Essentials of Economics
Fifth Edition
Chapter 4
1
Market Efficiency
and Market
Failure
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Chapter Outline
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
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Should the Government Control
Apartment Rents?
Rent control puts a legal limit on the rent that landlords can charge
for an apartment.
Since rent controlled rents are usually far below market rents, it
seems clear that this doesn’t make landlords better off.
• Does it make tenants better off?
• Would you prefer to look for an apartment in a city with or
without rent control?
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4.1 Consumer Surplus and Producer
Surplus
Distinguish between the concepts of consumer surplus and
producer surplus.
Surplus (noun): Something that remains
above what is used or needed
Economists use the idea of “surplus” to refer to the benefit that
people derive from engaging in market transactions.
• Consumer surplus is the difference between the highest price a
consumer is willing to pay for a good or service and the actual price
the consumer pays.
• Producer surplus is the difference between the lowest price a firm
would be willing to accept for a good or service and the price it actually
receives.
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Figure 4.1 Deriving the Demand Curve
for Chai Tea (1 of 2)
Imagine four people are
interested in buying a cup
of chai tea.
We can characterize them
by the highest price they
are willing to pay.
At prices above $6, no
chai tea will be sold.
At $6, one cup will be
sold, etc.
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Figure 4.1 Deriving the Demand Curve
for Chai Tea (2 of 2)
How much benefit do the potential
tea consumers derive from this
market?
That depends on the price and
their marginal benefit:
the additional benefit to a consumer from
consuming one more unit of a good or
service
If the price is low, many of the
consumers benefit.
If the price is high, few (if any) of
the consumers benefit.
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Figure 4.2 Measuring Consumer
Surplus (1 of 3)
At $3.50 per cup, Theresa, Tom, and
Terri will buy a cup.
Theresa was willing to pay $6.00; a
cup of chai tea is “worth” $6.00 to her.
She paid $3.50, so she derives a net
benefit of
$6.00 − $3.50 = $2.50.
Area A represents this net benefit, and
is known as Theresa’s consumer
surplus in the chai tea market.
• Notice that the area A is $2.50 × 1 =
$2.50
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Figure 4.2 Measuring Consumer
Surplus (2 of 3)
Tom and Terri also obtain
consumer surplus, equal to
$1.50 (area B) and $0.50 (area
C).
The sum of the areas of
rectangles A, B, and C is called
the consumer surplus in the chai
tea market.
• Consumer surplus:
area below the demand curve,
above the price that
consumers pay.
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Figure 4.2 Measuring Consumer
Surplus (3 of 3)
If the price falls to $3.00,
Theresa, Tom, and Terri each
gain an additional $0.50 of
consumer surplus.
Tim is indifferent between buying
the cup and not; his well-being is
the same either way.
• The overall consumer surplus
remains the area below the
demand curve, above the
(new) price.
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Figure 4.3 Total Consumer Surplus in
the Market for Chai Tea
The market for chai tea is
larger than just our four
consumers.
• With many consumers, the
market demand curve looks
like “normal”: a straight line.
Consumer surplus in this
market is defined in just the
same way: the area below the
demand curve, above price.
The graph shows consumer
surplus if price is $2.00.
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Making the Connection: Consumer
Surplus from Broadband Internet (1 of 2)
Having access to a broadband internet connection is beneficial for
consumers.
• We can measure just how beneficial it is by estimating the
consumer surplus derived in the market.
What would we need to know in order to do this?
• The demand curve for broadband internet service
• The price of broadband internet service
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Producer Surplus
Producer surplus can be thought of in much the same way as
consumer surplus.
• It is the difference between the lowest price a firm would accept
for a good or service and the price it actually receives.
What is the lowest price a firm would accept for a good or service?
• The marginal cost of producing that good or service.
Marginal cost: the additional cost to a firm of producing one more
unit of a good or service.
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Figure 4.4 Measuring Producer
Surplus (1 of 2)
Heavenly Tea is a (very
small) producer of chai tea.
When the market price of tea
is $2.00,
Heavenly Tea 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).
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Figure 4.4 Measuring Producer
Surplus (2 of 2)
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.
Total producer surplus is
equal to the area above the
supply curve and below the
market price of $2.00.
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What Do 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 (measured in dollars) 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.
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4.2 The Efficiency of Competitive
Markets
Explain the concept of economic efficiency.
We can think about efficiency in a market in two ways:
1. A market is efficient when the marginal benefit is equal to the
marginal cost.
2. A market is efficient if it maximizes the sum of consumer and
producer surplus (i.e. the total net benefit to consumers and
firms), known as the economic surplus.
This outcome is economically efficient because every tea has
been produced where the marginal benefit to buyers is greater
than or equal to the marginal cost to producers.
