Transcript Market Efficiency and Market Failure

Market Efficiency
SPHA511, John Ries
Market Economies and Perfect Competition
Which nations do not have market economies
today?
What characterizes a market economy?
• Prices are determined by supply and demand
• Demand represents aggregate preferences of
consumers (consumer sovereignty)
• Goods are supplied by individuals/firms
pursuing profitable opportunities (economic
freedom)
Market Economies and Perfect Competition
What characterizes perfect competition?
• A sufficiently large number of sellers and
buyers in a market such that no single buyer
or seller believes he can influence the
common price at which the commodity is sold.
(Prices are taken as exogenous.)
• Free entry and exit.
• Perfect knowledge of opportunities for
profitable exchange.
Market Economies and Perfect Competition
Two quotes from Adam Smith
"An individual generally neither intends to promote the
public interest nor knows by how much he is promoting
it... By directing industry in such a manner as its
product may be of greatest value, the entrepreneur
intends only his own personal gain, and he is in this
aim... led as if by an 'invisible hand' to promote an end
which was no part of his intention"
"By pursuing his own self-interest, the entrepreneur
frequently promotes that of society more effectually
than when he means to promote it"
(from Adam Smith, The Wealth of Nations, 1776)
Market efficiency
Price
S=MC
PC
D=MB
QC
Quantity
Market Economies and Perfect Competition
First Theorem of Welfare Economics
Competitive equilibria are Pareto-efficient (recall that
this implies both production and allocational
efficiency). In other words, there exists no possible
way to reallocate resources so as to benefit one or
more participants without making at least one other
participant worse off.
Market efficiency and social welfare
a. Recall that each point on the demand curve
represents willingness to pay and that allocation
efficiency requires that marginal willingness to pay
equals marginal cost.
b. Consider a developer deciding whether to build lowincome housing or a golf course on a plot of land.
With very unequal incomes, willingness to pay may
be very high for the golf course and thus the
developer may build a golf course.
Is this resource allocation Pareto efficient?
Is it socially optimal to build the golf course?
Market efficiency and social welfare
Second Theorem of Welfare Economics:
Redistributing income and letting competitive
markets operate will generate a Pareto efficient
outcome.
Suppose you redistributed income from rich golfers
to the unemployed. In that case the developer may
choose to build the low-income housing. This
outcome is Pareto efficient.
Market Economies and Welfare
Policy implications
(1) The competitive market is (Pareto) efficient
(2) Government may choose to reallocate income to
move from one Pareto efficiency point to another
that it deems more socially desirable.
Income redistribution, however, may have
undesirable incentive effects.
Trading off efficiency for equity
• Ideally, we prefer outcomes that are Pareto
efficient
• However, straight income redistribution in order
to achieve an optimal Pareto efficient distribution
may be undesirable due to its effect on effort
• Thus, society may choose to tolerate some
inefficiency in order to achieve more equitable
outcomes
Understanding the trade-off
• Consider the following market interventions that
aim to help certain people in society
– Minimum wage (w’>wc)
– Rent control (r’<rc)
– Limited supply (Q’<Qc)
– A sales tax to pay for public services
• Draw a supply and demand graph with the
intervention to show the efficiency and
redistribution effects
Equity versus efficiency
• Competitive markets generate Pareto efficiency
but there are many Pareto efficient outcomes
that are possible
• Governments certainly may choose to tolerate
some inefficiencies to achieve equity objectives
• However, to make good policy, we need to
understand the trade-off and the total
redistribution effects across groups in our society
• Simply economic tools allows these tradeoffs to
clearly depicted