Hubbard Efficiency and Market Failure

PowerPoint
to accompany
Chapter 5
Economic
Efficiency and
Market Failure
Hubbard, Garnett, Lewis and OBrien: Essentials of Economics 2010 Pearson Australia
Learning Objectives
1. Understand the concepts of consumer
surplus and producer surplus.
2. Understand the concept of economic
efficiency, and use a graph to illustrate how
economic efficiency is reduced when a
market is not in competitive equilibrium.
3. Use demand and supply graphs to analyse
the economic impact of price ceilings and
price floors.
Learning Objectives
4. Use demand and supply graphs to analyse
the economic impact of taxes.
5. Define positive and negative externalities
and identify examples of each.
6. Analyse government policies to achieve
economic efficiency in a market with
externalities.

Should the government control
prices?
Many historical
buildings in the city of
Georgetown fell into
disrepair, with
economists placing the
blame on rent controls.
Price controls are still
common around the
globe, particularly in
labour, agricultural,
financial and property
markets.
LEARNING OBJECTIVE 1
Marginal benefit: The additional benefit
to a consumer from consuming one more
unit of a good or service.

Consumer surplus: The difference
between the highest price a consumer is
willing to pay and the price the consumer
actually pays.
Consumer Surplus and Producer
Surplus
Price
(dollars per
cup)
Quantity (cups
per week)
0
4
The demand curve is also the marginal benefit
curve: Figure 5.1
Demand
$7.00
$3.00
5
Joes marginal
benefit from
consuming the
fourth cup is
$3.00.
$2.00
Joes marginal
benefit from
consuming the
fifth cup is $2.00.
Price
(dollars per
cup)
Quantity (cups
per week)
0
Total consumer surplus in the market for chai
tea: Figure 5.2
Demand
15 000
$2.00
Total consumer
surplus in the market
for chai tea
The Consumer Surplus from
Satellite Television
How much
consumer surplus
will the owner of
this satellite dish
receive?

Marginal cost: The additional cost to a
firm from producing one more unit of a
good or service.

Producer surplus: The difference
between the lowest price a firm would
have been willing to accept and the price
it actually receives.
Consumer Surplus and Producer
Surplus
Price
(dollars per
cup)
Quantity (cups
per week)
0
40
The supply curve shows marginal cost:
Figure 5.3a
Supply
$1.80
50
The marginal cost
of producing the
40
th
cup is $1.80.
$2.00
The marginal cost
of producing the
50
th
cup is $2.00.
Producer surplus on the
40
th
cup sold.
Price
(dollars per
cup)
Quantity (cups
per week)
0
Total producer surplus in the market for chai
tea: Figure 5.3b
15 000
$2.00
Total producer
surplus from selling
chai tea
Supply
Consumer surplus measures the net benefit
(total benefit minus total price paid) to
consumers from participating in a market.

Producer surplus measures the net benefit
(total benefit minus total cost of production)
to producers from participating in a market.

What Consumer Surplus and
Producer Surplus Measure?
Equilibrium in a competitive market results in
the economically efficient level of output
where marginal benefit equals marginal cost.
Economic surplus: The sum of consumer
surplus and producer surplus.
Deadweight loss: The reduction in
economic surplus resulting from a market not
being in competitive equilibrium.

The Efficiency of Competitive
Markets
Price (dollars
per cup)
Quantity (cups
per week)
0
14 000
Supply
$1.80
16 000
Both marginal benefit
and marginal cost =
$2.00, which means
an economically
efficient output level.
$2.20
Marginal benefit = $2.20,
marginal cost = $1.80,
therefore output is
inefficiently low.
Marginal benefit equals marginal cost only at
competitive equilibrium: Figure 5.4
15 000
$2.00
Demand
Marginal benefit = $1.80,
marginal cost = $2.20,
therefore output is
inefficiently high.
Price
(dollars per
cup)
Quantity (cups
per week)
0
Economic surplus equals the sum of consumer
surplus and producer surplus: Figure 5.5
Demand
15 000
$2.00
Consumer
surplus
Supply
Producer
surplus

Deadweight loss: Figure 5.6
Economic efficiency: A market outcome in
which the marginal benefit to consumers of
the last unit consumed is equal to its
marginal cost of production, and where the
sum of consumer surplus and producer
surplus is at a maximum.

Equilibrium in a competitive market results in
the greatest amount of economic surplus, or
total net benefit to society, from the
production of a good or service.

The Efficiency of Competitive
Markets
Price floor: A legally determined
minimum price that sellers may receive.

Price ceiling: A legally determined
maximum price that sellers may receive.

