6/02/2023

● The concepts of consumer & producer surplus, and marginal benefits and marginal
costs,Using a diagram.
● The meaning of allocative efficiency
● How are productive and allocative efficiency related?
● Activity - to access prior knowledge of the topic
● Explain in general the meaning of “market failure
Identify consumer and producer surplus on
demand and supply curve
Consumer surplus is shown as the shaded area
between the demand or MB curve and the
equilibrium price Pe. It represented the difference
between total benefits consumers receive from
buying a good and the price paid to receive them.
CS indicates -consumers are willing to pay a higher
price for a good that they can receive at a lower
cost. - many consumers will be willing to pay P2
price for Qa quantity, yet they receive Qa by paying
lower price at Pe.
The difference between P2 and Pe is consumer
surplus for Qa.
P3 - Qb - Pe ( P3-Pe is the consumer surplus)
Marginal cost - MC curve
PS = area above the supply curve below the
equilibrium price Pe.
Producers are willing to produce quantity Qa for
P5 price but actually receive Pe. Pe- P5 =
producer surplus for Qa quantity.
Market equilibrium and allocative efficiency At an output of 40, the marginal
cost of the good is $6, but at this
output, consumers would be
willing to pay a price of $15. The
price (which reflects the good’s
marginal utility) is greater than
marginal cost – suggesting under-
consumption. If output increased
and price fell, society would
benefit from enjoying more of the
good.
 The meaning of efficiency in an allocative market

● The competitive market realises allocative efficiency, producing the combination of

goods mostly wanted by society, thus answering the “what to produce”.

● This means production efficiency is also realized involving production with the fewest
possible resources- how to produce.

● These conditions are also known as economic efficiency or pareto optimality.

 Productive efficiency means that, given the available inputs and technology, it’s
How are allocative and productive efficiency
impossible to produce more of one good without decreasing the quantity of

related? another good that’s produced. All choices along the PPF in Figure 2, such as
points A, B, C, D, and F, display productive efficiency. As a firm moves from
any one of these choices to any other, either health care increases and education
decreases or vice versa. This makes sense if you remember the definition of the
PPF as showing the maximum amounts of goods a society can produce, given
the resources it has. Thus, producing efficiently leads to maximum production,
which is what the PPF shows. However, any choice inside the production
possibilities frontier is productively inefficient and wasteful because it’s possible
to produce more of one good, the other good, or some combination of both
goods. Wasting scarce resources means the society is not producing as well or as
much as it could, so it is not operating on the PPF. For example, point R is
productively inefficient because it is possible at choice C to have more of both
goods: education on the horizontal axis is higher at point C than point R (E 2 is

greater than E1), and health care on the vertical axis is also higher at point C

than point R (H2 is greater than H1).

1. Can you think of some goods or services that when consumed or produced cause harm to
others even though they didn’t consume or produce them ?

2. What do you think should be the role of the government to reduce the harm caused by
such harmful actions?
Activity - Common access resources
1. The following photograph illustrates one of
the world's most famous landmarks, the world's
highest mountain peak, Mount Everest. How
does this photograph highlight the difficulty
governments face protecting common access
resources from exploitation?

2. Explain some of the options that a

government should consider when
deciding how to prevent the further
deterioration of common access
resources.
Activity - Common access resources
1. The following photograph illustrates one of the world's most famous landmarks, the world's
highest mountain peak, Mount Everest. How does this photograph highlight the difficulty
governments face protecting common access resources from exploitation?
Like many common access goods, the MC of each additional user is 0, but as more
individuals use those resources their value reduces, impacting on all citizens.
When such goods such as lakes and seas are over exploited, fishing stocks diminish
and the price of fish rises.
Similarly, as mountains and forests are over used then their value also diminishes -
no longer being the places of peace and tranquillity that they were before. There
over use is inevitable because the users of those resources do not consider others
when using them. In other words each consumers MPB outweighs the external cost
of consumption. Only when the level of overuse becomes so obvious does it impact
on the individual and by then it is too late. No more so than the case of the once
deserted Mount Everest, but now due to package tourism and a lack of regulation it
has become a magnet for tourist groups.

2. Explain some of the options that a government should consider when

deciding how to prevent the further deterioration of common access
resources.

