― Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable
General Equilibrium and the Efficiency of Perfect Competition
(Part C)
by
Charles Lamson
The Sources of Market Failure
In suggesting some of the problems encountered in real markets and some of the possible solutions to these problems, this post previews the next part of this analysis, which focuses on the economics of market failure and the potential role of government in the economy. Market failure occurs when resources are misallocated, or allocated insufficiently. The result is waste or lost value. In this section, we briefly describe four important sources of market failure: (1) imperfect market structure, or noncompetitive behavior, (2) the existence of public goods, (3) the presence of external costs and benefits, and (4) imperfect information. Each condition results from the failure of one of the assumptions basic to the perfectly competitive model, and each is discussed in more detail in later posts. Each also points to a potential role for government in the economy. The desirability and extent of actual government involvement in the economy are hotly debated subjects. Imperfect Markets Until now we have operated on the assumption that the number of buyers and sellers in each market is large. When each buyer and each seller is only one of a great many in the market, no individual buyer or seller can independently influence price. Thus, all economic decision-makers are by virtue of their relatively small size forced to take input prices and output prices, as given. When this assumption does not hold---that is, when single firms have some control over price and potential competition---the result is imperfect competition and an inefficient allocation of resources. A Kansas wheat farmer is probably a price-taker, but Microsoft and Chrysler Corporation most certainly are not. many firms in many Industries do have some control over price. The degree of control that is possible depends on the character of competition in the industry itself.  An industry that comprises just one firm producing a product for which there are no close substitutes is called a monopoly. Although a monopoly has no other firms to compete with, it is still constrained by market demand. To be successful, the firm still has to produce something that people want. Essentially, a monopoly must choose both price and quantity of output simultaneously because the amount that it will be able to sell depends on the price it sets. If the price is too high, it will sell nothing. Presumably a monopolist sets price to maximize profit. The price is generally significantly above average costs, and such a firm usually earns economic profits. In competition, economic profits will attract the entry of new firms into the industry. A rational monopolist who is not restrained by the government does everything possible to block any such entry to preserve economic profits in the long run. As a result, society loses the benefits of more product and lower prices. A number of barriers to entry can be raised. Sometimes a monopoly is actually licensed by government, and entry into its market is prohibited by law. Taiwan has only one beer company; many areas in the United States have only one local telephone company. Ownership of a natural resource can also be the source of monopoly power. If I buy up all the coal mines in the United States and I persuade Congress to restrict coal imports, no one can enter the coal industry and compete with me. Between monopoly and perfect competition are a number of other imperfectly competitive market structures. Oligopolistic industries are made up of a small number of firms, each with a degree of price-setting power. Monopolistically competitive industries are made up of a large number of firms that acquire price-setting power by differentiating their products or by establishing a brand name. Only General Mills can produce Wheaties, for example, and only Miles Laboratories can produce Alka-Seltzer. In all imperfectly competitive industries, output is lower---the product is underproduced---and price is higher than it would be under perfect competition. The equilibrium condition P = MC (market price equal to marginal cost) does not hold, and the system does not produce the most efficient product mix. In the United States, many forms of non competitive behavior are illegal. A firm that attempts to monopolize an industry or that conspires with other firms to reduce competition risks serious penalties.  Public Goods A second major source of inefficiency lies in the fact that private producers simply do not find it in their best interest to produce everything that members of society want. More specifically, there is a whole class of goods called public goods, or social goods, that will be underproduced or not produced at all in a completely unregulated market economy. Public goods are goods or services that bestow collective benefits on society; they are, in a sense, collectively consumed. The classic example is national defense, but there are countless others---police protection, preservation of wilderness lands and public health, to name a few. These things are "produced" using land, labor, and capital just like any other good. Some public goods, such as national defense, benefit the whole nation. Others, such as clean air, may be limited to smaller areas---the air may be clean in a Kansas town but dirty in a Southern California city. Public goods are consumed by everyone, not just by those who pay for them. Once the good is produced, no one can be excluded from enjoying its benefits. Producers of private goods, like hamburgers, can make a profit because they do not hand over the product to you until you pay for it.  