# Economic Efficiency and Market Failure

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Economic Efficiency and Market Failure
Chapter 5 Economic Efficiency and Market Failure

Learning Objectives 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 analyse the economic impact of price ceilings and price floors.

Learning Objectives Use demand and supply graphs to analyse the economic impact of taxes. Define positive and negative externalities and identify examples of each. Analyse government policies to achieve economic efficiency in a market with externalities.

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.

Consumer Surplus and Producer Surplus
LEARNING OBJECTIVE 1 Consumer Surplus and Producer Surplus 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.

The demand curve is also the marginal benefit curve: Figure 5.1
Price (dollars per cup) Joes’ marginal benefit from consuming the fourth cup is \$3.00. \$7.00 Joes’ marginal benefit from consuming the fifth cup is \$2.00. \$3.00 Figure 5.1 ‘The demand curve is also the marginal benefit curve’ – The demand curve shows a consumer’s willingness to purchase a product at various prices. In this case, we know that Joe’s willingness to pay \$3.00 to purchase four cups of chai tea per week means that his marginal benefit from consuming the fourth cup is \$ Similarly, his willingness to pay \$2.00 to purchase five cups of tea per week means that his marginal benefit from consuming the fifth cup is \$ So, the demand curve is also a marginal benefit curve. \$2.00 Demand 4 5 Quantity (cups per week) Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Total consumer surplus in the market for chai tea: Figure 5.2
Price (dollars per cup) Total consumer surplus in the market for chai tea Figure 5.2 ‘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 \$ For each buyer, consumer surplus is equal to the difference between the highest price they are 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. \$2.00 Demand 15 000 Quantity (cups per week) 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? Consumer surplus is not just an abstract concept. US economists have applied the concept to estimate the consumer surplus American households receive from satellite TV subscriptions. With the average market price of US\$81 per month, average consumer surplus reached US\$127 per month. The total value of consumer surplus (shaded area on the graph) was estimated to be US\$2 billion.

Consumer Surplus and Producer Surplus
LEARNING OBJECTIVE 1 Consumer Surplus and Producer Surplus 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.

The supply curve shows marginal cost: Figure 5.3a
Price (dollars per cup) Producer surplus on the 40th cup sold. Supply \$2.00 The marginal cost of producing the 50th cup is \$2.00. \$1.80 Figure 5.3 ‘Producer Surplus’ - The supply curve shows a firm’s willingness to supply a product at various prices. In panel (a), we know that Heavenly Tea’s willingness to supply 40 cups of chai tea at a price of \$1.80 per cup means that the marginal cost of producing the 40th cup is \$1.80. Similarly, the firm’s willingness to supply 50 cups at a price of \$2.00 per cup means its marginal cost of producing the 50th cup is \$2.00. Producer surplus on the 40th cup sold is the difference between the \$2.00 market price of the cup and \$1.80, which is the lowest price tea sellers would have been willing to accept. The marginal cost of producing the 40th cup is \$1.80. 40 50 Quantity (cups per week) Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Total producer surplus in the market for chai tea: Figure 5.3b
Price (dollars per cup) Total producer surplus from selling chai tea Supply \$2.00 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, this is equal to the area above the supply curve and below the market price, shown in orange. 15 000 Quantity (cups per week) Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

What Consumer Surplus and Producer Surplus Measure?
LEARNING OBJECTIVE 1 What Consumer Surplus and Producer Surplus Measure? 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.

The Efficiency of Competitive Markets
LEARNING OBJECTIVE 2 The Efficiency of Competitive Markets 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.

Marginal benefit equals marginal cost only at competitive equilibrium: Figure 5.4
Marginal benefit = \$2.20, marginal cost = \$1.80, therefore output is inefficiently low. Price (dollars per cup) Supply Marginal benefit = \$1.80, marginal cost = \$2.20, therefore output is inefficiently high. \$2.20 \$2.00 Both marginal benefit and marginal cost = \$2.00, which means an economically efficient output level. \$1.80 Figure 5.4 ‘Marginal benefit equals marginal cost only at competitive equilibrium’ - In a competitive market, equilibrium occurs at a quantity of cups and 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 equal to the marginal cost to producers. Demand 14 000 15 000 16 000 Quantity (cups per week) Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Economic surplus equals the sum of consumer surplus and producer surplus: Figure 5.5
Price (dollars per cup) Consumer surplus Supply \$2.00 Figure 5.5 ‘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 Producer surplus Demand 15 000 Quantity (cups per week) Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Figure 5.6 ‘When a market is not in equilibrium there is a deadweight loss’ - Economic surplus is maximised 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. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

The Efficiency of Competitive Markets
LEARNING OBJECTIVE 2 The Efficiency of Competitive Markets 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.

