MRG - Socially Efficient and Inefficient Market Outcomes Lesson

Socially Efficient and Inefficient Market Outcomes Lesson

A market failure is a situation where an unfettered market fails to allocate resources efficiently. This means the price mechanism, which generally leads to allocative efficiency, is not able to allocate resources in such a way as to maximize the net total benefit to society. In these cases, government intervention usually occurs to correct the market failure.

The optimal quantity of a good occurs where the marginal benefit of consuming the last unit equals the marginal cost of producing that last unit, thus maximizing total economic surplus. The market equilibrium is equal to the socially optimal quantity only when all social benefits and costs are internalized by individuals in the market. Total economic surplus is maximized at that quantity.

Rational agents can pursue private actions to exploit or exercise market characteristics known as market power. Rational agents make optimal decisions by equating private marginal benefits and private marginal costs that can result in market inefficiencies. Policymakers use cost-benefit analysis to evaluate different actions to reduce or eliminate market inefficiencies. Market inefficiencies can be eliminated by designing policies that equate marginal social benefit with marginal social cost.

Equilibrium allocations can deviate from efficient allocations due to situations such as monopoly; oligopoly; monopolistic competition; negative and positive externalities in production or consumption; asymmetric information; and insufficient production of public goods. Producing any non-efficient quantity results in deadweight loss.

 

Market Failures Video

View the video below to learn more. To make the video full screen, select the double arrows at the bottom right corner of the object.

Inadequate Competition

As discussed in previous modules, all market structures outside of perfect competition result in some amount of inefficiency. If you remember, that inefficiency was expressed as the deadweight loss to society. The deadweight loss was the result of a lack of competition (which is centered around oligopoly and monopoly) that resulted in too little of the good being produced and sold for a price that was too high. When we consider "too little being produced", what does that mean? It means that the firm is producing less than the socially optimal quantity which is found where marginal benefit (demand curve) and marginal cost (supply curve) are equal. Furthermore, in these instances, price is not equal to marginal cost, so the price being charged for the product, while found on the demand curve, is not the optimal price. Society would rather see more of the good produced and sold such that price = marginal benefit = marginal cost. In the case of firms operating in structures outside of perfect competition, this would not lead to profit maximization. Therefore, being allocatively efficient is not a goal of monopolistic competitors, oligopolistic competitors, and monopolies. Since these forms of lesser competition produce inefficient outcomes, the government has intervened to ensure that competition is safeguarded to a degree that protects the consumer and society. Keep in mind, however, that these markets do have positive attributes – namely, product differentiation and economies of scale. Product differentiation is good for the consumer because it results in a variety of goods/services to choose from. Economies of scale are positive because it results in lowered production costs as the size of a firm grows.

Regulating Natural Monopolies

In some instances, monopolies can make economic sense. These are referred to as natural monopolies. The existence of natural monopolies is directly related to the costs of operating a business. In past modules, the focus has been mainly on variable and marginal costs. In the case of natural monopolies, fixed costs are responsible for making the determination that a market is best served by a monopoly.

Why Fixed Costs?

In certain markets, the start-up cost for establishing a firm is so great that it acts as a significant barrier to entry. The fixed costs are so expensive because of the amount of capital that the business must purchase to produce the good/service. Once the investment in those huge fixed costs is made, any expansion in output will decrease ATC for the natural monopolist. Examples of this are found in the markets for utilities (electricity, water, etc). Let's consider the time, expense, and effort needed to establish a power company. Power lines must be buried, poles and cables run, and power grids must be established. These steps are very costly. What would society gain by promoting competition in a market such as this? Consider your own home. Would it be better off if there were two options for electrical power? The answer is no. As long as the lights come on when you flip the switch, you are happy. That line of reasoning is the basis for allowing natural monopolies to exist. Encouraging multiple power providers to go to the expense of burying lines, running cables, and establishing power grids yields no real gain to the consumer – and it would waste those resources that could otherwise be used elsewhere.

So, in some instances, monopolies can be justified. However, we must not forget that if left to their own devices, they will behave as monopolies do…producing too little and charging a price that is too high. The government allows the natural monopoly to exist, but it will regulate the business to protect the consumer from being harmed.

Regulation

The video below highlights some of the options in terms of regulatory steps the government can take.  To make the video full screen, select the double arrows at the bottom right corner of the object.

Review

Practice what you've learned with the review activity below.

 

IMAGES CREATED BY GAVS (Image 1 from freepik.com and modified by GAVS)