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In lesson 3c we learned that
competitive markets are efficient and we learned two models
to show that markets are efficient: (1) MSB = MSC, and (2)
maximum consumer plus producer surplus. You must understand
these models to understand lessons 5a and 5b. In these
lessons we learn that SOMETIMES markets are NOT
efficient.
When are product markets not
efficient?
1. when there is not
competition (monopolies and oligopolies - lessons 10a,
10b, 11a, and 11b)
2. when the government sets the price (price ceilings and
price floors - lesson 5a)
3. when the supply curve does not
include all of the costs of producing or consuming the
product (negative externalities - lesson 5a)
4. when the demand curve does not include all of the
benefits of consumption (positive externalities - lesson
5b)
5. when the products are "public goods" (lesson 5b).
6. when there is a Tragedy of the Commons
In this lesson we also will begin our
look at the role of the government in a market economy. This
would be a good time to review lesson 2a. In that lesson we
learned that there is a limited role for government in
market economies. We learned in lesson 3c that markets are
efficient, so there is little need for the government. In
this lesson we will see what happens if the government
interferes in markets. We will learn that sometimes
governments will set prices (price ceilings and price
floors), rather than letting the market set the price. In
other words: SOMETIMES GOVERNMENTS CAUSE ALLOCATIVE
INEFFICIENCY. (This is the plywood after a hurricane example
discussed in the 5Es reading in lesson 1b.)
Then we will begin to look at
examples of when the markets on their own fail to achieve
allocative efficiency and examine what the government can do
to correct these market failures. SOMETIMES MARKETS BY
THEMSELVES ARE INEFFICIENT and the government may try to
modify the market to help it achieve allocative efficiency.
There are three MARKET FAILURES that we will look at in
lessons 5a and 5b. A "market failure" occurs when the market
fails to achieve allocative efficiency. In lesson 5a we look
at the market failure caused by negative externalities -
when the supply curve does not include all of the costs to
society of producing and consuming the product. Then in
lesson 5b we look at the market failures caused by positive
externalities and public goods.
We will assume that businesses will
always produce the profit maximizing quanitity since their
goal is to maximize profits. The profit maximizing quantity
is also the equilibrium quantity that we studied in lesson
3c, when the Qs = Qd. This is WHAT WE GET. We get whatever
they produce and they will produce the quantity that gives
them the biggest profits. The goal of business is not to be
efficient. Their goal is to maximize their profits. If a
business can make larger profits by being inefficient then
they will be inefficient. Or, if they can make larger
profits by being efficient then they will be efficient. The
main point is that efficiency is not their goal, rather,
maximizing profits is their goal.
The allocatively efficient quantity
is what society wants. We learned in lesson 3c that
allocative efficiency occurs at the quantity where MSB =
MSC. This is WHAT WE WANT. We want to maximize our
satisfaction and we learned in lesson 1b that this occurs
when we achieve the 5 Es. Allocative efficiency is one of
the 5 Es.
When the profit maximizing quantity
equals the allocatively efficient quantity then markets are
efficient . This means that profit maximizing businesses are
producing the quantity that maximizes society's
satisfaction. WHAT WE GET = WHAT WE WANT. This is the
INVISIBLE HAND of capitalism that was discussed in lesson
2a. It's as if there is an invisible hand guiding businesses
to not only make decisions that maximize their profits, but
also to maximize society's satisfaction. As if they don't
even know it is happening.
When markets fail to achieve
allocative efficiency, the profit maximizing quantity (WHAT
WE GET or the equilibrium quantity from lesson 3c) is not
the same as the allocatively efficient quantity (WHAT WE
WANT or the quantity where MSB=MSC). Since one of the
economic goals of government is to help the economy achieve
efficiency, governments often get involved to correct for
market failures. If the market produces too much (negative
externalities cause allocative inefficiency because of an
overallocation of resources) the government tries to get it
to produce less. If the market produces too little (positive
externalities and public goods causing allocative
inefficiency resulting in an underallocation of resources)
the government tries to get it to produce more.
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