Government intervention in the market
LEARNING OBJECTIVE 3 Government intervention in the market Price floor: A legally determined minimum price that sellers may receive. Price ceiling: A legally determined maximum price that sellers may receive.

Price Floor: Figure 5.7 S Surplus wheat A B C D \$3.50 \$3.00 1.8 2.0
Price (dollars per bushel) Consumer surplus transferred to producers S Price floor Surplus wheat \$3.50 A B Deadweight loss = B + C \$3.00 C Figure 5.7 ‘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 red rectangle A—which is transferred from consumer surplus—and falls by yellow triangle C. Consumer surplus declines by pink rectangle A plus yellow triangle B. There is a deadweight loss equal to 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 equal to 0.4 billion bushels. D 1.8 2.0 2.2 Quantity (billions of bushels per year) Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia 19 19

Shortage of apartments
Price Ceiling: Figure 5.8 Price (dollars per month) Producer surplus transferred from landlords to renters S B Deadweight loss = B + C \$1500 C A Rent control price ceiling Figure 5.8 ‘The economic effect of a rent ceiling’ - Without rent control the equilibrium rent is \$1500 per month. At that price, apartments would be rented. If the government imposes a rent ceiling of \$1000, the quantity of apartments supplied falls to , while the quantity of apartments demanded increases to , resulting in a shortage of apartments. Producer surplus equal to the area of 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. \$1000 Shortage of apartments D Quantity (apartments per month) Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia 20 20

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. The minimum wage is a controversial example of ‘price floor’. Supporters see the minimum wage 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. The national wage in Australia (June 2008) was \$13.74 per hour for adults, with lower levels for workers under 21 years of age. The graphical analysis shows that as a result of minimum wage, the number of workers hired in the labour market is lower. Many economists favour alternative policies for helping low income earners such as tax credits.

Price floors and price ceilings
LEARNING OBJECTIVE 3 Price floors and price ceilings 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.

Price floors and price ceilings
LEARNING OBJECTIVE 3 Price floors and price ceilings 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.

The economic impact of taxes
LEARNING OBJECTIVE 4 The economic impact of taxes 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.

The effect of a tax on the market for cigarettes: Figure 5.9
Price the consumers pay after the \$1.00 tax is imposed \$1.00 per pack federal tax on cigarettes shifts the supply curve up by \$1.00. Price (dollars per pack) S2 S1 \$2.90 Deadweight loss or excess burden from tax 2.00 1.90 Figure 5.9 ‘The effect of a tax on the market for cigarettes’ - Without the tax, market equilibrium occurs at point A. The equilibrium price of cigarettes is \$2.00 per pack and four billion packs of cigarettes are sold per year. A \$1.00 per pack tax on cigarettes will cause the supply curve for cigarettes to shift up by \$1 from S1 to S2. The new equilibrium occurs at point B. The price of cigarettes will increase by \$0.90 to \$2.90 per pack, and the quantity sold will fall to 3.7 billion packs. The tax on cigarettes has increased the price paid by consumers from \$2.00 to \$2.90 per pack. Producers receive a price of \$2.90 per pack (point B), but after paying the \$1.00 tax they are left with \$1.90 (point C). The government will receive tax revenue equal to the green-shaded box. Some consumer surplus and some producer surplus will become tax revenue for the government and some will become deadweight loss, shown by the yellow-shaded area. Tax revenue Price received by producers after paying the tax Demand 3.7 4 Quantity of cigarettes (billions of packets per year) Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

The Economic Impact of Taxes
LEARNING OBJECTIVE 4 The Economic Impact of Taxes 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
LEARNING OBJECTIVE 4 The Economic Impact of Taxes 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.

