(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 349

324 PART • Producers, Consumers, and Competitive Markets • market failure Situation in which an unregulated competitive market is inefficient because prices fail to provide proper signals to consumers and producers but not always, the case In some situations, a market failure occurs: Because prices fail to provide the proper signals to consumers and producers, the unregulated competitive market is inefficient—i.e., does not maximize aggregate consumer and producer surplus There are two important instances in which market failure can occur: • externality Action taken by either a producer or a consumer which affects other producers or consumers but is not accounted for by the market price Externalities: Sometimes the actions of either consumers or producers result in costs or benefits that not show up as part of the market price Such costs or benefits are called externalities because they are “external” to the market One example is the cost to society of environmental pollution by a producer of industrial chemicals Without government intervention, such a producer will have no incentive to consider the social cost of pollution We examine externalities and the proper government response to them in Chapter 18 Lack of Information: Market failure can also occur when consumers lack information about the quality or nature of a product and so cannot make utility-maximizing purchasing decisions Government intervention (e.g., requiring “truth in labeling”) may then be desirable The role of information is discussed in detail in Chapter 17 In the absence of externalities or a lack of information, an unregulated competitive market does lead to the economically efficient output level To see this, let’s consider what happens if price is constrained to be something other than the equilibrium market-clearing price We have already examined the effects of a price ceiling (a price held below the market-clearing price) As you can see in Figure 9.2 (page 320), production falls (from Q0 to Q1), and there is a corresponding loss of total surplus (the deadweight-loss triangles B and C) Too little is produced, and consumers and producers in the aggregate are worse off Now suppose instead that the government required the price to be above the market-clearing price—say, P2 instead of P0 As Figure 9.5 shows, although producers would like to produce more at this higher price (Q2 instead of Q0), consumers will now buy less (Q3 instead of Q0) If we assume that producers produce only what can be sold, the market output level will be Q3, and again, there is a net loss of total surplus In Figure 9.5, rectangle A now represents a Price S F IGURE 9.5 WELFARE LOSS WHEN PRICE IS HELD ABOVE MARKET-CLEARING LEVEL When price is regulated to be no lower than P2, only Q3 will be demanded If Q3 is produced, the deadweight loss is given by triangles B and C At price P2, producers would like to produce more than Q3 If they do, the deadweight loss will be even larger P2 A B P0 C D Q3 Q0 Q2 Quantity