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PowerPoint to accompany Chapter 5 Economic Efficiency and Market Failure.

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1 PowerPoint to accompany Chapter 5 Economic Efficiency and Market Failure

2 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Learning Objectives 1.Understand the concepts of consumer surplus and producer surplus. 2.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. 3.Use demand and supply graphs to analyse the economic impact of price ceilings and price floors.

3 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Learning Objectives 4.Use demand and supply graphs to analyse the economic impact of taxes. 5.Define positive and negative externalities and identify examples of each. 6.Analyse government policies to achieve economic efficiency in a market with externalities.

4 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Should the government control prices?  Many historical buildings in the city of Georgetown fell into disrepair, with economists placing the blame on rent controls. Price controls are still common around the globe, particularly in labour, agricultural, financial and property markets.

5 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia LEARNING OBJECTIVE 1  Marginal benefit: The additional benefit to a consumer from consuming one more unit of a good or service.  Consumer surplus: The difference between the highest price a consumer is willing to pay and the price the consumer actually pays. Consumer Surplus and Producer Surplus

6 Price (dollars per cup) Quantity (cups per week) 0 4 The demand curve is also the marginal benefit curve: Figure 5.1 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Demand $7.00 $ Joes’ marginal benefit from consuming the fourth cup is $3.00. $2.00 Joes’ marginal benefit from consuming the fifth cup is $2.00.

7 Price (dollars per cup) Quantity (cups per week) 0 Total consumer surplus in the market for chai tea: Figure 5.2 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Demand $2.00 Total consumer surplus in the market for chai tea

8 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia The Consumer Surplus from Satellite Television How much consumer surplus will the owner of this satellite dish receive?

9 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia LEARNING OBJECTIVE 1  Marginal cost: The additional cost to a firm from producing one more unit of a good or service.  Producer surplus: The difference between the lowest price a firm would have been willing to accept and the price it actually receives. Consumer Surplus and Producer Surplus

10 Price (dollars per cup) Quantity (cups per week) 0 40 The supply curve shows marginal cost: Figure 5.3a Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Supply $ The marginal cost of producing the 40 th cup is $1.80. $2.00 The marginal cost of producing the 50 th cup is $2.00. Producer surplus on the 40 th cup sold.

11 Price (dollars per cup) Quantity (cups per week) 0 Total producer surplus in the market for chai tea: Figure 5.3b Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia $2.00 Total producer surplus from selling chai tea Supply

12 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia  Consumer surplus measures the net benefit (total benefit minus total price paid) to consumers from participating in a market.  Producer surplus measures the net benefit (total benefit minus total cost of production) to producers from participating in a market. LEARNING OBJECTIVE 1 What Consumer Surplus and Producer Surplus Measure?

13 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia LEARNING OBJECTIVE 2  Equilibrium in a competitive market results in the economically efficient level of output where marginal benefit equals marginal cost.  Economic surplus: The sum of consumer surplus and producer surplus.  Deadweight loss: The reduction in economic surplus resulting from a market not being in competitive equilibrium. The Efficiency of Competitive Markets

14 Price (dollars per cup) Quantity (cups per week) Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Supply $ Both marginal benefit and marginal cost = $2.00, which means an economically efficient output level. $2.20 Marginal benefit = $2.20, marginal cost = $1.80, therefore output is inefficiently low. Marginal benefit equals marginal cost only at competitive equilibrium: Figure $2.00 Demand Marginal benefit = $1.80, marginal cost = $2.20, therefore output is inefficiently high.

15 Price (dollars per cup) Quantity (cups per week) 0 Economic surplus equals the sum of consumer surplus and producer surplus: Figure 5.5 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Demand $2.00 Consumer surplus Supply Producer surplus

16 Deadweight loss: Figure 5.6 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

17  Economic efficiency: A market outcome in which the marginal benefit to consumers of the last unit consumed is equal to its marginal cost of production, and where the sum of consumer surplus and producer surplus is at a maximum.  Equilibrium in a competitive market results in the greatest amount of economic surplus, or total net benefit to society, from the production of a good or service. LEARNING OBJECTIVE 2 The Efficiency of Competitive Markets

18 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia  Price floor: A legally determined minimum price that sellers may receive.  Price ceiling: A legally determined maximum price that sellers may receive. LEARNING OBJECTIVE 3 Government intervention in the market

19 B A C 0 $3.00 $3.50 S D Surplus wheat Price Floor: Figure 5.7 Price (dollars per bushel) Quantity (billions of bushels per year) Consumer surplus transferred to producers Deadweight loss = B + C Price floor Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

20 B C A 0 S D $1000 Price Ceiling: Figure 5.8 Price (dollars per month) Quantity (apartments per month) $ Deadweight loss = B + C Producer surplus transferred from landlords to renters Shortage of apartments Rent control price ceiling Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

21 Price Floors in Labour Markets: The Minimum Wage Some economists believe there are better policies than the minimum wage for raising the incomes of low-skilled workers.