The incidence of a tax on petrol: Figure 5.10
Figure 5.10 ‘The incidence of a tax on petrol’- With no tax on petrol the price would be \$1.10 per litre and 150 million litres of petrol would be sold each year. An excise tax of 40 cents per litre shifts the supply curve up from S1 to S2. It raises the price consumers pay from \$1.10 to \$1.45 and lowers the price producers receive from \$1.10 to \$1.05. Therefore, consumers pay 35 cents of the 40 cents per litre tax on petrol and producers pay 5 cents. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

The incidence of a tax on petrol paid by buyers: Figure 5.11
Figure 5.11 ‘The incidence of a tax on petrol paid by buyers’ - With no tax on petrol the demand curve is D1. If a 40 cents per litre tax is imposed that consumers are responsible for paying, the demand curve shifts down by the amount of the tax from D1 to D2. In the new equilibrium, consumers pay a price of \$1.45 per litre, including the tax. Producers receive \$1.05 per litre. This is the same result as when producers were responsible for paying the tax. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Do consumers receive the entire benefit of a sales tax reduction?
LEARNING OBJECTIVE 4 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. 1http://

STEP 3: Use the graph to evaluate the statement.
LEARNING OBJECTIVE 4 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. The problem is designed to help students understand the concept of tax incidence. It assists students in learning how to practically measure the distribution of tax burden. Moreover, it helps students to evaluate relevant policy statements made by politicians.

5 cents per litre excise reduction shifts the supply curve down
LEARNING OBJECTIVE 4 Price (dollars per litre) D S1 S2 \$1.50 5 cents per litre excise reduction shifts the supply curve down \$1.45 19 Quantity (billions of litres per year) Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Externalities and Efficiency
LEARNING OBJECTIVE 5 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.

Government Solutions to Externalities
LEARNING OBJECTIVE 6 Government Solutions to Externalities 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.

Government Solutions to Externalities
LEARNING OBJECTIVE 6 Government Solutions to Externalities 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.

Government Solutions to Externalities
LEARNING OBJECTIVE 6 Government Solutions to Externalities 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.

When there is a negative externality, a tax can bring about the efficient level of output: Figure 5.12 S2 = social cost and private cost after tax Price of electricity Market equilibrium with tax S1 = private cost before tax Cost of pollution = amount of tax imposed by government P2 P1 Market equilibrium without tax Figure 5.12: When there is a negative externality, a tax can bring about the efficient level of output. If utilities do not bear the cost of the pollution they cause, they will produce electricity beyond the economically efficient level. If the government imposes a tax equal to the cost of the consequences caused by pollution, the utilities will internalise the externality. As a consequence, the supply curve will shift up from S1 to S2. As a result, market equilibrium changes from Q1, where an inefficiently high level of electricity is produced, to Q2, the economically efficient equilibrium. The price of electricity will rise from P1—which does not reflect the cost of the pollution—to P2—which does reflect the cost. Demand Q2 Q1 Quantity of electricity Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

When there is a positive externality, a subsidy can bring about the efficient level of output: Figure 5.13 Price of university education Positive externality = amount of subsidy Supply Market equilibrium with subsidy = efficient equilibrium P2 P1 Market equilibrium without subsidy Figure 5.13: When there is a positive externality, a subsidy can bring about the efficient level of output. People who do not consume university education can still benefit from it. As a result, the social benefit from a university education is greater than the private benefit seen by university students. If the government pays a subsidy equal to the external benefit, students will internalise the externality. The subsidy will cause the demand curve to shift up from D1 to D2. The result will be that the market equilibrium shifts from Q1, where an inefficiently low level of university education is consumed and supplied, to Q2, the economically efficient equilibrium. D2 = social benefit and private benefit after subsidy D1 = private benefit before subsidy Q1 Q2 Quantity of university education Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

An Inside Look Reform on the way for EU agriculture

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.

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.

Key Terms Pigovian taxes and subsidies 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

Get Thinking! 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?

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? It means that marginal benefit equals marginal cost when five cups are consumed. It means that the total cost of consuming five cups is \$2.00. It means that the marginal cost of producing five cups is \$2.00. It means that the marginal benefit of consuming the fifth cup is \$2.00.

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? It means that marginal benefit equals marginal cost when five cups are consumed. It means that the total cost of consuming five cups is \$2.00. It means that the marginal cost of producing five cups is \$2.00. It means that the marginal benefit of consuming the fifth cup is \$2.00.

Check Your Knowledge 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 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 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. cups per month, because at this level of output, marginal benefit is less than marginal cost. Any of the output levels above is efficient.

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. cups per month, because at this level of output, marginal benefit is less than marginal cost. Any of the output levels above is efficient.

Check Your Knowledge 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. A decrease in wages but higher employment. and employment.

Check Your Knowledge 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. A decrease in wages but higher employment. and employment.

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.

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.