We can give two different interpretations of the conditions required for efficiency. The first stresses that competitive markets work. It also tells us that we ought to ensure that the prerequisites for competition hold, so that resources can be efficiently allocated. The second stresses that the prerequisites for competition are unlikely to hold. It tells us that we ought to concentrate on ways of dealing with market failures. Thus far we have focused on the first interpretation. For the remainder of the book, we concentrate on the second.
Competitive markets fail for four basic reasons: market power, incomplete information, externalities, and public goods. We will discuss each in turn.
1. Market Power
We have seen that inefficiency arises when a producer or supplier of a factor input has market power. Suppose, for example, that the producer of food in our Edgeworth box diagram has monopoly power. It therefore chooses the output quantity at which marginal revenue (rather than price) is equal to marginal cost and sells less output at a price higher than it would charge in a competitive market. The lower output will mean a lower marginal cost of food production. Meanwhile, the freed-up production inputs will be allocated to produce clothing, whose marginal cost will increase. As a result, the marginal rate of transformation will decrease because MRTFC = MCf/MCc. We might end up, for example, at A on the production possibilities frontier in Figure 16.9. Producing too little food and too much clothing is an output inefficiency because firms with market power use different prices in their output decisions than consumers use in their consumption decisions.
A similar argument would apply to market power in an input market. Suppose that unions gave workers market power over the supply of their labor in the production of food. Too little labor would then be supplied to the food industry at too high a wage (wF) and too much labor to the clothing industry at too low a wage (wc). In the clothing industry, the input efficiency conditions would be satisfied because MRTSck = wc/r. But in the food industry, the wage paid would be greater than the wage paid in the clothing industry. Therefore, MRTSLk = wF/r > wc/r = MRTSx;K. The result is input inefficiency because efficiency requires that the marginal rates of technical substitution be equal in the production of all goods.
2. Incomplete Information
If consumers do not have accurate information about market prices or product quality, the market system will not operate efficiently. This lack of information may give producers an incentive to supply too much of some products and too little of others. In other cases, while some consumers may not buy a product even though they would benefit from doing so, others buy products that leave them worse off. For example, consumers may buy pills that guarantee weight loss, only to find that they have no medical value. Finally, a lack of information may prevent some markets from ever developing. It may, for example, be impossible to purchase certain kinds of insurance because suppliers of insurance lack adequate information about consumers likely to be at risk.
Each of these informational problems can lead to competitive market inefficiency. We will describe informational inefficiencies in detail in Chapter 17 and see whether government intervention might help to reduce them.
The price system works efficiently because market prices convey information to both producers and consumers. Sometimes, however, market prices do not reflect the activities of either producers or consumers. There is an externality when a consumption or production activity has an indirect effect on other consumption or production activities that is not reflected directly in market prices. As we explained in Section 9.2 (page 323), the word externality is used because the effects on others (whether benefits or costs) are external to the market.
Suppose, for example, that a steel plant dumps effluent in a river, thus making a recreation site downstream unsuitable for swimming or fishing. There is an externality because the steel producer does not bear the true cost of wastewater and so uses too much wastewater to produce its steel. This externality causes an input inefficiency. If this externality prevails throughout the industry, the price of steel (which is equal to the marginal cost of production) will be lower than if the cost of production reflected the effluent cost. As a result, too much steel will be produced, and there will be an output inefficiency.
We will discuss externalities and ways to deal with them in Chapter 18.
4. Public Goods
The last source of market failure arises when the market fails to supply goods that many consumers value. A public good can be made available cheaply to many consumers, but once it is provided to some consumers, it is very difficult to prevent others from consuming it. For example, suppose a firm is considering whether to undertake research on a new technology for which it cannot obtain a patent. Once the invention is made public, others can duplicate it. As long as it is difficult to exclude other firms from selling the product, the research will be unprofitable.
Markets therefore undersupply public goods. We will see in Chapter 18 that government can sometimes resolve this problem either by supplying a good itself or by altering the incentives for private firms to produce it.
Source: Pindyck Robert, Rubinfeld Daniel (2012), Microeconomics, Pearson, 8th edition.