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AP Microeconomics – Chapter 5
Outline
I. Learning Objectives—In this chapter students should learn:
A. How to differentiate demand-side market failures and supply-side market failures.
B. The origin of consumer surplus and producer surplus, and how properly functioning
markets maximize their sum and total surplus, while optimally allocating resources.
C. Why free riding occurs with public goods, and illustrate why private firms cannot
normally produce public goods.
D. How positive and negative externalities cause under- and over allocations of
resources.
E. Why we normally won’t want to pay what it would cost to eliminate every last bit of a
negative externality such as air pollution.
II. Market Failure
A. Market failure occurs when the competitive market system produces the “wrong”
amounts of certain goods or services or fails to provide any at all.
B. Demand-side market failures happen when demand curves do not reflect consumers’
full willingness to pay for a good or service.
C. Supply-side market failures occur when supply curves do not reflect the full cost of
producing a good or service.
III. Efficiently Functioning Markets
A. Consumer Surplus
1. Definition—the difference between the maximum price a consumer is willing to
pay for a product and the actual price.
2. The surplus, measurable in dollar terms, reflects the extra utility gained from
paying a lower price than what is required to obtain the good.
3. Consumer surplus can be measured by calculating the difference between the
maximum willingness to pay and the actual price for each consumer, and then
summing those differences.
4. Consumer surplus is measured and represented graphically by the area under the
demand curve and above the equilibrium price (Figure 5.1).
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AP Microeconomics – Chapter 5
Outline
Use the formula for calculating the area of a triangle (1/2 base times height) to
find the area of consumer surplus.
5. Consumer surplus and price are inversely related—all else equal, a higher price
reduces consumer surplus.
B. Producer Surplus
1. Definition—the difference between the actual price a producer receives and the
minimum acceptable price.
2. Producer surplus can be measured by calculating the difference between the
minimum acceptable price and the actual price for each unit sold, and then
summing those differences.
3. Producer surplus is measured and represented graphically by the area above the
supply curve and below the equilibrium price (Figure 5.2).
Use the formula for calculating a triangle (1/2 base times height) to find the area
of producer surplus.
4. Producer surplus and price are directly related—all else equal, a higher price increases
producer surplus.
IV. Efficiency Revisited and Efficiency (Deadweight) Losses
A. Efficiency is attained at equilibrium, where the combined consumer and producer
surplus is maximized (Figure 5.3).
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AP Microeconomics – Chapter 5
Outline
1. Consumers receive utility up to their maximum willingness to pay, but only have
to pay the equilibrium price.
2. Producers receive the equilibrium price for each unit, but it only costs the
minimum acceptable price to produce.
3. Productive efficiency occurs at equilibrium, because competition forces firms to
produce at the lowest cost per unit.
4. Allocative efficiency occurs at the quantity where three conditions exist:
a. Marginal Benefit = Marginal Cost
b. Maximum willingness to pay = minimum acceptable price
c. Combined consumer and producer surplus is at a maximum
B. Efficiency (Deadweight) Losses
1. Underproduction reduces both consumer and producer surplus, and efficiency is
lost because both buyers and sellers would be willing to exchange a higher
quantity (Figure 5.4a).
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AP Microeconomics – Chapter 5
Outline
2. Overproduction causes inefficiency because at quantities greater than the
equilibrium quantity, it costs society more to produce the good than it is worth to
the consumer in terms of willingness to pay (Figure 5.4b).
V. Public Goods
A. Private goods are produced and sold in competitive markets and have two
characteristics:
1. Rivalry in consumption—when one person buys and consumes a good, it is not
available to others.
2. Excludability—sellers can keep people who do not pay for a product from
obtaining its benefits.
B. Market demand for private goods is found by horizontally summing the individual
demand schedules.
C. Private markets allocate goods and resources efficiently; those willing to pay to obtain
goods get them. Sellers produce goods to satisfy consumer wants, and consumer
behavior tells them whether to produce more or less of any particular good.
