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Topic 5 Market structure, efficiency and failure Lecture 20

Topic 5 Market structure, efficiency and failure Lecture 20. In this lecture, we consider market efficiency and market failure in the context of externalities and public goods. Topic 5 : Lecture 20. Reconsider Slide 5 of Lecture 17:. p. MC n =S n. AC n. p m. LRSS=MC. p c. D = MB.

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Topic 5 Market structure, efficiency and failure Lecture 20

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  1. Topic 5 Market structure, efficiency and failure Lecture 20 In this lecture, we consider market efficiency and market failure in the context of externalities and public goods. Robin Naylor, Department of Economics, Warwick

  2. Topic 5 :Lecture 20 Reconsider Slide 5 of Lecture 17: p MCn=Sn ACn pm LRSS=MC pc D = MB MR X Xm Xc This shows that the amount of output which will be produced in a perfectly competitive market (where D=S=MC) is also equal to the optimal level of output (where MC=MB). In contrast, there is a Welfare Loss associated with Monopoly. Robin Naylor, Department of Economics, Warwick

  3. Topic 5 :Lecture 20 More simply (but where we are now assuming an increasing-cost industry): p LRSS=MC pc D = MB X Xc The perfectly competitive outcome coincides with the Socially Optimal outcome: this market structure yields Efficiency – i.e., no Welfare Loss. But what are we assuming about MB and MC? Robin Naylor, Department of Economics, Warwick

  4. Topic 5 :Lecture 20 We are assuming that MB captures all the benefits to society associated with the consumption of the good and that MC captures all the costs. p LRSS=MC pc D = MB X Xc But what if there are costs to society over and above the production costs incurred by the firms? Robin Naylor, Department of Economics, Warwick

  5. Topic 5 :Lecture 20 What if there are costs to society over and above the production costs incurred by the firms? MSC p MEC LRSS=MPC pc D = MB X Xc Now what is the Socially Optimal level of output? Does this correspond to the competitive market outcome? Robin Naylor, Department of Economics, Warwick

  6. Topic 5 :Lecture 20 What is the Socially Optimal level of output? Does this correspond to the competitive market outcome? MSC p MEC LRSS=MPC pc D = MB X X* Xc In the competitive market outcome, there is a Welfare Loss given by the area between MSC and MB in the region of ‘over’ production (Xc – X*). Robin Naylor, Department of Economics, Warwick

  7. Topic 5 Lecture 20 Related issues: A difference between MPB and MSC is also a source of an externality which could generate market efficiency There are various possible responses to the potential problems caused by the existence of externalities: Regulation Taxation (subsidy) Facilitate market solutions (Coase theorem) Robin Naylor, Department of Economics, Warwick

  8. Topic 5 Lecture 20 Externalities are just one source of potential market failure Other sources include Natural Monopoly (we considered this in a previous lecture) Public Goods (we’ll now turn to look at this case) Information failures (we’ll do this in Year 2) Robin Naylor, Department of Economics, Warwick

  9. Topic 5 Lecture 20 Public Goods and market failure Until this point in the module we have assumed that whenever we talk about a good or service it is a ‘Rival’ good or service. Recall that when we derived a market demand curve by aggregating over the demand curves of each individual consumer in the market we did so by adding their demand curves vertically . . . . . . see Slide 3 from Topic 1 Lecture 8 (reproduced on the next slide) Robin Naylor, Department of Economics, Warwick

  10. Topic 1 Lecture 20 Market Demand in the case of goods which have the property of being Rival in consumption Reproduced from Lecture 8 for goods which are Rival For goods which are rival in consumption, we are asking the question: “At each price, how much does consumer A demand, plus how much does consumer B demand, etc” and then we add together their (separately consumed) quantities along the (horizontal) X axis. We can interpret the resulting market demand curve as the MB curve (so long as there are no externalities) and in a perfectly competitive market the intersection of MB and the market supply curve (given by MC) will give us the competitive and socially efficient outcome. p p p DM D1 D2 01 02 0M X Robin Naylor, Department of Economics, Warwick

  11. Topic 5 Lecture 20 In the case of Public Goods, consumption is not Rival: your consumption does not diminish the quantity that I consume. Think of street-lighting, radio broadcasts, . . . In this case, a given level of production can be consumed by each individual in the market. To determine whether it is socially efficient to produce any additional amount of the good, we should ask the question: “Is the MB to society associated with the additional amount at least as great as the MC of production.” This is our usual question – but the issue now is “How do we measure the MB?” And the answer, in the case of non-rivalry, is that for each quantity produced (measured on the horizontal axis), we add each consumer’s marginal benefit (measured on the vertical axis). So this is a Vertical Aggregation – unlike the Horizontal Aggregation which we used for goods which are rival. Robin Naylor, Department of Economics, Warwick

  12. Topic 1 Lecture 20 D1 is Consumer 1’s demand curve for the Public Good. Similarly, D2 for Consumer 2. D1 = MB1. D2 = MB2. Any amount consumed by one consumer can also be consumed by the other. So the MB to society for any amount X is the (vertical) sum of the individuals’ MBs (ie MB1 + MB2) at each output. As shown on the next Slide, this is MSB = MB1 + MB2 p pR1 D1 pR2 D2 X 01,2 Robin Naylor, Department of Economics, Warwick

  13. Topic 1 Lecture 20 So, in the case of goods which are non-rival, the MSB is obtained by the vertical rather than the horizontal aggregation of the individual consumers’ demand curves. The socially efficient level of production of the public good is then at the output level at which this MSB equals the MC . . . p MSB = MB1 + MB2 pR1 D1 pR2 D2 X 01,2 Robin Naylor, Department of Economics, Warwick

  14. Topic 1 Lecture 20 The socially efficient level of production of the public good is then at the output level, X*, at which the MSB equals the MC. What price would a private firm require in order to supply X*? What is the maximum Consumer 1 would be prepared to pay for X*? And Consumer 2? Are there problems here? How does your answer depend on the extent of MC? Note: role of ‘Excludability.’ p MC MSB = MB1 + MB2 pR1 D1 pR2 D2 X* X 01,2 Robin Naylor, Department of Economics, Warwick

  15. Topic 5 Lecture 20 Now read B&B 4th Ed., pp. 697-728. You might also consult: Estrin, Laidler and Dietrich, pp. 489-500. Morgan, Katz and Rosen, pp. 657-686. Robin Naylor, Department of Economics, Warwick

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