CECN 104 – Introduction to Microeconomics

CHAPTER 4: Consumer and Producer Surplus, Deadweight Loss

EFFICIENTLY FUNCTIONING MARKETS
COMSUMER SURPLUS
 Marginal benefit the additional benefit from consuming one more unit of a good or
service
 Consumer surplus:
o Benefit surplus received by a consumer or consumers in a market
o Difference between the max price a consumer is willing to pay for a product
(marginal benefit) and the actual price
o A pizza is $10 but at market it is $8 so the producer is making and extra benefit

**Add up all the consumer surplus and you get the market consumer surplus

- Shaded area is the consumer surplus

- When given values you can calculate the
consumer surplus
o (base/height)/2

PRODUCER SURPLUS
 Marginal benefit the additional cost of producing one more unit of a good or service
 Producer surplus:
o Benefit surplus received by a producer or producers in a market
o Difference between the actual cost a producer receives and the minimum
acceptable price(marginal cost) he is willing to sell
 - Shaded area is the producer surplus
o Distance between equilibrium
price and supply curve
- When given values you can calculate the
consumer surplus
o (base/height)/2

ECONOMIC EFFICIENCY
PRODUCTIVE EFFICIENCY:
 Goods produced in the least cost way
 Perfect competition forces firms to produce at the minimum average cost:
Price = Minimum Average Cost
o Unless firms use the best production methods and combinations of inputs, they
will NOT survive
 minimum amount of resources will be used to produce any particular output

ALLOCATIVE EFFICIENCY:
 Use of resources yield mix of goods/services MOST WANTED MY SOCIETY
 Realized when it is impossible to alter the combination of goods and achieve a net gain
for society

COMPETITIVE EFFICIENCY:
Price = Marginal Benefit = Marginal Cost
 Each item is produced to the point at which the value of the last unit is equal to the
value of alternative goods forgone
 - Market is efficient if it MAX the sum of
consumer and producer surplus

- Allocative Efficiency is achieved since CS

and PS are maximized

Efficiency of Competitive Equilibrium

At equilibrium: D= S, MB= MC
 If quantity is too low MB>MC
o Society will gain by producing
more
 If quantity is too high MC>MB
o Society will gain by producing less

Only at competitive equilibrium is the last unit valued by consumers and producers being equal
 economic efficiency

EFFICINCY LOSSES (OR DEAD WEIGHT)

Quantity levels less than efficiency quantity Q*

create efficiency losses
- Loss of consumer surplus
- Producers are also at a loss because they
are not selling the goods they need to sell

 Reduction in economic surplus resulting from market not being in competitive

equilibrium is known as deadweight loss
o Can be thought of as the amount of inefficiency in a market
o In competitive equilibrium, deadweight loss is zero
UNDER PRODUCTION

Quantity levels less than efficiency quantity Q*

create efficiency losses
- Seen by the blue shaded area

OVER PRODUCTION

Quantity levels more than efficiency quantity Q*

create efficiency losses
- Seen by the blue shaded area
- Society is losing because resources are
used inefficiently
 CHAPTER 4: Market Failures- Externalities
MARKET FAILURE
 Occurs when competitive market system:
o Produces the “wrong” amounts (over or under production)of certain goods and
services
o Fails to allocate any resources to the production of certain good/service that
should be produces
TWO SIDES:
DEMAND-SIDE MARKET FAILURE
- Demand curves do not reflect consumers’ full willingness to pay for a good or service

SUPPLY-SIDE MAREKT FAILURE

- Supply curves do not reflect the full cost of producing a good or service

NEGATIVE EXTERNALITY (SPILLOVER COSTS)

 Production or consumption costs inflicted on a third party without compensation
 third party is left with a cost
 Example: environmental pollution
o Presence of spillover costs:
social cost > private cost
o Markets produce more than what the society wants (they don’t take into
account third party costs)
 over-production
POSITIVE EXTERNALITY (SPILLOVER BENEFITS)
 Production or consumption certain goods/service may confer external benefits on third
party or the community at large without compensation
 Example: education (sharing knowledge)
o Presence of spillover benefit:
social benefit > private benefit
o Markets produce less than what the society wants
 under-production
- In both cases, the society suffered deadweight loss (blue shaded areas)
** this is the market failing to produce at optimal produce for society**

ELECTRICITY PRODUCTION (negative externality)

- Market equilibrium results from

the decisions of producers, who
only consider the cost given by S1

- Price (PMarket) is “too low” and

quantity (QMarket) is “too high”: the
cost to society of the additional
electricity exceeds its benefit to
society.

