Last Updated 08 Apr 2020

Market Efficiency and Market Failure

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CHAPTER 4 Market Efficiency and Market Failure 1. Chapter Summary Governments of over 200 cities in the United States have placed ceilings on the maximum rent some landlords can charge for their apartments. Some firms have coaxed governments into imposing price floors, which are legally determined minimum prices that sellers may receive. To understand the economic impact of government interventions in markets, it is necessary to understand consumer surplus and producer surplus.

Consumer surplus is the dollar net benefit consumers receive from buying goods and services at market prices less than the maximum prices they would be willing to pay. In a demand and supply graph, consumer surplus equals the area below the demand curve and above a horizontal line drawn from the price axis to the point on the demand curve that represents the market price. Producer surplus is the dollar net benefit producers receive from selling goods and services at prices greater than the minimum prices they would be willing to accept.

In a demand and supply graph, producer surplus is equal to the area above the supply curve and below a horizontal line drawn from the price axis to the point on the supply curve that represents the market price. In a competitive market, the equilibrium price for a good or service occurs at the quantity of product where the marginal cost of the last unit produced and sold is equal to the marginal benefit consumers receive from the last unit bought. Therefore, equilibrium in a competitive market results in an economically efficient level of output.

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At this same level of output economic surplus, the sum of consumer and producer surplus in this market is maximized. Some producers who believe an equilibrium price is too low will lobby for government action to set a higher legal price (a “floor price”). Some consumers who believe that an equilibrium price is too high will lobby government to legally require that a lower price (a “ceiling price”) be charged. Although price ceilings and price floors are not common, they have been established in some markets. Price floors were established in gricultural markets in the United States during the Great Depression. Government intervention in agriculture has continued ever since. Although the administration of price floors can be complex, the basic operation of this price control involves a government commitment to maintain a price (for example, $3. 50 per bushel of wheat) that exceeds the equilibrium price (for example, $3. 00). The price floor reduces the quantity demanded of the product while it encourages producers to increase the quantity supplied.

The difference between these two quantities, a surplus, is typically bought by government at the floor price. The result of the price floor is to (a) transfer some consumer surplus that would exist at the equilibrium price to producer surplus and (b) create a “deadweight loss” or a net loss of consumer and producer surplus. The deadweight loss is also the efficiency loss that results from the price floor. Another example of a price floor is the “minimum wage,” which is a legal wage imposed above the equilibrium wage offered in the United States for most occupations.

Since most workers earn wages above the minimum wage, this price (wage) floor affects low-skilled and inexperienced workers. Although the economic impact of the minimum wage is similar to that of price floors imposed in other markets (deadweight losses result), economists have disagreed about the extent to which the minimum wage reduces employment. Price ceilings are found most often in the markets for apartments in various cities; local governments will usually impose this type of price ceiling.

In New York City, about 1 million apartments are subject to rent control. A simple description of the impact of a price ceiling on rent (administration of the ceiling will vary by city and over time) is that the quantity demanded at the ceiling price, for example, $1,000 per month, exceeds the quantity supplied. In contrast, if an equilibrium price of, say $1,500, were allowed, the quantity supplied would be greater and the quantity demanded would be less; these two quantities would be equal and there would be no shortage of apartments.

The results of the price ceiling are to (a) transfer some producer surplus to consumer surplus and (b) create a deadweight loss or a net loss of consumer and producer surplus. Another possible result of the ceiling is the creation of a “black market” where buyers agree to rent apartments from landlords for greater than the legal price. Because the ceiling reduces quantity supplied, the black market price may exceed the equilibrium price. An externality is a benefit or cost that affects someone not directly involved in the production or consumption of a good or service.

Negative externalities are costs imposed on non-consenting individuals. Positive externalities are benefits for individuals not directly involved in producing or paying for a good or service. Externalities interfere with the economic efficiency of a market equilibrium since they cause a difference between the private cost of production (the cost borne by the producer of a good or service) and the social cost, or the private benefit from consumption (the benefit received by the consumer of a good or service) and the social benefit.

The social cost is the private cost plus any external cost resulting from production; the social benefit is the private benefit plus any external benefit that results from the consumption of a good or service. When there is a negative externality as the result of production, the market supply curve understates the true (social) cost of production. A supply curve that reflects social costs would lie to the left of the market supply curve. The equilibrium market price occurs where the marginal social cost of production exceeds the marginal benefit to consumers and there is a reduction in economic surplus.

