Lecture 9
MARKET EFFICIENCY
AND FAILURE
PRINCIPLES OF MICROECONOMICS
Prepared by: Minh Huynh, [Link].
1
In this lecture, look for the answers to these
questions:
• Do markets produce a desirable allocation of
resources? Or could the market outcome be
improved upon?
• What are the market failure? Explain each kind of
market failure.
2
Contents
• MARKET EFFICIENCY
One
• MARKET FAILURE
Two
3
MARKET EFFICIENCY
Consumer Surplus (CS) is consumers’ willingness to
pay (WTP) for a good minus the amount they
actually pay for it.
Producer Surplus (PS) is the amount producers
receive for a good minus their costs of producing it.
Is the allocation of resources determined by free
markets in any way desirable?
4
Consumer and Producer Surplus in the Market Equilibrium
Price A
D
Supply
Consumer
surplus
Equilibrium E
price
Producer
surplus
Demand
B
0 Equilibrium Quantity
quantity
Copyright©2003 Southwestern/Thomson Learning
How the Price Affects Consumer Surplus
Consumer Surplus at Price P
Price
A
Initial
consumer
surplus
C Consumer surplus
P1
B to new consumers
F
P2
D E
Additional consumer Demand
surplus to initial
consumers
0 Q1 Q2 Quantity
Copyright©2003 Southwestern/Thomson Learning
ACTIVE LEARNING 1:
Consumer surplus P
50
A. Find marginal $ 45
buyer’s WTP at 40
Q = 10. 35 demand curve
B. Find CS for 30
P = $30. 25
Suppose P falls to $20. 20
How much will CS increase 15
due to…
10
C. buyers entering
5
the market
0
D. existing buyers paying
0 5 10 15 20 Q
25
lower price
7
ACTIVE LEARNING 1:
Answers P
50
$ 45
A. At Q = 10, marginal
buyer’s WTP is $30. 40
B. CS = ½ x 10 x $10 35 demand curve
= $50 30
25
P falls to $20.
20
C. CS for the 15
additional buyers
10
= ½ x 10 x $10 = $50
5
D. Increase in CS
0
on initial 10 units
0 5 10 15 20 Q
25
= 10 x $10 = $100
8
How the Price Affects Producer Surplus
(b) Producer Surplus at Price P
Price
Additional producer Supply
surplus to initial
producers
D E
P2 F
B
P1
Initial C
Producer surplus
producer to new producers
surplus
0 Q1 Q2 Quantity
Copyright©2003 Southwestern/Thomson Learning
ACTIVE LEARNING 2:
Producer Surplus P
50
supply curve
A. Find marginal 45
seller’s cost 40
at Q = 10. 35
B. Find PS for 30
P = $20.
25
Suppose P rises to $30. 20
Find the increase
15
in PS due to…
10
C. selling 5
5
additional units
0
D. getting a higher price Q
0 5 10 15 20 25
on the initial 10 units
10
ACTIVE LEARNING 2:
Answers P
50
supply curve
A. At Q = 10, 45
marginal cost = $20 40
B. PS = ½ x 10 x $20 35
= $100 30
P rises to $30. 25
20
C. PS on
15
additional units
= ½ x 5 x $10 = $25 10
5
D. Increase in PS
on initial 10 units 0
0 5 10 15 20 Q
25
= 10 x $10 = $100
11
MARKET EFFICIENCY
Consumer Surplus
= Value to buyers – Amount paid by buyers
And
Producer Surplus
= Amount received by sellers – Cost to sellers
12
MARKET EFFICIENCY
Total Surplus
= Consumer surplus + Producer surplus
Or
Total Surplus
= Value to buyers – Cost to sellers
13
MARKET EFFICIENCY
Efficiency is the property of a resource
allocation of maximizing the total surplus
received by all members of society.
In addition to market efficiency, a social
planner might also care about Equity – the
fairness of the distribution of well-being
among the various buyers and sellers.
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MARKET EFFICIENCY
Three Insights Concerning Market Outcomes
Free markets allocate the supply of goods to the
buyers who value them most highly, as
measured by their willingness to pay.
Free markets allocate the demand for goods to
the sellers who can produce them at least cost.
Free markets produce the quantity of goods that
maximizes the sum of consumer and producer
surplus.
15
The Efficiency of the Equilibrium Quantity
Price
Supply
Value Cost
to to
buyers sellers
Cost Value
to to
sellers buyers Demand
0 Equilibrium Quantity
quantity
Value to buyers is greater Value to buyers is less
than cost to sellers. than cost to sellers.
