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Market Failure – Pareto Efficiency
Topic Fourteen

Previous - Goods and Services

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.

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. Because of economies of scale, the cost of producing an additional unit, known as the marginal cost, continually declines until it reaches a minimum. On the other hand, the marginal benefit, which is the benefit to society of the last unit, also declines with increasing quantity.

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.

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 and consumer surplus is ABP as can be seen in the following graph.

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 sort or 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

For there to have economic efficiency in the market, there needs to be the assumption that all economic agents realize substantially all of the costs and benefits of trade. Market failure is possible any time these conditions are not satisfied. Some of the factors that can contribute to market failure are as follows:

  • Market Power or Market Failure under Monopoly – market power reduces competition and restricts the free and effective functioning of the free market mechanism. Therefore, 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. 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.
  • 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 and subsidies such as food stamps that will allow citizens to afford certain goods and services.

Next - Market Failure – Externalities