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ACDC Leadership 2019

Socially Efficient and Inefficient Market Outcomes

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1 2 3 4 5 6 7 8 9 10

Quantity of Pizza

MB/MC

109

Benefits and Costs

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1 2 3 4 5 6 7 8 9 10

Quantity of Pizza

109

Not

Enough

(MB>MC)

MB/MC

Benefits and Costs

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1 2 3 4 5 6 7 8 9 10

Quantity of Pizza

109

Too Much

(MC>MB)

MB/MC

Benefits and Costs

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1 2 3 4 5 6 7 8 9 10

Quantity of Pizza

Demand and Supply

Price

Demand

Supply

109

Supply and demand results in efficient outcomes with no deadweight loss

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Does the Free Market ever FAIL to meet society’s needs?

ACDC Leadership 2019

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Market Failure

Recall: Adam Smith’s “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market.

But market failures can still happen.

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Socially Optimal Quantity

Supply and demand is great for determining how many pizzas to produce, but what about goods that are not sold in markets like aircraft carriers and parks?

MSB = MSC

ACDC Leadership 2018

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EXTERNALITIES AND MARKET INEFFICIENCY

An externality arises...

. . . when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect.

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EXTERNALITIES AND MARKET INEFFICIENCY

NEGATIVE EXTERNALITY: When the impact on the bystander is adverse, the externality is called a negative externality.

POSITIVE EXTERNALITY: When the impact on the bystander is beneficial, the externality is called a positive externality.

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EXTERNALITIES AND MARKET INEFFICIENCY

Negative Externalities

Automobile exhaust
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building

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EXTERNALITIES AND MARKET INEFFICIENCY

Positive Externalities

Immunizations
Restored historic buildings
Research into new technologies

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SOCIETY’S OPTIMAL AMOUNT

OF EXTERNALITY REDUCTION

Socially optimum

amount of

pollution

abatement

Society’s marginal benefit and marginal

cost of pollution abatement

Amount of pollution abatement

Q₁

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D=MSB

Supply = Marginal

Private Cost

Q_{Free Market}

NEGATIVE EXTERNALITIES: Cigarettes

The marginal private cost doesn’t include the costs to society.

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D=MSB

Supply = Marginal

Private Cost

Q_{Free Market}

Market for Cigarettes

Marginal

Social Cost

What will the MC/Supply look like when EXTERNAL cost are factor in?

Q_Optimal

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D=MSB

S=MPC

Q_{Free Market}

Market for Cigarettes

MSC

Q_Optimal

At Q_FMthe MSC is greater than the MSB_.Too much is being produced so there is deadweight loss

If the market produces Q_FMwhy is it a market failure?

Overallocation

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D=MSB

Q_{Free Market}

Market for Cigarettes

What should the government do to fix a negative externality?

Q_Optimal

S=MPC

MSC

Solution: Tax the amount of the externality

(Per Unit Tax)

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D=MSB

Q_{Free Market}

Market for Cigarettes

What should the government do to fix a negative externality?

Q_Optimal

S=MPC

Solution: Per-unit tax the amount of the externality

(No Deadweight loss)

= MPC

MSB = MSC

MSC

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D=Marginal Private Benefit

S = MSC

Q_{Free Market}

The marginal private benefit doesn’t include the additional benefits to society.

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POSITIVE EXTERNALITIES: FLU SHOTS

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Q_FM

What will the MB/D look like when EXTERNAL benefits are factor in?

Q_Optimal

D=Marginal Private Benefit

S = MSC

Marginal Social Benefit

Market for Flu Shots

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D=MSB

If the market produces Q_FMwhy is it a market failure?

S = MSC

Marginal Social Benefit

Q_FM

Q_Optimal

Market for Flu Shots

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Underallocation

S = MSC

Marginal Social Benefit

Q_FM

Q_Optimal

At Q_FMthe MSC is less than the MSB_.

Too little is being produced

Market for Flu Shots

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Q_FM

Q_Optimal

D=MPB

S = MSC

MSB

What should the government do to fix a negative externality?

Subsidize the amount of the externality (Per Unit Subsidy)

=MPB

Market for Flu Shots

ACDC Leadership 2019