Copyright©2003 Southwestern/Thomson Learning
Evaluating the Market Equilibrium
Market eq’m:
P
P = $30
Q = 15,000 60
Total surplus 50 S
= CS + PS
40 CS
Is the market eq’m
efficient? 30
PS
20
10
D
0 Q
0 5 10 15 20 25 30
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Which Buyers Get to Consume the Good?
Every buyer
P
whose WTP is
≥ $30 will buy. 60
50 S
Every buyer
whose WTP is 40
< $30 will not.
30
So, the buyers who
20
value the good most
highly are the ones 10
who consume it. D
0 Q
0 5 10 15 20 25 30
18
Which Sellers Produce the Good?
Every seller whose
P
cost is ≤ $30 will
produce the good. 60
Every seller whose 50 S
cost is > $30 will not.
40
Hence, the sellers
with the lowest cost 30
produce the good. 20
10
D
0 Q
0 5 10 15 20 25 30
19
Does Eq’m Q Maximize Total Surplus?
At Q = 20,
P
cost of producing
the marginal unit 60
is $35 50 S
value to consumers
of the marginal unit 40
is only $20 30
Hence, can increase
20
total surplus
by reducing Q. 10
D
This is true at any Q 0 Q
greater than 15.
0 5 10 15 20 25 30
20
Does Eq’m Q Maximize Total Surplus?
At Q = 10,
P
cost of producing
the marginal unit 60
is $25 50 S
value to consumers
of the marginal unit 40
is $40 30
Hence, can increase
20
total surplus
by increasing Q. 10
D
This is true at any Q less 0 Q
than 15.
0 5 10 15 20 25 30
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MARKET EFFICIENCY
The market eq’m is efficient
The govt cannot improve on the market
outcome.
Laissez faire (French for “allow them to
do”): the govt should not interfere with
the market.
22
Adam Smith and the Invisible Hand
Passages from The Wealth of Nations, 1776
“Man has almost constant occasion for
the help of his brethren, and it is vain for
him to expect it from their benevolence
only. He will be more likely to
prevail if he can interest their self-love in
his favor, and show them that it is for
their own advantage to do for him what
he requires of them…
It is not from the benevolence of the
butcher, the brewer, or the baker that we
Adam Smith,
expect our dinner, but from their regard
1723-1790
to their own interest….
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Adam Smith and the Invisible Hand
Passages from The Wealth of Nations, 1776
“Every individual…neither intends to
promote the public interest, nor knows how
much he is promoting it….
He intends only his own gain, and he is in
this, as in many other cases, led by an
invisible hand to promote an end which
was no part of his intention.
Nor is it always the worse for the society
INVISIBLE HAND : PRICE !!!!
that it was no part of it. By pursuing his
own interest he frequently promotes
that of the society more effectually than
when he really intends to promote it.”
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MARKET FAILURE
Imperfect Markets
Public Goods
Externalities
Imperfect Information
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MARKET FAILURE
Imperfect Markets
If a market system is not perfectly
competitive, market power may result.
Market power is the ability to influence
prices.
Market power can cause markets to be
inefficient because it keeps price and
quantity from the equilibrium of supply and
demand.
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MARKET FAILURE
Public Goods
2 Important Characteristics of Goods:
o Excludability refers to the property of a
good whereby a person can be prevented
from using it.
o Rivalry refers to the property of a good
whereby one person’s use diminishes other
people’s use.
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MARKET FAILURE
Public Goods
The Different Kinds of Goods:
o Private Goods: both excludable and rival.
o Public Goods: neither excludable nor rival.
o Common Resources: rival but not
excludable.
o Natural Monopolies: excludable but not
rival.
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ACTIVE LEARNING 1:
Categorizing roads
• A road is which of the four kinds of goods?
• Hint: The answer depends on whether the
road is congested or not, and whether it’s a
toll road or not. Consider the different cases.
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ACTIVE LEARNING 1:
Answers
• Rival in consumption? Only if congested.
• Excludable? Only if a toll road.
• Four possibilities
uncongested non-toll road: public good
uncongested toll road: natural monopoly
congested non-toll road: common resource
congested toll road: private good
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Four Types of Goods
Rival?
Yes No
Private Goods Natural Monopolies
Yes • Ice-cream cones • Fire protection
• Clothing • Cable TV
• Congested toll roads • Uncongested toll roads
Excludable?