Economic efficiency would be increased if less of the good or service were produced. When there is a positive externality, the market demand curve understates the social benefits from consumption of a good, and the demand curve that reflects the social benefits of this good would lie to the right of the market demand curve. At the equilibrium point, the marginal benefit exceeds the marginal cost and a deadweight loss results. Because of the positive externality, too little of the good is produced.

Negative and positive externalities lead to market failure due to the absence of private property rights for physical property (for example, a store or factory) or intangible assets (for example, for a new idea to improve a production process). Market failure may also result from the difficulty of enforcing private property rights (for example, lax government enforcement of copyright laws). Most of the time, the governments of the United States and other high income nations provide adequate enforcement of property rights, but in certain situations, these rights do not exist or cannot be legally enforced.

When private solutions to externalities are not feasible, government intervention is justified. For example, by imposing a tax equal to the external costs that result from production of a good, government can “internalize” the externality. This causes the social, not just the private, cost of production to be borne by producers. In effect, the supply curve for the good shifts to the left. This supply curve would then cross the demand curve at a higher equilibrium price and lower equilibrium quantity. When production of a good produces a positive externality, government can internalize the externality by providing a subsidy to consumers.

If the subsidy is equal to the value of the externality, this has the effect of shifting the demand curve for the good to the right; market equilibrium is achieved at the economically efficient level with a higher price and quantity. To reduce pollution, governments have often used a “command and control” approach. This may involve government imposition of quantitative limits on amounts of pollution firms can emit or the installation of specific pollution control devices. An exception to the command and control approach was the U. S. overnment’s attempt to reduce acid rain pollution. In the Clean Air Act passed by Congress in 1990, a reduction in sulfur dioxide emissions, a major cause of acid rain, from electric utilities was mandated. To achieve this goal, utilities were allowed to buy and sell emissions allowances. Each allowance is equal to one ton of sulfur dioxide. So long as the total amount of emissions does not exceed an annual mandated maximum amount (by 2010 this amount will be 8. 5 million tons), firms can emit sulfur dioxide in amounts equal to their allowances.

Firms that face high costs of reducing sulfur dioxide have an incentive to buy more allowances than they have been allocated. Utilities that can reduce their emissions at low cost have an incentive to do so and sell some of their allowances. This program has achieved emissions reductions at much lower costs than had been expected in 1990. The success of the sulfur dioxide program has led some to suggest that a similar program be used by the United States and other nations to reduce emissions of so-called “greenhouse gases” that contribute to global warming. . Learning Objectives Students should be able to: •Understand the concepts of consumer surplus and producer surplus. •Understand the concept of economic efficiency, and use a graph to illustrate how economic efficiency is reduced when a market is not in competitive equilibrium. •Use demand and supply graphs to analyze the economic impact of price ceilings and floors. •Identify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency. Analyze government policies to achieve economic efficiency in a market with an externality. 3. Chapter Outline Should the Government Control Apartment Rents? 1. Rent control is an example of government regulation of prices. Rent controls (a type of price ceiling) exist in about 200 cities in the United States. Although the rules that govern rent control are complex and vary by city, rent control drives up the demand and price for apartments not subject to the controls. Consumer Surplus and Producer Surplus 1.

Consumer surplus is the difference between the highest price a consumer is willing and able to pay and the price the consumer actually pays. 2. Producer surplus is the difference between the lowest price a firm would have been willing and able to accept and the price it actually receives. A. Consumer and producer surplus represent the net benefits consumers and producers receive from buying and selling a good or service in a market. B. Price ceilings and price floors reduce the economic surplus (this is consumer surplus plus producer surplus in a given market).

C. Marginal benefit is the benefit to a consumer from consuming one more unit of a good or service. D. The height of a market demand curve at a given quantity measures the marginal benefit to someone from consuming that quantity. Consumer surplus refers to the difference between this marginal benefit and the market price the consumer pays. E. Total consumer surplus is the difference between marginal benefit and price for all quantities bought by consumers; this is shown in a demand curve as the area below the demand curve and above the market price.

