Market Failure – Pareto Efficiency
Topic Fourteen

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Market Efficiency

Market efficiency refers to a situation where demand for goods and services in the economy matches supply of these goods and services. Therefore, there will be no shortage or surplus. The price mechanism will influence the allocation of resources and there is not supposed to be government intervention of any kind. This is the case with the perfect competitive version of market structure. In this case, optimization occurs where price is equal to marginal cost and consumer surplus is maximised Another way of saying the same thing is economic efficiency is where it is impossible to increase economic welfare from the available resources. In other words, it is the situation where some people cannot be made better-off without making others worse-off. Relating to the topic of efficiency is that of allocative efficiency which deals with solving the economic problem of what to produce and productive efficiency which deals with the problem of producing society’s desired goods and services with the least possible of its scarce resources.

Allocative Efficiency

How well economic resources are allocated to satisfy economic wants is known as allocative efficiency, which is the production of those goods and services that are most desired by society in the quantity that they desire. When allocative efficiency is maximized with respect to the good, then the manufacturer is producing the good in the exact quantities that society desires. The triangle under the demand curve and above the supply curve is referred to as the net benefit of allocative efficiency as seen in the following graph. It is the total of the consumer and producer surplus.

Figure 1

Consumer Surplus

Consumer surplus is derived whenever the price a consumer actually pays is less than they are prepared to pay. A demand curve indicates what price consumers are prepared to pay for a hypothetical quantity of a good, based on their expectation of private benefit. For example, at price P, the total private benefit in terms of utility derived by consumers from consuming quantity, Q is shown as the area ABQO in the following graph.

Figure 2

The amount consumers actually spend is determined by the market price they pay, P, and the quantity they buy, Q - namely, P x Q, or area PBQO. This means that there is a net gain to the consumer, because area ABQO is greater that area PBQO. This net gain is called consumer surplus, which is the total benefit, area ABQO, less the amount spent, area PBQO. Hence consumer surplus is ABQO - PBQO = area ABP.

Producer Surplus

Producer surplus is the additional private benefit to producers, in terms of profit, gained when the price they receive in the market is more than the minimum they would be prepared to supply for. In other words, they received a reward that more than covers their costs of production. The producer surplus derived by all firms in the market is the area from the supply curve to the price line, EPB as can be seen in the following graph.

Figure 3

Market Failure

Market Failure is when the market is not in equilibrium and there are shortages and surpluses. It is a situation when the government intervenes in order to correct for some of the problems that may exist in the free market system or the perfectly competitive system. One such problem is the fact that only persons with the means of financial affordability may be able to purchase what the economic system produces. This will mean that the poor may not be in a position to afford the basic necessities and so some level of intervention is necessary by the government. Even though this intervention is desirable, it is referred to as market failure.

Causes of Market Failure

Some of the factors that can contribute to market failure are as follows:

  • Market power or market failure under monopoly - some industries may enjoy economies of scale or even huge start-up costs and only companies with the capability to afford these start-up costs can exist in these industries. This market power reduces competition and so monopolies can be seen as a source of market failure.
  • Asymmetric or imperfect information of information failure – one of the assumptions of perfect competition is that all parties have access to all relevant information. There is market failure when this assumption is violated.
  • Externalities - When a transaction or trade imposes social and private costs to others who are not participating in the transaction, this is an externality. Externalities can either be positive or negative. A positive production externality occurs when a third party gains as a result of production. A negative externality is a cost that is suffered by a third party as a result of an economic action or transaction. These contribute to market failure.
  • Irrational actors - Another of the assumptions for perfect competition in economic trade is that all consumers and producers act rationally. If one person to a transaction or trade does not act rationally when making business decisions, then this can affect the free functioning market.
  • Government intervention – government intervention may be necessary in order to allow the less fortunate in society to obtain the bare necessities. However, theoretically, government intervention is seen as a market failure. Intervention on the part of the government may take the form of the provision of public and merit goods.

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