Market Failure Diagrams

 Learning Objective:  To understand how to illustrate market failure with diagrams  Learning Outcome / Success Criteria  Draw over/under production  Draw over/under consumption

 This is the diagram that we use to show how the market works  Now assume that there is market failure and the market produces too much  There are negative externalities  What curve do we need to add and where? Price Quantity D S Q* P* Q* = socially optimum quantity P* = socially optimum price

 When it is firms that are producing too much we need to add another supply curve  Where do we need to add it to show too much production (more Q?)  More = Right – Add curve to the right (S1)  Note that we do not talk about this being a shift – this is just adding a curve to illustrate market failure  Now we talk about movement…..  If there is too much production govt needs to get S1 to shift inwards (left) and get closer to the socially optimum of Q*  How can we get supply curves to shift to the left?  Increase the firm’s costs Price Quantity D S Q1 S1 Q* Q* = socially optimum quantity P* = socially optimum price

 So government needs to find a way to force supply to decrease  Or increase firm’s costs to reduce the overproduction  How could it do that?  Introducing pollution permits Price Quantity D S Q1 S1 Q* Q* = socially optimum quantity P* = socially optimum price

 Time for you to draw  Draw an overproduction diagram on your white boards

 Back to our perfect market diagram  This time we are going to change it so that there is market failure and the market produces too little – positive externality  What curve do we need to add and where? Price Quantity D S Q* P* Q* = socially optimum quantity P* = socially optimum price

 When it is firms that are producing too little it is the supply curve that needs to be added  To get closer to the socially optimum which way does the supply curve need to shift?  MoRe – Right  What makes the curve shift to the right?  A decrease in the firm’s costs Price Quantity D S Q1 S1 Q*

 So government needs to either make it produce more  Or decrease it’s costs  How could it do that?  A subsidy Price Quantity D S Q1 S1 Q*

 Time for you to draw  Draw an under-production diagram on your white boards

 Back again to our perfect market  Now assume that there is market failure and the market consumes too much  This is a market for demerit goods  Which curve needs to be added and where? Price Quantity D S Q* P*

 When we think of consumption we need to think of the demand curve  If the market is consuming too much we need to add a demand curve to show too much Q (Q1)  If government wants to reduce the market failure which way does it need to shift the demand curve?  We need to get less consumption  less - left Price Quantity D1 S Q1 D Q*

 Government needs to do something to shift demand  What can it do?  It could educate  This would shift demand  What else? Price Quantity D1 S Q1 D Q*

 It could also increase the price which would cause a contraction of demand.  How?  It could place an indirect tax on the product  This would shift the supply curve  The price would increase  Demand would contract to Q*  Could government actually reduce it to Q*?  Probably not because the tax would need to be so high that it might put the cigarette companies out of business  It can still reduce the market failure Price Quantity D S Q1 P1 S1 Q* P*

 Time for you to draw  Draw an over-consumption diagram on your white boards

 Back again to our perfect market  Now assume that there is market failure and the market consumes too little  This is a market for merit goods  Which curve needs to be added and where? Price Quantity D S Q* P*

 If the market is consuming too little we need to add a demand curve  Where?  There is not enough consumption so we need to add to the left (we need to illustrate less Q) Price Quantity D1 S Q1 D Q*

 Government needs to do something to shift demand  What can it do?  It could educate  This would shift demand  Giving more Q (Q*)  What else? Price Quantity D1 S Q1 D Q*

 It could also decrease the price which would cause an extension of demand.  How?  It could subsidise the product/service  This would shift the supply curve  The price would decrease  Demand would extend to Qso  Could government subsidise enough to get to Qso? Price Quantity D S1 Q* P1 S Q1 P*

 Time for you to draw  Draw an under-consumption diagram on your white boards

 Time for you to draw  Draw the following  Over-consumption  Under consumption  Over production  Under production

 Learning Objective:  To understand how to illustrate market failure diagrams with the proper notation  Learning Outcome / Success Criteria  Draw over/under production diagrams  Successfully answer a 10 mark question

