ECO109 Business

Economics

Week 4: Market Failure & Government

Intervention
Lesson Objectives
By the end of this topic, students will be able to:

1. Define efficiency
2. Define consumer and producer surplus and its implications in different economic systems
3. Discuss the effects of price floor and price ceiling in a market and the effect of taxes and other forms of
government interventions
4. Understand what is externalities, and why it is present, and why market fail
5. Explain what positive and negative externalities are and their effects
 Market failure refers to a situation defined by an
inefficient distribution of goods and services
• Market failure refers to the inefficient allocation of
resources that occurs when individuals acting in
Introduction rational self-interest produce a sub-optimal outcome.
• It may be possible to correct market failures using
government-imposed solutions (government
intervention)
Allocative efficiency: Pareto Optimality
• Optimality = the best possible outcome of a process
• Pareto Optimality = a distribution of things such that no one can
be made better off without someone becoming worse off.
• Allocative Efficiency: the distribution of things is “Pareto
optimal”
Hence,
• Allocative efficiency means that economic resources are distributed in a
way that produces the highest consumer satisfaction relative to the cost
of inputs.
 LO 2

Consumer Surplus
• Consumer surplus is the value of a good
minus the price paid for it, summed over
the quantity bought.
• It is measured by the area under the
demand curve and above the price paid,
up to the quantity bought.
 LO 2

• Cost, Minimum Supply-Price, and Supply

• The cost of one more unit of a good or service is its
Cost, Price, marginal cost, which we can measure as minimum
price that a firm is willing to accept.
and Producer • A supply curve of a good or service shows the
quantity supplied at each price. A supply curve also
Surplus shows the minimum price that producers are willing
to accept at each quantity.
• Supply curve is also the Marginal cost curve
• Hence producer surplus is revenue minus the
opportunity cost of producing a good.
 LO 2

Cost, Price, and Producer Surplus

• The price is the market
price, which is the same
for each unit sold.
• The quantity sold is
determined by the
supply curve and the red
area shows the total cost
of producing pizza.
• The blue triangle shows
the producer surplus
from pizza.
 LO 2

Is the Competitive
Market Efficient?
• Efficiency of Competitive
Equilibrium
• This diagram shows that
a competitive market
creates an efficient
allocation of resources
at equilibrium.
• In equilibrium, the
quantity demanded
equals the quantity
supplied.
 LO 2

Is the Competitive
Market Efficient?
• At the equilibrium
quantity, marginal
benefit equals marginal
cost, so the quantity is
the efficient quantity.

• The sum of consumer

and producer surplus is
maximized at this
efficient level of output.
 LO 3

Sources of inefficiency
Markets are not always efficient and the
obstacles to efficiency are:
 Price ceilings and floors
 Taxes, subsidies, and quotas
 Public goods
 Monopoly
 External costs and external benefits.
 LO 3

Price Ceilings: a maximum

Sources of price sellers are allowed to
inefficiency: charge for a good. It’s an
upper limit for the price.
Price ceilings
and floors
Price Floors: a minimum
price buyers are required to
pay for a good. It’s a lower
limit for the price.
 LO 3

Price controls: price ceilings

Why Price controls?

Price D S

During crisis times, emergencies or wars

3 the government wants to protect the
Price consumers from rapidly increasing prices.
Ceiling
2

Shortage If the equilibrium wage given by supply

and demand for low skilled workers is
800 Quantity of below poverty level, the government can
100 200
icecreams set a minimum wage.
 LO 3

Example: Price Celings in Apartments

 LO 3

Price controls: price ceilings

• Because of these ceilings, we are faced with a shortage.

• The shortage will lead to inefficiencies:
A market or an economy is inefficient if there are missed opportunities:
some people could be made better off without making other people
worse off.
 LO 3

Price controls: price floors

Price Floors: a The minimum wage is

minimum price buyers a legal floor on the
are required to pay for wage rate, which is
a good.I’ts a lower the market price of
limit for the price. labor.
 LO 3

Price controls: price floors

Price floor

Surplus
Price D S

3
Price
Ceiling
2

100 200 600 Quantity of

icecreams
 LO 3

Sources of inefficiency :
Taxes, subsidies, and quotas
• Taxes are mandatory financial charges imposed by a government on
individuals or corporations.
• A subsidy is a benefit given by the government to individuals, businesses,
or institutions. It can take two forms:
1. Direct Subsidies: These involve direct financial assistance, such as
cash payments or grants. For instance, a government might provide
subsidies to support specific industries or promote certain activities.
2. Indirect Subsidies: These come in the form of tax breaks or other
favorable treatment. For example, tax credits for renewable energy
projects encourage investment in clean technologies.
• A quota is a government-imposed restriction on the quantity of goods that
can be imported or exported.
Tax & Inefficiency

• Imposing a tax creates inefficiency.

• With no tax, the market is efficient,
and the sum of consumer surplus and
producer surplus is maximized
Tax & Inefficiency
• With a tax, marginal social benefit
exceeds marginal social cost
• This shrinks the producer surplus
and consumer surplus and creates a
deadweight loss
 LO 4

Externalities & Public Goods

Externalities occur when economic decisions create
costs or benefits for people other than the decision taker.
There could be external costs or benefits.

As markets do not account for this third party effect,

markets underprovide public goods, and create negative
externalities damaging the environment.

For e.g How much waste should firms dump into rivers,
how strict should automobile standards be, and how
much should government spend on national defense?
 LO 5

Types of Externalities
•Positive externalities
•Too little is produced
•Demand-side market failures

•Negative externalities
•Too much is produced
•Supply side market failures
 LO 5

Positive externalities
• The private benefit of consuming a good is its benefit to the people
who buy and consume it.
• The social benefit is its total benefit to everyone in the society
including people who do not produce or consume it.
• Social benefit = Private Benefit + Benefits enjoyed by bystanders
• A positive externality occurs when the social benefit exceeds the
private benefit. That is, Social Benefit > Private Benefit
• In other words, Social Benefit = Private Benefit + External Benefits
 LO 5

Negative Externality

• The private cost of producing a good is the cost paid by the firm that produces
and sells it
• The social cost of a good is its cost to everyone in the society, including people
who do not produce or consume it.
• Social Cost = Private Cost + Costs endured by bystanders
• A negative externality occurs when the social cost of a good exceeds its private
cost. That is, Social Cost > Private Costs
• In other words, Social Cost = Private Cost + External Costs
 LO 5

Government Intervention

Correct negative externalities

• Direct controls
• Specific taxes

Correct positive externalities

• Subsidies
• Government provision
LO 5
END of Lecture