If the provision of public goods were left to private, profit-seeking producers with no power to force payment, a serious problem would arise. Suppose, for example, that I value some public good, X. If there were a functioning market for X, I would be willing to pay for it. Suppose that I am asked to contribute voluntarily to the production of X. Should I contribute? Perhaps I should on moral grounds, but not on the basis of pure self-interest. At least two problems can get in the way. First, because I cannot be excluded from using X for not paying, I get the good whether I pay or not. Why should I pay if I do not have to? Second, because public goods that provide collective benefits to large numbers of people are expensive to produce, any one person's contribution is not likely to make much difference to the amount of the good produced. Would the national defense suffer, for example, if you did not pay your share of the bill? Probably not. Nothing happens if you do not pay. The output of the good does not change much, and you get it whether you pay or not. Private provision of public goods fails. A completely laissez-faire market system will not produce everything that all members of a society might want. Citizens must band together to ensure that desired public goods are not produced or produced, and this is generally accomplished through government spending financed by taxes. Externalities A third major source of inefficiency is the existence of external costs and benefits. An externality is a cost or benefit imposed or bestowed on an individual or group that is outside, or external to, the transaction---in other words, something that affects a third party. In a city, external costs are pervasive. The classic example is pollution, but there are thousands of others, such as noise, congestion, and painting your house a color that the neighbors think is ugly.  Not all externalities are negative, however. For example, housing investment may yield benefits for neighbors. A farm located near a city provides residents in the area with nice views, fresher air, and a less congested environment. Externalities are a problem only if decision-makers do not take them into account. The logic of efficiency presented in the last post required that firms weigh social benefits against social costs. If a firm in a competitive environment produces a good, it is because the value of that good to society exceeds the social cost of producing it---this is the logic of P = MC. If social costs or benefits are overlooked or left out of the calculations, inefficient decisions result. The market itself has no automatic mechanism that provides decision-makers an incentive to consider external effects. Through government, however, society has established over the years a number of different institutions for dealing with externalities. Tort law, for example, is a body of legal rules that deal with third-party effects. Under certain circumstances, those who impose costs are held strictly liable for them. In other circumstances, liability is assessed only if the cost results from negligent behavior. Tort law deals with small problems as well as larger ones. If your neighbors spray their lawn with a powerful chemical and kill your prize shrub, you can take them to court and force them to pay for it. The effects of externalities can be enormous. For years, companies piled chemical wastes indiscriminately into dump sites near water supplies in residential areas. In some locations, those wastes seeped into the ground and contaminated the drinking water. In response to the evidence that smoking damages not only the smoker but also others, governments have increased prohibitions against smoking on airplanes and in public places. For years, economists have suggested that a carefully-designed set of taxes and subsidies could help to "internalize" external effects. For example, if a Paper mill that pollutes the air and waterways is taxed in proportion to the damage caused by that pollution, it would consider those costs in its decisions. The market does not always force consideration of all the costs and benefits of decisions. Yet for an economy to achieve an efficient allocation of resources, all costs and benefits must be weighed.  Imperfect Information The fourth major source of inefficiency is imperfect information on the part of buyers and sellers. The conclusion that markets work efficiently rests heavily on the assumption that consumers and producers have full knowledge of product characteristics, available prices, and so forth. The absence of full information can lead to transactions that are ultimately disadvantageous. Some products are so complex that consumers find it difficult to judge the potential benefits and costs of purchase. Buyers of life insurance have a very difficult time sorting out the terms of the more complex policies and determining the true "price" of the product. Consumers of almost any service that requires expertise, such as plumbing or medical care, have a hard time evaluating what is needed, much less how well it is done. It is difficult for a used car buyer to find out the true "quality" of the cars in Big Jim's Car Emporium. Some forms of misinformation can be corrected with simple rules such as truth in advertising regulations. In some cases, the government provides information to citizens; job banks and consumer Information services exist for this purpose. In some industries, such as medical care, there is no clear-cut solution to the problem of noninformation or misinformation. All of these sources of inefficiency will be discussed in greater detail in upcoming posts.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 245-248* end |
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