Government intervention in the
market
B
A
C
0
$3.00
$3.50
S
D
Surplus
wheat
Price Floor: Figure 5.7
Price
(dollars per
bushel)
Quantity (billions of
bushels per year)
2.0 1.8 2.2
Consumer surplus
transferred to producers
Deadweight loss
= B + C
Price floor
B
C
A
0
S
D
$1000
Price Ceiling: Figure 5.8
Price
(dollars per
month)
Quantity
(apartments per
month)
$1500
1 900 000 2 000 000 2 100 000
Deadweight loss
= B + C
Producer surplus
transferred from
landlords to renters
Shortage of
apartments
Rent control
price ceiling
Price Floors in Labour
Markets: The Minimum Wage

Some economists
believe there are better
policies than the
minimum wage for
raising the incomes of
low-skilled workers.

Black markets: Buying and selling at
prices that violate government price
regulations.
When the government imposes price
floors or price ceilings, three important
effects occur:
Some people win.
Some people lose.
There is a loss of economic efficiency,
which is often very large.

Price floors and price ceilings
Positive and Normative Analysis of Price
Ceilings and Price Floors
Whether rent controls are desirable or
undesirable is a normative question.
Whether the gains to the winners more than
compensate the losses to the losers and the
decline in economic efficiency is a matter of
judgment and not strictly an economic
question.

Price floors and price ceilings
Taxes finance government activities.
Taxes on goods and services affect
market equilibrium and result in a decline
in economic efficiency.
Taxes reduce consumer surplus and
reduce producer surplus and result in a
deadweight loss.
Taxes reduce the production of goods
and services.
The economic impact of taxes
Price
(dollars per
pack)
Quantity of cigarettes
(billions of packets
per year)
0
4
2.00
S
1

Demand
$1.00 per pack federal
tax on cigarettes shifts
the supply curve up by
$1.00.
$2.90
3.7
S
2

Deadweight loss
or excess burden
from tax
Price
received by
producers
after paying
the tax
The effect of a tax on the market for
cigarettes: Figure 5.9
1.90
Price the
consumers
pay after the
$1.00 tax is
imposed
Tax
revenue
Tax incidence: The actual division of
the burden of a tax between buyers
and sellers in a market.
Who Actually Pays a Tax? The answer
depends on:
Slope of the demand curve and the
price elasticity of demand.
Slope of the supply curve and the
price elasticity of supply.

The Economic Impact of Taxes
Does it matter who has a legal
responsibility to pay the tax?

No, the incidence of the tax does not
depend on whether a tax is collected from
the buyers of the good or from the sellers.

The Economic Impact of
Taxes

The incidence of a tax on petrol: Figure 5.10
The incidence of a tax on petrol paid by
buyers: Figure 5.11

Do consumers receive the entire
benefit of a sales tax reduction?
The Hon Dr Brendan Nelson MP, a former Leader of
the Opposition, in his interview on 20th May 2008
made the following statement: We will take five cents
a litre off the excise. So every single day when you fill
up your car, whatever that price, itll be five cents a
litre cheaper than it would otherwise be
1
.
Briefly explain whether you agree with the statement.
Illustrate your answer with the graph.

1
http://www.liberal.org.au/info/news/detail/20080520_NelsonDoorstop2008Budgetcutinpetrolexcise.php


Solving the problem:

STEP 1: Review the section Tax incidence: Who actually pays
tax?, which begins on page 144.

STEP 2: Draw a graph like the one in Figure 5.10 to illustrate
the circumstances when consumers will receive the entire
benefit of a reduction in a sales tax.

STEP 3: Use the graph to evaluate the statement.
This statement is only correct if the demand curve is a vertical
line (perfectly inelastic). Although inelastic, demand curve for
petrol is not perfectly inelastic, therefore the statement is
unlikely to be true. The petrol price is likely to decrease by less
than 5 cents.


Price
(dollars
per litre)
0 19
$1.50
$1.45
D
S
1
S
2
Quantity (billions of
litres per year)
5 cents per litre
excise reduction
shifts the supply
curve down
Externalities and Efficiency
Externality: A benefit or cost that affects
someone who is not directly involved in the
production or consumption of a good or service.

Private cost: The cost borne by the producer of a
good or service.
Social cost: The total cost of producing a good,
including both the private cost and any external cost.

Private benefit: The benefit received by the
consumer of a good or service.
Social benefit: The total benefit from consuming a
good, including both the private benefit and any
external benefit.
Command and control versus market-
based approaches

Command and control approach: Government-
imposed quantitative limits on the amount of
pollution firms are allowed to generate, or
government-required installation by firms of
specific pollution control devices.

