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

324 PART 2 • 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.

1. Externalities: Sometimes the actions of either consumers or producers
result in costs or benefits that do 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.
2. 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