Market Failure

Diagrams

Learning Objective:To understand how to illustrate market failure with

diagrams

Learning Outcome / Success CriteriaDraw over/under productionDraw over/under consumption

This is the diagram that we use to show how the market works

Now assume that there is market failure and the market produces too much

There are negative externalities What curve do we need to add and

where?

Price

Quantity

D

S

Q*

P*

Q* = socially optimum quantityP* = socially optimum price

When it is firms that are producing too much we need to add another supply curve

Where do we need to add it to show too much production (more Q?)

More = Right – Add curve to the right (S1) Note that we do not talk about this being a shift

– this is just adding a curve to illustrate market failure

Now we talk about movement….. If there is too much production govt needs to

get S1 to shift inwards (left) and get closer to the socially optimum of Q*

How can we get supply curves to shift to the left?

Increase the firm’s costs

Price

Quantity

D

S

Q1

S1

Q*

Q* = socially optimum quantityP* = socially optimum price

So government needs to find a way to force supply to decrease

Or increase firm’s costs to reduce the overproduction

How could it do that? Introducing pollution permits

Price

Quantity

D

S

Q1

S1

Q*

Q* = socially optimum quantityP* = socially optimum price

Time for you to draw Draw an overproduction diagram on

your white boards

Back to our perfect market diagram This time we are going to change it so that there is market

failure and the market produces too little – positive externality

What curve do we need to add and where?

Price

Quantity

D

S

Q*

P*Q* = socially optimum quantityP* = socially optimum price

When it is firms that are producing too little it is the supply curve that needs to be added

To get closer to the socially optimum which way does the supply curve need to shift?

MoRe – Right What makes the curve shift to the right? A decrease in the firm’s costs

Price

Quantity

D

S

Q1

S1

Q*

So government needs to either make it produce more Or decrease it’s costs How could it do that? A subsidy

Price

Quantity

D

S

Q1

S1

Q*

Time for you to draw Draw an under-production diagram on

your white boards

Back again to our perfect market Now assume that there is market failure and the market

consumes too much This is a market for demerit goods Which curve needs to be added and

where?

Price

Quantity

D

S

Q*

P*

When we think of consumption we need to think of the demand curve

If the market is consuming too much we need to add a demand curve to show too much Q (Q1)

If government wants to reduce the market failure which way does it need to shift the demand curve?

We need to get less consumption less - left Price

Quantity

D1

S

Q1

D

Q*

Government needs to do something to shift demand What can it do? It could educate This would shift demand What else?

Price

Quantity

D1

S

Q1

D

Q*

It could also increase the price which would cause a contraction of demand.

How? It could place an indirect tax on the product This would shift the supply curve The price would increase Demand would contract to Q* Could government actually reduce it to Q*? Probably not because the tax would need to be so

high that it might put the cigarette companies out of business

It can still reduce the market failure

Price

Quantity

D

S

Q1

P1

S1

Q*

P*

Time for you to draw Draw an over-consumption diagram on

your white boards

Back again to our perfect market Now assume that there is market failure and the market

consumes too little This is a market for merit goods Which curve needs to be added

and where?

Price

Quantity

D

S

Q*

P*

If the market is consuming too little we need to add a demand curve

Where? There is not enough consumption so we need to add to the

left (we need to illustrate less Q)

Price

Quantity

D1

S

Q1

D

Q*

Government needs to do something to shift demand What can it do? It could educate This would shift demand Giving more Q (Q*) What else?

Price

Quantity

D1

S

Q1

D

Q*

It could also decrease the price which would cause an extension of demand.

How? It could subsidise the product/service This would shift the supply curve The price would decrease Demand would extend to Qso Could government subsidise enough to get

to Qso?