D. Unlike private goods, public goods are those goods that are nonrival and
nonexcludable.
1. National defense is a good example of a public good. Increased national security is
there for all to enjoy whether or not they paid for it.
2. Other examples include flood control and public health.
3. Public goods suffer from the free-rider problem, where a consumer can enjoy the
benefit of the good without having to pay for it. As a result, firms cannot
profitably provide public goods, and the market fails.
E. The demand for public goods differs from the market demand for private goods.
1. It is a “phantom” demand, because consumers will not be making individual
purchases.
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AP Microeconomics – Chapter 5
Outline
3. To find the collective demand schedule for a public good, we add the prices
people collectively are willing to pay for the last unit of the public good at each
quantity demanded (Table 5.3).
4. Figure 5.5 is a graphical illustration of this table. A collective demand curve is the
vertical sum of the individual demand curves for the public who want that good.
(Recall that the market demand for a private good was a horizontal summation of
the individual demand curves.)
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AP Microeconomics – Chapter 5
Outline
F. The supply curve for any good is its marginal cost curve. As with private goods, the
law of diminishing returns applies to the supply of public goods.
G. The optimal quantity of a public good is at the intersection of the collective demand
(marginal benefit) curve and the supply (marginal cost) curve. It can also be found
where marginal benefit equals marginal cost on the supply and demand schedules.
H. Cost-benefit analysis is a technique for decision making in the public sector.
1. The concept involves comparing the benefit of providing incremental units of
public goods with the costs of providing these additional units. Note that the
comparison is a marginal one (i.e., the comparison is made between the costs and
benefits of additional amounts of a public good or service).
2. Table 5.4 illustrates this concept in determining the scope of a national highway
construction project. Four possible phases of projects are considered, with costs
and benefits compared. By comparing the marginal costs and benefits as one
moves from the least expensive phase to the most expensive phase, you see Plan
C is the optimal choice.
3. The rule for this decision-making technique is to use the marginal benefit =
marginal cost rule; if the marginal cost exceeds the marginal benefit, that part of
the project should not be included.
4. The problem with this technique is the difficulty in measuring costs and benefits.
Benefits are particularly difficult to estimate, because there are many related
aspects that are not easily calculated. Nevertheless, the method is widely used.
5. Government provides public goods and quasi-public goods and services.
a. Private producers are not able to find enough paying buyers for public goods
because of the free-rider problem. Therefore, public goods are not produced
voluntarily through the market, but must be provided by the public sector
and financed by compulsory taxes.
b. Quasi-public goods are those that have large positive externalities, so
government sponsors their provision. Otherwise, they would be
underproduced. Medical care, education, and public housing are examples.
c. Resources are reallocated from private to public use by levying taxes on
households and businesses, thus reducing their purchasing power and using
the proceeds to purchase public and quasi-public goods. This can bring about
a significant change in the composition of the economy’s total output.
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AP Microeconomics – Chapter 5
Outline
I. Consider This … Street Entertainers
1. Street entertainers regularly appear in popular tourist areas in major cities. Even
though some people pay when the “hat is passed,” many benefit from the shows
without contributing to pay for the cost (free-riding).
2. Some street entertainers involve audience members or use “pay for performance”
in an attempt to reduce the free-rider problem, but the problem continues to
exist.
VI. Externalities
Figure 5.6
A. Externalities occur when some of the benefits or costs of production are not fully
reflected in market demand or supply schedules. Some of the benefits or costs of a
good may “spill over” to third parties.
B. Negative externalities are supply-side market failures, which occur when producers
do not take into account the costs that their negative externalities impose on others.
1. An example of a negative externality (or external cost) is pollution, which allows
polluters to enjoy lower production costs because the firm is passing along the
cost of pollution damage or cleanup to society. Because the firm does not bear
the entire cost, it will overallocate resources to the production of goods (Figure
5.7a).
