Quiz 5: Governments Role and Government Failure
The consumer surplus refers to the benefit that is received by the consumers in the market that is the difference between the maximum price the consumer is willing to pay for the product and the actual price that they pay. If the equilibrium price is $11, then it will have the following table: By definition, reservation price is the maximum price the person is willing to pay for the good. It will depend upon the opportunity cost for the next best consumption alternative of the individual. If the reservation price is lower than the equilibrium price, it means that someone values the item at less than what they would have to pay for it, they will not make the purchase. In the case that the equilibrium price is $11. Person Bart, Br and Be will not want to purchase this item at $11 because they only value the item at $10, $9, and $8, respectively. Because of that, they will get no consumer surplus. Moreover, Person Bi also gets $0 for consumer surplus because he values the item at exactly the same price as what it cost. Hence, the calculation for the consumer surplus is calculated by the formula given below: It is calculated as shown in the table below: To find the total consumer surplus in the market, it is calculated by adding the consumer surplus for all the persons which can be seen as done below: Hence, the market generates consumer surplus of .
Market failure refers to the failure of government policy in removing market distortions due to non-attainment of Pareto optimality. This is because a number of constraints in the working of perfect competition. The major causes of market failures are as follows: 1. Indivisibilities 2. Asymmetric information 3. Externalities 4. Public goods 5. Incomplete market, etc. Externalities in the production and consumption lead to market failure. Externalities refer to market imperfections. Here, the market will not pay the price for a service or disservice. The mal-allocation of resources causes to fall in the production and consumption. Negative externalities in the production: in this situation, the production of a good or service adversely affects the other firms or individuals. Here, social marginal cost is higher than the social marginal benefit. For example, smoking a cigarette, this will adversely affect to the non-smoker. Public goods lead to market failure. The main features of public goods are non-excludability and non-rivalrous. The use of public good does not reduce the amount available for others. Thus, its consumption is always joint and equal. One of the examples of public good is environmental quality. If the environment uses is valued at market price, then it leads to market failure. The market could be affected by both types of market failures simultaneously, because the adverse effect of a public good will leads to a negative externality. For example, if an industry is producing pharmaceutical goods by using the environmental resources which is public good and releasing the pollution, then it will affect adversely to others who are living beside the industry. Thus, this will leads to market failure by both types simultaneously.
We are given the following table of 6 producers, their cost (the minimum acceptable price is the same as the cost), equilibrium price, and producer surplus: Suppose that the equilibrium price, or the actual price, was $6 instead of $8. We first see that ProducerS1, 2, 3, and 4 would still produce because their cost is less than $6, meaning if they produce, they will not make a negative profit (a loss). However, Producers 5 and 6, who have costs of $7 and $8 respectively, will make a loss if they produce, since they will only get $6 in return for producing. Hence, we know they will not produce in equilibrium. We can then find the producer surplus generated in the entire economy by adding the producer surplus of ProducerS1, 2, 3, and 4 when the price is $6. Remember that producer surplus is simply the actual price (the price that the producers will receive if they sell the good) minus the cost. Note that producer surplus is the exact same thing as the profit of the producers. We then get the following table: Now that we have the individual producer surpluses, we can just add them up to get the entire market's producer surplus. We have $3+$2+$1+$0 = $6, meaning that the producer surplus of the market is $6.