ECA502: Introduction to Microeconomics - Lecture 13: Welfare and Market Failure

Social welfare $W$ is the sum of consumer surplus (CS) and producer surplus (PS): $W = CS + PS$ .
Competitive markets typically maximize welfare, but this assumes no externalities, public goods, or information asymmetries.
Deadweight Loss (DWL) is the net reduction in total welfare from underproduction or overproduction.

Consumer surplus is the benefit a consumer receives from consuming a good, measured as the maximum price they are willing to pay minus the actual price.
Graphically, it is the area under the demand curve and above the market price, up to the quantity purchased.
A price increase reduces consumer surplus, while a price decrease increases it.

Producer surplus is the monetary difference between the price at which a producer sells a unit and the minimum price necessary to produce it, also equal to $TR – VC$ .
Graphically, it is the area above the supply curve and below the market price, up to the quantity produced.
An increase in market price increases producer surplus, and vice versa.

Competition maximizes welfare when price equals marginal cost ( $P = MC$ ).
Deadweight loss (DWL) results from both underproduction and overproduction.
Underproduction occurs when P > MC, indicating consumers value the product more than its cost.
Overproduction occurs when P < MC, indicating production cost exceeds consumer valuation.

Market Failure occurs when unregulated markets fail to maximize social welfare.
This often necessitates government intervention.
Market efficiency occurs where $P = MC$ , ensuring marginal private benefit (MPB) equals marginal private cost (MPC).
Social efficiency occurs where marginal social benefit (MSB) equals marginal social cost (MSC).
Market failures include market power, externalities, non-private goods, and information asymmetry.

Monopolies lead to underproduction and higher prices compared to competitive markets.
This results in a deadweight loss because P > MC, indicating allocative inefficiency.

Externalities are costs or benefits affecting parties not directly involved in a transaction, creating a divergence between private and social costs/benefits.
Negative externalities lead to overproduction, while positive externalities lead to underconsumption.
Solutions involve taxes, subsidies, or regulations.

Negative Production Externality: MSC > MPC, leading to overproduction (e.g., factory pollution).
Positive Production Externality: MSC < MPC, leading to underproduction (e.g., re-forestation).
Negative Consumption Externality: MSB < MPB, leading to overconsumption (e.g., loud music).
Positive Consumption Externality: MSB > MPB, leading to underconsumption (e.g., vaccinations).

Economic goods are categorized into Private, Club/Toll, Common Resources and Public Goods.
Club/Toll Goods: Excludable but non-rivalrous up to capacity; inefficient exclusion occurs when prices are too high(e.g., toll roads).
Common Resources: Non-excludable but rivalrous; the tragedy of the commons results from overuse (e.g., fisheries).
Public Goods: Non-excludable and non-rivalrous; the free-rider problem leads to under-provision (e.g., national defense).

Information asymmetry occurs when one party has more information than the other, leading to adverse selection.
Solutions include screening, signaling, and regulation.