- Deadweight loss results

When there is a negative externality in consuming a good or service, too much of the good
or service will be produced at market equilibrium

COLLEGE EDUCATION MARKET

- People who do not consumer post-secondary education can still benefit from them.
 marginal social benefit > marginal private benefit
 Creates positive externalities
- MSB > MPB

Only marginal private benefit is

represented in the market demand curve
D1, the quantity of college education
produced

- Qmarket is too low

When there is a negative externality in consuming a good or service, too little of the good or
service will be produced at market equilibrium

GLOBAL WARMING AND CLIMATE CHANGE: CONTROVERSIAL ISSUES

 Economy vs Environment
 Production vs Pollution
o More production = more pollution
o No pollution is good for the environment but it will cause the production of
goods and services to decrease
IS ZERO POLLUTION EFFICIENT?
- A non-zero amount of pollution is optimal determined by where the marginal benefit
from pollution is just equal to the marginal cost of pollution
- Or equivalently, the marginal cost of pollution reduction equals the marginal benefit
from pollution reduction

- Total benefits
o A+B
- Total cost
o Area of B
  Technology vs Taxes
 Private solutions vs Public policies

Optimal level of production for society is Qefficent

Marginal benefit + Marginal Social Cost

GOVERNMENT ACTIONS IN CORRECTING EXTERANILITIES

 Taxes and subsidies are possible ways to “correct”
 Known as PIGOVIAN TAXES AND SUBSIDIES (Arthur Pigou)
Pigovian taxes: (MAINLY FOR EFFICIENCIES) increase efficiency while bringing in tax revenue
then(in theory) allows inefficiency-causing taxes in other markets to be reduced, a double
dividend of taxation

Utility companies do not bear cost of

pollution = produce too much

**If government imposes tax internalize

the externality
- S1 shifts to S2

The market equilibrium quantity falls to

efficient level

PRICE CHANGES they now pay Pefficient

TAX= PEFFICIENT – PMARKET

MARKET FAILURE CORRECTION
SPILLOVER COSTS: correction through
- Private bargaining
- Liability rules and lawsuits
- Tax on producers
o Government involvement
o Affects price
- Direct controls through legislation
o Affects quantity
- Market for externality
o Market for trading
SPILLOVER BENEFITS: correction through
- Private bargaining
- Subsidization of consumers and/or producers
- Provision via government

EXTERNALITIES AND PROPERTY RIGHTS

- Incomplete property rights, or from the difficulty of enforcing property rights in certain
situations
- Not clear
Property rights: rights individuals or businesses have to the exclusive use of their property,
including the right to buy or sell it.

Example: supposed a farmer and a paper mill share a stream

**farmer is the third party and being negatively affected**
- If no-one owns the stream, the paper mill will discharge waste into the stream making it
unusable for the farmer
- If the farmer owns the stream, he can
o Prevent the mill from discharging into the stream OR
o Allow the mill to discharge for a fee
 o Either way, good property rights avoid market failure
COASE THEOREM
If transaction costs are low, private bargaining will result in an efficient solution to the problem
of externalities
Transaction costs: cost in time and other resources that parties incur in the process of agreeing
to and carrying out an exchange of goods/services

The Coase theorem requires that

- Parties have full information about the costs and benefits
- Property rights are assigned and enforceable
- All parties willing to accept a reasonable agreement

 Coase’s most important observation was that it did not matter to whom property rights
were assigned

POSITIVE EXTERNALITIES AND CORRECTION

 when there are positive externalities, too little will be produced

Government Policies for positive externalities

- Public production
- Private Subsidy : and amount paid to producers or consumers to encourage the
production or consumption of a good
- Vouchers : provided or households which can be used to buy specified goods or services
Not everyone consumes post-secondary
education BUT it is good for all of us if
other people are smart

