© 2010 Jane Himarios, Ph.D.
Lecture 4
Chapter 4: Market Efficiency, Market Failure, and Government Intervention
Markets and Efficiency
A. Markets are efficient mechanisms for allocating resources
Five Institutional Requirements for Workable Markets
1. Accurate information is widely available
2. Property rights are protected
3. Contract obligations are enforced
4. There are no external costs or benefits
5. Competitive markets prevail
B. The Discipline of Markets
Explain how high prices ensure that firms will supply highly valued products.
Explain how firms that fail to innovate will be disciplined by the market.
C. Consumer and Producer Surplus Graphically
Remember that market efficiency is achieved when the sum of consumer and
producer surplus is maximized
Supply
Demand
Quantity
1. Show consumer surplus on this graph.
2. Show producer surplus on this graph.
3. Demonstrate that the sum of consumer and producer surplus will fall if a
smaller quantity is traded.
4. Demonstrate that the sum of consumer and producer surplus will fall if a larger
quantity is traded.
© 2010 Jane Himarios, Ph.D.
Market Failures
1. Asymmetric Information
The problem where one side to a transaction has more information than the other
side—leads to fewer than optimal trades
Example: the used car market--Since buyers can’t distinguish quality differences,
they will assume all cars are low quality. Sellers have no way to convince buyers
that their car is not a lemon.
Adverse selection
Occurs before the market transaction.
Adverse selection is the problem that the people or firms who are most eager to
make a transaction are the least desirable to parties on the other side of the
transaction (higher-risk individuals are more likely to buy insurance)
Moral hazard
Occurs after the market transaction.
Moral hazard the problem that one party to a transaction changes their behavior
in a way that harms the other party
Example: Without insurance I won’t engage in risky behaviors because I know I’ll
bear the entire cost if I have a problem. Then I buy insurance and promise the
seller that I won’t engage in risky behaviors but then I do because I know he
won’t be able to tell and also that he will bear most of the cost if I have a
problem.
Further example: Without health insurance I won’t go to the doctor very often
because I know I’ll bear the entire cost if I do. Then I buy insurance and then I go
to the doctor for every little thing since the insurer bears most of the cost.
2. Problems with Property Rights: Public Goods Exist
Public goods are nonexcludable: you can’t keep someone who hasn’t paid for
them from using them. See Lecture 1
3. Problems with Property Rights: Common Property Resources Exist
The Tragedy of the commons: Common property resources (ocean fish, the
atmosphere, common grazing lands) are owned by the community at large and
tend to be overused
© 2010 Jane Himarios, Ph.D.
4. Problems with Property Rights: Problematical Contract Enforcement
The legal system for enforcing contracts may be nonexistent, corrupt, or
inefficient
5. Third-Party Effects (Externalities) Exist
See Lecture 1 for definitions
Assuming that the external costs or benefits can be measured correctly, then we
can find the efficient quantity:
Supply after counting external costs
Price
Supply
Demand
Price
Supply
Demand after counting
Demand
external benefits
6. Monopoly Power Exists
Efficiency depends upon competitive markets. Lack of competition can reduce
efficiency.
© 2010 Jane Himarios, Ph.D.
Government-Controlled Prices
Economists have figured out that freely operating markets will adjust so that
there are no shortages or surpluses—the equilibrium price acts as a rationing
device. However, sometimes certain groups don’t like the equilibrium price
because, to them, it is “too high” or “too low.” These groups sometimes ask the
government to control the price by choosing what they consider to be a “better”
price.
This sounds like a good idea until you remember that prices convey important
and useful information, which we ignore at our peril. When the government
controls the price of a good, this important and useful information is lost. This
causes unintended problems.
Economists know that price controls are intended to have certain effects.
Economists have observed that price controls also, unfortunately, have
unintended effects. These unintended effects occur because price controls
prevent the price of a good to function as a rationing device.
Sequence of events:
________________________________________________________________
⌂
⌂
⌂
⌂
⌂
The
a shortage
the price
quantity supplied the shortage
government occurs which of the good
does not rise
persists
imposes a
is a signal
cannot legally and quantity
price below for the price
rise
demanded does not
equilibrium
to rise
fall
________________________________________________________________
⌂
⌂
⌂
⌂
⌂
The
a surplus
the price
quantity supplied the surplus
government occurs which of the good
does not fall
persists
imposes a
is a signal
cannot legally and quantity
price above for the price
fall
demanded does not
equilibrium
to fall
rise
© 2010 Jane Himarios, Ph.D.
A. Price Ceiling
Sometimes people say the price of a good is “too high” and they ask the
government to control the price by imposing a price ceiling designed to lower the
price.
Definition: A price ceiling is a legal maximum price that is lower than the
equilibrium price.
(A legal maximum price that is higher than the equilibrium price is not, by our
definition, a price ceiling.)
The intended effect of a price ceiling is to lower the price of a product, in order to
help buyers.
The unintended effects of a price ceiling include persistent shortages, fewer
trades than at equilibrium, and creation of the need for nonprice rationing
devices. The groups that lobby for price ceilings frequently ignore or fail to
consider these unintended effects.
Let’s look at the market for apartments:
Supply of apartments of a particular
quality
Price ceiling
Demand for apartments of a
particular quality
Let’s look at the market for kidneys:
Supply
Demand
© 2010 Jane Himarios, Ph.D.
B. Price Floor
Sometimes people say the price of a good is “too low” and they ask the
government to control the price by imposing a price floor designed to raise the
price.
Definition: A price floor is a legal minimum price that is higher than the
equilibrium price.
(A legal minimum price that is lower than the equilibrium price is not, by our
definition, a price floor.)
The intended effect of a price floor is to raise the price of a product, in order to
help sellers.
The unintended effects of a price floor include persistent surpluses, fewer trades
than at equilibrium, and, sometimes, the desire/need for additional government
action to dispose of the surplus. The groups that lobby for price floors frequently
ignore or fail to consider these unintended effects.
Let’s look at the market for workers:
Supply of workers of a particular quality
Demand for workers of a particular quality
Let’s look at the market for milk:
Supply of milk
Demand for milk
© 2010 Jane Himarios, Ph.D.
Taxes and Deadweight Loss
Tax policy affects efficiency.
Supply with an excise tax
Supply with no excise tax
a
e
b
Demand
Q2
Qefficient
1. Show the tax revenue (redistribution from consumers and producers to the
government.
2. Show consumer surplus after the tax is levied.
3. Show producer surplus after the tax is levied.
4. Show the deadweight loss of the tax.
The deadweight loss is the loss in consumer and producer surplus due to
inefficiency because some transactions do not occur and so their value to society
is lost.
What if the market quantity is not really the efficient quantity because of negative
externalities? If this is the case can an excise tax help move the market to the
true efficient quantity?
Tariffs
A tariff is a tax levied on an imported product.
Tariffs drive up prices of imports and have all the effects shown above. They also
invite retaliation.
If you are interested, read “Obama to Impose Tariffs on Chinese Tires,” Yahoo!
Finance, http://finance.yahoo.com/news/Obama-to-impose-tariffs-on-apf2199438691.html/print?x=0, Ian Johnson, “China Strikes Back on Trade,” Wall
Street Journal, 9/14/2009 and Timothy Aeppel, “Tariff on Tires to Cost
Consumers,” Wall Street Journal, 9/14/2009.