Hubbard Efficiency and Market Failure

PowerPoint
to accompany
Chapter 5
Economic
Efficiency and
Market Failure
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.
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia
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
Consumer Surplus and Producer

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

Surplus
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.
The supply curve shows marginal cost:
Figure 5.3a
Price
(dollars per
cup) Producer surplus on the Supply
40th cup sold.
$2.00
The marginal cost
$1.80 of producing the
50th cup is $2.00.
The marginal cost

of producing the
40th cup is $1.80.
0
per week)
Total producer surplus in the market for chai
tea: Figure 5.3b
Price Total producer
(dollars per surplus from selling
cup)
chai tea Supply
$2.00
0
per week)
What Consumer Surplus and

Producer Surplus Measure?
 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.
The Efficiency of Competitive

Markets
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.
Marginal benefit equals marginal cost only at
competitive equilibrium: Figure 5.4
Marginal benefit = $2.20,
Price (dollars marginal cost = $1.80,
per cup) therefore output is
inefficiently low. Supply
Marginal benefit = $1.80,

marginal cost = $2.20,
$2.20 therefore output is
inefficiently high.
$2.00
Both marginal benefit
$1.80 and marginal cost =
$2.00, which means
an economically
efficient output level.
Demand
0
14 000 15 000 16 000 Quantity (cups
per week)
Economic surplus equals the sum of consumer
surplus and producer surplus: Figure 5.5
Price
(dollars per Consumer
cup) surplus
Supply
$2.00
Producer Demand
surplus
0
per week)
Deadweight loss: Figure 5.6
The Efficiency of Competitive

Markets
 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.
Government intervention in the

market
Pricefloor: A legally determined
minimum price that sellers may receive.
Price
ceiling: A legally determined
maximum price that sellers may receive.
Price Floor: Figure 5.7
Price
(dollars per Consumer surplus
bushel) transferred to producers S
Price floor
Surplus
$3.50 wheat
A
B Deadweight loss
$3.00 =B+C
C
D
0 1.8 2.0 2.2 Quantity (billions of
bushels per year)
Price Ceiling: Figure 5.8
Price
(dollars per Producer surplus
month) transferred from
S
landlords to renters
Deadweight loss
=B+C
B
$1500
C Rent control
A price ceiling
$1000
Shortage of
apartments
D
0 1 900 000 2 000 000 2 100 000 Quantity
(apartments per
month)
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.
Price floors and price ceilings

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.
The economic impact of taxes

 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 effect of a tax on the market for
cigarettes: Figure 5.9
Price the $1.00 per pack federal
Price consumers S2 tax on cigarettes shifts
(dollars per pay after the the supply curve up by
pack) $1.00 tax is $1.00.
imposed
S1
$2.90
Deadweight loss
or excess burden
2.00 from tax
1.90
Price Tax
received by revenue
producers
after paying Demand
the tax
0
3.7 4 Quantity of cigarettes
(billions of packets
per year)
The Economic Impact of Taxes

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 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, it’ll 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.
1http://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
D
(dollars S1
per litre)
S2
$1.50 5 cents per litre

excise reduction
$1.45
shifts the supply
curve down
0 19 Quantity (billions of litres per

year)
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.
Government Solutions to
Externalities
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.
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.
When there is a negative externality, a tax can bring
about the efficient level of output: Figure 5.12
Price of S2 = social cost
electricity and private cost
after tax
Market S1 = private
equilibrium cost before
with tax tax
Cost of pollution =
P2 amount of tax imposed
by government
P1
Market
equilibrium
without tax
Demand
0
Q2 Q1 Quantity of electricity
When there is a positive externality, a subsidy can
bring about the efficient level of output: Figure 5.13
Price of
university Positive externality =
education amount of subsidy
Supply
Market equilibrium
P2 with subsidy =
efficient equilibrium
P1
Market
equilibrium D2 = social benefit
without and private benefit
subsidy after subsidy
D1 = private benefit
before subsidy
0
Q1 Q2 Quantity of university
education
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.
Key Terms
 Black market  Pigovian taxes and
subsidies
 Command and control
approach  Price ceiling
 Consumer surplus  Price floor
 Deadweight loss  Private benefit
 Economic efficiency  Private cost
 Economic surplus  Producer surplus
 Externality  Social benefit
 Marginal benefit  Social costs
 Marginal cost  Tax incidence
 Market failure
Get Thinking!
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?
Check Your Knowledge
Q1. Refer to the figure below. The graph shows an
individual’s 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.
Q1. Refer to the figure below. The graph shows an
individual’s 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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PowerPoint

4. Use demand and supply graphs to analyse

5. Define positive and negative externalities

6. Analyse government policies to achieve

Consumer Surplus and Producer

Consumer surplus: The difference

Consumer Surplus and Producer

Producer surplus: The difference

The marginal cost

What Consumer Surplus and

 Consumer surplus measures the net benefit

 Producer surplus measures the net benefit

The Efficiency of Competitive

Marginal benefit = $1.80,

The Efficiency of Competitive

 Equilibrium in a competitive market results in

Government intervention in the

Price floors and price ceilings

Price floors and price ceilings

The economic impact of taxes

The Economic Impact of Taxes

The Economic Impact of

 No, the incidence of the tax does not

Do consumers receive the entire benefit of a sales

The Hon Dr Brendan Nelson MP, a former Leader of

Solving the problem:

STEP 1: Review the section ‘Tax incidence: Who actually pays

STEP 3: Use the graph to evaluate the statement.

$1.50 5 cents per litre

0 19 Quantity (billions of litres per

Externalities and Efficiency

 Private cost: The cost borne by the producer of a

 Private benefit: The benefit received by the

Command and control approach: Government-

 Tradeable emissions allowances: The

 Identify the possible outcomes of this

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