4.1 Market Failures in Competitive Markets
Market failures sometimes happen in competitive markets, they fall into two categories:
When demand curve do not reflect consumers' full willingness to pay for a good or
private firms will therefore
i.e. outdoor firework displays -no way to exclude people who haven't pay also
Because it is impossible in certain cases to charge consumers what they are willing
Demand-side market failures
When supply curves do not reflect the full cost of producing a good or service.
Arise in situations which a firm does not have to pay the full cost of producing its
i.e. coal-burning power plant produces more electricity and generates more
pollution. (cost > benefit)
It is not possible for the market to correctly weight costs and benefits in a situation
in which some of the costs are completely unaccounted for.
Supply-side market failures
Demand curve must reflect consumers' full willingness to pay
Supply curve must reflect all the costs of production
Two conditions must hold if a competitive market is to produce efficient outcomes:
It will also maximize the amount of "benefit surpluses" that are shared between
If these two conditions hold, then market will produce only units for benefits are at least
Efficiently Functioning Markets
The area below the demand curve and above the price line P1
Inversely related with price
Consumer surplus-difference between the maximum price a consumer is willing to pay
and the actual price they pay.
The maximum price a person is willing to pay depends on the opportunity cost of that
person's consumption alternatives.
i.e. Tom wants to buy an apple $1.25, if he is charged less than $1.25 then he will
receive a consumer surplus equal to the difference between $1.25 maximumprice he
would willing to pay and the lower market price.
Nearly all markets, consumers gain greater total utility or satisfaction
in dollar terms from their purchases than the amount of their
expenditures (= product price x quantity)
Lower prices →large consumer surpluses
Figure 4.1, to obtain Q1bags of oranges, consumers need pay only the amount
represented by yellow rectangle (= P1x Q1)
consumer would have to pay the producer to make the output available.
Area shown in blue triangle
Directly related with price
Producer surplus-difference between the actual price a producer receives and the
minimum acceptable price that
Surplus is the sum of the vertical distances between supply curve and theequilibrium
The size of the producer surplus = market price - producer'sminimum acceptable price
Marginal cost = Σ rent, wages, interest, profit
A producer's minimum acceptable price for a unit will equal the producer's marginal cost
Producer's minimum acceptable price can also be interpreted as opportunity
cost of bidding resource away from the production of other products.
If producer A's minimum acceptable price is lower
than producer B's it is because producer A uses
less-costly combination of resources than producer B uses.
Producer B then has a higher marginal cost (Mc)
Producer revenue (P1x Q1) illustrated by the yellow area would be required to entice
Gap between minimum acceptable payments and actual prices widen when prices
resources available →minimize per-unit costs of output produced.
Productive efficiency -achieve because competition forces producers to use best
technologies and combinations of
Allocative efficiency-achieve because the correct quantity Q1is produced
Why Q1is the allocatively efficient quantity?
Demand curves are MB curves (Maximum price consumer are willing to pay =
Supply curves are MC curves
Points on the demand curves measure the marginal benefit at each level of
Points on the supply curve measure the marginal cost at each level of output
MB = MC means that the equilibrium quantity Q1must be allocatively efficient
Optimal allocation is achieved at MB = MC
Market failures in competitive markets have two possible causes: demand curves do
not reflect consumer's willingness to pay and supply curves do not reflect
producers' full cost of production
Consumer surplus is the difference between the maximum price that a consumer is
willing to pay for a product and the lower price actually paid
At the equilibrium price and quantity in competitive markets, MB = MC, maximum
willingness to pay = minimum acceptable price, and total of consumer surplus and
producer surplus is maximized.
Each of these conditions defines allocative efficiency
Quantities less than or greater than allocatively efficient level of output create
efficiency losses, often called deadweight losses.
Public goods are characterized by nonrivalry and nonexcludability.
The demand (Mb) curve for a public good is found by vertically adding the prices that
all the members of society are willing to pay for the last unit of output at various
The socially optimal amount of public good is the amount at which the marginal cost
and marginal benefit of the good are equal.
Cost-benefit analysis is the method of evaluating alternative projects or sizes of
projects by comparing the marginal cost and marginal benefit and applying the MC =
The government uses taxes to reallocate resources from the production of private
goods to the production of public and quasi-public goods.
Marginal-Cost-Marginal-Benefit Rule
Policies for coping with the overallocation of resources and therefore efficiency
losses, caused by negative externalities are (a) private bargaining, (b) liability rules
and lawsuits, (c) direct controls, (d) specific taxes, and (e) markets for externally
Policies for correcting the underallocation of resources, and therefore efficiency
losses, associated with positive externalities are (a) private bargaining, (b) subsidies
to producers, (c) subsidies to consumers and (d) government provision.
The optimal amount of negative externality reduction occurs where society's Mc= Mb
for reducing externality.
Political pressures often lead government to respond inefficiently when attempting
to correct for market failures.
Optimal Reduction of an Externality
Differentiate between demand-side market failures and supply-side market failures
A market failure happens in a particular market when the market produces an
equilibrium level of output that either overallocates or underallocates
resources to the product being traded in the market.
In competitive markets that feature many buyers and many sellers, market
failures can be divided into two types: demand-side market failures occur
when demand curves do not reflect consumers' full willingness to pay; supply-
side market failures occur when supply curves do not reflect all production
costs, including that may be borne by third parties.
Explain the origin of both consumer surplus and producer surplus and explain how
properly functioning markets maximize their sum, total surplus, while optimally
Consumer surplus is the difference between the maximum price that a
consumer is willing to pay for a product and the lower price actually paid;
producer surplus is the difference between the minimum price that a producer
Demand-side market failures
Supply-side market failures
Public Goods Characteristics
Subsidies and Government Provision
Society's Optimal Amount of Externality
Government's Role in the Economy
Chapter 4: Market Failures: Public Goods and
Wednesday, August 5, 2020
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