Chapter 3 Market Failure 3 1 Market Failure

Chapter 3 – Market Failure 3. 1 Market Failure 3. 2 Utility Maximisation 3. 3 Consumer Surplus 3. 4 Producer Surplus 3. 5 Consumer and Producer Surplus in Equilibrium 3. 6 Market Failure Apply Economic Principles to Work in the Financial Services Industry 1

Market Failure Market failure is a situation where the market does not produce a socially efficient outcome. Factors that cause market failure include: • Pricing that does not account for externalities, • A lack of competition between suppliers. Apply Economic Principles to Work in the Financial Services Industry 2

Utility Maximisation Utility is a measure of the satisfaction or benefit a consumer gets from consuming a good or service. A rational thinking consumer will attempt to maximise utility (satisfaction). Apply Economic Principles to Work in the Financial Services Industry 3

Consumer Surplus Consumer surplus is the monetary benefit that buyers get from participating in a market. Consumer surplus arises when consumers purchase a good at a price lower than their willingness to pay for that good. Consumer surplus = willingness to pay – actual price consumer surplus is the area under the demand curve above the price (see following diagram). Apply Economic Principles to Work in the Financial Services Industry 4

Consumer Surplus Apply Economic Principles to Work in the Financial Services Industry 5

Consumer Surplus We can calculate the size of the consumer surplus by working out the area of the triangle. A lower price will increase consumer surplus A higher price will reduce consumer surplus. Apply Economic Principles to Work in the Financial Services Industry 6

Producer Surplus Producer surplus reflects the monetary benefit that producers get from participating in a market. Producer surplus = price of a good – cost of producing the good The cost of producing the good includes the opportunity cost. Apply Economic Principles to Work in the Financial Services Industry 7

Producer Surplus Apply Economic Principles to Work in the Financial Services Industry 8

Producer Surplus Producer surplus is the area above the supply curve and under the price. See example pg. 95 Apply Economic Principles to Work in the Financial Services Industry 9

Consumer and Producer Surplus in Equilibrium Apply Economic Principles to Work in the Financial Services Industry 10

Can Society do Any Better Than Equilibrium? The higher total surplus, the better off society. Can society do any better than equilibrium? To find out, we examine what happens to total surplus when the market moves away from equilibrium. Apply Economic Principles to Work in the Financial Services Industry 11

Price Above Equilibrium Apply Economic Principles to Work in the Financial Services Industry 12

Price Above Equilibrium The higher price reduces consumer surplus. Consumers will consume less as the good is now more expensive. This results in a movement up the demand curve (to the left). Producers will produce more output as producing is now more profitable. This results in a movement up the supply curve (to the right). The difference between what producers will supply and consumers will demand is oversupply. Apply Economic Principles to Work in the Financial Services Industry 13

Price Above Equilibrium The triangle labelled deadweight loss is lost surplus. As a result of the deadweight loss, total surplus is lower than it was in equilibrium. Therefore, this outcome is less beneficial for society than if price was at equilibrium price. Apply Economic Principles to Work in the Financial Services Industry 14

Price Below Equilibrium Producers produce less than they did at equilibrium because of the lower price (movement down the supply curve to the left). Consumers will want to consume more of the good as it is now cheaper (movement down the demand curve to the right). Many consumers who want to consume cannot as supply is less than demand. As a result the market will be undersupplied. There will be a deadweight loss and a reduction in total surplus. (an inefficient outcome) Apply Economic Principles to Work in the Financial Services Industry 15

Equilibrium is Efficient Any price above equilibrium results in a worse outcome for society than the equilibrium price. Any price below equilibrium does likewise. So the best outcome for society is the equilibrium price and quantity. Therefore equilibrium is an efficient outcome. Apply Economic Principles to Work in the Financial Services Industry 16

Types of Market Failure In the presence of externalities When income is distributed unequally Market failure is a situation where the market does not produce a socially efficient outcome. When there is a lack of public goods When there is not enough competition Apply Economic Principles to Work in the Financial Services Industry 17

Externalities are a cost or benefit of economic activity incurred by people not directly involved in that activity. A positive externality is any social benefit that occurs through a market transaction that was not priced into the original transaction. Examples: –House renovations making a street look nicer –Education reducing crime Apply Economic Principles to Work in the Financial Services Industry 18

Negative Externalities that have a negative impact on society or bystanders outside the transaction. • Pollution is the most common example. • Firms may not have to pay for the full cost of the pollution they create. • Anyone living near a firm may experience the negative effects of breathing polluted air, whether they buy anything from the firm or not. Apply Economic Principles to Work in the Financial Services Industry 19

Negative Externalities Continued • For goods with negative externalities there are private costs and a public costs of producing. • Markets will only force producers to pay the private costs. • The public costs associated with pollution are health care for those who get sick, costs of cleaning waterways, rivers etc. • Prices will be too low as consumers face a price that does not reflect the public costs of producing. • See diagram pg. 103. Apply Economic Principles to Work in the Financial Services Industry 20

Government Responses to Negative Externalities • A Pigovian tax is a tax imposed that is equal in value to the negative externality. • This prices the negative externality into the market and provides an incentive for firms to reduce the public effect of their actions. • For example, cigarettes are taxed to reflect the costs to the health care system when people contract cancer. By imposing a tax the price of cigarettes includes both the private and public cost of producing. • In some cases the monetary values of externalities can be difficult to quantify, therefore, hard to know the size of the Pigovian tax to implement. Apply Economic Principles to Work in the Financial Services Industry 21

Carbon Tax • A carbon tax is a Pigovian Tax. • The government sets a price per tonne on carbon dioxide emissions. This raises a firm’s price of production. • Households received a cut in income tax to make the effect of the carbon tax on income neutral. • However, energy consumption is now relatively more expensive than other goods, so consumers will attempt to consume less energy. • Firms will look to cut their carbon emissions and therefore their tax liabilities by finding less carbon intensive production methods. Apply Economic Principles to Work in the Financial Services Industry 22

Emissions Trading Scheme (ETS) • Under an ETS firms are given an allocation of carbon permits and are allowed to emit carbon dioxide only up to the amount of permits they hold. • Firms can buy and sell permits in a carbon permits market. • The price of carbon permits will rise and fall according to supply and demand in this way an efficient equilibrium price for emitting carbon dioxide should be maintained, thus eliminating the negative externality. • Australia is moving towards establishing an ETS in 2015. Apply Economic Principles to Work in the Financial Services Industry 23

Public Goods that are provided by the government, or are not privately owned (parks, libraries, hospitals). A free rider problem is when people can use goods without having to pay for them. Private firms will not produce goods with a free rider problem as they cannot force users to pay, so governments must provide them. Public Goods A lack of public goods is a form of market failure. Apply Economic Principles to Work in the Financial Services Industry 24

Lack of Competition If there is not enough competition in a market equilibrium may not be achieved by the market on its own. Competition drives prices down to equilibrium. Therefore, a lack of competition cause market failure. Apply Economic Principles to Work in the Financial Services Industry 25

Income Inequality between Citizens Income inequa lity refe to the market's rs sometime inab distribute wealt ility to h equa among market lly participants. If som very r e citizens a ic r very p h and othe e rs oo less d r this is a outco esirable every me than i reaso one earned f nable incom a e. Apply Economic Principles to Work in the Financial Services Industry 26