Chapter 4: Market Failures

Honors Econ

Market failure

A market outcome that fails to allocate resources efficiently, causing overproduction, underproduction, or missing production.

Consumer surplus

The difference between a consumer’s maximum willingness to pay and the price actually paid.

Producer surplus

The difference between the price received and the minimum price a producer is willing to accept

Total surplus

Consumer surplus + producer surplus. Efficient output maximizes total social surplus

Surplus areas on a graph

CS is below demand and above price. PS is above supply and below price, over the quantity traded.

Triangle-area formula

Area = ½ base x height. Use it for triangular surpluses or deadweight-loss areas

Deadweight loss

Total surplus is lost because output is inefficiently high or low. A transfer of money alone is not deadweight loss.

Underproduction

occurs when the quantity supplied is less than the quantity demanded at a given price, leading to potential gains from trade that are not realized.

Overproduction

The condition where goods and services are produced in excess of the optimal level, leading to inefficiency and increased deadweight loss.

Externality

An uncompensated cost or benefit affecting someone outside the market transaction

Negative externality

An external cost, such as pollution. Private markets generally produce too much because they ignore part of the social cost

Positive externality

An external benefit, such as vaccination spillovers. Private markets generally produce too little because they ignore part of the social benefit.

Social marginal cost

Private marginal cost + marginal external cost

Social marginal benefit

Private marginal benefit + marginal external cost

Negative-externality graph

A graphical representation illustrating the societal costs incurred from negative externalities, showing the divergence between private and social costs.

Social MC lies above private MC. Efficient quantity is where social MC intersects social MB.

Positive-externality graph

For a positive consumption externality, social MB lies above private demand. The efficient quantity is higher than the private-market quantity

Pigovian tax

A corrective tax designed to make decision-makers account for external costs, ideally equal to marginal external cost at efficient output

Correcting positive externalities

Subsidies to consumers or producers, or public provision, can increase output toward the efficient quantity

Coase theorem

With clear property rights and low transaction costs, private bargaining can resolve an externality efficiently

Limits of private bargaining

Many affected people, costly negotiations, difficult enforcement, and incomplete information can prevent an efficient agreement

Optimal pollution abatement

Reduce pollution until the marginal benefit of the next reduction equals its marginal cost. Zero pollution is not automatically optimal.

Tradable emissions permits

Permits limit total emissions while allowing firms to trade. Firms with lower cleanup costs can reduce more and sell permits

Asymmetric information

One side of a transaction has more relevant information that the other

Adverse selection

Hidden characteristics affect who enters a transaction — for example, high-risk people disproportionately buying insurance

Moral hazard

An agreement changes incentives for hidden actions — for example, someone becoming less careful after obtaining insurance

Responses to information problems

Screening, disclosure, warranties, certification, reputation, monitoring, and incentive contracts