1. ANTHONY PATRICK O’BRIEN
R. GLENN HUBBARD
ANTHONY PATRICK O’BRIEN
Essentials of
Economics
THIRD EDITION

2. 4 Market Efficiency and Market Failure Chapter Outline and
Learning Objectives
4.1
Consumer Surplus and Producer Surplus
4.2
The Efficiency of Competitive Markets
4.3
Government Intervention in the Market: Price Floors and Price Ceilings
4.4
Externalities and Economic Efficiency
4.5
Government Policies to Deal with Externalities

3. Should the Government Control Apartment Rents?
Rent control puts a legal limit on the rent that landlords can charge for an apartment.
Market-determined rents are usually far above controlled rents.
Although rent control laws are intended to make housing more affordable for people with low incomes, high-income people can end up benefiting.
AN INSIDE LOOK AT POLICY on page 126 discusses a legal battle between Oscar-winning actress Faye Dunaway and the landlord of her rent-controlled New York City apartment.

4. Economics in Your Life
Does Rent Control Make It Easier for You to Find an Affordable Apartment?
Suppose you have job offers in two cities.
One factor in deciding which job to accept is whether you can find an affordable apartment.
See if you can answer this question by the end of the chapter:
If one city has rent control, are you more likely to find an affordable apartment in that city, or would you be better off looking for an apartment in a city without rent control?

5. Price ceiling A legally determined maximum price that sellers may charge.
Price floor A legally determined minimum price that sellers may receive.
Externality A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service.
When there is a negative externality, the market may produce a quantity of the good that is greater than the efficient amount.
When there is a positive externality, the market may produce a quantity that is less than the efficient amount.
Economists have developed the concepts of consumer surplus, producer surplus, and economic surplus to analyze the effects of price ceilings, price floors, and government policies toward externalities.

6. Consumer Surplus and Producer Surplus
4.1 LEARNING OBJECTIVE
Distinguish between the concepts of consumer surplus and producer surplus.

7. Consumer Surplus
Consumer surplus The difference between the highest price a consumer is willing to pay for a good or service and the price the consumer actually pays.
Marginal benefit The additional benefit to a consumer from consuming one more unit of a good or service.

8. Figure 4.1
Deriving the Demand Curve for Chai Tea
With four consumers in the market for chai tea, the demand curve is determined by the highest price each consumer is willing to pay.
For prices above $6, no tea is sold because $6 is the highest price any consumer is willing to pay.
For prices of $3 and below, every one of the four consumers is willing to buy a cup of tea.

9. Figure 4.2
Measuring Consumer Surplus
Panel (a) shows the consumer surplus for Theresa, Tom, and Terri when the price of tea is $3.50 per cup.
Theresa’s consumer surplus is equal to the area of rectangle A and is the difference between the highest price she would pay—$6—and the market price of $3.50.
Tom’s consumer surplus is equal to the area of rectangle B, and Terri’s consumer surplus is equal to the area of rectangle C.
Total consumer surplus in this market is equal to the sum of the areas of rectangles A, B, and C, or the total area below the demand curve and above the market price.
In panel (b), consumer surplus increases by the shaded area as the market price declines from $3.50 to $3.00.

10. Figure 4.3
Total Consumer Surplus in the Market for Chai Tea
The demand curve tells us that most buyers of chai tea would have been willing to pay more than the market price of $2.00.
For each buyer, consumer surplus is equal to the difference between the highest price he or she is willing to pay and the market price actually paid.
Therefore, the total amount of consumer surplus in the market for chai tea is equal to the area below the demand curve and above the market price.
Consumer surplus represents the benefit to consumers in excess of the price they paid to purchase the product.
The total amount of consumer surplus in a market is equal to the area below the demand curve and above the market price.

11. Making the Connection
The Consumer Surplus from Broadband Internet Service
The demand curve shows the marginal benefit consumers received in 2006 from subscribing to a broadband Internet service rather than using dialup or doing without access to the Internet.
The area below the demand curve and above the $36 price line represents the difference between the price consumers would have paid and the $36 they did pay.
The shaded area on the graph represents the total consumer surplus in the market for broadband Internet service, which was estimated to be $890.5 million per month.
Your Turn: Test your understanding by doing related problem 1.9 at the end of this chapter.
MyEconLab

12. Producer Surplus
Marginal cost The additional cost to a firm of producing one more unit of a good or service.
Producer surplus The difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives.