The solution, as far as it is possible to implement one, is for the

government to limit the use of such resources (as far as they can) or
charge an entrance fee to reduce the number of visitors. Examples of
such policies include fishing permits or entrance fees to enter a national
park − though such policies can be expensive to enforce.
Definition of market failure

Market failure refers to the failure of the market to allocate resources efficiently.
Market failure results in allocative inefficiency, where too much or too little of
goods or services are produced and consumed from the point of view of what is
socially most desirable. Overprovision of a good means too many resources are
allocated to its production(overallocation); underprovision means that too few
resources are allocated to its production. ( underallocation).
7/12/2023

Common Pool resources

● Definition
● The concept of rivalry & non-excludability
● The tragedy of commons
● Meaning of unsustainable production
● Meaning of externalities : diverging private ,
social benefits & costs ( MPC, MSC,MPB,MSB)
Common pool resources- are resources
that are not owned by anyone ,do not have
a price and are available for anyone to use
without payment or any other restrictions.
Examples- clean air, lakes,rivers, fish in
the open seas, wildlife,hunting grounds,
forests,biodiversity, ozone layer, open
grazing land and many more.
Common pool resources rivalrous and
non-excludable. This combination poses
serious threats to the environment. Rivalry
means that the use of resources reduces
their availability for others. Non-
excludability means that the resources
can be used abundantly without
restrictions and therefore may be
overused,degraded,depleted.
Private goods - It is rivalrous : its
consumption by one person reduces its
availability for someone else. Ex- Your
textbook, computer,pencils are
rivalrous, because when you buy them,
another person cannot buy the same
ones; most goods are rivalrous.
It is excludable - it is possible to excuse
people from suing the good;exclusion is
usually achieved by charging a price for
the good; if someone is unwilling or
unable to pay the price,he or she will
not have the benefit of using it;most
goods are excludable.
 Examples of overuse of common pool resources

1. When fish are overfished,the fishing industry uses up an excessive amount of

the global stock of fish and disrupts the marine ecosystem.
2. Similarly, the same river might provide drinking water to several cities.
Also, manufacturing firms might not hesitate to contaminate the riverbed
if not barred from doing so by legislation, as someone else would bear the
expenses.
3. When forests are cleared to create land for use in agriculture.

Leading to threats to wildlife, the ozone layer and the global climate -
unsustainable production refers to production that uses resources
unsustainably, depleting or degrading them .
For a tragedy of the commons to occur a resource must be scarce, rivalrous in consumption, and
non-excludable. Solutions to the tragedy of the commons include the imposition of private
property rights, government regulation, or the development of a collective action
arrangement. - Published in the year 1968 by biologist Garret Hardin.
Free rider problem The free-rider problem also applies to common pool
resources where some people choose to benefit from other people’s
actions. All people in the fishing industry might accept there is a need to
reduce fishing in the present to preserve stocks for the future and agree
to cut current fishing. But as a voluntary agreement, some producers
might keep fishing at the same level and free ride off the reduced
fishing of others.
Externalities
An externality occurs when the actions of consumers or producers give rise to negative or positive
side-effects on other people who are not part of these actions,and whose interests are not taken into
consideration.

Benefits on third party = positive externality

Costs (negative side- effects) = negative externalities

Four types of externalities:

● Negative production externalities

● Negative consumption externalities
● Positive production externalities
● Positive consumption externalities
Marginal private costs (MPC) refer to costs to producers of producing one more unit of a
good.

Marginal social costs (MSC) refer to costs to society of producing one more unit of good.

Marginal private benefits (MPB) refer to benefits to consumers from consuming one
more unit of good.

Marginal social benefits (MSB) refer to benefits to society from consuming one more unit
of good.

Socially optimum level of output - where the MSB for a good or service is equal to
MSC.
If there are no externalities,the actions of
buyers and sellers do not produce side-
effects on third parties, the MPB (D curve)
and MPC (S curve) determine an equilibrium
price and quantity that reflect a social
optimum, where there is allocative efficiency.
A social optimum refers to a ‘best’ situation
from the point of view of allocative efficiency.

Qopt = Socially optimum output

D = MPB = MSB AND S = MPC=MSC

Allocative inefficiency = MSC not equal to

MSB even if the MPC is equal to the MPB.
When there is an externality,the free market leads to an
outcome where the MPB= MPC, but where MSB is not equal
to MSC indicating allocative inefficiency. Either too much or
too little is produced relative to the social optimum.

Supply curve ‘S’ MPC = firm’s private cost of production

MSC = the full cost to the society of producing cement

For each level of output Q the social costs of producing

cement given by MSC > MPC = external costs.

Here, Externalities involves only production so D curve

represents both MPB & MSB.

Market outcome = MPB and MPC resulting in quantity Qm

& price Pm.

The social optimum or best outcome is given by

intersection of MSB with MSC which determines quantity
Qopt & Popt

Qm > Qopt and MSC > MSB at the point of production Qm

Welfare loss of negative production externalities
Whenever there is an externality, there is a
welfare loss involving a reduction in social
benefits due to misallocation of resources.

The shaded area = welfare loss due to

negative production externality.

All units output > then Oopt, MSC >MSB =

society would be better off if less were
produced.

