APPLIED

ECON
Antonio Jesus A. Quilloy, Ph.D.
Professor, Department of Agricultural and Applied Economics

 Lecture 3

Market Failure &

Policy
Topic 1

Welfare
 Welfare
Good fortune, Health,
Happiness, Prosperity
 Welfare
State of happiness of producers
(profit) and consumers (utility)
Welfare = Surplus
State of happiness of producers
(profit) and consumers (utility)
 Profit
Value of goods and/or services after
paying all factors of production

Profit = Revenue - Cost

Q = f(Land, Labor, Capital,
Management)
 Q = f(Land, Labor, Capital, Management)
Price Rent Wage Interest Pro t

Revenue Cost
fi
 Revenue
Value of goods and/or services
supplied by the producer

R=PxQ
Q = f(X1, X2)
 Cost
Value of inputs used to produce the goods
and/or services supplied by the producer

C = (g1 x X1) + (g2 x X2)

C = f(g1, g2, Q)
Marginal Revenue
Change in Revenue for every
unit change in output

dR
MR =
dQ
Marginal Benefit
Change in Utility for every unit change
in quantity of the product consumed

dU
MB =
dQ
 Marginal Cost
Change in Cost for every unit
change in output

dC
MC =
dQ
Equilibrium Condition
Exchange (transaction) will
continue to take place until:

MR = MC
MB = MC
 IF
MR > MC
It pays for the producer to sell an extra unit
of the product. Sales volume (quantity)
should be increased until MR = MC.
 IF
MR < MC
It pays for the producer NOT to sell an extra
unit of the product. Sales volume (quantity)
should be decreased until MR = MC.
 IF
MB > MC
It pays for the consumer to buy an extra
unit of the product. Purchase volume
should be increased until MR = MC.
 IF
MB < MC
It pays for the consumer NOT to buy an extra
unit of the product. Purchase volume
(quantity) should be decreased until MR =
MC.
Welfare = Surplus
State of happiness of producers
(profit) and consumers (utility)

W = Producer’s Surplus +
Consumer’s Surplus
Producer’s Price

Surplus S
Area above the
supply curve and
below the price
line E Price Level
P

Revenue = Area (0PEQ)

Cost = Area (0EQ)

Profit = Area (0PE)

0 Q Quantity
Producer’s Price

Surplus S
Area above the
supply curve and
below the price
line E Price Level
P

Revenue = Area (0PEQ)

Cost = Area (0EQ)

Profit = Area (0PE)

0 Q Quantity
Consumer’s Price

Surplus
K

Area below the

demand curve
and above the
price line E Price Level
P

Benefit = Area (0KEQ)

Cost = Area (0EQ)

Net Benefit = Area (PKE)

D
0 Q Quantity
Consumer’s Price

Surplus
K

Area below the

demand curve
and above the
price line E Price Level
P

Benefit = Area (0KEQ)

Cost = Area (0EQ)

Net Benefit = Area (PKE)

D
0 Q Quantity
 Total
Price

K
S
Surplus
PS = (0PE)

CS = (PKE)
E Price Level
TS = (0KE) P

D
0 Q Quantity
 Supply = MC
MC as the embodiment of a
producer’s willingness to sell.
Producers can observe MC (not MB).

Demand = MB
MB as the embodiment of a
consumer’s willingness to buy.
Consumers can observe MB (not MC).
 PERSPECTIVE
Private vs Social
Welfare Welfare
Disparity between private & social
welfare ensues when individuals act
on the basis of their self-interest only.
ADAM SMITH
Economic efficiency is
achieved when individuals
act on the basis of their self-
interest.
JOHN NASH
Economic efficiency is achieved
when individuals act on the
basis of their self-interest and
what is good for the group.
 Benefit = Gets Red (1)

Cost = Gets
unfriended by A & C (2)

Benefit = Gets Red (1)

Cost = Gets B Benefit = Gets Red (1)

Cost = Gets
unfriended by B & C (2) unfriended by A & B (2)

A C
 Benefit = Saves
friendship (2)

Cost = Loses Red (1)

Benefit = Saves
friendship (2)
B Benefit = Saves
friendship (2)

Cost = Loses Red (1) Cost = Loses Red (1)

A C
MARKET FAILURE
A situation when all mutually
beneficial transactions failed to occur
Inability of the market to efficiently allocate scarce
resources among different economic agents (e.g.,
producers, consumers, traders)
 Negative Externality due to
CASE 1
OVER-PRODUCTION
Price Social
K “TRUE” MC
MC Private

Deadweight
MC
Loss

E
“PERCEIVED” MC
P
E’
P’

MB
0 Q Q’ Quantity
 Negative Externality due to
CASE 2
UNDER-PRODUCTION
Price Private
“PERCEIVED” MC
K MC Social

Deadweight
MC
Loss

E’ “TRUE” MC
P
E
P’

MB
0 Q’ Q Quantity
 Negative Externality due to
CASE 3
OVER-CONSUMPTION
Price

K Deadweight MC
Loss

E’

E
P “PERCEIVED” MB
Private
P’
MB
Social
MB “TRUE” MB
0 Q Q’ Quantity
 Negative Externality due to
CASE 4
UNDER-CONSUMPTION
Price

K Deadweight MC
Loss

E’
P “TRUE” MB
Social
P’
MB
Private
MB
“PERCEIVED” MB
0 Q’ Q Quantity
MARKET FAILURE
A situation when all mutually
beneficial transactions failed to occur

Private vs Social
Welfare Welfare
 Topic 2

Sources of
Market Failure
PUBLIC GOODS
In reality, there is little financial incentive to produce
some things that the society value highly, such as
roads and bridges, because any one who produces
such goods cannot charge enough for them to make it
worthwhile.
 Types of Goods
Excludable Non-Excludable

COMMON
Rival PRIVATE GOODS
RESOURCES

Non- ARTIFICIALLY SCARCE PURE PUBLIC

Rival GOODS GOODS
 Types of Goods
Excludable Non-Excludable

COMMON
Rival PRIVATE GOODS RESOURCES

(Enforcement of property
rights is infeasible)

Non- ARTIFICIALLY SCARCE PURE PUBLIC

Rival GOODS
GOODS

(Piracy) (Free-riding)
MB = MC
Consumers’
embodiment of value
Producers’
embodiment of value
MB =P= MC
Consumers’
embodiment of value
Producers’
embodiment of value
Pure Public Goods
Assumptions:
1. P = MC

2. There are 2 consumers only.

3. Total Benefit = Benefit1 + Benefit2

P = MB1+MB2
Would any of the consumers be
willing to pay an amount equal to P?
Artificially Scarce Goods
Assumptions:
1. P = MB

2. There are 2 consumers only.

3. Total Benefit = Benefit1 + Benefit2

4. Total Cost = Cost1 + Cost2

5. Cost is symmetric for both consumers.

P = MC
(+)
1+MC2
(-)
Would any of the consumers be
willing to pay an amount equal to P?
Common Resources
Assumption: P = MB

P = MC+R
MB > MC
Is there an incentive for the
producer to overuse the resource?
R = Resource
Rent
Value of the resource in situ.
Value of the resource as it stands on site.

The rate of change of R depends on

whether there are “stock effects”.
 Negative Externality due to
CASE 1
OVER-PRODUCTION
Price Social
K “TRUE” MC
MC Private

Deadweight
MC
Loss

E
“PERCEIVED” MC
P
E’
P’

MB
0 Q Q’ Quantity