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Figure 4.5 Marginal Benefit Equals Marginal
Cost Only at Competitive Equilibrium (1 of 2)
Recall that the demand
curve describes the
marginal benefit of each
additional cup of tea, while
the supply curve describes
the marginal cost of each
additional cup of tea.
If the quantity is too low,
the value to consumers of
the next unit exceeds the
cost to producers.
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Figure 4.5 Marginal Benefit Equals Marginal
Cost Only at Competitive Equilibrium (2 of 2)
If the quantity is too high, the
cost to producers of the last
unit is greater than the value
consumers derive from it.
Only at competitive equilibrium
is the last unit valued by
consumers and producers
equally—economic efficiency.
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Figure 4.6 Economic Surplus Equals the Sum of
Consumer Surplus and Producer Surplus
The figure shows the
economic surplus (the sum of
consumer and producer
surplus) in the market for
chai tea.
At the competitive equilibrium
quantity, the economic
surplus is maximized.
Our two concepts of
economic efficiency result
in the same level of output!
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Economic Efficiency
Since our two ideas of economic efficiency coincide, we are in a
position to define economic efficiency:
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.
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Figure 4.7 When a Market is Not in
Equilibrium, There Is a Deadweight Loss (1 of 2)
At Competitive
Equilibrium
At a Price of
$2.20
Consumer Surplus
A+B+C
A
Producer Surplus
D+E
B+D
Deadweight Loss
None
C+E
Blank
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.
Economic surplus decreases by the sum of areas C and E.
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Figure 4.7 When a Market is Not in
Equilibrium, There Is a Deadweight Loss (2 of 2)
At Competitive
Equilibrium
At a Price of
$2.20
Consumer Surplus
A+B+C
A
Producer Surplus
D+E
B+D
Deadweight Loss
None
C+E
Blank
The reduction in economic surplus resulting from a market not being in
competitive equilibrium is known as deadweight loss.
Deadweight loss can be thought of as the amount of inefficiency in a
market. In competitive equilibrium, deadweight loss is zero.
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…
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4.3 Government Intervention in the
Market: Price Floors and Price Ceilings
Explain the economic effect of government-imposed price floors
and price ceilings.
One option a government has for affecting a market is the
imposition of a price ceiling or a price floor.
• Price ceiling: A legally determined maximum price that sellers can
charge.
• Price floor: A legally determined minimum price that sellers may
receive.
Price ceilings and floors in the USA are uncommon, but include:
• Minimum wages
• Rent controls
• Agricultural price controls
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Figure 4.8 The Economic Effect of a
Price Floor in the Wheat Market (1 of 2)
The equilibrium price in the
market for wheat is $6.50 per
bushel; 2.0 billion bushels are
traded at this price.
If wheat farmers convince the
government to impose a price
floor of $8.00 per bushel,
quantity traded falls to 1.8 billion.
Area A is the surplus transferred
from consumers to producers.
Economic surplus is reduced by
area B + C, the deadweight loss.
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Figure 4.8 The Economic Effect of a
Price Floor in the Wheat Market (2 of 2)
Unfortunately, the situation
may be even worse:
• If farmers do not realize
they will not be able to
sell all of their wheat,
they will produce 2.2
billion bushels.
• This results in a surplus,
or excess supply, of 400
million bushels of wheat.
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Making the Connection: Price Floors in
Labor Markets
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.
Assuming the minimum wage
does decrease employment, it
must result in a deadweight
loss for society.
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Figure 4.9 The Economic Effect of a
Rent Ceiling (1 of 2)
Without rent control, the
equilibrium rent is $2,500 per
month.
At that price, 2,000,000 apartments
would be rented.
If the government imposes a rent
ceiling of $1,500, 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.
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Figure 4.9 The Economic Effect of a
Rent Ceiling (2 of 2)
Producer surplus equal to
the area of the blue
rectangle A is transferred
from landlords to renters.
There is a deadweight loss
equal to the areas of yellow
triangles B and C.
This deadweight loss
corresponds to the surplus
that would have been
derived from apartments
that are no longer rented.
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Black Markets and Peer-to-Peer Sites
The shortage of apartments may lead to a black market–a market
in which buying and selling take place at prices that violate
government price regulations.
Alternatively, landlords might switch from long-term to short-term
rentals in order to avoid rent controls; peer-to-peer rental sites
such as Airbnb have facilitated this.
• These markets may alleviate some of the deadweight loss by
allowing additional apartments to be rented, but buyers and
sellers lose valuable legal protections.
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The Results of Government Price
Controls
It is clear that when a government imposes price controls:
• Some people are made better off,
• Some people are made worse off, and
• The economy generally suffers, as deadweight loss will
generally occur.
Economists seldom recommend price controls, with the possible
exception of minimum wage laws. Why minimum wage laws?
