3.4 Market failure and building on flood plains

Slide 1 shows a graph relating price (on the vertical axis) to quantity (on the horizontal axis). There are two straight lines plotted: market supply (S₁), and market demand. Market supply is positively sloped, while market demand is negatively sloped. Market supply and market demand meet at a point where price is equal to P_e and quantity equal to Q_e. Text reads: With no intervention, private demand from homebuyers and private supply from developers determine the equilibrium price of homes (P_e) and the equilibrium quantity bought and sold (Q_e).

Slide 2 shows a graph relating price (on the vertical axis) to quantity (on the horizontal axis). There are two straight lines plotted: market supply S₁=MPC, and market demand MPB. Market supply is positively sloped, while market demand is negatively sloped. Market supply and market demand meet at a point where price is equal to P_e and quantity equal to Q_e. Text reads: Recall that the demand curve equals the marginal  utility that buyers derive from consuming these homes. This is called the marginal private benefit (MPB). Similarly, the supply curve equals the marginal  cost for the developers. This can be labelled the marginal private cost (MPC).

Slide 3 shows a graph relating price (on the vertical axis) to quantity (on the horizontal axis). There are three straight lines plotted: market demand MPB, market supply S₁=MPC, and S₂. The market demand is negatively sloped. Both the market supply S₁ and S₂ are positively sloped with S₂ being to the left and above S₁. S₁ crosses the market demand curve at the point where price is equal to P_e and quantity equal to Q_e. S₂ crosses the market demand curve at a point with a higher price and lower quantity. Text reads: However, developers are not bearing the full costs of producing these homes. There are negative externalities – costs being borne by others. If the developers had to bear the full costs, they would need to charge more for every home. Their supply curve would shift upwards and to the left as shown by the curve labelled S₂. Note that S₂ is not parallel to S₁ because the scale of the externalities increases with quantity.

Slide 4 shows a graph relating price (on the vertical axis) to quantity (on the horizontal axis). There are three straight lines plotted: market demand MPB=MSB, market supply S₁=MPC, and S₂=MSC. The market demand is negatively sloped. Both the market supply S₁ and S₂ are positively sloped with S₂ being to the left and above S₁. S₁ crosses the market demand at the point where price is equal to P_e and quantity equal to Q_e. S₂ crosses the market demand at a point with a higher price and lower quantity. Text reads: Since S₂ shows the total cost the developers would pay if the externalities were internalised (in other words borne by them), it also represents the true cost to society as a whole of building on the flood plain. This is called the marginal social cost (MSC). Assuming that demand is based on full information and no externalities, the marginal benefit to society (MSB) is the same as the marginal private benefit to homeowners.

Slide 5 shows a graph relating price (on the vertical axis) to quantity (on the horizontal axis). There are three straight lines plotted: market demand MPB=MSB, market supply S₁=MPC, and S₂=MSC. The market demand is negatively sloped. Both the market supply S₁ and S₂ are positively sloped with S₂ being to the left and above S₁. S₁ crosses the market demand at the point where price is equal to P_e and quantity equal to Q_e. S₂ crosses the market demand at the point where price is equal to P2 and quantity equal to Q₂, with P₂ higher than P_e and Q₂ lower than Q_e. Text reads: If the negative externalities are taken into account, in other words the full cost to society not just the developer’s actual costs, the equilibrium price would be higher at P₂ and the quantity of floodplain homes bought and sold lower at Q₂

Slide 6 shows a graph relating price (on the vertical axis) to quantity (on the horizontal axis). There are three straight lines plotted. The first is negatively sloped and labelled market demand MPB=MSB. The other two are both positively sloped. One is labelled market supply S₁=MPC. The second, labelled S₂=MSC, is to the left and above S₁. S₁ crosses the market demand curve at the point where price is equal to P_e and quantity equal to Q_e. S₂ crosses the market demand curve at the point where price is equal to P₂ and quantity equal to Q₂, with P₂ higher than P_e and Q₂ lower than Q_e. From quantity Q_e, there is also a tracer line that extends upwards to meet S₂. This point corresponds to a price, P₃, which would have to be higher than P_e and P₂. The triangle formed by the pairs of points (Q_e, P_e), (Q₂, P₂), and (Q_e, P₃) is highlighted and labelled deadweight welfare loss. Text reads: At Q_e , the real cost to society is P₃. The price signalled by P_e is wrong and so too many of the economy’s resources are going into the production of floodplain homes. This is inefficient and represents a loss to society equal to the red triangle. This is called the deadweight welfare loss. It equals the difference between MSC and MSB at every quantity above Q₂.