S121 ECO504 BUSINESS ECONOMICS

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29/02/2016

1 of 38 For use with Business Economics 1e By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin

ISBN: 978-1-4080-6981-3

Market failure

PART 3

THE LIMITATIONS OF MARKETS

2 of 38 For use with Business Economics 1e By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin

ISBN: 978-1-4080-6981-3

Sources of Market Failure  Imperfect knowledge of and

between buyers & sellers • Can be distorted by advertising and

poor technical knowledge

 Goods are not homogenous • e.g. Branding, labeling

 Resource immobility

 Market power • Monopoly or collusion

 Inequality exists because of: • In factor or income endowment

• Unequal wealth distribution

• Poverty

• Discrimination

 Existence of external costs

and benefits

3 of 38 For use with Business Economics 1e By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin

ISBN: 978-1-4080-6981-3

Private and Social Costs  Private costs are paid by

individuals of firms

 Externalities are the third

part or knock on effects of a

firm or individuals’ actions

• Positive externalities

• Negative externalities

 Social costs are the private

costs and the external costs

added together

 Firms and people want to

keep costs as low as

possible. They won’t wish to

pay for a negative externality

such as:

• Air and noise pollution from

factories and car exhausts

• Water pollution

• Health side effects

• Visual pollution

 Research and immunization

are examples of positive

externalities

29/02/2016

4 of 38 For use with Business Economics 1e By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin

ISBN: 978-1-4080-6981-3

Welfare Economics: An Overview

The maximum price is the willingness to

pay, and it measures how much a buyer

values the good.

Consumer surplus is the amount a buyer is

willing to pay for a good minus the amount

the buyer actually pays for it.

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Consumer Surplus Consumer surplus

 Measures the benefit buyers receive from

participating in a market

 Closely related to the demand curve

Demand schedule

 Derived from the willingness to pay of the

possible buyers

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Consumer Surplus At any quantity, the price given by the

demand curve

 Shows the willingness to pay of the marginal

buyer

The buyer who would leave the market first if the price

were any higher

Consumer surplus in a market

 Area below the demand curve and above the

price

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Consumer Surplus: Discrete

Case

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Consumer Surplus Consumer surplus

 Benefit that buyers receive from a good

As the buyers themselves perceive it

 Good measure of economic well-being

 Exception: illegal drugs

Drug addicts are willing to pay a high price for heroin

Society’s standpoint

Drug addicts don’t get a large benefit from

being able to buy heroin at a low price

29/02/2016

10 of 38 For use with Business Economics 1e By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin

ISBN: 978-1-4080-6981-3

Producer Surplus

Producer surplus is the amount a seller is

paid minus the cost of production

Producer surplus is closely related to the

supply curve.

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Producer Surplus Cost

 Value of everything a seller must give up to

produce a good

 Measure of willingness to sell

Producer surplus

 Amount a seller is paid for a good minus the

seller’s cost of providing it

 Price received minus willingness to sell

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Producer Surplus Supply curve

 Reflects sellers’ costs

 Used to measure producer surplus

Producer surplus in a market

 Area below the price and above the supply

curve

29/02/2016

13 of 38 For use with Business Economics 1e By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin

ISBN: 978-1-4080-6981-3

Using the Demand Curve to Measure

Producer Surplus

The producer surplus is the area below the price and above the supply curve.

14 of 38 For use with Business Economics 1e By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin

ISBN: 978-1-4080-6981-3

Deadweight Loss  The deadweight loss is

the fall in total surplus that

results when a tax (or

some other policy) distorts

a market outcome

• A tax on a good reduces

consumer surplus (by the

area B + C) and producer

surplus (by the area D + E)

• Because the fall in producer

and consumer surplus

exceeds tax revenue (area

B + D), the tax is said to

impose a deadweight loss

(area C + E)

15 of 38 For use with Business Economics 1e By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin

ISBN: 978-1-4080-6981-3

Pollution & the Social Optimum  The market equilibrium only

reflects the private costs of

production

 In the presence of a negative

externality, such as pollution,

the social cost of the good

exceeds the private cost. The

optimal quantity, QOPTIMUM,

is therefore smaller than the

equilibrium quantity,

QMARKET

 Internalizing an externality

means altering incentives so

that people take account of the

external effects of their actions

Negative externalities lead markets to produce a larger quantity than is socially desirable.

29/02/2016

16 of 38 For use with Business Economics 1e By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin

ISBN: 978-1-4080-6981-3

Positive Externalities  Some activities yield benefits on third parties

 In the presence of a positive externality, the social value of the

good exceeds the private value. The optimal quantity,

QOPTIMUM, is therefore larger than the equilibrium quantity,

QMARKET

 The government can correct the market failure by providing a

subsidy to induce market participants to internalize the

externality

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Education and the Social Optimum

Price of

Education

Quantity of

Education

Demand (private value)

Supply

(private cost)

In the presence of a positive externality, the social value of the good exceeds the

private value. The optimal quantity, QOPTIMUM, is therefore larger than the equilibrium

quantity, QMARKET.

QMARKET

Equilibrium

Social value (private

value and external

benefit)

External Benefit

QOPTIMUM

Optimum

18 of 38 For use with Business Economics 1e By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin

ISBN: 978-1-4080-6981-3

Government Business & Externalities

 Regulation is a command and control method

 Market-based policies

• Provides incentives for decision makers to solve

problem themselves.

• Taxes enacted to correct the effects of negative

externalities are called Pigovian taxes

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19 of 38 For use with Business Economics 1e By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin

ISBN: 978-1-4080-6981-3

 In panel (a) the government sets

a price on pollution by levying a

Pigovian tax, and the demand

curve determines the quantity of

pollution

 In panel (b) the government limits

the quantity of pollution by

limiting the number of pollution

permits, and the demand curve

determines the price of pollution

Pigovian Tax Pollution Permits

The price and quantity of pollution are the same in the two cases.

20 of 38 For use with Business Economics 1e By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin

ISBN: 978-1-4080-6981-3

How Taxes on Sellers Affect Market Outcomes

Nail Varnish Example

• The tax on sellers makes the

nail varnish remover

business less profitable at

any given price, so it shifts

the supply curve to the left

• The tax reduces the size of

the nail varnish remover

market and buyers and

sellers share the burden of

the tax.

• A tax on sellers places a

wedge between the price

that buyers pay and the price

that sellers receive.

21 of 38 For use with Business Economics 1e By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin

ISBN: 978-1-4080-6981-3

How Subsidies Affect Market Outcomes

Rail Transport Example

• The €20 subsidy made to train

operators reduces the cost of

providing a train journey and so the

supply curve will shift to the right by

the amount of the subsidy

• More train journeys will be supplied

at each and every price

• Passengers and train operators

both benefit from the subsidy

29/02/2016

22 of 38 For use with Business Economics 1e By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin

ISBN: 978-1-4080-6981-3

Property Rights

Property rights grant the exclusive right of

an individual, group or organization to

determine how a resource is used

Landowners may have the rights to any

minerals underground.