1. c h a p t e r f o u r © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien Prepared by: Fernando & Yvonn Quijano Market Efficiency and Market Failure

2. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 2 of 26 After studying this chapter, you should be able to: Understand the concepts of consumer surplus and producer surplus. 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. Use demand and supply graphs to analyze the economic impact of price ceilings and price floors. Identify examples of positive and negative externalities and use graphs to show how externalities affect economic efficiency. Analyze government policies to achieve economic efficiency in a market with an externality. Should the Government Control Apartment Rents? LEARNING OBJECTIVES 1 2 3 4 New York City … About one million of New York City’s two million apartments are subject to rent control. The other one million apartments have their rents determined in the market by the demand and supply for apartments. 5

3. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 3 of 26 Market Efficiency and Market Failure Price ceiling A legally determined maximum price that sellers may charge. Price floor A legally determined minimum price that sellers may receive.

4. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 4 of 26 Consumer Surplus And Producer Surplus Consumer Surplus 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. 4 - 1 The Demand Curve is Also the Marginal Benefit Curve

5. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 5 of 26 Consumer Surplus and Producer Surplus Consumer Surplus 4 - 2 Total Consumer Surplus in the Market for Chai Tea

6. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 6 of 26 The Consumer Surplus from Satellite Television How much consumer surplus will the owner of this satellite dish receive? 4 - 1

7. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 7 of 26 Consumer Surplus and Producer Surplus Producer Surplus Producer surplus The difference between the lowest price a firm would have been willing to accept and the price it actually receives. Marginal cost The additional cost to a firm of producing one more unit of a good or service. 4 - 3 Producer Surplus

8. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 8 of 26 Consumer Surplus and Producer Surplus What Consumer Surplus and Producer Surplus Measure Consumer surplus measures the benefit to consumers from participating in a market, and producer surplus measures the benefit to producers from participating in a market.

9. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 9 of 26 The Efficiency of Competitive Markets LEARNING OBJECTIVE 2 Marginal Benefit Equals Marginal Cost in Competitive Equilibrium 4 - 4 Marginal Benefit Equals Marginal Cost Only at Competitive Equilibrium

10. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 10 of 26 The Efficiency of Competitive Markets Economic Surplus 4 - 5 Economic Surplus Equals the Sum of Consumer Surplus and Producer Surplus

11. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 11 of 26 The Efficiency of Competitive Markets Deadweight Loss 4 - 6 When a Market Is Not in Equilibrium There is a Deadweight Loss Deadweight loss The reduction in economic surplus resulting from a market not being in competitive equilibrium.

12. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 12 of 26 The Efficiency of Competitive Markets Economic Surplus and 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 where the sum of consumer surplus and producer surplus is at a maximum.

13. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 13 of 26 LEARNING OBJECTIVE 3 4 - 7 The Economic Effect of a Price Floor in the Wheat Market Government Intervention in the Market: Price Floors And Price Ceilings Price Floors: The Example of Agricultural Markets

14. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 14 of 26 Price Floors in Labor Markets: The Minimum Wage 4 - 2 Many economists believe there are better policies than the minimum wage for raising the incomes of low- skilled workers.

15. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 15 of 26 Government Intervention In The Market: Price Floors And Price Ceilings Price Ceilings: The Example of Rent Controls 4 - 8 The Economic Effect of a Rent Ceiling Don’t Confuse “Scarcity” with a “Shortage.”

16. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 16 of 26 What’s the Economic Effect of a “Black Market” for Apartments? 4 - 1 LEARNING OBJECTIVE 3

17. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 17 of 26 Government Intervention In The Market: Price Floors And Price Ceilings The Results of Government Intervention: Winners, Losers, and Inefficiency When the government imposes price floors or price ceilings, three important results occur:  Some people win.  Some people lose.  There is a loss of economic efficiency. 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 make up for the losses to the losers and for the decline in economic efficiency is a matter of judgment and not strictly an economic question.

18. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 18 of 26 Externalities and Efficiency LEARNING OBJECTIVE 4 Externality A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service. The Effect of Externalities 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.

19. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 19 of 26 Externalities and Efficiency HOW A NEGATIVE EXTERNALITY IN PRODUCTION REDUCES ECONOMIC EFFICIENCY 4-9 The Effect of Pollution on Economic Efficiency

20. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 20 of 26 Externalities and Efficiency HOW A POSITIVE EXTERNALITY IN CONSUMPTION REDUCES ECONOMIC EFFICIENCY 4-10 The Effect of a Positive Externality on Efficiency

21. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 21 of 26 Externalities and Efficiency Externalities Can Result in Market Failure Market failure Situations where the market fails to produce the efficient level of output. What Causes Externalities? Property rights The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it.

22. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 22 of 26 Government Solutions to Externalities LEARNING OBJECTIVE 5 4-11 When There is a Negative Externality, a Tax Can Bring About the Efficient Level of Output

23. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 23 of 26 Using a Tax to Deal with a Negative Externality 4-2 LEARNING OBJECTIVE 5

24. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 24 of 26 Government Solutions to Externalities 4-12 When There is a Positive Externality, a Subsidy Can Bring About the Efficient Level of Output Pigovian taxes and subsidies Government taxes and subsidies intended to bring about an efficient level of output in the presence of externalities.

25. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 25 of 26 Government Solutions to Externalities Command and Control versus Tradeable Emissions Allowances 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.

26. © 2007 Prentice Hall Business Publishing; Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien CHAPTER 4: Market Efficiency and Market Failure 26 of 26 Can Tradeable Permits Reduce Global Warming? 4-5 Rapid growth in China has led to rapid increases in CO 2 emissions.