Government Solutions to
Externalities
Market-based approaches

Tradeable emissions allowances: The
government can issue a fixed quantity of
emission allowances, which can then be
bought and sold in the market.
Rewards firms who reduce emissions, as they can
sell their allowances
Penalises firms with high emissions, as they must
buy more emission allowances.
Externalities
Pigovian taxes and subsidies:
Government taxes and subsidies intended
to bring about an efficient level of output in
the presence of externalities.
A tax on production equal to the cost of the
externality to internalise a negative externality.
A subsidy to consumers equal to the value of
the positive externality, that is, equal to the
external benefit.
Externalities
Price of
electricity
Quantity of electricity
0
Q1
P1
S
1
= private
cost before
tax
When there is a negative externality, a tax can bring
about the efficient level of output: Figure 5.12
Demand
Cost of pollution =
amount of tax imposed
by government
P2
Q2
S
2
= social cost
and private cost
after tax
Market
equilibrium
without tax
Market
equilibrium
with tax
Price of
university
education
Quantity of university
education
0
Q1
P1
Supply

Positive externality =
amount of subsidy
Market equilibrium
with subsidy =
efficient equilibrium
Market
equilibrium
without
subsidy
D
2 =
social benefit
and private benefit
after subsidy
P2
Q2
When there is a positive externality, a subsidy can
bring about the efficient level of output: Figure 5.13
D
1 =
private benefit
before subsidy
An Inside Look
Reform on the way for EU agriculture
An Inside Look
Figure 1: The excess supply of food is sold on world
markets and causes the world supply of food to shift to
the right.
An Inside Look
Figure 2: The imposition of a floor price in the
European market for food causes an increase in price
and excess supply of food.
Black market
Command and control
approach
Consumer surplus
Deadweight loss
Economic efficiency
Economic surplus
Externality
Marginal benefit
Marginal cost
Market failure

Pigovian taxes and
subsidies
Price ceiling
Price floor
Private benefit
Private cost
Producer surplus
Social benefit
Social costs
Tax incidence

Key Terms
In April 2007, the European Union imposed a
five-year minimum price on Chinese frozen
strawberries with the aim of protecting its
farmers.

Identify the possible outcomes of this
regulation.
Do you think the benefits of such a policy
outweigh the costs?
Get Thinking!
Q1. Refer to the figure below. The graph shows an
individuals demand curve for tea. At a price of two
dollars, the consumer is willing to buy five cups of tea
per week. More precisely, what does this mean?
a. It means that marginal benefit equals marginal
cost when five cups are consumed.
b. It means that the total cost of
consuming five cups is $2.00.
c. It means that the marginal cost
of producing five cups is $2.00.
d. It means that the marginal
benefit of consuming the fifth cup is $2.00.

Check Your Knowledge
Q1. Refer to the figure below. The graph shows an
individuals demand curve for tea. At a price of two
dollars, the consumer is willing to buy five cups of tea
per week. More precisely, what does this mean?
a. It means that marginal benefit equals marginal
cost when five cups are consumed.
b. It means that the total cost of
consuming five cups is $2.00.
c. It means that the marginal cost
of producing five cups is $2.00.
d. It means that the marginal
benefit of consuming the fifth cup is $2.00.

Q2. If the average price that cable subscribers
are willing to pay for cable television is
$208, but the actual price they pay is $81,
how much is consumer surplus per
subscriber?
a. $208 + $81.
b. $208 $81.
c. $81 + $127.
d. $81.

Q2. If the average price that cable subscribers
are willing to pay for cable television is
$208, but the actual price they pay is $81,
how much is consumer surplus per
subscriber?
a. $208 + $81.
b. $208 $81.
c. $81 + $127.
d. $81.

Q3.Refer to the graph below. To achieve economic
efficiency, which output level should be produced?
a. 14 000 cups per month, because at this level of output,
marginal benefit is greater than marginal cost.
b. 15 000 cups per month, because at this level of output,
marginal benefit is equal to marginal cost.
c. 16 000 cups per month,
because at this level of
output, marginal benefit is
less than marginal cost.
d. Any of the output
levels above is efficient.

Q3. Refer to the graph below. To achieve economic
efficiency, which output level should be produced?
a. 14,000 cups per month, because at this level of output,
marginal benefit is greater than marginal cost.
b. 15,000 cups per month, because at this level of output,
marginal benefit is equal to marginal cost.
c. 16 000 cups per month,
because at this level of
output, marginal benefit is
less than marginal cost.
d. Any of the output
levels above is efficient.

Q4. Refer to the graph below. According to this graph,
the existence of a minimum wage in the market for
low-skilled workers results in:
a. An increase in wages and employment.
b. An increase in wages but lower employment.
c. A decrease in wages
but higher employment.
d. A decrease in wages
and employment.

Q4. Refer to the graph below. According to this graph,
the existence of a minimum wage in the market for
low-skilled workers results in:
a. An increase in wages and employment.
b. An increase in wages but lower employment.
c. A decrease in wages
but higher employment.
d. A decrease in wages
and employment.

Q5. After a Pigovian tax that represented the cost of
the negative externality was put on producers,
which point would best represent market
equilibrium?
a. Point A.
b. Point B.
c. Point C.
d. None of
the above.
Q5. After a Pigovian tax that represented the cost of
the negative externality was put on producers,
which point would best represent market
equilibrium?
a. Point A.
b. Point B.
c. Point C.
d. None of
the above.

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