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Market Efficiency, Market Failure,
and Government
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Slides By: Solina Lindahl
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Overview
After studying this chapter, you should be able to:
• Understand how markets allocate resources.
• Define the conditions needed for markets to be efficient.
• Understand how markets impose discipline on producers
and consumers.
• Understand and be able to use the concepts of consumer
and producer surplus.
• Understand what market failure is, and when it occurs.
• Describe the different types of market failure.
• Understand the history of the changing landscape between
free markets and government intervention.
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Food for Thought….
Some good blogs and other sites to get the juices flowing:
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Efficient Market Requirements
To function efficiently, a market must
exhibit the following:
• Accurate information is widely
available
• Property rights are protected
• Contract obligations are enforced
• There are no external costs or
benefits
• Competitive markets prevail
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Property Rights
Property rights: The clear
delineation of ownership of
property backed by government
enforcement.
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The Discipline of Markets
• Markets channel the self-interest of
producers and consumers into an
efficient, ordered economy.
• Markets ration the limited
resources toward those goods
society wants most.
• Prices are the signal.
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The Market System
Prices signal to
resources exactly
WHERE they are most
valued
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Ponder this:
What is the value of your college
degree to you?
What does a Bachelor’s Degree
signal to your future employers?
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Measuring Market Efficiency
Markets are efficient: we can
measure their benefit to society by
measuring:
• Consumer surplus
• Producer surplus
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Consumer Surplus
Consumer surplus: The difference
between market price and what
consumers (as individuals or the
market) would be willing to pay.
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Individual Consumer Surplus
Consumer “a” is willing to pay $11
But only HAS to pay $6 (market price
= $6)
Consumer “a” has a
“consumer surplus”
of
$5
= ($11 - $6)
And so on…..
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Total Consumer Surplus
Total Market
Consumer Surplus
is:
• The sum of all
individual consumer
surpluses
• The area UNDER the
demand curve and
ABOVE the market
price
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Producer Surplus
Producer surplus: The difference
between market price and the price
at which firms are willing to supply
the product.
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Individual Producer Surplus
Producer “c” is willing to accept as
little as $4 each to supply the third
unit
But gets to collect $6 (market price =
$6)
Producer “c” has a
“producer surplus” of
$2
= ($6 - $4)
And so on….
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Total Producer Surplus
Total Market
Producer Surplus
is:
• The sum of all
individual producer
surpluses
• The area UNDER the
market price and
ABOVE the supply
curve
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Market Failures
Markets are usually efficient…but
not always.
Market failure happens when a
market fails to provide the socially
optimal amount of goods and
services.
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Sources of Market Failure
Markets fail for three main reasons:
• Asymmetric information
• Problems with property rights
• There are significant external costs
or benefits
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Asymmetric Information
Asymmetric information: occurs
when one party to a transaction
knows more than the other.
• can prevent some otherwise efficient
trades from taking place
• Example: the market for used cars
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Asymmetric Information
Asymmetric information creates two
types of market failure:
• Adverse Selection
• Moral Hazard
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Asymmetric Information
Adverse selection: occurs when
products of different qualities are
sold at the same price because of
asymmetric information.
• Example: voluntary insurance markets
• Most of those who willingly buy insurance are
higher-risk consumers.
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Asymmetric Information
• Moral hazard: occurs when an
insurance policy or some other
arrangement changes the
economic incentives and leads to a
change in behavior.
• To limit the moral hazard problem,
insurance companies will place
restrictions on individual behavior in
some contracts.
Snowboarding? Not if you’re in contract with the NFL.
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Problems with Property Rights
There are two general cases of
market failure caused by property
right issues:
• Public goods
• Common property resources
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Public Goods
Public goods are:
• non-exclusive
• Once provided, no one person can be
excluded from consuming.
• non-rival
• One person’s consumption does not
diminish others’ benefit.
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The Free Rider Problem
Free rider: When a public good is
provided, consumers cannot be
excluded from enjoying the product,
so some consume the product
without paying.
As many as 90%
of listeners “free
ride” National
Public Radio
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The Free Rider Problem
• Since no one can be excluded (regardless of
payment) some will choose NOT to pay.