22 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Black markets: Buying and selling at prices that violate government price regulations.  When the government imposes price floors or price ceilings, three important effects occur:  Some people win.  Some people lose.  There is a loss of economic efficiency, which is often very large. LEARNING OBJECTIVE 3 Price floors and price ceilings

23 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Positive and Normative Analysis of Price Ceilings and Price Floors  Whether rent controls are desirable or undesirable is a normative question.  Whether the gains to the winners more than compensate the losses to the losers and the decline in economic efficiency is a matter of judgment and not strictly an economic question. LEARNING OBJECTIVE 3 Price floors and price ceilings

24 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia  Taxes finance government activities.  Taxes on goods and services affect market equilibrium and result in a decline in economic efficiency.  Taxes reduce consumer surplus and reduce producer surplus and result in a deadweight loss.  Taxes reduce the production of goods and services. LEARNING OBJECTIVE 4 The economic impact of taxes

25 Price (dollars per pack) Quantity of cigarettes (billions of packets per year) 0 4 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia 2.00 S1S1 Demand $1.00 per pack federal tax on cigarettes shifts the supply curve up by $1.00. $ S2S2 Deadweight loss or excess burden from tax Price received by producers after paying the tax The effect of a tax on the market for cigarettes: Figure Price the consumers pay after the $1.00 tax is imposed Tax revenue

26 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia LEARNING OBJECTIVE 4 Tax incidence: The actual division of the burden of a tax between buyers and sellers in a market.  Who Actually Pays a Tax? The answer depends on:  Slope of the demand curve and the price elasticity of demand.  Slope of the supply curve and the price elasticity of supply. The Economic Impact of Taxes

27 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia  Does it matter who has a legal responsibility to pay the tax?  No, the incidence of the tax does not depend on whether a tax is collected from the buyers of the good or from the sellers. LEARNING OBJECTIVE 4 The Economic Impact of Taxes

28 The incidence of a tax on petrol: Figure 5.10 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

29 The incidence of a tax on petrol paid by buyers: Figure 5.11 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

30 Do consumers receive the entire benefit of a sales tax reduction? The Hon Dr Brendan Nelson MP, a former Leader of the Opposition, in his interview on 20th May 2008 made the following statement: “We will take five cents a litre off the excise. So every single day when you fill up your car, whatever that price, it’ll be five cents a litre cheaper than it would otherwise be” 1.  Briefly explain whether you agree with the statement.  Illustrate your answer with the graph. 1 LEARNING OBJECTIVE 4

31 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Solving the problem: STEP 1: Review the section ‘Tax incidence: Who actually pays tax?’, which begins on page 144. STEP 2: Draw a graph like the one in Figure 5.10 to illustrate the circumstances when consumers will receive the entire benefit of a reduction in a sales tax. STEP 3: Use the graph to evaluate the statement. This statement is only correct if the demand curve is a vertical line (perfectly inelastic). Although inelastic, demand curve for petrol is not perfectly inelastic, therefore the statement is unlikely to be true. The petrol price is likely to decrease by less than 5 cents. LEARNING OBJECTIVE 4

32 Price (dollars per litre) 019 $1.50 $1.45 D S1S1 S2S2 Quantity (billions of litres per year) 5 cents per litre excise reduction shifts the supply curve down Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

33 Externalities and Efficiency  Externality: A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service.  Private cost: The cost borne by the producer of a good or service.  Social cost: The total cost of producing a good, including both the private cost and any external cost.  Private benefit: The benefit received by the consumer of a good or service.  Social benefit: The total benefit from consuming a good, including both the private benefit and any external benefit. LEARNING OBJECTIVE 5

34 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Command and control versus market- based approaches Command and control approach: 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. LEARNING OBJECTIVE 6 Government Solutions to Externalities

35 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Market-based approaches  Tradeable emissions allowances: The government can issue a fixed quantity of emission allowances, which can then be bought and sold in the market.  Rewards firms who reduce emissions, as they can sell their allowances  Penalises firms with high emissions, as they must buy more emission allowances. LEARNING OBJECTIVE 6 Government Solutions to Externalities

36 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia  Pigovian taxes and subsidies: Government taxes and subsidies intended to bring about an efficient level of output in the presence of externalities.  A tax on production equal to the cost of the externality to internalise a negative externality.  A subsidy to consumers equal to the value of the positive externality, that is, equal to the external benefit. LEARNING OBJECTIVE 6 Government Solutions to Externalities

