market price increases, and the equilibrium quantity

decreases.

In general, the price that consumers pay increases and the price that suppliers
receive net of the tax decreases.

This causes both consumer surplus and producer surplus to fall

Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Market Failures

Markets can fail to achieve efficiency as the result of

1 Externalities: spillovers
2 Imperfect competition: market structure
3 Public goods: non-rival, non-exclusive goods
4 Information imperfection/asymmetries
Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Externalities
Externalities
Externalities are by-products (spillovers) from activities that generate
“non-priced” effects on third parties. Externalities can be positive (beneficial) or
negative (costly/harmful) to these third parties.

What does “priced” mean?

A priced interaction is the normal bids and asks of buyers and sellers in a market. Benefits are
paid for and costs are incurred voluntarily.
Who are “third parties”?
Those affected.
Why don’t we call them “second parties”?
Because typically the 1st and 2nd parties are the producer and consumer of the good itself
(rather than the by-product).
What are examples of positive and negative externalities?
Negative: pollution, traffic congestion, ... Positive: crop pollination by bees, vaccination, ...
Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

What is imperfect competition?

Imperfect competition
A market structure that violates the assumptions of pure or perfect competition. It
is characterized by (a) sellers and/or buyers exerting some control over prices; or
(b) blocked entry and/or exit.

In imperfect competition some sellers or

buyers are said to have “market power”.
Examples:
Monopoly
Oligopoly
Monopolistic Competition
Monopsony
Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Public goods

Public goods
Public goods are goods enjoyed in common and are described by
non-excludability and by non-rivalry.

Non-rival: the benefits obtained by one “consumer” are not subtracted from
benefits available to others.
Non-excludable: it is prohibitively costly to selectively prevent people from
using it.
Public goods encounter free riding (consumers can take advantage of public
goods without contributing sufficiently to their creation).
Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Public goods vs. Private Goods

Excludable Non-Excludable
Rivalrous Private Goods Common Goods
food, clothing fish, forests
cars, toys
Non-Rivalrous Club Goods Public Goods
(simultaneous cable television air,
consumption) national defense

Policy response: private and club goods are mainly left to the market; public
goods are often provided by, or regulated by, the government.
The word “public” conveys to many the idea of provided by the government
or available for free to the public.
But economists mean a private seller cannot prevent the public from
consuming it, so they would go out of business.
Intro Consumer and producer surpluses Efficient Outcome Taxation Market Failures

Imperfect Information

Exchange is guaranteed to be mutually beneficial only if both parties are

rational and well-informed.

A poorly informed buyer may pay more than the true worth of the product.

When both parties have the same amount of uncertainty there is not
necessarily a market failure.

Market failure arises mainly from asymmetric information—when the seller

knows product characteristics that the buyer does not know.

If consumers cannot distinguish before buying, the existence of bad products

can drive good ones out of the market.