• Problem: society WANTS the good and enjoys
its benefits but will not (voluntarily) pay enough
for its provision.
• Government must provide the good (and require
tax payments) to solve this “market failure.”
• On its own, the free market will not provide enough of
these goods.
• Examples: national parks, national security
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Common Property Resources
Common property resources:
Resources that are owned by the
community at large and therefore tend
to be overexploited because individuals
have little incentive to use them in a
sustainable fashion.
The Southern Bluefin
Tuna: soon to be a
memory? Overfishing is
decimating the “King of
Sushi.”
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Externalities
• When externalities are present, the free
market will overproduce or
underproduce the good in question.
• External cost (or negative externality):
Occurs when a transaction between two
parties has an impact on a third party not
involved with the transaction.
• External benefits: Positive externalities,
such as education and vaccinations.
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Markets with External Costs
Example: if a good’s production
generates pollution, the cost of
production is artificially cheap.
The good with a
negative externality
will be
overproduced.
Supply would shift left if
producers paid the full cost of
production.
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Who’s Who
Paul A. Samuelson (1915-2009)
• Nobel Prize in Economics 1970
• (first American to win)
• “Generalist” whose interests were
broad
• Developed MIT’s economics
department, advised President
Kennedy
• Wrote much, from Newsweek articles
to monthly technical papers, his
entire career.
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U.S. Economic History
Industrialization: Post Civil-War to
1900
• Railroads grew and large firms developed
• First anti-monopoly law (1890)
• Beginnings of labor unions
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U.S. Economic History
• Rise of Consumerism and World War I
• Automobiles!
• Financial crises were common, many
banks failed.
• 1913: Federal Reserve is created
• October 29, 1929: Black Tuesday
• 90% of stock market wealth is lost over the
year.
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Crowd at New York's American Union Bank during a
bank run early in the Great Depression.
The Bank opened in 1917 and went out of business on June 30, 1931.
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U.S. Economic History
• The Great Depression: 1930–1941
• Income and output fall by half
• 25% of Americans unemployed
• Government is not prepared to deal with
such a crisis
• Passed Smoot-Hawley Tariff
• Increased taxes to balance the federal budget
• 1932: A new president and a New Deal
Frances Perkins, Roosevelt’s
Labor Secretary and important
architect of the New Deal
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Images of the Great Depression
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U.S. Economic History
• World War II 1942–1945
• US arms buildup begins in 1940
• Unemployment falls from 15% to 1%
• GDP (output) doubles in five years
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U.S. Economic History
• The Postwar Economy: 1946–1960
• The Great Depression and World War II
fundamentally changed our view of
economic policy.
• Employment Act of 1946: made it the
responsibility of government to “promote
maximum employment, production and
purchasing power.”
• Unions were made less powerful by the
Taft-Hartley Act
• Civil Rights Movement
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U.S. Economic History
• Growing Government
and Stagflation: 1960–
1980
• Kennedy and Johnson
focused less on deficits,
more on growth
• Johnson’s “War on Poverty”
was successful
• 1970s: OPEC raises oil
prices 500%, creating
inflation and recession.
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U.S. Economic History
The creeping inflation, stagflation
and disinflation of the period.
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U.S. Economic History
• Disinflation and Bubbles: 1980 to the
Present
• Reagan believed large government was a
problem:
• He deregulated and cut taxes to help business
growth.
• He fired striking air traffic controllers and
decertified the union.
• Spending growth increased and deficits
became large.
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U.S. Economic History
• 1990s: technology helped the economy
grow and the deficits shrink.
• Clinton repealed the 1933 Glass-Steagall Act
that had separated commercial and investment
banking.
• Because of this (and many other reasons) the
financial system collapsed in 2008.
President Bush and Treasury
Secretary Paulson briefing the
press on the financial crisis.
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Which of the following is an example
of a private good?
a.
b.
c.
d.
Superbowl tickets
National Public Radio
The emergency broadcast system
Homeland security precautions
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The market price of the
product is $20 per unit.
Calculate the dollar
amount of consumer
surplus being earned in
this market.
a) $120,000
b) $60,000
c) $100,000
d) $80,000
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