• Price controls might be justified if there are strong equity effects
to override the efficiency loss.
• The people benefitting from minimum wage laws are generally
poor.
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Making the Connection: Why is Uber
Such a Valuable Company?
Uber is a mobile app used to order a taxi-like ride from an
individual serving as an independent contractor.
• Users benefit from cheaper rides.
• Operators benefit from being able to operate a taxi-like service
without expensive licenses.
• Uber allows these parties to communicate and avoid restrictive
taxi-licensing laws that restrict output in the market.
Uber’s estimated market value is $50 billion, giving a sense of the
size of the deadweight loss (due to restricted output) it is trying to
alleviate.
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4.4 Externalities and Economic
Efficiency
Identify examples of positive and negative externalities and use
graphs to show how externalities affect economic efficiency
Externality: a benefit or cost that affects someone who is not
directly involved in the production or consumption of a good or
service.
• Think of an externality like a side effect.
For example, pollution is an externality: no one sets out to create
pollution, but the effect of pollution is felt by many who were not
involved in its creation.
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Electricity Production
Electricity production is an incredibly important industry for a
modern economy.
Consider the market for electricity. It consists of:
• Sellers, who face increasing marginal costs to produce
electricity
• Buyers, who face decreasing marginal benefits of additional
electricity
The actions of these groups generate market supply and demand
curves for electricity.
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Cost of Electricity Production
When firms produce electricity, they bear certain costs of
production:
• Buildings
• Equipment
• Fuel
• Labor, etc.
Those firms make their decisions about how much to produce
based on these private costs.
But because of pollution the social cost is higher: the total cost to
society of producing a good or service, including both the private
cost and any external cost.
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Figure 4.10 The Effect of Pollution on
Economic Efficiency (1 of 3)
Supply curve S1 represents just
the marginal private cost that
the electricity producer has to
pay.
Supply curve S2 represents the
marginal social cost, which
includes the costs to those
affected by pollution.
The optimal level of production
for society is QEfficient; at this
quantity, the marginal cost to
society is just equal to the
marginal benefit.
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Figure 4.10 The Effect of Pollution on
Economic Efficiency (2 of 3)
However, the market
equilibrium results from the
decisions of producers, who
see their cost of production
given by S1.
Price (PMarket) is “too low” and
quantity (QMarket) is “too high”:
the cost to society of the
additional electricity exceeds
its benefit to society.
Deadweight loss results.
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Figure 4.10 The Effect of Pollution on
Economic Efficiency (3 of 3)
When there is a negative
externality in producing or
consuming a good or service,
too much of the good or
service will be produced at
market equilibrium.
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Types of Externalities
Pollution is an example of a negative externality in production.
• Negative externalities might result from consumption.
• Example: cigarette smoke.
Externalities might also be positive when the private benefit (the
benefit received by the consumer of a good or service) is less than
the social benefit (the total benefit from consuming a good or
service, including both the private benefit and any external
benefit).
• Example: college education
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Figure 4.11 The Effect of a Positive
Externality on Economic Efficiency (1 of 2)
College educations have
positive externalities.
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.
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Figure 4.11 The Effect of a Positive
Externality on Economic Efficiency (2 of 2)
When there is a positive
externality in producing or
consuming a good or service,
too little of the good or service
will be produced at market
equilibrium.
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Externalities and Market Failure
If there are negative or positive externalities, the market
equilibrium will not result in the efficient quantity being produced.
• Overproduction with negative externalities; underproduction with
positive externalities.
• There will be deadweight loss.
This is an example of market failure: a situation in which the
market fails to produce the efficient level of output.
• The larger the externality, the greater is likely to be the size of
the deadweight loss—the extent of the market failure.
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What Causes Externalities?
Externalities arise because of incomplete property rights, or
from the difficulty of enforcing property rights in certain
situations.
Property rights: The rights individuals or businesses have to the
exclusive use of their property, including the right to buy or sell it.
Suppose a farmer and a paper mill share a stream.
• If no-one owns the stream, the paper mill will discharge waste
into the stream, making it unusable for the farmer.
• If the farmer owns the stream, he can:
• Prevent the mill from discharging into the stream, or
• Allow the mill to discharge for a fee, if that is beneficial to him.
• Either way, good property rights avoid the market failure.
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4.5 Government Policies to Deal with
Externalities
Analyze government policies to achieve economic efficiency in a
market with an externality.
Earlier in the chapter, we learned that taxes caused inefficiency
(deadweight loss) by moving the level of production away from the
efficient level.
In this chapter, externalities cause inefficiency for the same
reason.
• A tax of just the right size could cause these two effects to
cancel out, returning us to the efficient level of production.
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Figure 4.12 When There Is a Negative Externality, a
Tax Can Lead to the Efficient Level of Output (1 of 2)
Utilities do not bear the cost of
pollution, so they produce too
much.
