CH4 Microeconomics

LO4.1 Explain consumer surplus, producer surplus, and how properly functioning markets maximize total surplus and allocate resources optimally.

Consumer surplus is the difference between the maximum price that a consumer is willing to pay for a product and the lower price actually paid; producer surplus is the difference between the minimum price that a producer is willing to accept for a product and the higher price actually received.

Graphically, consumer surplus is represented by the triangle under the demand curve and above the actual price. Producer surplus is shown by the triangle above the supply curve and below the actual price.

The combined amount of producer and consumer surplus, or total surplus, is represented graphically by the triangle to the left of the intersection of the supply and demand curves that is below the demand curve and above the supply curve.

At the equilibrium price and quantity in a competitive market, marginal benefit equals marginal cost, maximum willingness to pay equals minimum acceptable price, and total surplus is maximized.

Output levels that are either less than or greater than the equilibrium output create efficiency losses, also called deadweight losses. These losses are reductions in total surplus. Underproduction creates efficiency losses because output is not being produced for which maximum willingness to pay exceeds minimum acceptable price. Overproduction creates efficiency losses because output is being produced for which minimum acceptable price exceeds maximum willingness to pay.

LO4.2 Explain how positive and negative externalities cause under- and overallocations of resources.

Externalities, or spillovers, are costs or benefits that accrue to someone other than the immediate buyer or seller. Such costs or benefits are not captured in market demand or supply curves and therefore cause the output of certain goods to vary from society’s optimal output. Negative externalities (or spillover costs or external costs) result in an overallocation of resources to a particular product. Positive externalities (or spillover benefits or external benefits) result in an underallocation of resources to a particular product.

Direct controls and specifically targeted Pigovian taxes can improve resource allocation in situations where negative externalities affect many people and community resources. Both direct controls (for example, smokestack emission standards) and Pigovian taxes (for example, taxes on the production of toxic chemicals) increase production costs and hence product price. As product price rises, the externality, overallocation of resources, and efficiency loss are reduced because less output is produced.

Government can correct the underallocation of resources and efficiency losses either by subsidizing consumers (which increases market demand) or by subsidizing producers (which increases market supply). Such subsidies increase the equilibrium output, reducing or eliminating the positive externality, the underallocation of resources, and the efficiency loss.

The Coase theorem suggests that under the right circumstances private bargaining can solve externality problems. Thus, government intervention is not always needed to deal with externality problems.

LO4.3 Explain why society is usually unwilling to pay the costs of completely eliminating negative externalities, such as air pollution.

The socially optimal amount of externality abatement occurs where society’s marginal cost and marginal benefit of reducing an externality are equal. With pollution, for example, the optimal amount of pollution abatement is likely to be less than a 100 percent reduction.

Market failures present government with opportunities to improve the allocation of resources and thereby enhance society’s total well-being, but political pressures may make it difficult or impossible to implement an effective solution.

LO4.4 Understand why asymmetric information may justify government intervention in some markets.

Asymmetric information can cause a market to fail if the party with less information decides to withdraw from the market because it fears being exploited by the party with more information. If the party with less information reduces its participation in a market, the reduction in the size of the market may cause an underallocation of resources to the production of the product sold in the market.

The moral hazard problem is the tendency of one party to a contract or agreement to alter their behavior in ways that are costly to the other party. For example, a person who buys insurance may willingly incur added risk.

The adverse selection problem arises when one party to a contract or agreement has less information than the other party and incurs a cost because of that asymmetrical information. For example, an insurance company offering “no medical exam required” life insurance policies may attract customers who have life-threatening diseases.