 When we draw market failure diagrams we change the labelling slightly  Often the price axis becomes costs and benefits (there is no penalty for leaving at Price)  The supply curve is the Marginal Social Cost curve (MSC)  The demand curve is the Marginal Social Benefits curve (MSB) Costs & Benefits Quantity MSB MSC Q* P* Marginal Social Cost (Remember we associate supply with costs) Marginal Social Benefits (Remember we associate demand with benefits)

 When the market is working properly we have allocative efficiency  The perfect market with the socially optimum output (Q*)  The Marginal Social Costs equal the Marginal Social Benefits  Consumer surplus and Producer Surplus are maximised

 Too much production happens because the firms only think about their private costs (Marginal Private Costs)  They think about their profit  They are profit maximisers  They don’t think about the cost to third parties (external costs)  The marginal social costs are larger than the marginal private costs Costs & Benefits Quantity MSB MSC Q1 P1 MPC Q* P*

 The external cost in this case is what?  It is the pollution to those not involved in the production  The external cost is the vertical distance between the MPC and MSC curve  EC is the negative externality  MPC + EC = MSC  When MPC is not equal to MSB there is market failure Costs & Benefits Quantity MSB MSC Q1 P1 MPC Q* P* EC

 When MPC is not equal to MSC there is market failure  So Government can use the market to fix the failure  It can try to make MPC equal to MSC  They increase the private costs by making the firms pay for the pollution permits Costs & Benefits Quantity MSB MSC Q1 P1 MPC Q* P* EC

 When there are negative externalities there is welfare loss  We can illustrate this using this diagram  The turquoise triangle shows the size of the welfare loss Remember that when you draw the welfare loss for a negative externality it points towards the zero (think of a number line – the negative numbers are behind the zero – the triangle points towards the negative numbers!!

 By taxing the firm  The marginal private costs increase  The supply decreases  The quantity reduces from Q1 to Q2  The welfare loss is decreased  The turquoise triangle is decreased  The quantity is closer to Q* The socially optimum amount is Q* but to get this amount government would have to accurately measure the external cost (the pollution) and also the tax may be so large that firms may exit the market Q2 is still better than Q1

 Time for you to draw  Draw a negative externality diagram on your white boards

 This diagram illustrates a positive externality  The socially optimum amount is Q*  Firms in this market are not producing enough  This time they are only thinking about their benefits and not the benefits to society  There is potential welfare gain if more is produced (turquoise triangle) Remember that when you draw the welfare loss for a positive externality it points away from zero (think of a number line – the positive numbers are in front of the zero – the triangle points towards the positive numbers!!

 Time for you to draw  Draw a positive externality diagram on your white boards

 Learning Objective:  To understand how to illustrate over and under consumption market failure with diagrams  Learning Outcome / Success Criteria  Draw over/under consumption  Successfully answer a 10 mark question

 This diagram illustrates a negative externality in consumption  Too much consumption of a demerit good  Consumers are only thinking about their costs and benefits  There is welfare loss that needs to be reduced Again the triangle is pointing to the negative!

 With either of these solutions the triangle will reduce The socially optimum amount is Q* but to get this amount government would have to accurately measure the external costs/benefits. To reduce the triangle (rather than remove it) and have a quantity less than Q1 will be an improvement

 Time for you to draw  Draw a positive externality diagram on your white boards

 This diagram illustrates a positive externality in consumption  Too little consumption of a merit good  Consumers are only thinking about their costs and benefits  There is potential welfare gain Again the triangle is pointing to the negative! Positive externality points to the positive!

 With either of these solutions the triangle reduces The socially optimum amount is Q* but to get this amount government may have to pay large subsidies (opportunity cost). To reduce the triangle (rather than remove it) and have a quantity more than Q1 will be an improvement

 Learning Objective:  To understand how to illustrate market failure with diagrams  Learning Outcome / Success Criteria  Draw over/under production  Draw over/under consumption  Did we achieve these?