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 chapter 5. In chapter
5 we learn that SOMETIMES markets are NOT
efficient.
When are product markets
not efficient?
- when the
government sets the price (price ceilings and price
floors - lesson 5a, chapter 3, pp 61-64 )
- when the
supply curve does not include all of the costs of
producing or consuming the product (negative
externalities - lesson 5a, chapter 5)
- when the
demand curve does not include all of the benefits of
consumption (positive externalities - lesson 5b, chapter
5)
- when the
products are "public goods" (lesson 5b, chapter
5).
- when
there is not competition (monopolies and oligopolies -
chapters 10 and 11)
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 chapter
2. In chapter 2 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 chapter 5. 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 chapter 3, 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 they
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 at the
end of chapter 3 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 chapter one 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 chapter 2. 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
chapter 3) 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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