PART 3 Market failure THE LIMITATIONS OF MARKETS. Sources of Market Failure. Private and Social Costs 29/02/ of 38

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1 PART 3 Market failure THE LIMITATIONS OF MARKETS ISBN: of 38 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 ISBN: Chapter of of 23 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 ISBN: Chapter of of 23 1

2 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. ISBN: Chapter of of 23 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 5 of 38 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 6 of 38 2

3 Consumer Surplus: Discrete Case 7 of 38 8 of 38 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 9 of 38 3

4 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. ISBN: Chapter of of 23 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 11 of 38 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 12 of 38 4

5 Using the Demand Curve to Measure Producer Surplus The producer surplus is the area below the price and above the supply curve. ISBN: Chapter of of 23 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) ISBN: Chapter of of 23 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. ISBN: Chapter of of 23 5

6 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 ISBN: Chapter of of 23 Education and the Social Optimum Price of Education External Benefit Supply (private cost) Equilibrium Optimum 0 Q MARKET Q OPTIMUM Social value (private value and external benefit) Demand (private value) Quantity of Education In the presence of a positive externality, the social value of the good exceeds the private value. The optimal quantity, Q OPTIMUM, is therefore larger than the equilibrium quantity, Q MARKET. 17 of 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 ISBN: Chapter of of 23 6

7 Pigovian Tax In panel (a) the government sets a price on pollution by levying a Pigovian tax, and the demand curve determines the quantity of pollution Pollution Permits 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 The price and quantity of pollution are the same in the two cases. ISBN: Chapter of of 23 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. ISBN: Chapter of of 23 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 ISBN: Chapter of of 23 7

8 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. ISBN: Chapter of of 23 8

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