37 Price of electricity Quantity of electricity 0 Q1 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia P1 S 1 = private cost before tax When there is a negative externality, a tax can bring about the efficient level of output: Figure 5.12 Demand Cost of pollution = amount of tax imposed by government P2 Q2 S 2 = social cost and private cost after tax Market equilibrium without tax Market equilibrium with tax

38 Price of university education Quantity of university education 0 Q1 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia P1 Supply Positive externality = amount of subsidy Market equilibrium with subsidy = efficient equilibrium Market equilibrium without subsidy D 2 = social benefit and private benefit after subsidy P2 Q2 When there is a positive externality, a subsidy can bring about the efficient level of output: Figure 5.13 D 1 = private benefit before subsidy

39 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia An Inside Look Reform on the way for EU agriculture

40 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia An Inside Look Figure 1: The excess supply of food is sold on world markets and causes the world supply of food to shift to the right.

41 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia An Inside Look Figure 2: The imposition of a floor price in the European market for food causes an increase in price and excess supply of food.

42 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia  Black market  Command and control approach  Consumer surplus  Deadweight loss  Economic efficiency  Economic surplus  Externality  Marginal benefit  Marginal cost  Market failure  Pigovian taxes and subsidies  Price ceiling  Price floor  Private benefit  Private cost  Producer surplus  Social benefit  Social costs  Tax incidence Key Terms

43 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia In April 2007, the European Union imposed a five-year minimum price on Chinese frozen strawberries with the aim of protecting its farmers.  Identify the possible outcomes of this regulation.  Do you think the benefits of such a policy outweigh the costs? Get Thinking!

44 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Q1.Refer to the figure below. The graph shows an individual’s demand curve for tea. At a price of two dollars, the consumer is willing to buy five cups of tea per week. More precisely, what does this mean? a.It means that marginal benefit equals marginal cost when five cups are consumed. b.It means that the total cost of consuming five cups is $2.00. c.It means that the marginal cost of producing five cups is $2.00. d.It means that the marginal benefit of consuming the fifth cup is $2.00. Check Your Knowledge

45 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Check Your Knowledge Q1.Refer to the figure below. The graph shows an individual’s demand curve for tea. At a price of two dollars, the consumer is willing to buy five cups of tea per week. More precisely, what does this mean? a.It means that marginal benefit equals marginal cost when five cups are consumed. b.It means that the total cost of consuming five cups is $2.00. c.It means that the marginal cost of producing five cups is $2.00. d.It means that the marginal benefit of consuming the fifth cup is $2.00.

46 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Q2.If the average price that cable subscribers are willing to pay for cable television is $208, but the actual price they pay is $81, how much is consumer surplus per subscriber? a. $208 + $81. b. $208 – $81. c. $81 + $127. d. $81. Check Your Knowledge

47 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Q2.If the average price that cable subscribers are willing to pay for cable television is $208, but the actual price they pay is $81, how much is consumer surplus per subscriber? a. $208 + $81. b. $208 – $81. c. $81 + $127. d. $81. Check Your Knowledge

48 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Q3.Refer to the graph below. To achieve economic efficiency, which output level should be produced? a cups per month, because at this level of output, marginal benefit is greater than marginal cost. b cups per month, because at this level of output, marginal benefit is equal to marginal cost. c cups per month, because at this level of output, marginal benefit is less than marginal cost. d.Any of the output levels above is efficient. Check Your Knowledge

49 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Check Your Knowledge Q3.Refer to the graph below. To achieve economic efficiency, which output level should be produced? a.14,000 cups per month, because at this level of output, marginal benefit is greater than marginal cost. b.15,000 cups per month, because at this level of output, marginal benefit is equal to marginal cost. c cups per month, because at this level of output, marginal benefit is less than marginal cost. d.Any of the output levels above is efficient.

50 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Q4.Refer to the graph below. According to this graph, the existence of a minimum wage in the market for low-skilled workers results in: a.An increase in wages and employment. b.An increase in wages but lower employment. c.A decrease in wages but higher employment. d.A decrease in wages and employment. Check Your Knowledge

51 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Q4.Refer to the graph below. According to this graph, the existence of a minimum wage in the market for low-skilled workers results in: a.An increase in wages and employment. b.An increase in wages but lower employment. c.A decrease in wages but higher employment. d.A decrease in wages and employment. Check Your Knowledge

52 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Check Your Knowledge Q5. After a Pigovian tax that represented the cost of the negative externality was put on producers, which point would best represent market equilibrium? a. Point A. b. Point B. c. Point C. d. None of the above.

53 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Check Your Knowledge Q5. After a Pigovian tax that represented the cost of the negative externality was put on producers, which point would best represent market equilibrium? a. Point A. b. Point B. c. Point C. d. None of the above.


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