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AP Microeconomics – Chapter 5
Outline
2. Correcting for negative externalities requires that government get producers to
internalize these costs (Figure 5.7b).
a. Direct controls place limits on the amount of the offensive activity that can
occur. Clean air and water legislation are examples. The effect is to force the
offenders to incur costs associated with pollution control. This should shift
the product supply curve leftward and reduce the equilibrium quantity.
Therefore, it should reduce the resource allocation in a socially optimal way.
b. Specific taxes can be levied on polluters. The tax payment will increase costs to
the producer, shifting the product supply curve leftward, and reducing
resource allocation to this type of production.
Sarver
AP Microeconomics – Chapter 5
Outline
C. Positive externalities are demand-side market failures, which occur when market
demand fails to include the willingness to pay of third parties who receive benefits
caused by the positive externality.
1. Examples of positive externalities include public health vaccinations and
education. Because some of the benefits accrue to others, individuals will
demand too little for themselves, and resources will be underallocated by the
market (Figure 5.8a).
2. Correcting for positive externalities requires that the government somehow
increase demand or supply to increase benefits to socially desirable amounts.
a. Buyers can be subsidized. This increases the demand and the quantity
produced, eliminating the underallocation of resources (Figure 5.8b).
b. Producers can be subsidized. This reduces the producers’ costs of production,
increasing the supply and eliminating the underallocation of resources
(Figure 5.8c).
c. The government could provide the product as a public good where spillover
benefits are extremely large. An example would be administering free
vaccines to all children in India to end smallpox.
D. Table 5.5 reviews the methods for correcting externalities.
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AP Microeconomics – Chapter 5
Outline
E. Society’s optimal amount of externality reduction is not necessarily total elimination.
1. The cost of reducing spillover costs increases with each additional unit of
reduction. The benefit received from each additional unit of reduction decreases
due to diminishing marginal utility.
2. In general, the marginal benefit of reducing the next unit of pollution should
equal the marginal cost of reducing that unit of pollution. At this point, society
has found its optimal amount of pollution abatement (Figure 5.9).
3. In reality, it is difficult to measure benefits as well as costs, but this analysis
demonstrates that some degree of pollution may be socially efficient.
F. Another approach to reducing the externality or misallocation problem is the market
approach of individual bargaining.
1. The Coase theorem, named after Nobel prize-winning economist Ronald Coase,
suggests that government may not be needed to remedy external costs and
benefits when property rights are clearly defined, few people are involved, and
bargaining costs are negligible.
2. The Coase theorem has limitations, because many externalities affect large
numbers of people and bargaining is too costly and inefficient to find solutions
effectively.
G. Another corrective approach is the development of markets for externality rights,
known as “cap and trade” systems. This is the latest policy innovation for dealing
with pollution abatement.
1. A pollution control agency decides the acceptable amount of pollution in a
particular region and creates permits that firms can purchase to allow them to
pollute. Each permit allows a certain amount of pollution. The total supply of
permits is perfectly inelastic.
Sarver
AP Microeconomics – Chapter 5
Outline
2. The demand for permits should be downward sloping. At high prices, polluters
will either stop polluting or pollute less by acquiring pollution-abatement
equipment, which is more attractive when the permits are more expensive.
3. With the given supply and demand for permits, an equilibrium price will be
established for each permit to pollute.
4. The advantage to a “cap and trade” system is that it reduces society’s costs
because pollution rights can be bought and sold. Some firms will find it cheaper
to buy the rights than to acquire abatement equipment; other firms can sell their
rights because they may be able to reduce pollution at a lower cost. In both
situations, the firms reduce their cost below what the cost would have been
under direct controls.
5. The disadvantages are the costs of monitoring all firms, the level of cheating that
has occurred in existing programs, and the ability of politically-connected
polluters to gain exemptions and free permits. As a result, many economists have
concluded that a “cap and trade” system would not be the most effective system
for reducing CO2 emissions in the United States.
VII. Government’s Role in the Economy
A. Government carries out its economic functions within a political context (and the
constraints on activity that come with that).
B. In attempting to balance and satisfy both political and economic objectives,
government may end up over- or under-regulating, or over- or under-providing
public goods.
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