Welfare loss = MSC - MSB for the amount

of output that is overproduced (Qm-Qopt)

It may be useful to note - point of welfare

loss triangle always lies at the Qopt quantity
of output.
Area of the

Consumer surplus =a+b+c+d

Producer surplus = f+g+h

External cost = c+d+e+g+h

(a+b+c+d) + (f+g+h)-(c+d+e+g+h) = a+b+f-e (Social benefits)

Activity :

a) Explain why the consumption of petrol

is above the socially optimum level of
Qso.
b) Explain why in an unregulated market
the market for fuel will also represent a
market failure?
c) Explain why some third parties suffer
as a result of the purchase.
 Policies to correct negative production externalities and prevent overuse of common
pool resources

Market based Government

policies legislation
and
regulation
Indirect taxes
( Pigouvian) Tradable
Carbon permits
taxes

Advantages and Disadvantages

Pigouvian tax - named after english economist
Arthur Cecil Pigou.Indirect tax is imposed on firms
per unit of output produced. Tax results in the
upward shift of the supply curve (MPC) to MSC. The
best tax policy is to impose a tax exactly equal to the
external cost. The new after tax equilibrium is given
by the intersection of MSC and the D curve, resulting
in lower optional quantity produced - Qopy.

Carbon taxes - is a tax per unit of carbon emissions

of fossil fuels. Fossil fuels do not emit the same
amounts of carbon when burned, therefore the
carbon tax is calculated on the basis of how much
carbon the fuel emils, the more carbon emitted -
higher the tax - to buy fossil fuels. (Oil ,coal, natural
gas). - Substitute energy sources with lower carbon
emissions (thus taxed at a lower rate)
Qopt will increase because the
external costs of producing the
output will become smaller. MSC -
MSC1 to MSC2 - indicating the
external costs are lower due to less
polluting resources. Fall in external
costs - Qopt1 to Qopt2.

CT are used in many countries to

reduce pollution - Denmark,
Finland, Jan, mexico,poland and
more.
Tradable permits - permits to pollute issued by a
government. These permits to produce can be
traded. The government grants each firm a
particular number of permits to produce a
particular level of pollutants over a given time
period. - if firm can produce its product by
emitting a lover level of pollutants than the level
set by its permits, it can sell the extra permits in
the market or vice versa.

The supply of permit is perfectly inelastic.

Kazakhstan 2013, switzerland 2008, New

Zealand 2008 or a group of countries like the
European union emissions trading system.

Real world focus 5.1

 Advantages of MBP
1. Taxes on emissions such as carbon
tax is superior to taxes on output.
2. Provides incentives to firms to
economise on the use of polluting
resources & the use of production
methods that pollute less.
3. Internalizing the externality - paid by
consumers and producers who are
parties to the transaction.
Disadvantages of MBP
1. Taxes and tradable permits are
simple in theory, in practice they are
faced with numerous technical
difficulties.
2. Difficult to answer key questions -
What production methods produce
pollutants?, which pollutants are
harmful?, what is the value of the
harm? What is the appropriate
amount of tax? How will consumers
be affected?
3. Producers might keep paying high
tax and polluting the environment.
4. Tradable permits have been
developed only for few pollutants like
Co2 & So2 - because it is difficult to
identify the quantity of each pollutant
suitable for the environment.
Government legislation and regulation
These typically involve emissions
standards, quotas, licences, permits or
outright restrictions.
Examples include -
● requirements for steel mills and
electricity generating plants to install
smokestack scrubbers to reduce
emissions.
● Banning the use of harmful
substances
● Issuing licences or permits for
particular activities like hunting.
● prohibiting construction such as
housing or industry in protected
Higher the cost of production = value of negative
areas.
externality.
Advantages Disadvantages

1. Simple to put into effect and 1. Do not offer incentives

oversee. 2. Pollution is reduced at a higher
2. Easier to implement compared to overall cost.
market based policies.
3. Most effective

Correction of negative production externalities by market based approaches or

government legislation are regulation usually involve shifting the MPC curve
upward towards the MSC curve through a variety of policies. For allocative
efficiency to be achieved. The quantity of goods produced must fall as price
increases.
Negative consumption The buyers of cigarettes have a
externality/Welfare loss demand curve,MPB but when
smoking,creates external costs -
causes the MSB curve to lie below the
MPB curve. The vertical difference
between MPB & MSB = external costs.

Equilibrium quantity = Qm and price

Pm.

Social optimum = Qopt & Popt

Policies to correct negative consumption
externality
Decrease in supply - upward shift in the supply
curve from MPC to MPC + tax.
MPC+tax curve intersects MPB at Qopt level of
output ( Quantity consumed & produced drops at
Qopt - price increases from Pm to Pc)
Legal restriction on activities like - smoking
in public places or age restrictions has the
effect of shifting the D1 = MPB curve
towards the MSB curve - until D2 overlaps
with MSB.This could alimiate externality
with production & consumption at Qopt
and price falling to Popt.