13. Panel (a) shows Heavenly Tea’s producer surplus.
Figure 4.4a
Measuring Producer Surplus
Panel (a) shows Heavenly Tea’s producer surplus.
Producer surplus is the difference between the lowest price a firm would be willing to accept and the price it actually receives.
The lowest price Heavenly Tea is willing to accept to supply a cup of tea is equal to its marginal cost of producing that cup.
When the market price of tea is $2.00, Heavenly receives producer surplus of $0.75 on the first cup (the area of rectangle A), $0.50 on the second cup (rectangle B), and $0.25 on the third cup (rectangle C).

14. Figure 4.4b
Measuring Producer Surplus
In panel (b), the total amount of producer surplus tea sellers receive from selling chai tea can be calculated by adding up for the entire market the producer surplus received on each cup sold.
In the figure, total producer surplus is equal to the area above the supply curve and below the market price, shown in red.
The total amount of producer surplus in a market is equal to the area above the market supply curve and below the market price.

15. What Consumer Surplus and Producer Surplus Measure
Consumer surplus measures the net benefit to consumers from participating in a market rather than the total benefit.
Consumer surplus in a market is equal to the total benefit received by consumers minus the total amount they must pay to buy the good or service.
Similarly, producer surplus measures the net benefit received by producers from participating in a market.
Producer surplus in a market is equal to the total amount firms receive from consumers minus the cost of producing the good or service.

16. The Efficiency of Competitive Markets
4.2 LEARNING OBJECTIVE
Understand the concept of economic efficiency.

17. Figure 4.5
Marginal Benefit Equals Marginal Cost Only at Competitive Equilibrium
In a competitive market, equilibrium occurs at a quantity of 15,000 cups and a price of $2.00 per cup, where marginal benefit equals marginal cost.
This is the economically efficient level of output because every cup has been produced where the marginal benefit to buyers is greater than or equal to the marginal cost to producers.
Equilibrium in a competitive market results in the economically efficient level of output, where marginal benefit equals marginal cost.

18. Economic surplus The sum of consumer surplus and producer surplus.
Figure 4.6
Economic Surplus Equals the Sum of Consumer Surplus and Producer Surplus
The economic surplus in a market is the sum of the blue area, representing consumer surplus,
and the red area, representing producer surplus.
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.
Economic efficiency A market outcome in which the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production and in which the sum of consumer surplus and producer surplus is at a maximum.

19. Deadweight loss The reduction in economic surplus resulting from a market not being in competitive equilibrium.
Figure 4.7
When a Market Is Not in Equilibrium, There Is a Deadweight Loss
Economic surplus is maximized when a market is in competitive equilibrium.
When a market is not in equilibrium, there is a deadweight loss.
When the price of chai tea is $2.20 instead of $2.00, consumer surplus declines from an amount equal to the sum of areas A, B, and C to just area A.
Producer surplus increases from the sum of areas D and E to the sum of areas B and D.
At competitive equilibrium, there is no deadweight loss.
At a price of $2.20, there is a deadweight loss equal to the sum of areas C and E.

20. Government Intervention in the Market: Price Floors and Price Ceilings
4.3 LEARNING OBJECTIVE
Explain the economic effect of government-imposed price floors and price ceilings.

21. Price Floors: Government Policy in Agricultural Markets
Figure 4.8
The Economic Effect of a Price Floor in the Wheat Market
If wheat farmers convince the government to impose a price floor of $3.50 per bushel, the amount of wheat sold will fall from 2.0 billion bushels per year to 1.8 billion.
If we assume that farmers produce 1.8 billion bushels, producer surplus then increases by the red rectangle A—which is transferred from consumer surplus—and falls by the yellow triangle C.
Consumer surplus declines by the red rectangle A plus the yellow triangle B.
There is a deadweight loss equal to the yellow triangles B and C, representing the decline in economic efficiency due to the price floor.
In reality, a price floor of $3.50 per bushel will cause farmers to expand their production from 2.0 billion to 2.2 billion bushels, resulting in a surplus of wheat.