Common Resources Public Goods
No • Fish in the ocean • Tornado siren
• The environment • National defense
• Congested nontoll roads • Uncongested nontoll roads
Copyright © 2004 South-Western
MARKET FAILURE
Public Goods
A free-rider is a person who receives the
benefit of a good but avoids paying for it.
Since people cannot be excluded from
enjoying the benefits of a public good,
individuals may withhold paying for the
good hoping that others will pay for it.
The free-rider problem prevents private
markets from supplying public goods.
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MARKET FAILURE
Public Goods
Solving the Free-Rider Problem
o The government can decide to provide the
public good if the total benefits exceed the
costs.
o The government can make everyone better
off by providing the public good and paying
for it with tax revenue.
33
MARKET FAILURE
Externalities
An externality refers to the uncompensated impact
of one person’s actions on the well-being of a
bystander.
Externalities cause markets to be inefficient, and
thus fail to maximize total surplus.
o Negative externality:
the effect on bystanders is adverse. Ex: Pollution.
o Positive externality:
the effect on bystanders is beneficial. Ex: Industrial
Park.
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• Negative Externalities
– Automobile exhaust
– Cigarette smoking
– Barking dogs (loud pets)
– Loud stereos in an apartment building
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• Positive Externalities
– Immunizations
– Restored historic buildings
– Research into new technologies
36
MARKET FAILURE
Externalities
Private Solutions to Externalities: Coase
theorem
o received the Nobel Prize in Economics in
1991
o If property rights are well defined and there
are no transaction costs, private bargaining
can correct for the presence of positive or
negative externalities
37
MARKET FAILURE
Asymmetric Information
Asymmetric information – one party to a
contract has different information than
the other party
Adverse selection
Moral hazard
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MARKET FAILURE
Asymmetric Information
Adverse selection
o Occurs when the parties who are willing to
accept a contract are of “lower quality”
(from the perspective of the other party)
than a random member of the population
o Examples: used cars, insurance issues,…
39
MARKET FAILURE
Asymmetric Information
Moral hazard
o Occurs when one party to a contract has
an incentive to alter his or her behavior
to the detriment of the other party once
a contract exists.
40
SUMMARY
Consumer surplus equals buyers’ willingness
to pay for a good minus the amount they
actually pay for it.
Consumer surplus measures the benefit
buyers get from participating in a market.
Consumer surplus can be computed by
finding the area below the demand curve and
above the price.
41
SUMMARY
Producer surplus equals the amount sellers
receive for their goods minus their costs of
production.
Producer surplus measures the benefit sellers
get from participating in a market.
Producer surplus can be computed by finding
the area below the price and above the supply
curve.
42
SUMMARY
An allocation of resources that maximizes the sum
of consumer and producer surplus is said to be
efficient.
Policymakers are often concerned with the
efficiency, as well as the equity, of economic
outcomes.
The equilibrium of demand and supply maximizes
the sum of consumer and producer surplus.
This is as if the invisible hand of the marketplace
leads buyers and sellers to allocate resources
efficiently.
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SUMMARY
A good is excludable if someone can be
prevented from using it. A good is rival in
consumption if one person’s use reduces others’
ability to use the same unit of the good.
Markets work best for private goods, which are
excludable and rival in consumption. Markets do
not work well for other types of goods.
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SUMMARY
Public goods, such as national defense and
fundamental knowledge, are neither excludable
nor rival in consumption.
Because people do not have to pay to use
them, they have an incentive to free ride, and
firms have no incentive to provide them.
Therefore, the government provides public
goods, using cost-benefit analysis to determine
how much to provide.
45
SUMMARY
Common resources are rival in consumption
but not excludable. Examples include
common grazing land, clean air, and
congested roads.
People can use common resources without
paying, so they tend to overuse them.
Therefore, governments try to limit the use of
common resources.
46
SUMMARY
An externality occurs when a market
transaction affects a third party. If the
transaction yields negative externalities (e.g.,
pollution), the market quantity exceeds the
socially optimal quantity.
If the externality is positive (e.g., technology
spillovers), the market quantity falls short of
the social optimum.
47
SUMMARY
Sometimes, people can solve externalities
on their own. The Coase theorem states that
the private market can reach the socially
optimal allocation of resources as long as
people can bargain without cost. In practice,
bargaining is often costly or difficult, and the
Coase theorem does not apply.
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SUMMARY
The government can either regulate
behavior or internalize the externality by
using Pigovian taxes or by issuing pollution
permits.
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