Argument for subsidy in the market for

education

Shift from D1 to D2

Student pay price P

SUBSIDY= PEFFICENT - P

ALTERNATIVE TO TAXATION FOR SOLVING EXTERNALITIES

COMMAND AND CONTROL
 involves the government imposing quantitative limits on the amount of pollution firms
are allowed to emit
 requiring firms to install specific pollution-control devices
EXAMPLE: requiring car manufacturers to equip cars with catalytic covers
EMISSION REDUCTION POLICIES
CARBON TAX
 raises cost of polluting, firms will have incentive too reduce production, or to adopt new
technology to reduce emission
 easier to enforce
CAP AND TRADE
 government sets a cap for the total amount of emissions
 government assigns property right to pollute
 rights can then be bought and sold : “market-based” solution
 A LOT OF WORK  needs political backing for success

- government establishes an allowable amount of emissions

- emissions permits are distributed
- firms can trade emissions permits
o firms with high cost reducing pollution will buy permits from firms with low costs
of reducing pollution ensuring that pollution is reduced at the lowest possible
cost
Hence the market is used to achieve efficient pollution reduction
CRITICISM OF CAP AND TRADE
o Environmentalists object to cap and trade  Licenses to pollute
 but pollution has a benefit: allows more production
 production decision uses up some scarce resources(time, natural
resources, clean air, etc.)
 In this sense, paying for using the clean air seems appropriate
o May produce hot-spots, locations where a lot of pollution takes place
 This would be the case if the firms with high cost of pollution-reduction
were geographically close
 CHAPTER 4: Market Failures – Public Goods
ATTRIBUTES OF GOOD/SERVICE
PRIVATE GOODS
- Produced by firms
- Offered for sale in the market
- Efficient
- Characteristics
o Rivalry
o Excludability
Rivalry: situation that occurs when one person’s consuming a unit of a good means no one else
can consume it
Excludability: The situation in which anyone who does not pay for a good cannot consume it
PUBLIC GOODS
Non-rivalry:
- Everyone can simultaneously obtain the benefit of the good, one person’s benefit does
not reduce the benefit available to others
Non-excludability:
- No effective way to exclude individuals from the benefit of the good
Free rider problem: people can receive the benefits without paying for it
o Unprofitable for private firm to produce the good or service
Examples: national defence, environmental protection
QUASI-PUBLIC. GOODS AND COMMON RESOURCES
Quasi-Public Goods:
- Excludable but not rival (two people can use internet at the same time not rivalry)
- Could be provided through the market system
o Example: cable television and internet services
- Presence of positive externalities government provides them
o Example: education, library
Common Resources:
Rival but not excludable  consumption is rival – negative externality
o Example: fishes in the open sea/ forest on public land
no individual has property right to it
no one can be excluded from using it (over consumption)

Avoiding tragedy of commons

1. Community norms and laws
2. Legal restrictions through taxes, quotas, and tradable permits on access to the common

CONTSRUCTING MARKET DEMAND CURVES

PRIVATE GOOD
- Determined by adding horizontally the quantity of the good demanded at each price by
each consumer
PUBLIC GOOD
- Add up the price at which each consumer is willing to purchase at each quantity of the
good

 Once we know the market demand curve, determining the efficient level of production
is the same as for private good
where the demand and supply curves intersect
 But finding market demand curve can be difficult
consumers may not have incentives to reveal their willingness to pay for public good

Optimal quantity of public good is produced where sum of consumer surplus and producer
surplus is maximized When demand curve intersects supply curve

COST-BENEFIT ANALYSIS
Cost (opportunity cost)
- Resources diverted from private good production
- Private goods that will not be produced
Benefit
- Extra satisfaction from the output of more public goods

**government can use cost-benefit to decide whether to produce a good and how much to
produce**

Table shows annual benefit exceeds total annual cost for plans A,B,and C
 some highway construction is economically justifiable
Plan D is not justifiable because the Net benefit is negative