22. Making the Connection
Price Floors in Labor Markets: The Debate over Minimum Wage Policy
Supporters of the minimum wage see it as a way of raising the incomes of low-skilled workers.
Opponents argue that it results in fewer jobs and imposes large costs on small businesses.
Whatever the extent of employment losses from the minimum wage, because it is a price floor, it will cause a deadweight loss.
Your Turn: Test your understanding by doing related problem 3.11 at the end of this chapter.
MyEconLab

23. Price Ceilings: Government Rent Control Policy in Housing Markets
Figure 4.9
The Economic Effect of a Rent Ceiling
Without rent control, the equilibrium rent is $1,500 per month.
At that price, 2,000,000 apartments would be rented.
If the government imposes a rent ceiling of $1,000, the quantity of apartments supplied falls to 1,900,000,
and the quantity of apartments demanded increases to 2,100,000,
resulting in a shortage of 200,000 apartments.
Don’t Let This Happen to You
Don’t Confuse “Scarcity” with “Shortage”
There is no shortage of most scarce goods.
Your Turn: Test your understanding by doing related problem 3.14 at the end of this chapter.
MyEconLab

24. Price Ceilings: Government Rent Control Policy in Housing Markets
Figure 4.9
The Economic Effect of a Rent Ceiling
Without rent control, the equilibrium rent is $1,500 per month.
At that price, 2,000,000 apartments would be rented.
If the government imposes a rent ceiling of $1,000, the quantity of apartments supplied falls to 1,900,000,
and the quantity of apartments demanded increases to 2,100,000,
resulting in a shortage of 200,000 apartments.
Producer surplus equal to the area of the blue rectangle A is transferred from landlords to renters,
and there is a deadweight loss equal to the areas of yellow triangles B and C.
Black market A market in which buying and selling take place at prices that violate government price regulations.

25. Solved Problem 4.3
What’s the Economic Effect of a Black Market for Apartments?
Suppose that competition among tenants results in the black market rent rising to $2,000 per month. Use a graph showing the market for apartments, noting any differences in consumer surplus, producer surplus, and deadweight loss.
Solving the Problem
Step 1: Review the chapter material.
Step 2: Draw a graph similar to Figure 4.9, with the addition of the black market price.
Step 3: Analyze the changes from Figure 4.9.
Producer surplus has increased by an amount equal to rectangles A and E, and consumer surplus has declined by the same amount.
Deadweight loss is equal to triangles B and C, the same as in Figure 4.9.
The remaining consumer surplus is the blue triangle D.
Eventually, the market could even end up at the competitive equilibrium.
Your Turn: For more practice, do related problem 3.13 at the end of this chapter.
MyEconLab

26. Positive and Normative Analysis of Price Ceilings and Price Floors
The Results of Government Price Controls: Winners, Losers, and Inefficiency
When the government imposes price floors or price ceilings, three important results occur:
• Some people win.
• Some people lose.
• There is a loss of economic efficiency.
Positive and Normative Analysis of Price Ceilings and Price Floors
Our analysis of rent control and of the federal farm programs in this chapter is positive analysis. Whether these programs are desirable or undesirable is a normative question.
Whether the gains to the winners more than make up for the losses to the losers and decline in economic efficiency is a matter of judgment and not strictly an economic question.

27. Externalities and Economic Efficiency
4.4 LEARNING OBJECTIVE
Identify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency.

28. The Effect of Externalities
Private cost The cost borne by the producer of a good or service.
Social cost The total cost of producing a good or service, 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 or service, including both the private benefit and any external benefit.

29. How a Negative Externality in Production Reduces Economic Efficiency
Figure 4.10
The Effect of Pollution on Economic Efficiency
Because utilities do not bear the cost of acid rain, they produce electricity beyond the economically efficient level.
Supply curve S1 represents just the marginal private cost that the utility has to pay.
Supply curve S2 represents the marginal social cost, which includes the costs to those affected by acid rain.
If the supply curve were S2, rather than S1, market equilibrium would occur at price PEfficient and quantityQEfficient, the economically efficient level of output.
But when the supply curve is S1, the market equilibrium occurs at price PMarket and quantity QMarket, where there is a deadweight loss equal to the area of the yellow triangle.
Because of the deadweight loss, this equilibrium is not efficient.
When there is a negative externality in producing a good or service, too much of the good or service will be produced at market equilibrium.

30. How a Positive Externality in Consumption Reduces Economic Efficiency
Figure 4.11
The Effect of a Positive Externality on Economic Efficiency
People who do not consume college educations can still benefit from them.
As a result, the marginal social benefit from a college education is greater than the marginal private benefit to college students.
Because only the marginal private benefit is represented in the market demand curve D1, the quantity of college educations produced, QMarket, is too low.
If the market demand curve were D2 instead of D1, the level of college educations produced would be QEfficient, which is the efficient level.
At the market equilibrium of QMarket, there is a deadweight loss equal to the area of the yellow triangle.
When there is a positive externality in consuming a good or service, too little of the good or service will be produced at market equilibrium.

31. Externalities and Market Failure
Market failure A situation in which the market fails to produce the efficient level of output.
What Causes Externalities?
Property rights The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it.
Externalities and market failures result from incomplete property rights or from the difficulty of enforcing property rights in certain situations.