If the government imposes a tax
equal to the cost of the pollution,
the utilities will internalize the
externality.
• The supply curve will shift up,
from S1 to S2.
• The market equilibrium quantity
falls to the economically efficient
level.
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Figure 4.12 When There Is a Negative Externality, a
Tax Can Lead to the Efficient Level of Output (2 of 2)
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.
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Can Taxes “Solve” Positive Externalities
Too?
Taxes worked to solve the problem of negative externalities
because:
• Negative externalities caused too much to be produced, while
• Taxes reduced the amount of output.
When there are positive externalities, too little will be produced.
• Taxes won’t work; but subsidies might.
Subsidy: An amount paid to producers or consumers to
encourage the production or consumption of a good.
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Figure 4.13 When There Is a positive Externality, a
Subsidy Can Bring about the Efficient Level of
Output (1 of 2)
Individuals make decisions about
whether or not to “consume” a
college education, with a resulting
market price and quantity.
But what if there are positive
externalities to a college
education?
• It is good for us all if other people
are smart and make good
decisions.
• This is an argument for a subsidy in
the market for college education.
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Figure 4.13 When There Is a positive Externality, a
Subsidy Can Bring about the Efficient Level of
Output (2 of 2)
The subsidy will cause the
demand curve to shift up,
from D1 to D2.
The market equilibrium
quantity will shift from QMarket
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.
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Corrective Taxes and Subsidies
The taxes and subsidies seen in the last few slides “correct” the
externality problem.
They are known as Pigovian taxes and subsidies, after the
English economist Arthur Cecil Pigou, who first demonstrated the
use of government taxes and subsidies in bringing about an
efficient level of output in the presence of externalities.
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Making the Connection: Should We Tax
Cigarettes and Soda? (1 of 2)
The consumption of cigarettes and soda are thought to have
negative externalities. Why?
• Both cigarettes and soda have negative health consequences.
• This by itself is not sufficient to be a negative externality.
• But people’s medical expenses are shared with others, either
via public or private health insurance.
Therefore we expect there to be too much consumption of
cigarettes and soda, and they are candidates for Pigovian taxes.
In general, cigarettes are taxed much more heavily than soda.
Is this appropriate?
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Making the Connection: Should We Tax
Cigarettes and Soda? (2 of 2)
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Alternatives to Taxation for Solving
Externalities
The traditional solution to the externality problem is commandand-control: a policy 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.
Example: Requiring car manufacturers to equip cars with catalytic
converters.
Problem: What if firms have very different costs of reducing
pollution? It may not be efficient for them to reduce pollution by
the same amount.
• i.e. the same amount of pollution-reduction could be achieved
with less cost
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Two Car Manufacturers
Suppose Ford can reduce pollution in its cars very cheaply, while
GM has very high costs of reducing pollution.
• If we want to achieve a particular level of pollution reduction, it
would be efficient to ask Ford to reduce pollution more than GM.
• But this doesn’t seem fair to Ford; why should GM be held to a
lesser standard?
The efficient solution has Ford perform more pollution reduction,
but have GM compensate Ford; both companies can be made
better off, compared with requiring both to reduce pollution by a
moderate amount, while keeping the amount of pollution reduction
the same.
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Tradable Emissions Permits
This is the concept behind tradable emissions permits, also known
as cap-and-trade:
• The government establishes an allowable amount of emissions.
• Emissions permits are distributed.
• Firms can trade emissions permits.
‒ Firms with high costs of reducing pollution will buy permits from
firms with low costs of reducing pollution, ensuring that pollution is
reduced at the lowest possible cost.
• Hence the market is used to achieve efficient pollution
reduction.
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The Sulfur Dioxide Cap-and-Trade
System
In 1990, Congress enacted a cap-and-trade system for sulfur
dioxide emissions.
• Improvements in pollution reduction technology resulted, with
the cost of compliance ending up almost 90 percent less than
firm initially estimated.
This program was very effective, with benefits at least 25 times
the cost of implementing the program.
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The End of the Sulfur Dioxide Cap-andTrade System
By 2013, the program had effectively ended. Why?
• Further emissions reductions were needed; President Bush
attempted to lower the cap, but Congress resisted.
• As a result, the EPA decided to return to a command-andcontrol approach in order to achieve the reductions.
While cap-and-trade appears to be very effective, any policy
needs political backing to have a chance at success.
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Criticisms of Cap-and-Trade
Environmentalists object to cap-and-trade as it gives firms
“licenses to pollute.”
• But pollution has a benefit; it allows cheap production.
• Every production decision uses up some scarce resource: time,
natural resources, clean air, etc.
• In this sense, paying for using the clean air seems appropriate.
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Copyright
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