3.5 Market failure and buying 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 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 for developers determine the equilibrium price of home (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 =MPC, and market demand D₁=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 supply =MPC, market demand D₁=MPB, and D₂. Market supply is positively sloped, while market demand D₁=MPB and D₂ are negatively sloped. D₂ is lower and to the left of market demand D₁=MPB. Market supply and market demand D₁=MPB meet at a point where price is equal to P_e and quantity equal to Q_e. Market supply and D₂ meet at a point with a price lower than P_e and a quantity lower than Q_e. Text reads: However, buyers do not have the full information they need to make a rational decision. If they understood the extra costs they might incur as owners of a floodplain home, at every price, they would choose to buy fewer such homes, as indicated by a shift in the demand curve downwards and to the left, shown by demand curve, D₂

Slide 4 shows a graph relating price (on the vertical axis) to quantity (on the horizontal axis). There are three straight lines plotted: market supply =MPC=MSC, market demand D₁=MPB, and D₂=MSB. Market supply is positively sloped, while market demand D₁=MPB and D₂=MSB are negatively sloped. D₂=MSB is lower and to the left of market demand D₁=MPB. Market supply and market demand D₁=MPB meet at a point where price is equal to P_eand quantity equal to Q_e. Market supply and D₂=MSB meet at a point with a price lower than P_e and a quantity lower than Q_e. Text reads: Since D₂ shows the price and quantity that would be bought if all information were known, it also represents the true benefit to society as a whole of building on the floodplain. This can be called the marginal social benefit (MSB). Assuming there are no externalities involved in the supply of the homes, the marginal cost to society (MSC) is the same as the private cost to suppliers.

Slide 5 shows a graph relating price (on the vertical axis) to quantity (on the horizontal axis). There are three straight lines plotted: market supply =MPC=MSC, market demand D₁=MPB, and D₂=MSB. Market supply is positively sloped, while market demand D₁=MPB and D₂=MSB are negatively sloped. D₂=MSB is lower and to the left of market demand D₁=MPB. Market supply and market demand D₁=MPB meet at a point where price is equal to P_e and quantity equal to Q_e. Market supply and D₂=MSB meet at a point where price is equal to P₂ and quantity equal to Q₂, with P₂ and Q₂ lower than P_e and Q_e respectively. Text reads: If all information is taken into account, in other words the much lower benefit to society as a whole is recognized not just the perceived private benefit when information is asymmetric, the equilibrium price would be lower at P₂ and the quantity of floodplain homes bought and sold would also be 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: market supply =MPC=MSC, market demand D₁=MPB, and D₂=MSB. Market supply is positively sloped, while market demand D₁=MPB and D₂=MSB are negatively sloped. D₂=MSB is lower and to the left of market demand D₁=MPB. Market supply and market demand D₁=MPB meet at a point where price is equal to P_e and quantity equal to Q_e. Market supply and D₂=MSB meet at a point where price is equal to P₂ and quantity equal to Q₂, with P₂ and Q₂ lower than P_e and Q_e respectively. From quantity Q_e, there is also a tracer line upwards to meet D₂=MSB. This point corresponds to a price, P₃, which would have to be lower than P_e and P₂. The triangle formed by the pairs of points (Q_e, P_e), (Q₂, P₂), and (Q_e, P₃) has been highlighted and labelled deadweight welfare loss. Text reads: At Q_e, the real benefit to society is P₃. The price signalled by Pe 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 to the difference between MSC and MSB at every quantity above Q₂