32. Government Policies to Deal with Externalities
4.5 LEARNING OBJECTIVE
Analyze government policies to achieve economic efficiency in a market with an externality.

33. As a consequence, the supply curve will shift up, from S1 to S2.
Figure 4.12
When There Is a Negative Externality, a Tax Can Lead to the Efficient Level of Output
Because utilities do not bear the cost of acid rain, they produce electricity beyond the economically efficient level.
If the government imposes a tax equal to the cost of acid rain, the utilities will internalize the externality.
As a consequence, the supply curve will shift up, from S1 to S2.
The market equilibrium quantity changes from QMarket, where an inefficiently high level of electricity is produced, to QEfficient, the economically efficient equilibrium quantity.
The price of electricity will rise from PMarket—which does not include the cost of acid rain—to PEfficient—which does include the cost.
Consumers pay the price PEfficient, while producers receive a price P, which is equal to PEfficient minus the amount of the tax.

34. Solved Problem 4.5 Using a Tax to Deal with a Negative Externality
Some toilet paper plants discharge bleach into rivers and lakes, causing substantial environmental damage. Explain how the federal government can use a tax on toilet paper to bring about the efficient level of production. What should the value of the tax be?
Solving the Problem
Step 1: Review the chapter material.
Step 2: Use the information from the graph to determine the necessary tax.
The graph shows that at the optimal level of production, the difference between the marginal private cost and the marginal social cost is $50.
Therefore, a tax of $50 per ton is required to shift the supply curve up from S1 to S2.
Your Turn: For more practice, do related problem 5.8 at the end of this chapter.
MyEconLab

35. Figure 4.13
When There Is a Positive Externality, a Subsidy Can Bring About the Efficient Level of Output
People who do not consume college educations can benefit from them.
As a result, the social benefit from a college education is greater than the private benefit to college students.
If the government pays a subsidy equal to the external benefit, students will internalize the externality.
The subsidy will cause the demand curve to shift up, from D1 to D2.
As a result, the market equilibrium quantity will shift from QMarket, where an inefficiently low level of college educations is supplied, to QEfficient, the economically efficient equilibrium quantity.
Producers receive the price PEfficient, while consumers pay a price P, which is equal to PEfficient minus the amount of the subsidy.
Pigovian taxes and subsidies Government taxes and subsidies intended to bring about an efficient level of output in the presence of externalities.

36. Making the Connection Should the Government Tax Cigarettes and Soda?
Governments impose “sin taxes” on certain products.
The effect of a tax on soda is shown in the figure.
Your Turn: Test your understanding by doing related problem 5.9 at the end of this chapter.
MyEconLab

37. Command-and-Control versus Market-Based Approaches
Command-and-control approach An approach that involves the government imposing quantitative limits on the amount of pollution firms are allowed to emit or requiring firms to install specific pollution control devices.
Are Tradable Emissions Allowances Licenses to Pollute?
Some environmentalists have criticized tradable emissions allowances, arguing that just as the government does not issue licenses to rob banks or to drive drunk, it should not issue “licenses to pollute.”
But this criticism ignores one of the central lessons of economics: Resources are scarce, and trade-offs exist.
Resources that are spent on reducing one type of pollution are not available to reduce other types of pollution or for any other use.
Because reducing acid rain using tradable emissions allowances has cost utilities $870 million rather than $7.4 billion as originally estimated, society has saved more than $6.5 billion per year.

38. Making the Connection
Can a Cap-and-Trade System Reduce Global Warming?
Although CO2 emissions rose slightly during the first few years of a cap-and-trade plan set up in Europe in 2005, they should decline over time as the number of allowances is reduced.
Your Turn: Test your understanding by doing related problem 5.14 at the end of this chapter.
MyEconLab

39. Economics in Your Life
Does Rent Control Make It Easier for You to Find an Affordable Apartment?
At the beginning of the chapter, we posed the following question:
If you have two job offers in different cities, one with rent control and one without, will you be more likely to find an affordable apartment in the city with rent control?
Although rent control can keep rents lower than they might otherwise be, it can also lead to a permanent shortage of apartments. You may have to search for a long time to find a suitable apartment, and landlords may even ask you to give them payments “under the table,” which would make your actual rent higher than the controlled rent. Finding an apartment in a city without rent control should be much easier, although the rent may be higher.

40. AN INSIDE LOOK AT POLICY
. . . and the Rent-Controlled Apartment Goes
to Actress Faye Dunaway!
The effect of rent control laws on the supply of affordable apartments.