Price

Quantity

D

S1

Q*

P1S

Q1

P*

Time for you to draw Draw an under-consumption diagram

on your white boards

Time for you to draw Draw the following

Over-consumption Under consumption Over production Under production

Learning Objective:To understand how to illustrate market failure diagrams

with the proper notation

Learning Outcome / Success CriteriaDraw over/under production diagrams Successfully answer a 10 mark

question

When we draw market failure diagrams we change the labelling slightly

Often the price axis becomes costs and benefits (there is no penalty for leaving at Price)

The supply curve is the Marginal Social Cost curve (MSC) The demand curve is the Marginal Social Benefits curve (MSB)

Costs & Benefits

Quantity

MSB

MSC

Q*

P*

Marginal Social Cost (Remember we associate supply with costs)

Marginal Social Benefits (Remember we associate demand with benefits)

When the market is working properly we have allocative efficiency

The perfect market with the socially optimum output (Q*) The Marginal Social Costs equal the Marginal Social Benefits Consumer surplus and Producer Surplus are maximised

Too much production happens because the firms only think about their private costs (Marginal Private Costs)

They think about their profit They are profit maximisers They don’t think about the cost to third parties

(external costs) The marginal social costs are larger

than the marginal private costs

Costs & Benefits

Quantity

MSB

MSC

Q1

P1

MPC

Q*

P*

The external cost in this case is what? It is the pollution to those not involved in the

production The external cost is the vertical distance

between the MPC and MSC curve EC is the negative externality MPC + EC = MSC When MPC is not equal to MSB there is market

failure

Costs & Benefits

Quantity

MSB

MSC

Q1

P1

MPC

Q*

P*

EC

When MPC is not equal to MSC there is market failure

So Government can use the market to fix the failure

It can try to make MPC equal to MSC They increase the private costs

by making the firms pay for the pollution permits

Costs & Benefits

Quantity

MSB

MSC

Q1

P1

MPC

Q*

P*

EC

When there are negative externalities there is welfare loss We can illustrate this using this diagram The turquoise triangle shows the size of the welfare loss

Remember that when you draw the welfare loss for a negative externality it points towards the zero (think of a number line – the negative numbers are behind the zero – the triangle points towards the negative numbers!!

By taxing the firm The marginal private costs increase The supply decreases The quantity reduces from Q1 to Q2 The welfare loss is decreased The turquoise triangle is decreased The quantity is closer to Q*

The socially optimum amount is Q* but to get this amount government would have to accurately measure the external cost (the pollution) and also the tax may be so large that firms may exit the market

Q2 is still better than Q1

Time for you to draw Draw a negative externality diagram on

your white boards

This diagram illustrates a positive externality The socially optimum amount is Q* Firms in this market are not producing

enough This time they are only thinking about

their benefits and not the benefits to society

There is potential welfare gain if more is produced (turquoise triangle)

Remember that when you draw the welfare loss for a positive externality it points away from zero (think of a number line – the positive numbers are in front of the zero – the triangle points towards the positive numbers!!

Time for you to draw Draw a positive externality diagram on

your white boards

Learning Objective:To understand how to illustrate over and under

consumption market failure with diagrams

Learning Outcome / Success CriteriaDraw over/under consumption Successfully answer a 10 mark

question

This diagram illustrates a negative externality in consumption

Too much consumption of a demerit good Consumers are only thinking about their

costs and benefits There is welfare loss that needs to

be reduced

Again the triangle is pointing to the negative!

With either of these solutions the triangle will reduce

The socially optimum amount is Q* but to get this amount government would have to accurately measure the external costs/benefits. To reduce the triangle (rather than remove it) and have a quantity less than Q1 will be an improvement

Time for you to draw Draw a positive externality diagram on

your white boards

This diagram illustrates a positive externality in consumption

Too little consumption of a merit good Consumers are only thinking about their

costs and benefits There is potential welfare gain

Again the triangle is pointing to the negative!

Positive externality points to the positive!

With either of these solutions the triangle reduces

The socially optimum amount is Q* but to get this amount government may have to pay large subsidies (opportunity cost). To reduce the triangle (rather than remove it) and have a quantity more than Q1 will be an improvement

Learning Objective:To understand how to illustrate market failure with

diagrams Learning Outcome / Success Criteria

Draw over/under productionDraw over/under consumption

Did we achieve these?