F. Marginal cost is the additional cost to a firm of producing one more unit of a good or service. G. The height of a market supply curve at a given quantity measures the marginal cost of the last unit produced for the producer. Producer surplus refers to the difference between this marginal cost and the market price the producer receives. H. Total producer surplus equals the difference between marginal cost and price for all quantities sold by producers. The Efficiency of Competitive Markets 1.

When equilibrium is reached in a competitive market, the marginal benefit from the last unit sold will equal the marginal cost of producing that last unit. This is an economically efficient outcome. A. If less than the equilibrium output were produced, the marginal benefit of the last unit bought would exceed its marginal cost. B. If more than equilibrium quantity were produced, the marginal benefit of this last unit would be less than its marginal (opportunity) cost. C. Economic surplus is the sum of consumer and producer surplus.

Economic surplus, or the net benefit to society from the production of a good or service, is maximized at equilibrium in a competitive market (when there are no externalities). D. A deadweight loss is the reduction in economic surplus resulting from a market not being in competitive equilibrium. E. Economic efficiency is a market outcome in which the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production, and where the sum of consumer and producer surplus is at a maximum. Government Intervention in the Market: Price Floors and Price Ceilings 1.

Though the total benefit to society is maximized at a competitive market equilibrium, individual consumers would be better off if they could pay a lower than equilibrium price, and individual producers would be better off if they could sell at a higher than equilibrium price. 2. Consumers and producers sometimes lobby government to legally require a market price different from the equilibrium price. These lobbying efforts are sometimes successful. 3. Price floors were established in agricultural markets during the Great Depression in response to pleas from farmers who could sell their product only at low prices.

A. A price floor is a legally determined minimum price that sellers may receive. B. A price floor encourages producers to produce more output than consumers want to buy at the floor price. C. The surplus (equal to the quantity supplied minus the quantity demanded at the floor price) that results from a price floor is typically bought and stored by the government. D. The marginal cost of the last unit produced exceeds its marginal benefit and there is a deadweight loss which reflects a decline in efficiency due to the price floor. 4.

A price ceiling is a legally determined maximum price that sellers may charge. A. Price ceilings are meant to help consumers who may lobby for a price ceiling after a sharp increase in the price of an item on which they spend a significant amount of their budgets (for example, rent and energy). B. At the ceiling price, the quantity demanded is greater than the quantity supplied so that the marginal benefit of the last item sold (the quantity supplied) exceeds the marginal cost of producing it. C. Price ceilings result in a deadweight loss and a reduction of economic efficiency.

D. Price ceilings create incentives for black markets. A black market refers to buying and selling at prices that violate government price regulations. Externalities and Efficiency 1. An externality is a benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service. A. Positive externalities refer to benefits received from a good or service by consumers who do not pay for them. B. Negative externalities refer to costs incurred by individuals from a good or service for which no one pays.

C. A private cost is a cost borne by the producer of a good or service. D. A social cost is the total cost of production, including both the private cost and any external cost. E. A private benefit is the benefit received by the consumer of a good or service. F. A social benefit is the total benefit from consuming a good, including both the private benefit and any external benefit. G. A negative externality causes the social cost of production for a good or service to be greater than the private cost. As a result, more han the economically efficient level of output is produced. H. A positive externality causes the social benefit from the production of a good or service to be greater than the private benefit. As a result, less than the economically efficient level of output is produced. A. Market failure refers to situations where the market fails to produce the efficient level of output. B. Figure 4-9 illustrates the effect of acid rain on the market for electricity and the deadweight loss that occurs due to a negative externality. C.

Figure 4-10 illustrates the impact of a positive externality in the market for a college education and the deadweight loss caused by this externality. 3. In the absence of private solutions to externalities, government intervention is warranted. To achieve economic efficiency, governments may intervene in different ways. A. To reduce pollution, “command and control” policies have often been employed. A command and control approach refers to government-imposed quantitative limits on the amount of pollution firms are allowed to generate, or government-required installation by firms of specific pollution control devices.

B. Since 1990, a market-based approach to reducing sulfur dioxide emissions from electric utilities has reduced emissions at much lower cost than was expected. The success of this approach has led economists to advocate more extensive use of market-based approaches, and less use of command and control policies, to reduce other forms of pollution. Homework Problems – Not to be submitted: 1. From the Review Questions: Try all of them! 2. From the Problems and Applications: #s: 3, 4, 5, 16, and 20. 3. From the APPENDIX: REVIEW QUESTIONS #S 3 AND 4.

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